How to set prices profitably, get ahead of the competition, and generate value for customers.

How to determine a price? How much should you charge for a product or a service? In the correct and incorrect response to these critical questions are found numerous success stories and business failures. Traditionally, the most common method of setting a price has been the proverbial “costs + profit”. In fact, this method, logically, continues to be at the base of the majority of models for any company. However, limiting oneself to thinking that the proper price is simply that which takes into account the impact of costs on the product or service offered, to which is added the appropriate profit, is as naive as it is unreal.

There is an enormous difference between setting prices and deploying a true Pricing Strategy. In the former, the focus is only tactical, almost always “short-term”, and basically reactive. However, a good Pricing Strategy is entirely the opposite: it strives for pro-activity and leadership in terms of prices. It’s about controlling markets, competition, and customers, and not being controlled by these three elements.

When companies set a price based simply on the “costs + profit” formula, they usually commit a very common mistake: the prices they set are too low in expanding markets, and too high in maturing or declining markets.

In order to find a proper Pricing Strategy, it is essential to keep three key aspects in mind, which will affect its success or failure: obviously costs are one aspect, but there is also the competition and the customers. This recipe is no secret. Almost all companies use it, but not always correctly. The majority usually ask themselves “how much is the market willing to pay for this product or service?”, instead of asking themselves “what value does the market perceive for this product or service?” Value is an absolutely key term in the design of a proper Pricing Strategy. Only the focus on value can transform the mere setting of prices into a Profitable Pricing Strategy, but we will not benefit at all from knowing what value it is that differentiates us and justifies our prices, if we are not capable of properly communicating it our customers. A correct Pricing Strategy is based, then, on the three aforementioned axes: costs, competition and customers, as well as on the company’s ability to reach the market with its value message; that is, “the reason for its prices”.

Costs: cost structure vs. cost per unit

It is very common for companies to consider almost exclusively the cost per unit as a judgement criterion, when the essential thing is to have a broad vision of the entirety of their cost structure. It is unacceptable, for example, for a product to always cost the same. A ticket for a flight that is practically empty and very affordable for the airline that offers it is not the same as a ticket at a peak time, which could end up costing another plane’s freight charge.

It is essential for every company to be able to respond to the following questions: What is our cost structure like? What fixed costs can we reduce or avoid? What are our variable costs, and how are they structured? What is the cost of an additional sale, the cost of our products or services? What are our opportunity costs? The answers must be much more oriented towards strengthening a well-defined cost structure than towards determining the cost per unit.

Competition: being pro-active, not reactive

One of the main goals of a good Pricing Strategy is to lead movements; being pro-active in price setting, and not reactive, as happens in so many cases. There are many companies that determine their prices according to those of their competitors, with the sole objective of obtaining market share, when the real goal is to be as profitable as possible. Limiting oneself to offering a lower price than that of the competition can be “bread for today and hunger for tomorrow”, as is clearly illustrated by the case of telecommunications operators in the United States. In order to corner AT&T, local operators offered extremely aggressive rates for mobile phones. When AT&T launched its flat rate for national and long-distance calls–a move that didn’t increase costs, since its network was underused- it forced its small competitors into a situation that some did not survive.

Customers: perceived value as a key factor

While costs and competition are factors of great importance in a proper Pricing Strategy, the customers are the critical element, because their willingness and tendency to pay the price we’ve set for our products or services will depend on how they perceive their value. Therefore, it is absolutely critical for the Pricing Strategy to be based on an appropriate Segmentation Strategy that divides customers into like-minded groups around price. Therefore it is equally important that the price meters be capable of maximally quantifying the concept of value. The ultimate goal is for the customer to perceive the price as fair; that they are not being overcharged, but… not undercharged either.

Current customers’ level of demand and training shows that they pay with a very refined sense of “integrity”. They accept that which is expensive if it’s worth it, and they accept buying something cheaply – even when they’re able to buy something more expensive – if they see that it’s worth it.

Communication is the key. Being sure of having the most well-adjusted price to the product or service’s value will be pointless if the customer does not perceive it, especially with a new launch, since the consumer will have little experience on which to base their opinion. A recent study carried out by the Product Development Management Association in the United States shows that new products and services introduced onto the market have a less than 50% chance of reaching their profitability goals.

