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Which Pricing Strategy Should You Choose?

Finding the right price for your product or service is tough. Just simply calculate your costs and add a markup is not enough anymore.

 

Quote Pricing Strategy

 

Whether you are a total beginner or already advanced in pricing, this blog will introduce you the five main models for pricing strategy to help you get a better feeling about what to choose for your business to get paid for the value your customers perceive.

The 5 most common pricing strategies

In previous posts, we have spoken in general terms about the importance of pricing strategy and why, out of all the other factors which impact on profitability, pricing has the biggest effect. We have also looked at the relationship between pricing and demand, explaining the role of demand curves in identifying an optimum unit price for a product.

Depending on the literature you read, the number of defined pricing strategies out there easily runs into double figures. But most analysts agree that these can be boiled down to five main categories which we will now share with you.

1. High price

Also known as premium or luxury pricing, this approach is commonly adopted by brands that want to build and maintain their identity around quality and exclusivity.

It is based on the reasoning that certain customers would prefer to pay higher prices in return for a brand with an exceptional image and credentials

– price in itself becomes a key differentiator.

Because unit prices are kept high, margins are also extremely healthy. The calculated risk is knowing you have the kind of brand equity, as well as the quality of products, that will keep demand and sales strong.

There are high profile examples of brands that thrive on premium pricing strategies right across the world. It is often the choice in commerce business, from luxury motor car marques like Bentley and Rolls Royce to watchmaker Rolex. For these brands, paying more than you would have to pay for similar products from other vendors is part of the appeal for customers. It’s like buying your way into an exclusive club.

A pricing phenomena we see in fashion at the moment are exclusive “Drops”. By using this tactic, brands release very limited runs of a new garment and charge exceptionally high prices for them.

Widely credited to have been masterminded by New York streetwear brand Supreme, it is an approach that has been adopted successfully by the likes of Gucci, Adidas, Nike and Louis Vuitton in recent years. Besides enjoying high profit margins, this approach has another goal. “Drops” are also enabling fashion marques to get the most out of their own direct-to-consumer online channels, attracting consumers away from mainstream retail channels to their own websites with the promise of cutting edge, limited edition runs.

 

Rolex Premium Pricing

Brands like Rolex use high pricing as part of broader strategy to maintain a reputation based on exclusivity and premium quality.

2. Mid-price

Although the likes of Nike and Adidas have become well known for their premium-priced ‘drops’, the majority of their business is built on what might be called a mid-price model

– an everyman, all-things-to-all-people approach.

A mid-price strategy can be seen as trying to strike a balance between a reputation for quality and good value. Unlike premium pricing models, the aim is not to target people who like to spend big, but rather to appeal to the mass market and therefore gain deeper penetration. At the same time, many brands are also conscious of pushing prices too low, as they don’t want customers to start questioning if the quality stands up and start thinking of them as a discount brand.

Mid-range pricing strategies are the most common type you see in mass market goods because they seek to find a middle-ground compromise between all competing factors – costs versus revenues, quality versus value, demand versus competition.

3. Low price

Low or economy pricing is arguably the strategy that takes the principle of the demand curve most literally – that if you drop your prices, demand will increase. That’s great if you want to boost your sales volumes, but the flipside is that lower unit prices mean lower margins.

Economy pricing is widely employed by specialist discount or value brands that seek to

– make high demand profitable by cutting back costs as far as possible.

Most supermarkets engage in economy pricing on the core grocery lines they sell, using their buying power and economies of scale to drive down wholesale costs. Most also now produce their own ‘no frills’ product lines, pushing down costs further still with minimal branding and marketing expenditure.

 

Supermarket pricing

Supermarkets routinely adopt economy pricing models with a wide range of high volume, low margin grocery items.

 

Budget airlines like Ryan Air are also renowned for their low price strategy. They are focusing on offering the cheapest price in the market and bring you from A to B on time. No more, no less.

4. Price skimming

Price skimming can be seen as an attempt to straddle the divide between premium and mid-range pricing strategies.

What it typically involves is brands rolling out new products at a high price point, banking on creating a lot of hype around the launch and the fact that early adopters are often prepared to pay whatever it takes to get first look. After this early shot for profits, prices will be scaled back to more of a mid-range point, seeking to broaden the appeal and keep sales volumes high.

