Every business wants to maximize its profits in order to survive and grow. Profit and earnings growth are measures of a company’s success and shareholder value, and product pricing is one of the key factors that affect business profitability. Price the product too high and sales may go down; price it too low, and revenues (and therefore profits) go down, unless the sale of the product goes up commensurately. You can cut the price of the product in half, but then you would have to sell twice as many. This tactic only works for a short time unless the demand for the product goes up significantly. A slight miscalculation in pricing a product can have an enormous effect on the company’s bottom line and should be given close scrutiny by the top leadership in every organization.
Generally there are five different types of pricing models that companies use; sometimes they use multiple models, depending on the circumstances. The models are described below:
1. Market-Driven Pricing:
This is a reactive approach, driven primarily by short-term market conditions. Unfortunately, many companies tend to take this approach when pressured by the Marketing Department to boost market share or by the Finance Department to maintain short-term profitability. Price fluctuations resulting from this approach confuse customers and there is constant pressure on Product Development, Manufacturing and the Procurement Departments to lower the cost of goods sold, often resulting in poor product quality. Bad inventory management also leads to price cuts, resulting in lower profit margins. When companies have to choose between the cost of carrying inventory and lowering prices to “move” products, the outcome is always less than desirable. Market-driven pricing is not sustainable over the long run because the company must rely on external factors and has little control over its own profitability.
2. Cost-Plus Pricing:
This assumes a “fair markup” (i.e., profit) after all the costs are taken into account. But this model has some inherent problems as well. First, customers don’t really care about your costs. And they shouldn’t. It is your job to rein in your total costs in line with your competitors. Customers care about value and the return on their investment. Secondly, “fair” is a relative term. What is a fair markup to a seller may not be so fair to the buyer. Also, the main focus is on the benefit of the seller rather than the benefit the customer realizes by buying your product. Shifting the attention from the buyer to the seller is a sure way to lose customers fast. This model does work in a few cases, where a highly specialized service is involved, with few service providers available.
3. Customer-Driven Pricing:
The goal of this approach is to get as many happy customers as possible in a short time, and increase market share through heavy promotions, discounts, deals and incentives. It also makes the false assumption that the customer is willing to pay that discounted price, regardless of how they perceive the product. Inevitably, this leads to price wars as competitors start slashing prices as well. No one wins, and in the long run, companies with weaker financial foundations go under. Cynics will tell you that big companies sometimes start a price war to drive a smaller competitor out of business. This assertion may or may not be true, but it undoubtedly strains relationships between companies and their distributors, retailers and suppliers.
4. Competition-Driven Pricing:
This is almost an unintended consequence of customer-driven pricing. Slash prices and make a sale “at any cost”. Commercial airlines have mastered this model to the detriment of passengers as well as their own employees. Long term, it’s a loser.
5. Strategy-Driven Pricing:
The best companies use strategic pricing to maximize their profit margins in a focused and controlled manner. To do that, companies must have a greater grasp of two important factors that make up the profit equation: Revenue and Cost. Minimizing cost and maximizing revenue is the formula for maximizing profits (Profit = Revenue – Cost).
Businesses incur fixed and variable costs. Understanding what they are, how they impact the bottom line and creating a long-term plan to manage and control those costs go a long way towards formulating a stable price structure.
However, businesses cannot cost-cut their way out of a hole all the time for a very long time. They must have a plan for sustained revenue growth. A strategic cost reduction plan, coupled with a comprehensive product and marketing strategy, is a winning combination. Numerous books have been written on how to develop a robust product strategy, and I will touch on some of those strategies and tactics in a future article. For now, be aware that 90% of new products fail in the market mainly because the company launched a product that the market didn’t need. Which pricing model do you use?