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Developing a Pricing Model

A solid pricing process will enable you to differentiate your pricing across distinct market segments. Unfortunately the most common pricing strategies are often not a very good approach.  In a survey of its members by the Professional Pricing Society, 30 percent of respondents said they priced new products by mirroring their nearest competitors, and another 22 percent set new-product prices to recover costs and tack on a profit. Only 18 percent said they did customer research to determine the value of the product or service to potential customers.

Higher profitability targets, greater competitive pressures, and the emergence of new technologies are all impacting a company’s approach to pricing.   Why is a pricing model important? A McKinsey study found that a 1 percent change in price could result in an 8.6 percent change in profitability.  The company found that pricing can have a greater impact on the bottom line than just reducing costs. For example, a 1 percent improvement in fixed costs generates only a 1.7 percent increase in operating profits, while the same 1 percent improvement in variable costs (including raw materials, labor, etc.) begets a 5.9 percent rise in operating profits.  As a result many organizations have asked us what factors to use in developing a model that is right on target.

Other research suggests that your pricing process can increase your company’s profitability from 25% to 75%. Most companies don’t have a pricing process. Pricing is treated more like an event than a process. Whatever pricing model you select, account for these four elements:

  1. Well defined standards. Establish allowable discount ranges and other standards to ensure accountability and control and facilitate decision making.
  2. Clear performance measures. Determine what key indicators of pricing performance your company will use, such as percentage of volume sold at a discount or the rate of compliance to the volume discount structure.
  3. Invest in pricing optimization tools that will help you find the optimum volume and margin.
  4. Establish rewards focused on margin rather than revenue.

We’ve been involved in a few pricing strategy and model conversations lately mostly around the question, “What is the ideal pricing strategy?” Almost every conversation covers these basic tenets:

  • Develop a strategy that will capture the value of the product or service for a particular customer or customer segment without putting the brand at risk.
  • Make sure your pricing strategy takes two marketing activities into account:  price formulation and price execution.
    • The price formulation is the development of the strategy, tactics, guidelines and policies and should be driving by pricing objectives, production costs, customer demand, competitive behavior, and environment factors (such as price regulations and the state of the economy).
  • Derive your pricing objectives  from your corporate objectives.  If the corporate objective is to increase net profits by 10% per year over the next five years, then a strategy will need to be developed to increase profitability.  The strategy might be to grow market share by introducing new customer-request features into a product with a pricing objective to maximize profit for this new product.

You want to develop a strategy that will capture the value of the product or service for a particular customer or customer segment without putting the brand at risk. Your pricing strategy should take two Marketing activities into account: price formulation and price execution.

The price formulation is the development of the strategy, tactics, guidelines and policies and should be driving by pricing objectives, production costs, customer demand, competitive behavior, and environment factors (such as price regulations and the state of the economy). The pricing objectives should be derived from your corporate objectives. If the corporate objective is to increase net profits by 10 percent per year over the next five years, then a strategy will need to be developed to increase profitability. The strategy might be to grow market share by introducing new customer-request features into a solution with a pricing objective to maximize profit for this new offer.

Types of Pricing Models

Before finalizing the price, use a variety of different methods to calculate your price. Common approaches include:

  • Cost-based pricing. Costing out your price which essentially take all costs into account and the desired profit, and the total of these are used to set the price. When using this method it is important to account for both indirect and direct costs. Direct costs are those you incur when delivering your service and typically include labor and materials. Indirect costs are all the other costs not accounted for in your direct costs, and include things like rent, insurance, phone and utility bills and office supplies. These indirect costs cover everything you need to keep your business operating every day, whether or not you make any sales.
  • Competitive-based pricing. In this method, before you set your price investigate what are prices your competitors are already getting. If their prices are different for the same offer, you should try to understand why. If higher, what are they offering to justify the price? If they’re lower, is it because there is a quality difference, a cost difference, or some other reason they are able to offer a lower price. If you can’t just go to the store or a website to do competitive pricing, here are a few other ways to gather the information. Ask some of your best customers if they will supply you with a price sheet from competitors. Ask your trade association if they monitor pricing among the trade and what information they have. Interview people from the competitor for job openings.
  • Position-based pricing. This method is about how you want to be perceived in the market. Think Ford truck, now think Toyota truck. Different perceptions, different positioning, different pricing. If you decide to be take a premium price position, you will more expensive than 2/3 of the other similar products/services in your category. A budget price position suggests that 2/3 of the other similar products/services in your category will be more expensive than you. If you choose Middle Market, your price(s) should fall within the middle third of all prices in your market.A common practice is to set a price low and then try to raise it over time. Most pricing experts believe this is a terrible mistake. Often times you cannot recover enough of your investment if you set you product cost too low, potentially endangering your survivability. In addition, setting too low a price leaves you no room to negotiate. It takes very deep pockets to use this strategy. It also potentially sends a message that in some way your product is of lower quality than the competition. If after you’ve done your homework and are considering two price points, choose the higher one. This will position you as higher quality and will ensure adequate profitability from the get-go. And should you meet resistance at this price, you can discount down to an acceptable price.
  • Value-Based pricingValue-based pricing is based on understanding that the overall value of an offering to any one buyer

What factors should go into building your model? Market and customer-centric companies should account for the following when building a pricing model

  1. Customer behavior, expectations, relative size of expenditure, price-quality perception
  2. Competitive behavior and substitutes (the availability of alternatives)
  3. Value- your solutions end- benefit (the relative value or need for the product or service) and differentiators (the special features or services that distinguish the product),
Build your pricing model.