Skimming is very common in electronic device markets such as smartphones and games consoles. Brands like Apple, Samsung and Sony are renowned for skimming – the Playstation 3, for example, originally retailed in the US for $599, but was reduced over a period of a couple of years to just a third of that original price.

– Skimming aims to segment consumer markets into different bands:

● Early adopters who show inelastic demand however high the price is
● Mainstream shoppers
● More value-conscious buyers

By treating each segment as separate, and drawing a different demand curve for each, brands determine a series of optimum price points that they can adjust to over time, trying at each stage to minimise the consumer surplus – the difference between what people are prepared to pay for a product, and what they actually pay. In other words, price skimming tries to find the optimum price for different groups at different times.

This strategy works well for brands that exert a near-monopolistic influence over a market – Apple, for example, at various stages has known that the main obstacle to people buying its iPods, iPads and then iPhones is price, rather than competition. Adjust the price, and you can hoover up everybody. But once competition increases and rivals are prepared to undercut a brand’s price on launch, skimming becomes much harder.

5. Penetration

Finally, penetration price strategies can be seen as working in the opposite direction as skimming.

They see products launched at a budget price point, and then gradually increase towards the middle ground. This is the classic “special introductory price” strategy, and

– the goal is to rapidly grab market share, rather than aim for profitability.

Penetration pricing is the model often adopted by disruptors looking to enter an already crowded market and attract customers away from incumbent brands. It works most effectively when markets are highly saturated with little product differentiation – someone coming along and offering a better price is then enough of a point of difference to attract custom.

To follow on from the consumer gadgets example used above, smartphone vendors like Samsung and, later, Huawei adopted penetration pricing as a way to grab market share from Apple, which dominated smartphone sales at first. Both companies were highly successful, and now boast a bigger share of the global smartphone market than their Californian rival.

Plus, in classic penetration pricing style, both Samsung and Huawei have gradually moved away from aiming to undercut the market to now providing products at a wide range of price points – including the premium end Apple deals in.

 

Samsung pricing

Samsung, now the world’s biggest smartphone vendor, started out undercutting Apple’s iPhone prices, before moving to higher price points once it has established market share – a classis penetration pricing approach.

 

Unlike economy pricing, penetration pricing is not about squeezing every last drop of margin out of low prices through aggressive cost cutting. It is about deferring profitability until you have the market muscle to either gradually raise prices, or start to up-sell more profitable products.

A classic example here is Uber. Widely regarded as one of the greatest disrupters of the digital age – a ride-sharing app that changed the private vehicle hire market the world over – Uber spread like wildfire on the back of a ground-breaking, uber-convenient app-based purchasing model and lower prices than most standard taxi firms. It grabbed market share ok, but profitability has remained stubbornly elusive.

Ironically, Uber is now the target of dozens of new entrants all over the world looking to grab its market share with lower prices – DiDi in China and south-east Asia, DiDi-backed Lyft in the US, Bolt in northern and eastern Europe. That makes it virtually impossible for Uber to get to where it wants to be, raising prices in a market it thought it had snatched control of.

Pricing is a Process

Considering everything that goes into an effective pricing strategy can easily make your head spin: labor, material costs, logistics, demand, competition … the list is endless. Thankfully, you don’t have to master everything at once.

 

Breaking down Pricing

 

Simply sit down, look at your current sales data and see how effective your pricing is today. Start with playing around with your prices and consider the impact on your sales volume. This will help you pinpoint the right kind of pricing strategy to use.

More than anything, though, remember pricing is an ongoing process. It’s highly unlikely that you’ll set the right prices right away — be assured that it often takes a trial and error approach until you find the right prices for your business, and that’s OK.

 

th!nkpricing is a brand of Smart Pricer. We are making professional pricing accessible to everyone by offering a platform to understand, simulate, and optimize your pricing with machine learning-driven algorithms and advanced demand prediction.

Want to stay in the loop and become a #pricinghero? Subscribe to our thinkpricing newsletter to not miss any upcoming blog posts.

 

Why to Consider a Pricing Software?

You want to determine the right pricing strategy for your business objectives, and then implement those strategies in the right way to maximise profits? As you may have already realized that requires you to be in command of a complex web of competing factors and considerations.

