Understanding the benefits and effects of price changes

Sometimes it seems that the harder you work and the more you sell, the less money you appear to make. This is because volume isn’t everything, particularly if you have not set your price right. Indeed, you could drive yourself out of business. On the other hand, while higher prices usually mean lower volumes, margins are disproportionately higher. It could well be you are better off selling less overall. It all comes down to pricing.

Pricing is both an art and a science. Mathematics has a part to play, but there are as many intangible factors as tangible, external ones as internal, unpredictable elements as predictable. You have to try to account for them all – then make your best guess. This guide will explain the main elements involved when setting a price.

The basic rule

The basic rule is that you must sell your product for more than it costs you. There are partial exceptions to this rule, however – for example, loss leaders. You may also decide to trade at a loss while you establish yourself in a market. Or, if you are a new business, you may have to trade at a loss until volume takes you over the break-even point. At the other end of the spectrum, a major player may try to force a smaller competitor out of business. However, these are all risky short-term strategies. In the longer term, you must at least cover your costs. This ought to be fairly obvious but the fact is that many businesses do not really know how much their products cost them to sell.

Costing

So, before contemplating a price change, there are three things you must know about your product:

• Average cost: Total expenditure on the product + Overheads
• Marginal cost: The additional cost of producing one additional unit.
• Direct selling cost: This includes commission, delivery, credit cost and so on.

What to consider as overheads is a source of constant debate. For this guide, let us define it as all costs not directly associated with producing or making products available for sale. This includes general overheads like running the office, rent, rates, bank charges and marketing. You would incur these costs whether or not you produce anything yourself and you pay for them out of the gross profit.

Since overheads are, by definition, almost constant, the marginal cost of producing one more unit should not include any additional overheads and so should be cheaper than the average cost.

For mass production it is almost impossible to say how much it costs to produce 12,352 units as opposed to 12,351. A compromise here is to cost in batches. For example, it may be possible to calculate that to make 2,000 units as opposed to 1,000 may require one additional machine, two additional employees to operate it, one additional truck for transport, one additional driver, and so on.

Of course, many businesses, especially in the service sector, deal with jobs or contracts of varying size involving different skills, knowledge and time. However, the basic principles still apply – in some service sectors, for example, the component units are chargeable hours.

Marginal costs can sometimes soar when you near your maximum capacity levels. For example, you may have to pay overtime, hire temps, outsource production, buy in extra materials at a premium rate, and so on.

The bottom line

If average revenue is less than average cost plus direct selling cost, you are making a loss.

If the marginal revenue of selling an extra unit is less than the marginal cost of producing it, you are making a loss on it, though you may still be profitable overall. This can happen if you’ve set your margins too low and you have to pay overtime, say, to produce the goods. Then producing more simply eats into overall profitability and you would be better off not selling the extra. This is why it is vital to have an accurate understanding of your fixed and variable costs at various levels of output.

Factors in pricing

There are seven main factors to consider when setting prices. They combine the internal with the external, the tangible with the intangible.

1. Costs
   
   Costs are the foundation of price. They are internal and tangible, and are the easiest to calculate and control. In determining a price, the key is to find a point that covers those costs and maximises profit.
2. Customers
   
   This is an external and fairly intangible factor. People are prepared to pay what a product is worth to them.
   
   The net result is that a customer usually has an idea of a fair price that they are prepared to pay for a product or service. It may be possible to persuade them to go above this, but that requires something extra from you in the form of added value.
3. Competition
   
   If you have competition, it is necessary to offer a similar or lower price to theirs, unless you can show that your customers perceive clearly that your product is in some way superior.
   
   However, if you hold a monopoly (if only in a given locality), you can name your own price. Whether the customers accept that price is another matter.
   
   Remember that a competitor is not necessarily someone selling the same product. It may be a product that is similar or at least an acceptable substitute. For example, if wine is significantly overpriced, many wine drinkers might switch to beer.
4. Conditions
   
   This covers the complex area of discounts, credit arrangements, delivery, free gifts, warranty, staged payments, loyalty bonuses, and so on. Some of these ideas are largely ways of adding value and of disguising direct price and quality comparisons.
   
   Remember, however, that they all come out of the same pot. You must cost them carefully and account for them all in your calculations.
5. Context
   
   There are times when your product is worth more to customers. This is either because the value to them is greater – like fans in a heat wave – or there’s a shortage of supply. Abraham Lincoln is reputed to have said that the best way to make money out of a gold rush was to, ‘Go to the goldfields and sell every shovel you can carry’.
6. Cachet
   
   Cachet is beyond calculation. There is no logic behind it but people can pay ten, even a hundred times more for a particular fashionable brand or label than for a generic product, which is identical in all other respects. Unfortunately, there is no reliable way of predicting in advance which products will be so fashionable. However, you can influence your brand image to some extent by your marketing and distribution.
7. Confidence
   
   This is the biggest intangible of all. It is often said that pricing is a confidence trick. Many small businesses badly under-price their products and services for just this reason – they cannot believe people will pay them any more! On the other hand, there is a natural suspicion of those who are too cheap.
   
