Pricing II

McKinsey & Co Research* shows that a 1% increase in price can provide an 8% improvement in Operating profit.  

*See full article here

Is this some sort of Magic?

Not at all, but we can call it magic for fun! 

It is a good example of how important it is for any business – from a start-up to a scale-up – to understand its numbers to maximise its profit and cash flow.

I’ll show you, below, how you can use this magic, but first I want to talk about some techniques for pricing your product or service. Ones that you may be using instinctively; ones that don’t often get talked about, and have their uses in different circumstances.

The Science and Art of Pricing continues.

In my previous post I discussed the fact that Pricing is part of the marketing mix and so should be contextualised by your product/market strategy.

What? Strategy you say?

Yes.  Early stage businesses will be focused on making sales – and whether, or not, they are consciously doing that within a strategy other than HUSTLE probably doesn’t occur to them.

In the early stages, founders will look at their product, will look at what the competition is charging, and will peg their price somewhere around that…. Maybe charging a little more because they feel their offering is superior, or a little less – to get some ‘traction’ for their offering.

A little more – value-based pricing

A little less – penetration pricing.

And if they are using the competitor price as a benchmark – competitor-based pricing

Also, there is cost-plus pricing…. Where you look at your variable costs, add a percentage mark-up to make a profit and there’s your price. How hard can it be, right?


Let’s have a look at these in a bit more detail, starting with Cost-plus.

Cost-Plus Pricing

Calculating cost plus pricing levels
Calculating cost plus prices

Applicable to:

  • Volume production businesses, in a mature market,  that have been established a while and fully understand their costs and the required margins to make a profit. 
  • Think commoditised products like milk, petrol, butter, bread…

Upsides: 

  • Can be fairly easy to calculate once you have your costs under control.

Downsides:

  • You are reliant on being able to pass on any cost increases to your customers through increased pricing.
  • Your competitiveness in your market may be determined by how you can control your costs better than your competitors.
  • To differentiate yourself in the market you will need to develop more sophistication in the other elements of the marketing mix – product features, place (distribution/availability) and promotion.

In Summary:

  • If you don’t understand your cost drivers you are at risk of setting any price with this method
  • In some respects this approach reflects the “build it and they will come” mentality.  Cost-plus pricing is very introverted; with little consideration of the value the customer finds in your product.

Penetration Pricing

Discounted prices, penetration pricing
Penetration pricing

Applicable to:

  • Early stage products / services trying to get traction in an established market, where product differentiation is limited. 
  • Think tractor parts (see my previous post) or discounted membership fees for a new Gym.

Upsides:

  • This is a particular variant of Competitor-based pricing.
  • The market is setting a reference point for your pricing, giving you some confidence in the pricing level.
  • In effect you are hacking the market price to get noticed, and can be useful to get short-term recognition in the market.
  • If you combine penetration pricing with other superior product / service features to gain longer-term customer commitment it can be really powerful.  For instance, if you combine a discounted initial product purchase with a bundle of subscription-based customer-care services your overall lifetime value per customer might be higher than your competition.

Downsides:

  • You still need to know your costings to make sure that you are making a profit margin at these levels; or that this short-term strategy can provide revenue upside into the future.
  • Your reference point is mainly the price being set through your competitors in the market; though you are starting to consider the customers’ price-sensitivity for your product.
  • By setting a low initial price for your product you may be setting expectations from your customer as a low-price option in the market and therefore make it difficult to raise prices in the future.

In Summary:

  • Competitor-based pricing, in general, is a good reference point for pricing decisions – But you really want to dominate your own space in the market, and pricing is a key element in the mix.
  • Understanding costs and trying to establish the price-sensitivity of your product in the market requires a somewhat data-driven approach.
  • This strategy can work at an early stage in your product/market lifecycle. It would need to be considered carefully if you wanted to introduce it at later stages, when you’ve already got some traction, to ensure it is setting the right tone and expectations for your brand.

Value-Based Pricing

You have to survey your customers to understand the value proposition they see in your product
Understand your customer to get the pricing right

Applicable to:

  • Products and services that can be differentiated in the market – virtually everything other than commodities.
  • Value-based pricing supports strong brand-building and providing a customer-orientated approach to your product or service provision.
  • Particularly important for new-to-market, innovative products. 
  • Price-skimming” is a sub-strategy where the first to the market can charge a higher price for uniqueness, until competitors join the market which then changes the dynamic.