A number of attributes go into developing your pricing model.

Considerations for Pricing New Products

According to McKinsey companies consistently undercharge for products thinking lower prices will results in a quick grab for market share or return on investment. There research suggests that as much as 80 to 90 percent of prices for new products are set too low!

Many companies forgo conducting a price-benefit analysis to determine not only whether price barriers might make products unfeasible but also as a way to determine which attributes customers are most willing to pay for. Instead they employ a common approach to pricing known as incremental pricing, where existing products are used as a reference point for establishing the new products’ price. The incremental approach often underestimates the value of new products and while this approach may create demand for a new product, potential profits are lost.

Here are important considerations for developing your price.

  • Is your product a me-too product, that is, does it replicate others in the market or offer small improvements? If so, then incremental pricing approaches may come close to the optimal price. Just a reminder, incremental prices tend to focus on the lower end of the price range so it’s very likely you will leave money on the table.
  • Do you know the price ceiling? Establish a ceiling before determining your price. This is just the opposite of incremental pricing, the focus here is on determining the higher end of the price range. To determine the price ceiling requires that you have a firm handle on the
    • product’s benefits
    • value it creates
    • size of the market
    • competitive landscape, and
    • degree of market demand.

Be wary of relying to heavily on your internal perceptions. Market research is most likely going to need to be done to establish a price ceiling. Be sure to avoid building in a bias when you do your research, ask as many open ended questions as possible to gain an understanding of your customers’ economics.

  • Have you assessed trade offs and benefits? Deploy conjoint analysis and perceptual mapping to assess how much value each benefit offers to customers. (Conjoint analysis examines the direct trade-offs among competing products. Perceptual mapping, which assesses the benefits of different products that may not be direct substitutes for one another, seeks to identify the benefits that no other product offers.).
  • Do you know the actual cost of your product? An accurate analysis of costs per unit, plus a margin representing a minimally acceptable return on investment, reveals a new product’s lowest reasonable price level. When you do this analysis be sure to account for all costs that should be allocated to products; including R&D expenses associated with a product category and goodwill linked to acquisitions that lead directly to new products.
  • Do you know the size of the market? Similar research is needed to gauge the size of the market or market segments for various prices at and below the ceiling. Estimating the size of a market at various price points clarifies the range of pricing options, suggests which price models to use at any price and volume point, and increases the accuracy of estimates of profitability along the spectrum and of the unit-cost calculations needed to define the price floor.
  • Where is the product in the life cycle? Is this a product aimed at early-adopters or the late majority? Early adopters may be willing to pay a premium enabling you to capture the extra value.
  • What impact will the new product have on your existing portfolio? It may be important to establish a higher reference price to manage cannibalization.

Once you have the answers to above questions, you are ready to formulate a price. When you establish your release price, you are telling the market what you really think your new product is worth. In doing so you are creating a reference price. Be wary of establishing to low a release price which will create a low reference price. A low reference point generally signals a company is targeting market share. This strategy is known as penetration pricing and often triggers a response from competitors resulting in price war.

It may make sense to undercut the competition, but this should be a very conscious strategic decision, not an outcome of poor pricing. If the product is targeting a new or under developed market and if the target customers are particularly price sensitive, the competition is weak, and you believe you can quickly build a presence and establish yourself as the market leader, the penetration pricing may be appropriate. Be advised, this is a risky strategy and you can ultimately end up forfeiting profits. If the cost-to serve is going to decline rapidly and the demand is going to rise sharply, then margins may rise over time enabling you to capture profits using this strategy.

If you can, we advise establishing a high reference price, which generally signals a company is targeting profits. High reference prices typically generate few if any immediate reactions from competitors. Rather than offering too low a price or too many discounts early in the products life, consider ways to offer samples or trials to speed up market penetration without impacting the perception of value. Standard discounts or rebates are usually a mistake, however, since they do cut it and also provoke doubts about the product’s benefits.

Make Sure Your Pricing Strategy Improves Your Bottom Line

Price is all about the bottom line. Keep these five factors in mind when you build your pricing model.

  1. Customer behavior: As a market-centric company,  take customer behavior into account to build your pricing model.
  2. End Benefit: What is the the relative value or need for the solutions
  3. Differentiators: These are the special features or services that distinguish your solutions
  4. Substitutes: This accounts for the availability of alternatives
  5. Price expectations: What has been historical pricing for this type of product/category and competitive pricing. Also consider the price-quality perception, relative size of expenditure, any shared costs and the competitive behavior your competitors’ are likely to take in reaction to your pricing strategy.

Once you have formulated the pricing model, your next step is to address price execution, which involves capturing, configuring and institutionalizing the strategy.

Let’s talk if you need help developing your model.

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