When a business manager is setting a price, he or she must understand first, all internal and external variables that may impact that decision.
So, what impacts pricing?
Price setting is impacted by 3 main drivers and the relative importance between them may be different from location to location, industry to industry and/or company to company:
1st Driver - Willingness to Pay
From Economics perspective, this critical pricing driver is boosted from the "Demand" side of the equation.
As you may expect, it has sub-layers as well:
You always need to keep in mind that in the market field, perception is reality.
As already explained in the article “Brand Strategy vs. Pricing Strategy”, you can in fact have the best product in the market but that is useless if customers´s don´t perceive that quality.
On top of the rational value of the product or service that you are offering, you may also have an emotional value from your brand that enables differentiation, allows to charge a premium price and also generates customer loyalty.
An example of brand value materialized in additional pricing value occurs when you have two shirts, with the same design, with the same material, from the same factory and you are able to sell that shirt with a higher price if it is branded with a recognizable and appreciated brand.
- Nature of the Product/Service
From the customer point of view there are some key questions that will allow you to understand the nature of your product/service.
Is your product/service unique or exclusive? Do you have a patent?
If you are alone in the market you probably will be able to explore higher margins, at least until competitors arrive and only if there isn´t any regulatory control.
What is the overall customer demand for your product/service category?
It’s common sense that demand is the number one key element that will affect your success. Usually the focus is on the present demand, however with forecasted technology development, "demand" can be observed also as "potential demand".
Example: When mobile phone touchscreens were launched, there wasn’t any current demand; it was a new product category that was developed under the assumptions of potential demand migrating from the mainstream keypad mobile phones.
Is it easy to find in the market any substitute for your product/services?
Even if you are the only provider in your product/service category, if customers can satisfy their needs with other offers even if not exactly the same, those substitutes will affect your pricing as well.
Example: During the Napolean wars, tea became a substitute product of coffee in England and English colonies, which changed consumption behaviors in those places until today.
Is your product/service easy to compare with others?
Even if your product/service is unique and if there isn’t any substitute offer in the market, you still must evaluate what are the relevant pricing references around, because customers will always try to evaluate if your price reasonable.
Example: Some companies are trying to launch space trips offers. When the first company launches that service, customers are already expecting a mark-up on top of the premium airline fees, therefore although is not the same service, there is already a baseline as a reference from the customer perspective.
What is the importance of your product/service category in the customer monthly budget?
Your competition is not only from your industry. You are also competing with your customer overall wallet share, so you must understand how important is your product/service category for your customers.
What is the benefit acquired when your product/service is purchased?
It’s the easiest answer for you, because probably you already have it written in your product/service slogan.
Is it possible to split the product/service price in installments?
Depending of the product/service nature, or price value, you must evaluate if you can sell your product/service in smaller installments and even communicate your price in installments instead of the total price. That is very common in automotive industry.
What is the investment already made by the customer before buying your product/service?
In this case investment is not only about money. It can be time, it can be travel distance or emotional involvement. Just keep in mind that, the greater is the previous investment of the customer the more hooked is your customer to your product/service, so you may have a chance to charge him a premium price.
Is it possible for the customer to stock your product?
In some industries this question is critical, especially when temporary price discount promotions are considered.
When the product is perishable, the customer cannot stock it for a long time therefore a temporary discount will not impact significantly your future sales. However if your customers can stockpile your product and if there is a huge temporary price discount, it is expected that many of your customers will anticipate their purchases, and although it looks a promotion success in the short term, your future sales will suffer a huge hit.
What is the nature of the demand of your product/service related with customer income?
It is very important that you know your product/service nature, to avoid making pricing mistakes in the future.
Therefore if the customer income increases how that impacts your product/service demand?
- If the demand decreases, you are dealing with an inferior good type of product/service.
- If the demand increases but at a lower level than the income variation, you are dealing with a normal good type of product/service.
- If the demand increases more that the income variation, you are dealing with a luxury good type.
Let me clarify that if you are dealing with an inferior good is not negative per se. There are many “inferior goods” that are very successful in the market and they tend to shine even more in economic downturn cycles.
2nd Driver - Competition
Your positioning in the market is relative to your competitors positioning.
An usual mistake that marketeers make is that they think they can define alone their product or brand positioning in the market.
That is a huge mistake because your Brand/Offer positioning is made solely by your customers and also considering your competitors Brands/Offers, therefore what marketeers can do is define and implement a strategy to aim an intended positioning, but that positioning is never 100% under control of the business manager.
Before you define your pricing strategy it’s imperative that you make a comparative analysis with your current and potential competitors, regarding:
- Prices
- Perceived Quality
- Market Share
Keep in mind that you must expect a reaction from your competitors when you make a market move.
3rd Driver - Cost Structure
This driver influences the supply curve in the market and is the backbone of your strategy because it is through this assessment that you will understand your pricing limits.
Regardless of the willingness to pay of your customers or your competitors positioning, to survive, you must have a sustainable cost structure to be competitive in the market.
Understanding and controlling your costs defines your competitiveness level in the market, your margins and in the end your profit so that is why it is so important in pricing.
So, the first step to understand your cost structure is to split your costs in 3 different types:
. Variable costs – This type of cost is directly linked with your production or selling operation and it is applicable per unit produced and/or sold. Therefore you only have these costs if you are active in your business (producing or selling), so if you would froze your business activity, those costs would stop immediately.
On the long run in competitive markets, all prices tend to meet the variable cost per unit.
So, with that premise when you launch a new product line without incremental fixed costs, the
Variable Cost Method is applied to evaluate that price setting.
. Fixed Costs – Those are different from the previousones because they don’t depend directly on your activity, which means that you still have them even if you stop producing or selling your product/service for some time.
Example: Even if you don’t produce or sell anything, you still have to pay your office rent. That is an example of a fixed cost.
When launching a new business or a new offer portfolio that requires an incremental CAPEX budget (Capital Expense), the
Total Cost Method (variable costs + fixed costs) is more suitable to evaluate the price setting.
. Opportunity Costs – These costs are extremely important and harder to manage since most of them are driven by assumptions and by future forecasts. Long story short, it is the expected outcome of the best alternative of your intended action.
Usually the
Opportunity Cost Method is applied by companies already set in the market when they are evaluating a change on their products (offer replacement or price adjustment) without incremental fixed or variable costs.
Sometimes this method is also applied on top of one of the previous two described (variable or total cost methods).
CONCLUSION
Price setting is a complex business activity with many variables to consider within the 3 key drivers:
- Willingness to Pay
- Competition
- Cost Structure
The main objective of this article is to show that Pricing should not be driven by gut feeling and you would be surprised with the number of companies that drive their pricing strategy solely based on gut feeling instead of these drivers.
