We are all wary, in fact, usually very reluctant to put prices up, in case we lose customers. We ignore the sage advice of Warren Buffett who knows something about making a bob when he said: ‘If you have to go to a prayer meeting before raising your prices, you have a lousy business’
Increasing prices is a valid concern if two conditions are not met.
- You are undifferentiated in a way customers value
- You are in a commodity market.
There are five strategic drivers of price, the items that should be considered in your strategic thinking that delivers your pricing architecture:
- Your business model
- Price packaging
- Strategic priorities
- Market power
- Behavioural drivers.
Before you consider the actual price you will be charging, you need to have built the pricing architecture that best accommodates the dynamics at play in your market, and the price elasticity of demand.. Any pricing decision has two dimensions:
Strategic: The pricing architecture that is consistent over time, which provides the structure of your price list.
Tactical. Price can be moved around as necessary, while always remaining inside the pricing architecture.
Many just leave price decisions to the end, a grave mistake, as finding the Optimum Price, the one that leaves a minimum ‘on the table’ will have a profound impact on your profitability.
If you produce a simple spreadsheet, such as the one below, you will be able to model how the profit changes at various price assumptions. It is almost always the case, that to a point it is better to put your prices up and take a modest volume loss, than to drop prices hoping that the added volumes will deliver greater profit.
The assumptions in the chart:
- The Price we charge is entirely our decision.
- The volumes we forecast at any price point are the combination of experience, assumptions, and gut feel. They can be very tactical, varying time to time, and customer to customer in some circumstances.
- Cost of goods sold/unit and fixed costs are unchanged at any volume or price.
Developing a simple model is just maths and a range of assumptions, but we use it too infrequently. Our instinct is usually to drop prices in a crisis to preserve market share, rather than thinking about the impact on profit. If you have a gross margin of 40%, for every $1 you drop your price, you have to gather in $2.50 in added revenue to break even.
| Option 1 | Option 2 | Option 3 | Option 4 | |
| Price/unit | $15 | $18 | $21 | $25 |
| Quantity/period | 100 | 85 | 80 | 55 |
| GOGS/unit | $6.0 | $6.0 | $6.0 | $6.0 |
| Fixed costs/period | $400 | $400 | $400 | $400 |
| The profit outcome of the various options can be seen below | ||||
| Revenue Price X Quantity | ||||
| Minus Total cost = ((COGS X Quantity) + fixed costs)) | ||||
| Equals Net profit | ||||
| Option 1 | Option 2 | Option 3 | Option 4 | |
| Revenue | $1,500 | $1,530 | $1,680 | $1,375 |
| COGS | $600 | $510 | $480 | $330 |
| Total cost | $1,000 | $910 | $880 | $730 |
| Net Profit | $500 | $620 | $800 | $645 |
| Breakeven point. | ||||
| Fixed costs/Unit Gross margin | 44 | 33 | 27 | 21 |
The break-even point also changes. This is one of the most under-rated but simple calculations available to businesses to gauge their financial health.
Whatever you do, there will be some for whom the price is too high and will not therefore buy.
There will be others for whom you are pricing below what they would have been prepared to pay.
Either way, you leave profitability on the table when you pick a single ‘Optimum price’ point.
This is represented by the left-hand graph in the header.
When you can have two price points, you tend to increase the profitability.
I.e., You drop one price below the ‘optimum’ single price, and pick up those ‘cheapskates’.
You have a second option with prices higher to capture those who are willing to pay the higher prices.
The challenge is, how do you effectively fence off the two, so you are not just delivering an extra reward to those prepared to pay the higher price, just to capture the cheapskates?
It is in the ‘Fencing’ that the creative strategic thinking must take place.
This is represented by the right-hand graph in the header.
The obvious example is economy airline seats. Every economy seat is almost identical, yet there are price fences based on time, and ticket flexibility. Book early, cheaper than in peak booking time. Book very late, you might get a very cheap price, or you might miss out altogether. This is in addition to loadings on location: aisle and window, forward and aft. This is also in addition to the fences that exist between economy, business and first class, which has similar demarcation, for time, as well as the premium to be there instead of cattle class.
A final thought. Many SME’s are not selling time, or input costs & materials, they are selling the results of knowledge and experience and the value they can deliver to their clients.
How do you put a price on experience?
We all have trouble with that, at least I do, and most people I have come across do also. There are three basic rules to follow as you consider how to price for a job.
- Price the client rather than the service. This means if you make them a million, shoot for a share of the outcome. This involves a ‘value conversation‘ early on. E.g., If I was able to deliver you added profit of 100k, how much would that be worth to you? This sets a benchmark, from which you can come to an arrangement. Remember, that a client asking you to do something for them is all about removing risk. You cannot offer guarantees with certainty, as there is always risk involved, but a bit of creativity can expose some useful ways to share the risk and reward. To quote Peter Drucker: ‘In business all profit comes from risk‘. Therefore, the answer to how much they are willing to pay would be tempered by the risk and reward to both parties.
A further example: A friend of mine is a hypnotherapist, and often helps smokers become non-smokers. The value conversation around her services should not be about the price/session, but by how many packets of cigarettes it was worth, in which case, success would mean an ROI in a couple of sessions. E.g., How much does a packet of ciggies cost? How many packets a week do you smoke? Quick mental arithmetic… that means that success here will save you $250/ month on cigarettes, and that is before you factor in the health benefits. What a great deal!!!
- Offer options. Where possible, offer more than one option at differing price points. A premium version, and one or more cheaper versions that have had some features removed. Think about the SAAS software options offered on the web. There are differing features listed for various price points, and it is always three.
- Anchor high. Three price options, start with the highest first, it acts as an ‘anchor’. This is opposite to what we do automatically, we tend to price low as it seems that will be more effective at closing, but the opposite is true. Price high, usually they will go in the middle. In addition, it is far easier to price high and give a discount than it is to price low and try to add features at an increased price.
None of this is easy, if it was, everyone would be doing it. However, it can be done with some creative thought, experience, domain knowledge, and good feedback mechanisms to enable ‘fine-tuning’
Note: Please excuse the dodgy graphs in the header. I am a strategic thinker, not a graphic artist! However, despite their dodgy state, I hope they convey the message.