The solution: by bringing a variety of financial and market data together in one place, pricing software products provide users with the tools they need to understand their pricing requirements, evaluate different pricing models and adjust policies flexibly in response to changes in demand, competition and other market forces for optimum impact.

Pricing is fundamentally important to business success. But it is far from an easy thing to get right.

A recap of the basics of pricing

A few blog posts ago, we outlined the basics of why pricing is crucial to every company. Compared to other factors like cost control and increasing sales volumes, pricing has a proportionally bigger impact on profitability than any other financial variable at a company’s disposal.

But while higher prices can lead to higher profits, they also tend to have a detrimental impact on demand. The law of supply and demand teaches us that, as prices go up, fewer and fewer consumers are willing to buy. The precise relationship between rising prices and falling demand varies from product to product, market to market and brand to brand.

Businesses use mathematical models known as demand curves to forecast projected sales at different price points, and therefore work out the optimum ‘sweet spot’ where price and volume will return the highest revenues. Increase price any further past this point and the continued fall in sales will start to have a negative impact on profits.

 

demand curve for milk

Figure 1: The demand curve for milk

 

Even then, we’re still only dealing with the bare bones of pricing. Demand curves are not stable and to maintain the ‘sweet spot’, companies have to account for a host of variable factors that influence the relationship between price and demand, such as consumer tastes and habits, competitor behaviour, seasonal fluctuations and so on.

It is also common for businesses to work with several different demand curves simultaneously, for different markets, demographics and channels, trying to juggle a variety of different optimum price points which are all liable to change over time while still maintaining consistency.

And then, finally, we get onto the issue of pricing strategies, or the use of pricing to achieve specific business and marketing objectives. Vendors looking to grab market share, for example, may delay concerns about profitability and adopt a discounting strategy to attract customers, adjusting prices upwards at a later date when they have an established foothold in the market.

Pricing also has a strong influence on brand identity and reputation. Some brands purposefully stick to high price points in full knowledge that they put off the majority of consumers. The intention is to tap into demand for exclusive, high quality, aspirational products. You might only attract 10% of the market, but that 10% is prepared to pay enough per item to support very high margins.

On the flipside, discount brands rely on a reputation for value to drive high sales volumes, but at the expense of very low margins per item.

Pricing Software combines the complexity with considerable benefits

Given that brief overview of pricing, it’s clear that it is not a straightforward thing to get right. Choosing the right strategy, forecasting demand, accounting for external market variables which will impact on sales volumes, revenue and profitability — this all requires commercial businesses to have their finger on the pulse of various sources of data and intelligence, many of which are liable to fluctuate considerably over time. It is this complexity, and the considerable benefits of taking a truly dynamic approach to pricing optimisation, that recommend pricing software platforms to any business looking to get the most from pricing.

 

Variable factors affecting pricing

Figure 2: Variable factors affecting pricing

 

Pricing in the cloud

In the digital age, the world has become more agile and dynamic. Consumers are used to the convenience of having dozens and dozens of purchasing options literally at their fingertips. It doesn’t take much for someone to switch from one brand or one retailer to another — a negative customer service experience, a recommendation from a friend on social media, spotting a better price through Amazon or Google.

Similarly, with so many channels available to reach target markets, commercial operators have never had so many opportunities to reach new audiences and make grabs for share with creative pricing and service offers. Competition has accordingly never been so fierce.

In this fast-paced environment, businesses have to be increasingly agile and dynamic about pricing, too. That is why pricing software which can process and interrogate vast quantities of available data efficiently, making accurate predictions and adjusting according to fluctuating variables in rapid time, is becoming more and more popular. Instead of having to wait for signs that a pricing strategy is no longer working and reacting once ground has already been lost, pricing platforms allow businesses to proactively stay ahead of the curve.

The emergence of pricing products stems from the revenue management solutions that evolved in industries like hospitality and aviation. For these two sectors, the internet represented a major disruption of decades-old business models. Instead of controlling sales of flights and hotel rooms through a few carefully selected and managed retail partners, ecommerce suddenly meant that there were dozens of different places to buy seats and rooms available online, often through sources not controlled by the airline or hotel chain, and with a variety of different price points.

