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:
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.
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:
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:
Elastic demand – commodity | ||||||||
Price | 8 | 9 | 10 | 11 | 12 | 13 | 14 | 15 |
Cost | 8 | 7.5 | 7 | 7 | 7 | 7 | 7 | 7 |
Margin | 0 | 1.5 | 3 | 4 | 5 | 6 | 7 | 8 |
Demand | 130 | 120 | 110 | 100 | 90 | 80 | 65 | 50 |
Profit | 0 | 180 | 330 | 400 | 450 | 480 | 455 | 400 |
Fixed overheads | 200 | 200 | 200 | 200 | 200 | 200 | 200 | 200 |
Net profit | 200 | -20 | 130 | 200 | 250 | 280 | 255 | 200 |
Note: the costs increase as demand reaches the limit of production. Profit peaks over quite a wide price band.
Inelastic demand – speciality | ||||||||
Price | 8 | 9 | 10 | 11 | 12 | 13 | 14 | 15 |
Cost | 7 | 7 | 7 | 7 | 7 | 7 | 7 | 7 |
Margin | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 |
Demand | 102 | 106 | 103 | 100 | 97 | 94 | 90 | 92 |
Profit | 102 | 212 | 309 | 400 | 485 | 564 | 630 | 736 |
Fixed overheads | 200 | 200 | 200 | 200 | 200 | 200 | 200 | 200 |
Net profit | -98 | 12 | 109 | 200 | 285 | 364 | 430 | 536 |
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:
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:
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:
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:
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.