Upsides:

  • A more sustainable strategy where pricing is based on deep engagement with your customer.  Meaning that you could expect repeat custom from your customer; as long as they receive a product or service that meets or exceeds their expectations.
  • Allows for greater differentiation in the market and a higher potential price point because you have found customers that value your service or product and willing to pay for it.
  • This deeper engagement with your customer can help you understand how you can improve your offering and provide even more value, for even more dollars, into the future.
  • You are staking your place in the market; You use your cost structure and your competitors’ pricing as reference points; The major influence on your price points come from customers who want to buy your offering.

Downsides:

  • You have to invest time and effort to engage and understand your customers; what they want, what problems you are solving, and what they are willing to pay.
  • You still need to know your costs as a backstop to your decisions; There’s no avoiding the need to “know your numbers”.

In Summary:

  • Value-based pricing will provide a closer approximation to the maximum price you can charge for your product or service.
  • It provides you with extra levers in the market, since you are matching your customer expectations with the value of your product or service, which your competitors may not.
  • It forms an integral part of a coherent marketing mix.  By this I mean, if you feel you have a premium offering and your promotion activities reflect this, but you are pegging your prices to the competitor average you will not demonstrate a consistent message to your customers.

OK.  That’s a helicopter view of some common pricing strategies.

A whole World of difference comes into play when you consider pricing for export markets.  I’ll leave that to another post.

Getting back to the ‘magic’ of pricing.

The magic of Pricing - the multiplier effect on profit and cashflow
The magic multiplier effect of pricing

The Art of pricing actually involves a fair amount of science as well !

Have you heard of instances where a business simply charged a high price for its mediocre product and set in the mind of its customers that it had a high-end offering?

It can be done, and it is another example of the Science and Art of pricing.  The science in this case is in understanding and leveraging the psychology of customers.

Testing consumer behaviour in relation to product pricing
Testing and Analysing the data for consumer pricing

A really good blog post covering this subject is found here .. it gives excellent pointers for how to present your pricing in your promotional mix for maximum effect.

Want to see this working in practice ?

I really enjoy this experiment by Best & Less which demonstrates that shoppers are influenced by the whole marketing mix experience and that the price point is a huge element of the cohesion of the message.  Watch their faces…. !


Back to the Magic….. Are you leaving money on the table…?

As a mentor to many small businesses over the years I often encounter the ‘timid mouse pricing model’ – where businesses are reluctant to charge a full value for their product or service. Not necessarily because they don’t believe in themselves or their offering, but because they haven’t had the chance or bravery to experiment with their pricing.

I estimate that the average under-pricing would be 15% from my experience as a business coach and mentor.

If, following the McKinsey research findings outlined at the beginning of this post, they uplifted their pricing by that 15% that would be equivalent to a huge 100% increase in operating profit.

Of course that multiplier effect will vary based on the type of business and the cost drivers in that business….. the lower the fixed costs and overheads, the bigger the multiplier effect.

Let me show you the magic!

In the example below I have used a fairly typical breakdown of an income statement, or Profit and Loss statement.

The business makes 100 unit dollars of revenue, with 50% Gross Margin, 30% Operating Profit and 10% Net profit.  I think many businesses would see this as a familiar breakdown of their accounts.

Simply by increasing the price by 15% you can see how the multiplier effect works.

Why? How?

Cost of Goods Sold (COGS) doesn’t change because it doesn’t cost you any more to make them.

Cost of Sales (COS) doesn’t change because you don’t pay more to make the same number of sales in that market

Operating Costs don’t change much until you increase volume significantly.

Overheads don’t change, because they are fixed costs.

Price increase of 15% delivers Operating Profit increase of 50%
The magic price to profit multiplier

So you can see, that simply by raising your prices the effect on your profitability can be significant.

Now tell me…. Are you leaving money on the table ?

Think about how you are setting your prices.

Do any of the scenarios above look familiar?

Is there a way of testing how price sensitive your offering is in the market?

Do you understand the value that your customer places on your products or service ?

How about experimenting by raising your prices in smallish increments until you start to hit some resistance. I’d love to hear if you get to that 15% level, or even break through it!


Understanding your numbers as a business can provide both clarity and confidence in moving your business forward.

In my coming posts I’m going to talk about costs…. Fixed vs Variable, Prime vs Operating, Expenditure vs Capital …… there’s a whole wide world of numbers to explore for your business!


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I hope you’ve found this post interesting and useful for consideration in your business.  If you have, please like and share amongst your colleagues and friends.



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