The response of the smartest airline operators and hoteliers was to apply careful analysis of sales at different price points to determine who bought at what prices and when, based on the understanding that the elasticity of demand (how prepared people are to pay more for a product) changes as availability drops. Armed with these insights, revenue managers at airlines and hotel operators were able to develop variable pricing strategies which maximise yield by adjusting price over time in line with changing availability, and targeting different demographics each time.

 

cloud-based pricing

 

This kind of approach therefore represents a way of optimising revenue/profitability through data analytics and flexible pricing. This is central to how th!nkpricing works. But the key difference is that our software is being designed to model a variety of different pricing strategies so you can come up with the best possible approach for your different product lines. It therefore works at a level above revenue management, applying in-depth analysis and modelling to pricing strategy as well as to the pricing policies you implement over time.

The accessibility and flexibility of a cloud-based pricing platform has many benefits for businesses, but the main ones include:

  • It helps businesses to fully appreciate the impact of pricing on their performance with clear statistical visualisations and simulations based on real business data.
  • It allows brands to dig deep into the effectiveness of their pricing and easily find alternative solutions that deliver a greater impact, capitalising on opportunities they may otherwise have missed.
  • It delivers definitive comparisons between different pricing strategies based on robust business intelligence.
  • It supports the kind of speed and agility in pricing decisions that companies increasingly need in ultra-competitive, fast-paced markets, helping them to respond quickly to changing conditions.
  • It provides a bedrock for businesses to continually assess and improve their pricing strategies over time, with robust real-time monitoring supported by visual reporting that helps to identify and analyse patterns over times that can inform beneficial adjustments.

 . . .

We will be digging deeper into how to use these tools to take advantage of pricing opportunities and build a long term pricing strategy in future blog posts.

th!nkpricing is a brand of Smart Pricer. We are making professional pricing accessible to everyone by offering a platform to understand, simulate, and optimize your pricing with machine learning-driven algorithms and advanced demand prediction.

Want to stay in the loop and become a #pricinghero? Subscribe to our thinkpricing newsletter to not miss any upcoming blog posts.

The Demand Curve and its Role in Pricing Decisions

In the last post, we introduced you the concept of the Law of Supply and Demand. We learned that the relationship between supply, demand and price can be represented as two curves on a graph. Now we deep dive and explain this impact on pricing decisions.

One of the properties analysts look at when they study demand curves is movement, or the way demand shifts along the line in tandem with price and vice versa. In particular, they look at how steep the movement curve or line is.

Take a look at Figure 1 and Figure 2, hypothetical demand curves for the price of oil and Netflix subscriptions respectively. Figure 1 shows a shallow line, which indicates that demand is elastic — changes in the price have a significant impact on demand. Figure 2, on the other hand, shows a steep line, which suggests that demand is inelastic, or changes relatively little in relation to price.

 

demand curve for oil

Figure 1: The demand curve for oil

 

demand curve for Netflix

Figure 2: The demand curve for Netflix subscriptions

 

Using Figure 2, Netflix could be confident that raising its subscription prices would have such a modest negative impact on demand that further increases would keep increasing revenues. At a €15 charge, it stands to make €1500m, considerably more than the €1025m it would make at €10 per subscription, despite having 2.5 million fewer subscribers.

For the oil industry, however, Figure 1 would caution strongly against price increases. In terms of turnover, the peak earnings here would be at €30 per barrel (€1900m), tailing off sharply after €50 per barrel.

In real world scenarios, the relationship between price and demand would rarely produce straight lines like these, which is why we talk about demand curves. Take a look at Figure 3 plotting the possible correspondence between price and demand for a litre of milk.

 

demand curve for milk

Figure 3: The demand curve for milk

 

This concave shape is considered the classic demand curve. It demonstrates both an elastic section (between €1 and €3) and an inelastic section (between €3 and €5). This kind of curve is typical of most products, where price increases from a floor value will quickly drive away a large proportion of customers, before the impact of further hikes gradually decelerates. The ‘sweet spot’ in this curve is actually €2 per litre, which would return the highest revenue based on demand. For a product like milk, you might imagine that the higher price points represent a premium product like organic, lactose-free or farm bought, where there remains a smaller but loyal customer base that are not put off by increased prices.

