Archive for 1. Pricing Fundamentals
Think about supply and demand. Years ago I wrote a blog post on how supply and demand aren’t typically related to pricing because supply is usually abundant. Implicit collusion, not supply and demand holds prices above costs.
Today, let’s think about when supply is limited. We see this for consultants who have more business than available hours. We see this for airlines and hotels during the holidays and other busy times. Each year, some toy will become the hot, unattainable plaything that every kid clamors for.
In each of these cases, demand exceeds supply. This means ideal pricing is driven by supply and demand. Excess demand is an opportunity to increase price.
We see that airlines and hotels charge higher prices during their busy times, when demand exceeds supply. Savvy consultants do the same. Ticket scalpers for sold-out events are taking advantage of excess demand while new dynamic pricing methods are trying to capture more of that profit for the venue and promoter.
Constraints don’t mean you have to raise prices, but it is an opportunity.
Remember when Volkswagon re-launched their Beetle. It was a huge hit and there were long waiting lists to purchase one. However, VW did not raise their prices. Notice that because VW didn’t increase prices, some entrepreneurial people were able to buy a Beetle off the showroom floor and then sell it aftermarket for a profit.
The same is true for the new video game consoles when they are first released. Usually there is a temporary “used” market at prices higher than what the manufacturer charges. Of course this market goes away once the supply constraints go away.
Constraints can drive higher prices even if you are constrained and your competition isn’t. Since the constraint means you can’t completely serve all of your customers, you may choose to only serve those with the highest willingness to pay. This often means raising prices. Of course, be clear about what may happen when your constraints diminish and you try to win back lost customers.
Now apply this concept to your business. What constraints can you foresee? Are there super busy times, or a lack of supply of a critical component, or not enough hours in the day? Plan now what you will do when these constraints arise. It is much easier to make these decisions logically when customers aren’t screaming for more.
Constraints often look like challenges, but pricing power is frequently a silver lining
If you think of any other constraints I haven’t mentioned, please share with the community.
Photo by Hanna
One of the earliest Pragmatic Pricing blogs was about “Will I? and Which one?” (If you’re not familiar with this very important concept, please go read it here.) “Will I?” and “Which one?” are two questions your customers almost always answer before making a purchase, and price plays a different role for each of these questions.
The key takeaway – customers aren’t very price sensitive when making the “Will I?” decision but are very price sensitive when deciding “Which one?” But those aren’t the only two decisions your customers make where price is considered. They are the two most common, but you want to think deeper.
Another very common decision is “Where?” Where do they make their purchase? Do they always shop at their favorite store? Do they shop around for the best price?
For example, when I’m getting my bicycle worked on, I always go to the same retail outlet. I trust the mechanic and don’t want to look for another one. Yet, when I’m buying a new piece of electronics I usually read reviews on the Internet, decide “Which one?” and then find the place where I get the best deal and have it delivered to my house.
Notice two different purchases, two different “Where?” decision processes, and most important two different perspectives on price. At the bike shop I’m not looking for a good price. Buying electronics, price influences my decision.
There are many decisions like this. Another common one might be “When?” Should I wait? Is it an impulse purchase? Do I need to save?
Now the tricky part. Your business is different from everyone else’s. YOU have to think through all of the decisions YOUR customers make and then determine how price might influence them.
To make it more complicated, your customers are different. Some act one way and some another. Now it’s time to segment. Which customers do you really care about? How do they act? What decisions do they make? How does price effect those decisions?
Nobody said this was easy. But if you really want to understand pricing for your business, you first need to understand all of the decisions your customers make and how price influences each decision. Yet it’s not that hard. Start with one potential customer. Think through their entire process. Talk to them. Ask them how they got to your door? Do this enough and you’ll have great visibility into the mind of your customer.
Once you understand how your customer thinks, you can best decide how to use price to influence their entire purchase process.
Mark Stiving, Ph.D. – Pricing Expert, Speaker, Author
Photo by cuellar
Sign up for the Pricing Perspective to get a monthly recap of these blogs plus more insights on pricing.
Take a company that drops 10% of its revenue to its bottom line. In other words, after all fixed and variable costs are taken into account, after all salaries are paid, the company’s profit is 10% of its total sales. For example, a company with $1M in sales has profits of $100,000.
