When companies get their pricing wrong – it’s far more likely that they’ve pitched it too low than too high.
That’s according to management consultants McKinsey anyway. Underpricing your product means your company doesn’t achieve the profits that it could potentially have generated. But pitch prices too high and you won’t make the sales.
It’s difficult to get pricing right, especially when venturing into new markets or selling a new product for the first time. Companies are often tempted to price low in order to grab market share, but once those prices are set it’s hard, if not impossible, to raise them later on.
How pricing works
When setting prices, companies often take historic prices as their guide, or they’ll base their pricing decision on the existing market.
For instance, if a seller is launching an updated version of their product and the updated version costs 10% more to build than older versions, many sellers would choose to charge 10% more than for their old product. Alternately, they may price their product slightly cheaper than a competitor’s similar item in order to gain market share.
What these approaches fail to consider is the value of the product to the customer. Products should be priced to reflect the value customers place on them, rather than by reference to what competitors charge for similar products.
To use an example, whilst a customer may be able to buy a pint of milk more cheaply in an out-of-town supermarket than in a local shop, many people are prepared to pay more for the convenience of making the purchase closer to home. In this instance, local shopkeepers don’t need to match their prices to supermarkets some distance away but instead consider the convenience of their sale to the customer in their pricing strategy.
In B2B especially, it’s valuable to consider process improvements as part of pricing decisions. When the first portable bar code readers were developed, the main supplier priced the devices with reference to the cost of static (non-portable) bar code readers.
The company assumed buyers would save a bit of time by using a portable device, so they added a small amount to the cost of a similar static device to reflect the labour-saving advantage. What they didn’t realise was that the product allowed customers to redesign their entire supply chain and make huge cost savings.
The seller significantly undervalued the value of the portable unit to the customer, and hence underpriced it massively, losing out on huge potential profits. This was a case of the seller misunderstanding the true value of the product to its target audience.
It’s usually easier to price a product that’s relatively similar to existing products, or just offers a small update to an item already on offer in the market. When products are more revolutionary, they are harder to price but there is more room for creativity when it comes to picking a price point.
Profit loss caused by sub-optimal pricing can be considerable. One study suggested that if a vendor charged just 1% less than the product’s optimal price, up to 8% of profits could potentially be forfeited.
Whilst companies might hope that lower pricing might lead to higher sales volumes, in reality demand is not really that sensitive to pricing. For a typical company on the S&P 1500 index, it’s claimed that it would take a rise in sales of 18% to make up for a price cut of 5%.
Price-benefit analysis
It’s important to start thinking about the benefits to the customer and the associated pricing of a product early on in the product development process.
At IKEA, both the price and design of a new product are developed at the same time. Product designers working alongside the product development team and suppliers to understand how the manufacturing process can build a product that can achieve a certain target price. This approach means that the manufacturing process is geared towards the price of a product rather than the other way around, and the focus is very much on cost savings.
That’s a way of developing new products that really understands the role cost plays in the customer’s valuation of them. IKEA is also active in getting into customer homes to identify what needs people may have for certain products, which helps the company understand the value that products could potentially deliver to people.
Determining value
What is the value of your product to your customer? That’s a tricky question to answer as some products might represent significant savings to your buyers.
Fairy Liquid boasted that a bottle of its washing up liquid could wash twice as many dishes as rival brands, a claim it later defended successfully against a legal challenge.
The brand is able to justify the higher price of its washing up liquid compared to competitor products based on this claim. Fairy’s customers clearly value a long-lasting product.
Other product benefits are harder to quantify, particularly ones that deliver process improvement for the customer or advantages to the buyer’s reputation. Product benefits are also subjective: different buyers will place different values on the benefits, possibly at different times.
Pricing for new markets
When entering a new market, it’s likely that you’ll find the local audience’s needs are not the same as in that of your home market audience. Finding buyers with different values could have a significant impact on your pricing strategy, so identifying these audiences should form a major part of your market research prior to entry.
If demand exists in the new market it’s likely a competitor may already be active there, in which case gaining market share will inform your approach to pricing.
Finally, you need to ensure you can serve all customers in the new market at the price you’ve decided to set. If you can’t fulfil all demand in the market then you leave space for a competitor; if you risk oversupply then you’ll end up having to discount. It’s important to consider your capacity when setting pricing.