Less commonly, you might see a convex demand curve that slopes the other way (Figure 4). This type of curve would be typical of a product where there is a certain amount of tolerance for price increases in the market up to a certain point, meaning demand is inelastic. But after that tipping point, tolerance for further price increases is lost, demand becomes very elastic (shown by the curve shallowing out) and further price increases are likely to become counter-productive. It is probable that brands like Apple and Netflix work with these kinds of demand curve, adopting price increase policies up to the tipping point but no higher.

 

demand curve for IPhone

Figure 4: The demand curve for the latest IPhone

 

Applying the Demand Curve to Pricing Strategy

We will look more closely at specific pricing strategies in our next blog. But in general terms, a correctly calculated demand curve can help a brand determine two things:

  1. The optimum unit price for a product
  2. The type of pricing strategy that is likely to deliver best results going forward.

One thing to bear in mind about the accuracy of any demand curve calculations is that, once plotted, the graph assumes all other factors which could influence both price and demand are constant. But of course in the real world they are not, and many other variables — product supply, consumer demographics and habits, the price of substitute goods, levels of competition, innovation and disruption, seasonality — all play a part.

Accurate demand modelling needs to take all of these factors into account, allowing for what are known as shifts in the price-demand relationship. If something should happen to lower demand with price remaining constant, the demand curve will shift to the left; if demand increases with price constant, the curve shifts to the right. Businesses are often building their pricing strategies within a range of probabilities from the lowest to the highest shift away from the anticipated norm.

Businesses calculate unit price using the following formula:

Sales Revenue = Unit Demand x Unit Price

So in other words, to calculate sales revenue, you pick a point on your demand curve and multiply the values for demand and price. The point on the curve that gives you your highest revenue figure tells you the optimum unit price. However, it again has to be acknowledged that maximising sales revenues is not the only objective to consider with pricing.

Most businesses are more concerned with profit, and that also has to factor in unit costs. In some situations, the level of demand which gives the optimum sales revenue may not deliver the highest profits, as the cost of producing so many or so few units may eat into margins. This is where the strategic business objectives come into play and add another layer to pricing decisions. Aside from revenue and profit considerations, for example, vendors might weigh up the brand reputation and identity implications of pricing, keeping unit prices low if they want to be associated above all else with value, keeping them high if their brand is built around quality and prestige.

. . .

Next time, we will dive into the details of different pricing strategies brands and businesses might adopt, looking at how the science and art of pricing is a key part of marketing any product and how important it is to sustaining success in the long term.

th!nkpricing is a brand of Smart Pricer. We are making professional pricing accessible to everyone by offering a platform to understand, simulate, and optimize your pricing with machine learning-driven algorithms and advanced demand prediction.

Want to stay in the loop and become a #pricinghero? Subscribe to our thinkpricing newsletter to not miss any upcoming blog post.

An Introduction into the Law of Supply and Demand

In our last blog post Why Pricing is Crucial for You, Your Customer and Your Company, we have discussed why pricing is the number one profit driver of business and what you need to consider around pricing. Now we introduce you the concept of price-demand curves in a 2-part series. Let’s start with the basics, before diving in deeper next week.

One of the biggest secrets to success in business is knowing how to set prices. While pushing up prices can seem a great way to boost profits, increase them too much and you will drive away customers. Before deciding on a pricing strategy, business owners need to understand the relationship between price and demand, and how one affects the other. The Demand Curve, which models customer demand against price fluctuations, is one very useful tool for bringing this understanding into pricing decisions.

For certain companies in certain industries, price increases seem to have little impact on how much consumers want to buy their products. Apple, for example, has consistently pushed up the price of each new iPhone release, so much so that the latest handsets now top €1000. Despite only having a 12.1% share of global smartphone sales in 2016, Apple was still able to take 91% of the market profits.

 

apple market share

 

When Netflix hiked its subscription rates between 13% and 18% in January 2019, the company’s stock leapt 6.5%. No one expected even these considerable price increases to have any negative effect on the brand.

But these companies are the exception rather than the rule. Figures show that a tiny minority of companies — as few as 3% — manage to hit annual targets on price increases intended to bolster profits. In other words, 97% of planned price increases fail.

Why? Because, as a rule of thumb, when prices go up, sales volumes fall. Customers generally don’t like paying more for goods and services and are highly motivated by value when they make purchasing decisions.

This inverse relationship between price and demand is described by a model known as the demand curve. The demand curve is used to predict just how much of an impact raising or lowering prices is likely to have on demand, and is therefore a crucial tool in establishing pricing strategies.