If this company increases pricing an average of 1% without changing anything else, their revenue would be up 1% to $1,010,000, an increase of $10,000. This $10,000 is all profit so their profit increases from $100,000 to $110,000 - a 10% increase in profit. In other words, a 1% improvement in pricing can yield a 10% increase in profit.
What percentage of your company’s revenue is profit? If your profit margin is normally 20% of revenue (very rare) then a 1% price improvement increases profit by 5%. If your profit margin is normally only 5%, then this same price improvement can yield a whopping 20% improvement in profit. Wow!
This is not saying you should raise all of your prices 1%. It is very likely you can raise some prices to some customers 5%, 10%, 20% or even more with minimal impact. You only need an average price improvement of 1% to see these effects. Yes, pricing is hard, but it is so powerful. It is worth investing resources to improve it.
Mark Stiving, Ph.D. – Pricing Expert, Speaker, Author
Photo by Photo-Fenix
The Math (feel free to skip this part)
Start with price minus cost and call that margin dollars (per unit). Markup is margin dollars divided by cost. Margin is margin dollars divided by price.
Markup = (price – cost)/cost
Margin = (price – cost)/price
As an example, if you purchase something for $1.00 and sell it for $1.50, you have a 50% markup and a 33% margin.
Markups are commonly used in retail. They buy something for a price and apply a standard markup to get to the price. Since retailers buy thousands of items at different prices this seems to make sense. BE AWARE – This is cost plus pricing. Starting with a cost and adding a markup is the definition of cost plus pricing. Hopefully by now you realize that cost plus pricing is not optimal. It leaves money on the table.
Margins are what are reported on companies’ annual reports. Margins represent what you actually realized from a price and cost perspective. The implication is that margins are what materialized, not how to set the price. If you use Value Based Pricing (as you should) then you are closely monitoring your margins, looking for areas of improvement, watching for indicators of decline. Margins are a KPI (key performance indicator), not a means to drive pricing.
What are you using? If your company commonly uses markup, you are almost certainly in the cost plus pricing mentality. Throw that concept away and focus instead on margins. If your company uses margins, it is not a guarantee that you use value based pricing, but at least it’s an enabler.
Mark Stiving, Ph.D. – Pricing expert, speaker, author
Photo by The Consumerist
You know the traditional 3 C’s of pricing: Cost, Customer, Competitor. We can think of these as the environmental factors that drive optimal pricing, but as pricing people we have little control over them.
Several months ago we proposed a 4th C, corporate strategy. This met the same criteria as the original 3 C’s.
The other day it became apparent we need a 5th C, capacity constraints.
I was working with a client who, as a consultant, charges by the hour and has regular weekly work hours at each of her customers. For example, she would spend the day with the same customer 8 hours every Monday, a different customer 4 hours Tuesday afternoons, etc. As we discussed her pricing situation, it became apparent that she should be charging higher prices to NEW customers when she already has an almost full calendar. When her calendar is more empty, she is more in need in clients and less able to lose the opportunity. Then she should charge less to make certain she fills her time.
After stepping back and thinking about her situation, she should charge different prices based on how close she is to full capacity. Wait, airlines do this as well. The more full an airplane is, the more expensive the seats. Hotel rates go way up when demand increases. (I heard that a room at a Best Western in Indianapolis over Super Bowl weekend was over $1,000.) Some spas only offer their most expensive services during their busy hours. It’s all around us.
Think about your business. Are there times when you are capacity constrained? Can you find a way to increase prices during those periods. One way is to be selective of your customers during those times. Typically you will want to continue to serve your regular, loyal customers without price increases, but there is nothing to keep you from raising prices on new customers. Who knows, they may remain customers at higher prices, even after the capacity constraints have eased.
Mark Stiving, Ph.D. – Pricing expert, speaker, author
Photo by Sarah Elizabeth Simpson
I had a wild thought the other day about features and benefits. Posted it on the AllBusiness site. Your comments and thoughts are most welcome.
Every academic pricing book will tell you, pricing is well understood. Simply plot your demand curve which is the quantity you sell at each price. Use that information to plot your profit Qty*(price – variable cost). If you’ve done this right, your profit looks like an upside down U. Now select the price that correlates with the top of the U. That is your profit maximizing price. Easy, huh?