If the customer is the final consumer, it will be essential for us to know what leads them to buy our brand, and we must know how to carefully explain to them why our products and services cost what they cost. That’s what IKEA wisely does; the company even details in their catalogues the reasons why their prices are low (absences of transport and assembly, self-service structure...).

On the other hand, if the customer is a company, B2B Pricing Strategies may seem simpler at first – if only because the number of customers is usually less -, but the reality proves otherwise. The most direct contact with the customer can work in a company’s favor… but it can also work against it. In general, customers know the market, they know other providers, and often they know each other. When the customer is a company, it is very typical to see greater arbitrariness than in the final market. The tougher the customer is as a negotiator, or the greater their reputation, the less rigid we will be when settling on a price. We must be careful with these types of actions, because customers can easily be “contaminators”, and we could mistakenly communicate that the better customer is that which applies the most pressure, which in the long-term would transform “good customers” into “difficult customers”. The customer in the B2B situation must perceive integrity above all, and not the feeling that the price is set in order to take advantage of a favorable union or its eventual disinformation.
Moreover, if the company has a true, well-structured Pricing Strategy, it will be helping its sales force in negotiations. If the sales team knows its references, it will be able to act in the moment, without the need for previous authorization, and without the need to establish “ad hoc” prices whose profitability has not been studied.

If they do not perceive this integrity, the customers are very likely to begin flirting with the competition or even join them in order to apply pressure. This fact applies to both the B2B environment and that of the final consumer. There are already numerous examples of intermediaries who negotiate better prices because of their purchase volume (mortgages, unified loans, vehicle purchase…). It is imperative that the customers not perceive that they will be rewarded for negotiating strongly.

The need for Pricing Processes

For a Pricing Strategy to work properly, it is not only necessary for it to be well defined, but also to be properly executed, used, and evaluated. In order to do that, every company must have established price-setting processes with a clearly defined chain of communication and command. Unfortunately, only few exceptions confirm the rule that no one directly governs prices in a company.

Do you know anyone whose responsibility it is to correctly set prices and who is evaluated according to the prices’ profitability? The response is mainly negative. Price determination usually falls to the hands of either functional, isolated, or coordinated areas, or to the hands of the Product Managers themselves, who respond as a last resort for the effectiveness of the prices and discounts applied to their product line. And who estimates what impact the price policy of another brand in the same company may have on a product line? The absence of processes in Pricing Strategies can end up not only giving customers a feeling of arbitrariness, but also creating internal competition between product lines or business units.

Discounts are not always advisable

The lack of clearly defined price strategies, processes, and structures in many companies causes the decisions regarding price variations to often be inaccurate. Whether they are price increases –which must be purely justified in order to successfully communicate them to the customer -, price reductions, or the setting of prices for new products, they must have a clear and comprehensible basis for the customer. One famous database company that planned to launch groundbreaking software set an initial price at $99, and found out by consulting with its customers that they could have commercialized it at $350. The same thing happened to a well-known pharmaceutical laboratory: after in-depth market research, it decided to multiply its initial launch price by 40.

Discounts are another clear example. Many companies offer, for example, a 10% discount for customers that reach 10,000 euros in spending. This type of model does not promote loyalty, since customers will still compare offers before each purchase and decide on the most attractive one. Scaled discounts – reducing prices for each new purchase beyond a certain amount – have proven to be much more efficient. On the other hand, it is essential that the discount reward the customer for their value and potential lifecycle, and not only for occasional purchases, in order not to transform them into a “commodity”.

In the same way that a customer’s lifecycle and value must be important factors in the price strategy applied to them, the product or service’s lifecycle is also crucial. It is not the same thing to determine a price when a market is on the rise – higher prices will be tolerated – as it is to determine it when the market is declining or maturing, which is the time to aim more towards profitability than towards prices. Therefore, within a correct Pricing Strategy, it is entirely unadvisable to enter into the price wars that usually break out in very strong markets: these wars only erode profits for everyone and end up shifting the focus from profitability in favor of market share, which is recommendable during the first stages of the life-cycle.

And above all, a good Pricing Strategy is that which achieves profitable prices, taking into account the triple axis of costs, competition, and customers, and properly communicating the intrinsic value of our products and services.