If the impact of a price rise on demand is relatively low, businesses are still able to profit from them — this is what brands like Apple and Netflix, for a variety of factors, have been able to achieve. But if even a modest price increase is likely to lead to sharp decline in demand, it risks putting overall profitability at risk.

So what does the demand curve model actually describe? To fully understand its implications, we must look first at the economic principles which underpin it.

The Law of Supply and Demand

The concept of the demand curve has its origins in the law of supply and demand. One of the fundamental principles of market economics, this law states that, all other factors being constant, commodity prices will increase when supply is low and/or demand is high.

Flip this around and the law also shows that demand, or the quantity of a product bought, is a function of price. Assuming supply is stable/high, an increase in price will cause consumers to buy less of a product while, conversely, a fall in price will lead them to buy more.

What this law captures is consumer attitudes to value. If supply is low or demand outstrips supply, people are prepared to pay more for a product they want or need rather than not have it at all. But if supply remains good — which means consumers will be able to find equivalent goods or services elsewhere — they are less likely to be prepared to pay more because they see no value in doing so. Similarly, if prices go down while supply is constant, consumers respond to the better value on offer by buying more.

Demand Curves

The relationship between supply, demand and price can be represented as two curves on a graph — one curving upwards to plot the relationship between supply and price, one curving downwards to show the relationship between demand and price. For the purposes of this article, we will put supply to one side and consider only the relationship between demand and price.

demand curve

Figure 2: Typical demand curve

Demand curves are used to forecast how changes in price will impact on demand, and therefore to inform pricing strategy. They are drawn with price on the vertical axis and quantity on the horizontal axis. In almost all cases, the line/curve will slope down from left to right as this indicates the inverse relationship between price and demand. The exact shape of the line/curve will vary from market to market, product to product and brand to brand. Interpreting the shape and position of the curve gives businesses important insights into the impact pricing fluctuations may have on revenue and therefore on profitability.

. . .

In the next blog post, we will dive deeper into the topic of demand curves and explain its role for making pricing decisions.

th!nkpricing is a brand of Smart Pricer. We are making professional pricing accessible to everyone by offering a platform to understand, simulate, and optimize your pricing with machine learning-driven algorithms and advanced demand prediction.

Want to stay in the loop and become a #pricinghero? Subscribe to our thinkpricing newsletter to not miss any upcoming blog post.

Why Pricing is Crucial for You, Your Customer and Your Company

“For many goods and services, price is the #1 factor which influences a purchase decision.” — Christian Kluge

In business, we’re often taught that higher sales volumes and reduced costs pave the path to profit enlightenment. But this overlooks one key fact — that in most cases, pricing will likely be the #1 driver of higher profits. To kick off our new #PricingBasics blog series, let’s delve into why pricing has such a significant impact on how your business performs.

Remember the last time you stood in front of your local supermarket’s wine shelf? What were you thinking about as you mulled over which wine to buy? What influenced your final decision? We’re willing to bet that price played some part in attracting you to that particular bottle.

Research suggests that, for 70% of consumers, price is either very important (15%) or important (55%) in making their purchasing decision.

 

Importance of price for wine

Figure 1: Importance of price when buying wine. Source: Tomorrow Focus Media, Statista 2015

 

Just how much influence pricing has on purchasing decisions varies according to the type of goods or service bought. This variability in the importance of pricing is known as price elasticity and will be explored later in this series of blogs. Typically, however, for the vast majority of goods and services, price is one of the top three factors customers consider at point of purchase.

For most companies, price is the #1 profit driver

PROFITS = QUANTITY X PRICE ー COSTS

This simple mathematical formula captures something fundamental about the role price plays in the profit equation. Most obviously, it shows that by changing the price, you can change your profits. But what is also very special about price in this equation is that it has no impact on costs. Most activities undertaken to drive up sales volumes — marketing campaigns, for example — also involve raising additional costs, reducing the impact on profits.

But price is not like that. However you choose to alter your pricing strategy, the effect on profit will be direct, without being mitigated by changes to costs.

We have been struck by how often managers overlook these key facts about price. They will happily invest enormous sums in marketing and sales to drive volume, or go through several rounds of cost cutting. The benefits of pricing structure and optimisation are often fairly new to them.