As Lee Corso would say, “Not so fast my friend.”
There are two huge reasons why this is completely impractical. First, who knows their demand curve? It is almost impossible to know the demand at any given price with any certainty at all. There are many market research methods, based on statistics, to make estimates, and these estimates are probably better than guessing, but not very accurate. Besides, they still don’t account for the second huge reason.
Reason 2, your demand curve doesn’t include competitive reactions. How will your competitors respond to your price changes? If you lower your price, and they don’t change theirs, you gain more share, sell more units, and probably increase profits. However, if they lower prices too, you probably don’t gain any unit sales, and what you do sell is at a lower price, so profits certainly decrease. Demand curves do not explicitly take into consideration competitors’ responses. In other words, demand curves aren’t overly useful in figuring out what price to set.
This is good news! You don’t have to estimate a demand curve.
So what do you have to do? You must have a set of beliefs about how your competitors and customers will respond when you change prices. Then, playing mental “what if” games possibly combined with price testing, you will make decisions on how to best set your prices.
You’re probably thinking, “But that doesn’t sound easy.” You’re right. I never said pricing is easy, I just said you don’t have to create a demand curve.
A demand curve is a great theoretical tool for economists, but it’s not practical for people who have to actually run a business. This reminds me of one of my favorite quotes: “In theory, theory and practice are the same. In practice, they are not.” – Yogi Berra
If you enjoy my writing on pricing would you please do me a favor? Recommend my book, Impact Pricing, to a friend. Evelyn said, “I spent an entire Saturday afternoon reading Impact Pricing–and discussing its lessons and insights–with my entrpreneurial son-with-the-small-business. We were both fascinated at the clarity of ideas and workable solutions to his business model.”
Mark Stiving, Ph.D. – Pricing Expert, Speaker, Author
AllBusiness, a subsidiary of D&B, asked me to write a weekly blog for them. Here is the first one. Please show your support and comment on the AllBusiness site.
Seth Godin wrote a blog titled “About Pricing Power” where he claims the type of company or individual who has the power to determine prices is irreplaceable, essential and priceless.
Also this week Bloomberg published an article titled “Buffett Says Pricing Power Beats Good Management When Evaluating Companies.” Here is a paragraph from the article.
“The single most important decision in evaluating a business is pricing power,” Buffett told the Financial Crisis Inquiry Commission in an interview released by the panel last week. “If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”
My first thought after reading Buffet’s quote was “if a firm can raise prices without losing business why don’t they?” The answer to that will require more creative thought.
The second question though was what do Seth Godin and Warren Buffet really mean when they talk about pricing power? Technically it means inelastic demand curves, but that still doesn’t really tell us anything. What I think defines pricing power is value. How much value does your product offer relative to your competitors? Value is in the wallet of the customer, so it’s a combination of your differentiation and the value your customers place on that differentiation. Pricing power means creating more value than your competitors.
My spin on their comments: Seth Godin says create more value, then you can charge for it. Warren Buffet says he looks for companies that create value and then capture it through value based pricing. Mark Stiving says … I agree with both of these very smart guys. Do you?
What is the difference between 75% gross margin and 50% gross margin?
That’s easy, 25%. So you might be tempted to jump to the incorrect conclusion that if you currently have 50% gross margin and want to grow that number to 75%, you simply raise your price by 25%.
To go from 50% to 75% gross margin you have to double your price (assuming costs don’t change of course). Let’s go through an example.
The formula for gross margin is (Price-cost)/Price
You have a product that costs 1 dollar to make. You sell it for 2 dollars. Use the above formula (2-1)/2=0.5 or 50%.
If you double the price to 4 dollars, the new gross margin is (4-1)/4=0.75 or 75%.
These graphs shows what the gross margin % is at different prices for a product that costs $1 to make.
The lesson is to not be fooled into thinking a certain percentage change in price results in a similar change in gross margin percent. When your gross margin is very small, small changes in price make large changes in gross margin %. When your gross margin % is very large, it takes large price moves to change the gross margin % even a little.
This is only important though if you are thinking in terms of gross margin %. Why would you think in terms of gross margin % and not gross margin dollars?