The Art of Pricing: Fundamental Principles

One single aspect of your business has a huge impact on your revenue and your profit. It’s not lowering costs, it’s not being better at selling to your customers, it’s not even getting the attention of influential people (although none of these hurts!). It’s your prices. Imagine you’re selling a product at 20% margin. Being able to sell it for $109 instead of $100 means you’re making $29 instead of $20 of profit. That’s 30% more profit, without additional effort! You would think; ‘But I’ll sell less product at $109 than at $100?’. Well, it is not necessary the case... Avoid pricing as ‘Cost +’ Most businesses tend to price with a ‘cost plus margin’ calculus. If a gizmo costs you $50, you may plan to make a 30% margin, so you would sell it at $65. But from the customer perspective, it doesn’t make any sense. At all. No customers will care if you make a 5% or a 500% margin; and there is no such thing as a ‘normal’ margin. Only the value to the customer is important, and there’s two kind of businesses: the good ones, where the customer’s value is higher than your costs, and the ones you should avoid. You may think that a ‘cost plus’ approach will keep you inline with your competitor, but even this is a fallacy: it’s very probable that your competitors don’t have the same costs or the same profit target than you, anyway. In any case, watching your cost is no substitute for monitoring the prices of your competitors. So if you do not know how to price, keep an eye on your competition, and position yourself accordingly. It’s all about perception Customer buys when the perceived value is higher than the perceived cost. In economic terms, when customers think there’s a ‘surplus’. Note that the true value or the true cost do not count, only the ones perceived by the customer! For instance, digital camera manufacturers boast higher mega-pixels counts, not because it translates in better pictures, but because consumers think so (perceived value). Apple decided to price they black MacBook at higher prices than the white ones, even if technical differences were few (value perception again). Starbucks prices double-cream-macchiatos outrageously higher than drip coffees, while the cost difference is minimal. At last, anybody can observe $19.99 price tags are much more frequent than $20 in supermarkets (price perception) Mapping value Truly understanding your pricing opportunities requires to map your competitors’ and your own offerings, with the perceived prices as Y-axis and perceived values as X-axis.  There’s a imaginary line going from bottom left (free, no value) to top right (expensive, high value). Any product below that line means surplus for customers, and will sell. You will also be able to better understand the true alternatives for your customers. For instance, they may regard a very similar product of one of your competitor as of significantly lower value, simply because a detail says ‘cheap’. In this case, you can afford to position yourself higher in the value map, and make better margin. Obviously, the real difficulty is in obtaining the perceived values and the perceived prices. Statistical analysis of the price brackets may help for determining perceived prices. As for perceived values, one solution is to conduct customer surveys with conjoint analysis. You would present alternatives products to customers, each with some ‘points’ distributed amongst a couple of attributes. For instance, to find the perceived values of flat-screen TVs, one could use the following attributes: diagonal size, bulk, brand prestige, audio quality, colors and contrast. Adopt a scientific approach to Pricing By far the ideal solution is ‘Scientific Pricing’. What is a scientific approach? In science, you imagine a theory, then you test it. If the experiment is against your theory, you go back to the blackboard, otherwise you refine your theory. Here is how it goes for pricing: first, try to ‘guess’ what’s the best price for your business. Then apply that price. Once you got several customers, try a slightly different price. Say your initial price was $49 per month, then you try $54 per month. Now divide this by your marketing cost, number of people entering you shop, whatever makes the most sense. Do you make more money at $54 than $49? If so, try $59. Otherwise, try $44. It is amazing how such a simplistic algorithm (which is called ‘derivative following’, by the way) can change your business... A more sophisticated solution is to interpolate the demand curve based on experimental facts. From there, it’s a ‘simple’ maximization problem to determine the price yielding the optimum revenue. Let us know what you think: based on the reception of this article, there could be a Part II: ‘concrete pricing methods’ 2009-09-08T22:50:51Z

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the-art-of-pricing-fundamental-principles

2009-09-13T12:55:58Z

2009-09-13T19:56:23Z

Price is the variable with the greater impact on revenues and profits. Learn to avoid common mistakes and get introduced to some proven pricing techniques.

The Art of Pricing: Fundamental Principles

2009-11-12T21:36:59Z