Let’s take a closer look at the potential impact of pricing strategy using this simple profit equation.

Imagine you are running a company that sells one million products at €100 each. Your variable and fixed costs are €40m each, creating total costs of €80m. That gives you profits of €20m.

 

Profit Formula (1)

Figure 2: Illustration of profit calculation for company X, Source: th!nkpricing

 

Now consider what would happen if…

  • …you optimized price by +10%.
  • …you sold more and increased quantity by +10%.
  • …you reduced your fixed costs by -10%.
  • …you reduced your variable costs by -10%.

 

Profit Formula (2)

Figure 3: Impact of 10% improvement on each factor, assuming all others to be constant, Source: th!nkpricing

 

If you run all of these figures through the profit equation once more, while keeping the other three as they were, you will see that a 10% increase in price (so €110 per unit) achieves the biggest increase in profit:

€110 x 1million ー €40m ー €40m = €30m

An impressive 50% increase for a 10% change. A 10% improvement in volume only raises profits by 30%; a 10% reduction in fixed or variable costs just 20% each.

 

Profit Formula (3)

Figure 4: Profit impact, Source: th!nkpricing

 

So pricing optimization will have the biggest impact on your profits out of all the factors involved in the profit equation. However, to take full advantage of the benefits, there are some other factors businesses also need to consider.

Five further considerations around pricing
1. Digitization has boosted speed of implementation:

One of the reasons so many businesses perhaps overlook pricing strategy as they look to boost profits is the perception that price alterations are logistically cumbersome and take too much time to take effect. In the old days of manually adjusting pricing spreadsheets and printed labels, this might have been the case. But with modern digitalized systems, businesses can adjust prices centrally and have them applied on shelf and at point of sale in seconds, meaning the impact on profits can be rapid.

2. Price is a top attention grabber:

We’ve mentioned how businesses often have to invest heavily in marketing when their aim is to drive up sales volumes. Pricing is a topic that instantly grabs attention and, with the right approach, can drive its own awareness-raising campaign to support greater sales. This is something very much evident in the social media age — look, for example, at how Twitter conversations about the original iPad release spiked when Steve Jobs announced the price during his famous 2010 unveiling.

 

Twitter Ipad Activity

Figure 5: Twitter activity during iPad announcement 27th January, 2010; Source: Pricing to Create Shared Value by Marco Bertini, John T. Gourvill (2012), Article in Harvard business review 90(6):96 · June 2012

 

3. Customers must buy-in:

Social media reactions to pricing also signal an area where businesses need to be careful how they tread. Another factor in the profit calculation is that customers do not always react kindly to price hikes. Any increase perceived as being unfair or which looks like profiteering can nowadays provoke furious social media backlash. Such negative reactions are spread rapidly and can undermine efforts to increase profits.

4. Companies should remain flexible with their pricing:

The role of customer reactions in the success of pricing strategies underlines how businesses need to be flexible in their approach. If a price increase is received badly by the market, then you must be willing to change — otherwise people will stop buying your product and your profits will fall. On the flipside, there are many stories of brands getting locked into the discounter mentality, on the basis that low prices will attract customer loyalty and drive sales volumes. But long term this can be destructive. A famous case is Praktiker, formerly one of the top German home improvement retailers that traded on the slogan “20% on everything except animal food” and eventually went bankrupt when it found it couldn’t sustain margins.

5. Pricing strategy must align with company strategy:

How you approach pricing is an extension of your company strategy. It will influence how you position yourself in the market in relation to other competitors, how customers perceive you, how you market yourself, your cost-cutting requirements to sustain margins and so on. But as the Praktiker story cautions, there are dangers in creating an entire company identity around pricing. The most successful companies are agile and able to predict and respond to changing demands in the market. This kind of mindset should be reflected in pricing strategy too.

 . . .

In our next post, we will introduce the concept of price-demand curves. Following on from some of the points made above, price demand curves demonstrate the relationship between the price of goods and services and how many items are sold. Understanding them is key to optimizing your profits. We will discuss the different models and how they can be used to adjust the basic profit calculation formula for greater accuracy.

th!nkpricing is a brand of Smart Pricer. We are making professional pricing accessible to everyone by offering a platform to understand, simulate, and optimize your pricing with machine learning-driven algorithms and advanced demand prediction.

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