PRICING 101

PRICING 101

If you've developed your product and identified your market, how do you then come up with a workable pricing plan?  Both JC Penney and Netflix learned expensive lessons about the perils of getting it wrong.

Opposing Forces

There are two basic influences on your pricing decision, financial and commercial (marketing).
Each has a role to play in your decision regarding how much to charge for your product. However,
these two forces pull in opposite directions.  The task is to create a profitable balance between he
two.

The ultimate pricing strategy is to be the most expensive brand with the greatest market share. In
that case you charge whatever you want and still outsell the competition. Good luck! In almost all
cases, the higher the price the less people buy. So, what's the optimum pricing model? Let's look
through the eyes of the finance guys and the marketing guys to see how they view pricing strategy.

Financial

The main pricing objective from the financial view point is to maximize profitability (margin) on a
per unit basis. To achieve that objective cost needs to be low and price needs to be high.

Econ 101, Day 1: "To the low cost producer go the spoils". The professor's prophetic statement
will get most companies farther down the road than almost anything else. All else equal, low cost
production and/or low overhead cost allows flexibility to compete with lower prices. Or, it
allows the capture of greater profits that can be reinvested in promotion or other development. So,
the first step toward increased profitability is to refine purchasing, manufacturing and operating
processes to reduce cost. That may require reducing features or quality.

Once costs are down, how is price determined? Often, we hear about a price structure set to yield
a specific margin.  Margin means the amount of the sale price in excess of the production cost,
stated as a percentage of the sale price. This is noted as: (price - cost) / price. A product selling
for $10 with a $7 cost would have a margin of (10-7) / 10 = 30%. That's math.

Unfortunately, there's no one right margin for all companies. Each industry, in fact each company
within a single industry, has a different way to calculate product cost. Some methods vary slightly,
others greatly from each other. So, to say you have a margin of X% is meaningless without some
information about how that number was calculated.

What costs were included? Were any overhead absorbed into product costs on a per unit basis?
Do you pay a commission based on sales dollars or volume? Were packaging and shipping costs
included? Were calculations made with low volume production that is expected to rise in the
future and bring down unit costs? Also consider the average margin and how it's affected by
product mix. Companies with a broad array of products or services certainly have different
margins for each. The average margin changes as the relative volume of each product changes.

From a financial standpoint, the "bottom line" is literally the bottom line in the Income Statement,
i.e. Net Profit. Regardless of the margin percentage, the total dollar "gross margin" from all unit
sales has to be enough to pay for all overhead plus provide working capital and a return for the
shareholder(s). So - all else equal - from a financial view point the higher the price the better the
margin and the greater the profit....all else equal.


Commercial (Marketing)


The main objective from the commercial view point is to maximize unit sales. To do that, quality
needs to be high and price needs to be low.

A sales force instinctively hates high prices because lower prices usually bring higher sales
volume. It doesn't matter what the finance guys say about margin and profit. If customers wont pay
the price you charge, margin calculations are pointless. Sales staff are happier when sales
transactions are frequent and unit volume is up. Since, volume usually drops when prices rise the
sales force naturally prefers lower prices.

To make sales, businesses need to choose prices acceptable to customers who have choices.
Customers' choices and purchasing decisions are based on their value structure and the perceived
value of your product. Pricing needs to be rational in the context of that value, relative to any
competing options.

Knowing the value of a product to its market can help determine a low or high pricing strategy.
Price is often perceived as an indication of value. "You get what you pay for.” How inclined are
people to purchase half priced food? Something too inexpensive is perceived as cheap and poor
quality even though it may not be. However, a properly executed low price business model can be
very successful in the right markets.

On the other hand, luxury pricing can be a part of a successful business model. While, in most
cases, volume goes down when prices go up, the drop in volume may not be as great as the
increase in price. So, total revenue increases. There are even cases of volume increasing as prices
increase - when the quality or value of the product was emphasized by the high price. Don't count
on this happening. Even with the best value and well communicated "value proposition"  there is a
limit to how much purchasers are willing to pay for a product.

How To Balance Financial and Commercial

From a financial view point: Create a spreadsheet (pro forma) model with which you can
determine your overhead cost and how much gross profit margin your venture needs to be
profitable at the bottom line. Make an estimate of your unit volume. Estimate what your unit
production cost will be. From that comes the price you need to charge to make the profit you need.

From a commercial view point: Compare the price you calculate in the financial analysis with
other pricing information you have, such as prices charged by competitors or prices for other
products of yours. Focus on your value proposition for the product in question. How can you
justify the financially necessary price in the context of that value? Will customers feel the product
is worth the price you need to charge? Does the price make sense compared to other available
options, including other products of yours? Don't be afraid to charge more than the financial
analysis indicates.

Pricing Structures

Once you've arrived at your target price, you need to consider the structure of your pricing plan.
What is a common pricing structure in your market? How do products flow from manufacturer to
end user? What is your company's role in that process?

In some cases a single price for a product is sufficient when you are selling a simple product
directly to consumers. However, there are complicating factors. In cases with multiple steps in the
distribution channel, such as distributors and resellers, the end user retail price and the price the
manufacturer charges can differ by a large amount. Each participant in the channel makes a profit
by marking the product up and reselling it.

Here are some other possible situations that need to be kept in mind when creating a pricing
structure.
* Volume discounts reduce the price
* The posted retail price is discounted before the final sale
* The base price is set low and profit is made on accessories or add-ons
* Discounts are given for frequent purchases
* Regular seasonal discounting is common
* Commissions are paid to sales representatives
* A new product will soon meet competition that will drive the price down

Bottom Line

Pricing is a very important part of a business plan. It is a link between the financial and market
needs of a company. Take time to study and analyze the aspects and consequences of your pricing
decision.
Posted by Peter on 4/30/2014 5:35:31 PM