Pricing for Success: Simple Pricing Ideas With Big Bottom-Line Impact

Pricing is one of the most powerful, yet underappreciated marketing tools. While some larger companies spend millions of dollars experimenting and crafting intricate pricing strategies, many smaller companies treat pricing as an afterthought.

Pricing strategically can be a major challenge. For example, it can be difficult to price an innovative product that is establishing a brand-new market niche. Moreover, market forces such as competitive reaction, supply-chain pressures, and customer feedback make pricing decisions even more complicated. On top of these difficulties, decision-makers within the company itself often have competing interests with respect to the product price. For example, I have never met a salesperson who pushed for higher product prices, nor have I met a CFO who actively pursued price reductions.

Strategic pricing is not a simple matter and challenges abound. However, the reward for pricing strategically can be great and should provide an incentive to do so, especially in a market as fiercely competitive as the New York area. This article offers some simple insights and concepts that should help you to start thinking strategically about pricing, with minimal cost. Most of these ideas are company and industry independent and, if implemented correctly, could improve any company's bottom line.

Which Is Better: Overpricing or Underpricing?

When pricing a new product, it is very common to make pricing errors that later require correction. It is very hard to set the optimal price on the first attempt. In such cases, executives should almost always try to err on the side of overpricing. For one thing, it is always easier to discount a product than to raise its price. Customers are rarely open to price increases, but a customer who complains about a reduction in price is a rare bird indeed.

Another advantage to initial overpricing is professionally known as "skimming." The skimming process is one in which prices are initially high, and fall over time. This means that customers who are less price-sensitive, or ones for which the economic value generated by the product is higher, purchase the product first and at a higher price than those who are more price-sensitive. In some industries, skimming is a very frequent strategy. For example, book publishers first publish expensive hardcover versions of their books, which are later followed by cheaper, paperback editions. Similarly, when a new chip is first made available, chip manufacturers set its price high and repeatedly cut the price as newer models are introduced. Some of this is due to the higher costs and lower yield that are to be expected when manufacturing a new product; however, this is also a way for the company to obtain more revenue from customers who are price-insensitive.

In some cases, higher prices can be used as a signaling device, since customers sometimes take higher prices as an indication of higher quality. This signaling effect tends to be stronger in situations where customers find it hard to compare between products, and where the price differences are not dramatic. 

Of course, this strategy is not desirable in all cases. For example, if you are in the business of selling a commodity product, such as electricity or long-distance phone service, pricing higher than the prevailing market price may be a recipe for disaster. Nevertheless, few products are true commodities, and effective marketing and differentiation of your product may assist you even in such cases.

In summary, when in doubt, err on the side of higher prices. You can always reduce prices later.

Run the Numbers

When considering a price change, many knowledgeable executives use a simple but highly effective tool to determine whether the proposed change makes sense. This tool is known as Iso-Profit Analysis, which is simply a fancy name for a break-even calculation.

Since the number of units sold is closely tied to the price per unit, break-even analysis will allow you to forecast whether a price change is likely to increase or decrease your company's profitability. The following example illustrates the idea:Product A is currently sold for $10 and has a (variable) cost of $6. The company is considering a $2 price increase. This means that margins would increase from $4 to $6 per unit, which implies that to get the same profit the company needs to sell only two-thirds as many units. In other words, the price change will be profitable as long as the quantity of units sold does not drop by more than one-third.

The same exact process can be used to determine whether a price reduction is desirable.

Generally speaking, the lower your margins, the less likely it is that a price reduction would be profitable, since the number of units needed to deliver the same profit would increase dramatically. In the scenario presented above, for example, if we exchanged the $2 price increase for a $2 discount, the company would need to double the number of units sold to achieve the same level of profitability!

As a businessperson you probably have a good sense of how your sales will react to a price change, and need to decide whether the contemplated change in price will at least achieve the break-even point. If the break-even point appears unreasonable, you may want to reconsider the proposed price change.

If Possible, Experiment!

Pricing hardly qualifies as an exact science. Because so many variables are involved and since obtaining all of the information to make an exact decision is often nearly impossible, an important part of every pricing strategy is experimentation.

It may be useful to explore any number of the following ideas:And always, if prudent, err on the side of higher prices!