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Fundamentals of pricing

Fundamentals of pricing

Pricing is one of the single most important decisions any business can take. This is because:

  • Price is the only element of the marketing mix that directly produces revenue. All the other elements produce cost.
  • Small changes in price can have significant effects on volume, market share and profitability.

Whilst pricing is a business critical decision, few managers are skilled at pricing. This is hardly surprising given that pricing is a difficult decision involving complex inter-relationships between price, margin and volume. In the worst case, this can mean pricing is abdicated to:

  • Either to the sales department, in which case, prices and profitability tend to be lower than they could otherwise be.
  • Or to the accountants, in which case, prices tend to be based on a cost plus mark up formula or the recovery of cost inflation.

Neither situation is satisfactory as it results in a company failing to capture the true economic value of its products and services and consequently the company underperforms.

When considering the pricing decision, it is critical to appreciate that customers buy benefits rather than products or services (i.e. a hole in the wall rather than a drill) and that they buy on value not price per se. Furthermore, not all customers are homogeneous. This means different customers will value the same product or service differently and are therefore prepared to pay different prices.

Whenever the customer value increases, a company will gain market share and whenever the customer value diminishes, it will lose market share. In order to improve the value to the customer, a company can do one of two things. It can:

  • Add more benefits, although this may add cost
  • Reduce its price, although this will reduce margin

Customers always buy the product or service they perceive to represent best value. The customer’s perception of value is therefore always relative to the competition.

Adding more or new benefits to a product or service enables a company to increase its prices providing these additional benefits are relevant and motivating to the target market customer. Adding benefits need not however necessarily lead to an increase in costs. Learn more about how to value engineering a product or service to achieve a higher value, lower cost win win.

Fundamental pricing relationships

There are five fundamental pricing relationships to understand. These are:

  • Demand relationship i.e. how volume varies with changes in price
  • Revenue relationship i.e. how revenue varies with changes in price
  • Cost relationship i.e. how cost varies with volume and thus changes in price
  • Profitability relationship i.e. how revenue minus costs vary with changes in price
  • Supply relationship i.e. how volume supplied varies with changes in price

Unfortunately, in many companies, these relationships are rarely understood.

Pricing strategies

There are a number of commonly used pricing strategies in business. These include:

  • Cost plus – with cost plus, a mark up is applied to the cost. Whilst being easy to administer, cost plus is an ineffective way to price as it ignores the value to the customer and the impact on profitability resulting from changes in price, margin and volume.
  • Price taking – in markets where there are numerous small suppliers, the price is in effect set by the market forces of demand and supply over which no individual supplier has any influence. Price taking is common in commodity markets with undifferentiated products or services.
  • Skimming – with price skimming, a company sets a high initial price during the early stage of a product’s life cycle in order to capitalise on the product or service’s novelty. As demand becomes more elastic due to increased competition, prices are progressively lowered to retain competitiveness. This strategy is effective when:
    • There are high barriers to entry
    • Demand is price inelastic i.e. changes in price only have small effects on volume
    • Product life cycles are short
    • There is limited scope for economies of scale
  • Penetration – with penetration pricing, a company sets a low initial price in order to capture a large share of the market quickly. This strategy is along term play where losses may have to be accepted in the short-term in order to discourage new entrants. Penetration pricing is an effective strategy when:
    • There are low barriers to entry
    • Demand is price elastic i.e. small changes in price have large effects on volume
    • There is mass market appeal for the product or service
    • Product life cycles are long
    • There is scope for economies of scale
  • Segmentation – with price segmentation, different prices are charged to different customers for essentially the same product or service. Price segmentation is widely practised and examples include peak andoff peak travel and gym memberships. For segmentation to be an effective strategy:
    • The different segments must have different price elasticities
    • The lower price segment must not be able to resell to the higher price segment
  • Bundling – with bundling, a company prices a bundle of complementary goods and services at a price that is less than the sum of the individual components i.e. a packaged holiday or a Big Mac meal deal. Bundling is an effective strategy when:
    • There is a low marginal cost of bundling
    • It captures an increased share of the available customer spend
    • It increases the customer’s spend

Pricing is a business critical decision and one, where for many companies, there is considerable scope to improve economic performance.

Some do’s

  • Focus on benefits and value to the customer rather than products or services or price
  • Appreciate that price is widely understood to also be a statement of quality
  • Sustain higher prices by delivering superior customer value
  • Experiment
  • Seek expert professional help

Some do not’s

  • Abdicate pricing to either the sales or finance department
  • Over-emphasise price in your marketing communications
  • Ignore the competition or competitor responses
  • Avoid price wars

To discuss your business critical issue

Please call Paul New on 020 8390 9972 or send a message.

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