Setting prices is one of the most challenging, but often sidelined management decisions. Given that price has more impact on the bottom line than any other single factor, it is crazy that it is so often left until the last moment, or to a superficial assessment. The manner in which price is packaged and delivered should attract considerable time and creative effort.
In many cases the consideration goes little further than looking at costs, competing prices, and perhaps the gross margin.
Nowhere near enough.
Just setting an arbitrary price, struck at the last moment, without deep consideration seems irresponsible. Pricing strategy is the most important variables over which management has control, and that control should be exercised to reflect your strategic priorities, while delivering maximum value to your customers.
In order to find the best ‘fit’ between these two usually competing outcomes, there needs to be more than just passing consideration given.
There are two processes to undertake.
- Set a pricing architecture.
- Set a price list.
These are fundamentally different, but the first should always drive the second.
Striking a price architecture should be a strategic process. It is a trade-off between the wide range of factors that drive a customers purchase choice in various circumstances, and the costs and margins involved in addressing those choices. However, once set, the architecture of your pricing should be reasonably stable.
The actual price lists built on top of the pricing architecture can be varied as often as you like, and as often the market in which you operate will allow, in response to the factors that drive purchase.
In some markets, you will have little room to move, in others, there will be a wide range of options. The common factor is that a responsible management maximises the return over the long term, which necessarily involves having satisfied, repeat customers, with a minimum of churn.
In every case the price set will be the end result of a range of trade-offs that are made. The most obvious and clearly understood is the simple price/units trade-off, but this comes at the end of a wide range of trade-offs made in the manner in which the architecture is constructed.
Business model.
Every business model has its own characteristics that have an impact on the way prices are set.
In a retail franchise model, the prices are often set by head office, and the individual franchised outlet has limited ability to vary them. A supplier of grocery products through an Australian supermarket, has almost no control over price if they want to retain distribution. The seller of a bespoke solution to an expensive problem can set their own price, so long as it remains slightly below the cost of the problem, and guarantees the solution.
The emergence of the web as a sales channel has led to a rapidly expanding menu of pricing options. The SAAS industry in increasingly using subscription models differentiated by the availability or otherwise of some sort of ‘tripwire’ or ‘freemium’ model followed by varying price levels based on features, available seats, transaction numbers, and a host of other variables from which customers can choose.
Market power.
In a monopoly, the monopolist can set his own prices at the point that maximised the profitability, without regard to the well-being of stakeholders beyond the shareholders. At the other end of the scale, when supplying a raw commodity, you have no pricing power at all, you will be purely a price taker.
Spending some time considering Michael Porters ‘5 forces’ will be time well spent.
Almost all situations fall somewhere in between a commodity and a monopoly, and in most situations there are substitutes, or the threat of substitutes emerging when the margins become sufficiently attractive.
Market power can be built by the process of branding, which requires long term investment and again, trade-offs. Apple currently sells about 15% of mobile phone units sold around the world, but has 85% of the profit in the mobile phone market. This is an almost unique situation, matched by few ever before, the possible only others were Kodak, in their heyday, and Microsoft in the 90’s. Currently emerging we see the Digital trio, Facebook, Google and Amazon who have huge market power setting prices in ways that reflect the depth of that power.
Strategic priorities.
Price is a primary indicator of the positioning of your product in the minds of customers. The level of price is very often used as a signal of quality. Think about the array of wines in your local grog shop. To most, the majority are unfamiliar, and they lack the objective experience to make judgements, so price becomes a default indicator of quality.
Apple as noted has done a masterful job of reflecting the strategic priority of margin over volume. By contrast, Aldi has become successful in every market they expand into by keeping overheads and transaction costs to an absolute minimum throughout their supply chains, and reflecting these savings in low shelf prices, which delivers volumes.
One producer of dried pasta in Australia holds a 70% market share with a combination of a dominating proprietary brand, many alternative and cheaper brands across every conceivable distribution channel, together with supplying pretty much all the house brand products in the market. There is a pricing matrix that covers the whole market, creating meaningful differentiation of price and brand. They do this by leveraging the economies of scale they have built in the operational processes throughout the production chain, from the control of the supply of grain through to the packaging of the end product, and ensuring that nobody else can compete on price. It has been a masterful job, implemented with consistency and determination over a 30 year span. The retail price you pay for dried pasta varies enormously, but the cost of the products are differentiated only by the characteristics of the semolina used, a marginal cost difference in the scheme of things. However, having watched blind tastings of pasta, the knowledgeable consumers can pick the premium brand from the others, in order of quality of the grain in some (hidden to me) taste and texture characteristics with unfailing accuracy.
Price packaging
Packaging of price is not something most would think about in a specific manner as they would the external product packaging. However, any price list with some sort of structure that reflects volume, channel, or some other sort of difference is in effect price packaging.
Creative thinking about the packaging of pricing can pay huge dividends. A feature that adds no value will not attract a customer, but the same feature that does add value to someone else becomes a benefit that can be priced for that customer.
A friend just bought a European sports car, lovely thing at an inflated price based on the marque, with a long list of ‘optional extras’. He chose the few ‘extras’ he wanted, all the while whingeing that a much cheaper Korean sports car, with similar performance (according to his research) that did not have the cachet of the brand he bought, had them all as standard. Both are examples of price packaging, in a manner that is driven by many of the other marketing and strategic characteristics of the choices available.
Behavioural drivers
We are increasingly aware that psychology has a huge impact on our behaviour, and as a result, those who understand the psychology can ‘manage’ the drivers of price to their benefit. Anyone with responsibility for the construction of price should be aware of the basics at least. The original (readable) book was ‘Influence’ by Robert Cialdini in 1993, followed up more recently by a new book ‘Pre-Suasion’ in late 2016, both of which add considerably to the well-known principals of ‘anchoring‘ and the ‘Rule of three.’
Anchoring is simply the first price that is mentioned usually becomes the basis of the following conversation, so the logic is anchor high. The rule of three is where you ensure there are three alternatives with differing prices, and you present the highest first, which makes the others look cheaper, and uses the high price as the anchor. Any more options than three, and you risk confusion creeping in and the greater possibility of a no decision as a result. Add to these models is the obvious $24.99 price instead of $25.00 which works all the time, and the common ‘Huge savings on special’ offers where the saving is calculated against a price that nobody in their right mind would pay.
The more you dig into the behavioural drivers of price, the greater the range of options you can create. Scary when you think about it, as they are all being used on us every day.
The final word should go to Warren Buffett, someone who knows a bit about making a profit.
“The single most important decision in evaluating a business is pricing power. If you have the power to raise prices without losing business to a competitor, you have a very good business. If you have to have a prayer session before raising the price by 10% then you have a terrible business’.