   Put simply, if you act as if you are worth a certain price, people will assume that you are. And so you will be.
   
   However, if such confidence is part of your strategy, you will have to go all the way if you are to carry it off.
   
   One consultant was comfortably busy when she was invited to chair an industry conference. It was something she didn’t want to do, so she said, ‘My daily rate is [double her usual rate]’, hoping this would put the organiser off. His reply was ‘Fine. Does that include expenses?’

Elasticity

Elasticity is the extent to which demand varies with price. The higher the price, the lower the demand. But the range of change is neither linear nor predictable, and it varies dramatically for different products and markets.

Generally speaking specialist, unusual or occasional products will be relatively insensitive to modest price changes. On the other hand, even a small price change will tend to have a big effect on demand for your product if one or more of the following apply:

• There is strong competition, and it is hard to differentiate between your product and the competitors’.
• The product is a commodity that is bought frequently, rather than something bought occasionally.
• The product has no particular status or cachet.

For some specialist or fashion products, the elasticity can be quite complex because of value perceptions – too cheap and people believe ‘it can’t be any good’, while very expensive implies it must be highly desirable.

Petrol is a classic example of both mechanisms at work.

It is a commodity in that if one garage is out of line by even 1p it can lose sales to its nearby rivals. But when the Budget puts 4p on a litre there is very little change in sales either at a particular garage or overall. It seems we will buy petrol whatever the cost.

There are no reliable formulae or predictors of price elasticity. Only experience will show. However, you must monitor sales figures constantly, especially after changes in price or other conditions of sale, to assess the elasticity of your products as accurately as you can.

Maximising profit

Elasticity is the key to maximising overall profit. So even though it may be a ‘guesstimate’, try to assess the elasticity of demand for your product over a range of prices. Assess also your costs, fixed and variable – over a likely range of demand. Then draw up a simple spreadsheet to compute the resulting gross profit. The results may surprise you. Crude though the calculations may be, they can sometimes highlight dramatically the folly of cutting (or raising) prices.

The next step is to try to estimate price sensitivity by using slightly different sets of figures in your spreadsheets. You may find that changing one dimension has relatively little effect, while tweaking another has enormous repercussions. This is especially true when operating at low margins.

When forming a pricing strategy, use a spreadsheet to run through as many models as you can. Cost your product pessimistically, and then calculate how much you will make, or lose, at different prices with different levels of sales.

Here are some simple examples to illustrate the effect of price/demand in different types of market:

Note: the costs increase as demand reaches the limit of production. Profit peaks over quite a wide price band.

Note: profits increase as the price goes up, as demand is not greatly influenced by price.

Strategies

Many factors may have a part to play in setting a price, and you must ensure the final pricing decision is yours (not set by competition) and arrived at only after due consideration. That means working to a strategy. As with so many things, a proper business plan is crucial. Such a plan will determine your overall strategy, of which your pricing strategy must be an integral part.

Business plans revolve round a ‘unique selling proposition’ (USP) – the basic reason why someone should buy your product from you. A USP in turn usually comes down to one of three things:

• Price differentiation – for example, your product/service is the cheapest.
• Product/service differentiation – for example, your product/service is either better or unique.
• Customer service differentiation – you are easier or more fun to do business with.

The three are not mutually exclusive, but the emphasis has to be on one of them if you are to present a clear image. This should determine your pricing for you.

The product life cycle

All products have a life cycle. For some things, such as bread, this cycle can last for centuries; some technology products last two to three years; fashion clothing lasts a season; the life of craze toys is measured in weeks.

There is usually a relative short period while the public gets used to a new type of product. Then follows a period in which it is more or less fashionable, followed by a period of decline of varying length as other things overtake it or it becomes a commodity item.

When the product is established and at the height of its popularity, it may be possible to raise prices. However, it may be unwise to launch at too high a price or raise prices soon after a product has been launched.

Exceptions to this rule include products that are:

• a genuine innovation, or at least a novelty,
• aimed at the prestige market from the start,
• otherwise unique or exclusive.

Such trendy or high-tech products attract a group of consumers known as ‘early adopters’ who will pay a surprisingly high premium to be among the first to buy. This helps you to recoup your development costs, but such a high price can seldom be sustained if you want to reach a mass market.

It is also unwise to raise prices of products past their peak. It may be that a product has a long period of decline, during which it is no longer fashionable, though it retains a degree of customer loyalty. Such a product can remain a steady source of income requiring low marketing costs. Excessive (albeit in line with inflation) price rises during this period could force people prematurely into the arms of newer competitive replacements.

On the other hand, even the price of bread goes up, though it does so incrementally in line with inflation. A partial exception may be made where you deliberately decide to bring a declining product to a premature end. In such a case, it might be advantageous to raise prices and milk the product as a short-term ‘cash cow’ to finance new product development.

Another strategy is to try to revive a declining product by improving the specification and including added value. You can usually use this to disguise a price rise. Combine this with a short burst of marketing, and you can extend the profitable life of a product quite significantly.

Penetration pricing

Penetration pricing is one of two possible strategies for entering the market. It is the application of price differentiation early in the product life cycle – sell cheap to get started. The disadvantage is that, having started low, it is often difficult to persuade the market to pay more later. It can also be tough to shake off a cheap image.

The most immediate danger is that it could lead to a price war with an established competitor – in which case, the odds are usually against the newcomer. In general, price wars are dangerous and things to be avoided where possible. To compound the problem, you may find that you have created a high demand for your product, but you will have to spend more to produce enough to meet that demand.

This applies equally to a company in the opposite position: the established supplier who seeks to under-price a newcomer and force them quickly out of the market. Although the incumbent supplier’s chances of success are greater, the newcomer might hold on longer than expected, all the while putting a strain on the old firm’s profitability and possibly on reserves. The Competition Act also opposes such a blatantly monopolistic tactic.

Prestige pricing

The alternative to penetration pricing is prestige pricing. It relies on you establishing clear quality differentiation. Prestige pricing is obviously good if you can do it, but it is often difficult for a newcomer to establish a reputation for quality from scratch, especially against an established competitor. Even harder to predict is what will attract the public fancy and become arbitrarily fashionable or prestigious.

The alternatives to changing prices

Your work is not done when you set a price. You must review sales figures and profitability continually, and rework your spreadsheet models in the light of new data.

You may have to adjust your prices slightly but within your overall strategy. If, however, sales figures and profitability remain a problem in the longer term, it may be necessary to reconsider your whole strategy.

Cutting prices

Going from a strategy of product differentiation to one of price differentiation usually means cutting costs.

However, if you originally costed your product carefully, this means you probably have little room to spare. You can only look for reductions through:

• New technology.
• New suppliers (or renegotiating new deals with old ones).
• New processes, procedures or structures.
• New channels for sales or distribution.

Of course, this side of your business needs constant review anyway to ensure that you remain competitive. An alternative to cutting costs is to see what happens if you cut profitability. However, this rather defeats the object.

You might achieve lower average costs by planning to sell much higher volumes, but sales would have to be significantly higher and it may take much higher marketing costs to achieve them.

Changing your image

Moving from price differentiation to product differentiation is even harder. Once a product is labelled ‘cheap and cheerful’, it tends to remain that way.

Repositioning

Repositioning a product upwards in the market is difficult, but it can be done. You will need to change your entire marketing strategy, however.

Repositioning is therefore a combination of minor alteration, and marketing techniques, including rebranding and repackaging and using added value to its full. Do not try to do everything at once – changing attitudes takes time. Rather proceed in stages, moving from ‘cheap’ to ‘reliable’ to ‘quality’ to ‘prestige’. This is the route taken by German and Japanese car makers. It took decades.
It may sometimes be easier to create a completely separate brand with a new image. However, it is commercial suicide to attempt to jump straight from ‘cheap’ to ‘prestige’. Instead you might introduce intermediate brands, such as a ‘luxury’ brand of the original product. This ‘luxury’ then becomes the standard, the original has to be discontinued – even if it is still profitable – or the negative associations will remain. This step-process will have to happen several times before you get where you want to be.

Summary

Pricing is indeed a science and an art. It also involves guesswork and testing. Try out a range of pricing models to identify key factors. Your aim is to achieve the maximum profit for the least amount of effort and resources. Volume is not always king. Sometimes you might find it is more profitable to turn clients away if they force you above your maximum capacity. If this is the case, you should already be planning how to take your business to the next stage of its development.

Further information

The Competition Act

The Competition Act 1998 came into force on 1 March 2000 making it illegal to:

• fix purchase or other selling practices or trading conditions,
• limit or control production, markets, technical development or investment,
• apply different trading conditions to equivalent transactions that will put some parties at a competitive disadvantage,
• make contracts subject to unrelated supplementary conditions.

The Office of Fair Trading has wide-ranging powers to investigate suspected breaches. Companies found to be in breach of the Act face a fine of up to 10% of their UK turnover. The more recent Enterprise Act 2002 also introduced a cartel offence under which anyone who dishonestly takes part in the most serious types of anti-competitive agreements may be criminally prosecuted. It also allows directors involved in anti-competitive practices to be disqualified for up to 15 years from being directors of companies.

• For more information OFT produces a series of guides, including 'How will the Enterprise Act 2002 change the Competition Act 1998 regime?'
• You can download all the Competition Act guidelines from the OFT’s website at www.oft.gov.uk
• For general enquiries, and a copy of its Compliance Matters training video, call the enquiry line on 08457 224499.