Pricing 101. Why pricing strategy is important and why you need to have one?

by Maciej Wilczyński in Profitability Generation
March 17, 2019

board with coffee prices

What is the most important factor in evaluating business according to Warren Buffet? It’s company’s pricing power. So why we’re spending so little time working on that?

The following post will tell you:

1. What is the impact of price for overall profitability?

2. Why do you need pricing strategy?

3. What are four pricing strategies you need to know?

Profitability and magical power of 1%

Wizard of Omaha said:

_ “If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business.”_

In this simple sentence he didn’t mention just the pricing, but included strong statement on competitive advantage, brand, company products and most important: profitability.

When I’m writing this post, economy is growing, VCs keep pumping start-up heart and despite few obstacles, everything goes pretty well. We live in a world where making profit doesn’t follow growth. Machine keeps spinning, but one day the market says “check”. Companies that enjoy healthy profit margins may prevail, while others will go belly up. If you want to prepare for that I suggest to read “Beat the Crisis” from Herman Simon, he is a pricing guru you need to know.

One of the essential reasons for company existence is “to make money”. Of course, you can say that it’s all about making great products, mission and making a world a better place, but in the end, investors and founders want to get their cash back. And even if they don’t, you probably need it to run further product development, get more customers and pay the office rent. Profitability is critical here.

We all know that equation for economic profit is:

Profit = Revenue [Unit Volume x Price of product] – Costs [Variable Costs + Fixed Costs]

The simplest question is: which of these variables have the highest impact on profitability? Please guess.

Impact of price on profitability

I’ve been exploring this area for a while and research results done by top consulting companies provide consistent information: if you want to improve your profitability, you should improve your price.

A study from Yankee Group (available in this book) proves that 90% of investments in pricing meets or exceed the expected return on investment (ROI). They even mentioned it in other way:

_“For any dollar invested in performance improvement, the greatest return comes when it’s invested in pricing.” _

Of course, initial results from calculating your costs properly, identifying waste and leaning them in a systematic way (there will be separate series on that). However, if you’re looking for substantial improvements, try working with the price. Friendly reminder: I’m not mentioning you should go and randomly play around with it as you wish. It needs to be properly researched, data-driven and well-thought as you can screw up your profitability. It’s a strong weapon and you need to use it carefully.

Why pricing is critical? Story of Porsche Cayenne

From economics standpoint, price is an instrument of rent creation. It pretty much divides the value between the final customer and company. To put it simpler: “you give me cash, I give you value”.

In fact, if you don’t understand the value your products or services provide, you simply don’t follow your customers and what makes them tick and what makes them buy the stuff you make. \
Product value is exactly the thing that makes your clients leave money with you and when they stop seeing it, they will leave. \
Simple as that, yet easily forgotten. Let me give you an example about one of the most successful cars in history of automotive industry. You can read more about it in this book.

You have probably heard of Porsche and its SUV Cayenne model, but you may not know why it’s so special. In 1990s, Porsche was facing pretty hard situation. Pressure from top competitors, new ways of manufacturing (Japanese cars) and increased production costs were enough to drive company on the brink of financial distress. They needed something bold, risky and new to change the odds.

Porsche knew they’re known as tremendous horse power, luxurious fast car producer. Making family-like SUV seemed revolutionary and a little bit off from the previous strategy. Understanding the circumstances, company decided to build their new product around the price instead of starting from design and then trying to sell it with a premium mark-up. Producer wanted to check how much customer is willing-to-pay for the product and then decide to move forward with the project.

Before they produced first model of a car, Porsche surveyed hundreds of potential customers from new segment. Found out that their new target group consist of people who always wanted to have a Porsche, but didn’t like the edgy feel of buying “middle age crisis” car. Pretty much BMW X-series or Lexus buyers. Getting them would not only boost profits but may also hurt competitors. We’re talking about a serious market entry here.

Company realized there is a potential for investment and started design process. They literally researched every feature and checked if it was on wish-list.

_-Racer gear is not on the list? Out. _

_-Manual transmission not wanted? Out. _

_-Cup holders needed? Oh yes! _

_-Strong performance combined with design? Bring it on! _

Instead of listening to engineers only, they were focused on voice of customer. It was highly innovative and totally different than what others did.

Cost-based pricing vs value-based pricing

Not only Porsche did their customer development work, but also learnt what is the actual value of the features and how much they can charge for it. Company produced one of the most customizable cars in history with different pricing schemes for different set of clients.

Customers loved it, making Cayenne most profitable car model in automotive history.

Currently it consists of over half of company’s total profit, exceeding 911 or Carrera series. Also, it allowed company to increase their cash reserves and pay debts. You already know from previous part that cash may be actually quite useful in financial crisis.

Porsche story is a highly MBA-level strategic case study, but provides important lesson into what pricing, especially it’s value-based version is.

If done right, it allows to use pricing capabilities to ensure profitability and gain significant competitive advantage. Side product is a tremendous amount of customer insights you generate as simply you need to know your clients better. It reduces risk of wrong decision and allows to predict market outcomes more precisely.

However, the most important part is: your price have a chance to capture full value as the product is neither too expensive, nor to cheap. In economics, we call it optimal. You want to create a new version of product and conquer the world with it. Before you do so, please start from homework.

Big 4 of pricing strategies

We can identify four main pricing strategies. They’re ordered from easiest-to-implement, but least impactful to hardest and most game changing:

1. Cost-based pricing

2. Competitor-based pricing

3. Context-based pricing

4. Value-based pricing

From my experience, companies start from first two strategies and move up the value creation line as their strategies sophistication increase.

Four pricing strategies: cost-based pricing, competitor-based pricing, context-based pricing, value-based pricing

Cost-based pricing

It’s the simplest one. It takes costs under consideration, adds “healthy” surplus like 15-20% and price it accordingly. It’s one of the most basic strategies and it’s super easy-to-implement. Also, if you have stable margin goal, you always make money with every transaction.

What is the disadvantage then? First of all, it doesn’t capture full value. For instance, SaaS products have very low cost base due to cloud-computing and marginal cost of adding new users approaches zero – in this case, company would have to charge only few bucks for every new user, which doesn’t make sense at all.

Another problem is that you may not take all costs under consideration and they tend to grow with time. Initially, it’s only hosting, but later we have upkeep, customer service and we also need to increase our office space. It may be hard to adjust prices so fast and generally, customers don’t like it.

Competitor-based pricing

I personally hate it, yet it’s leveraged by majority of start-up companies I see. We create new product, have some cool functionalities and have no idea how to price it. 15 minutes Google search and we know – it should be around $150 for seat as our competitor has $200. We won’t scare customers as it’s comparable and close enough. It’s also not risky at all - the market conditions are like that, so we follow.

And that is the problem. It is not your strategy, but your competitors. By following and not using your own guidance, you pretty much give a potential competitive advantage away. To go with military reference: “observe, but don’t engage with the enemy”. It’s always good to know how the market conditions look like, but ultimately we want to change them and become leaders. If we simply follow, how do we differentiate from others?

Context-based pricing

That one is actually tricky and very often doesn’t belong to top four. I like to include it as it’s the natural step between benchmarking/costs and value-based approach. In this strategy, we already use customer insights and their voice to better understand their needs and divide them into groups properly (it’s also called segment-based). Thanks to that, we can target the right offering to the predefined groups and context.

In B2B, it’s giving discounts, charging for new functionalities, cross/up-selling etc. Sales reps need to have clear pricing guidance and knowledge to put the right quote on the client need. In B2C it would be pricing the product differently for discount store, supermarket and hotel, so it’s important to have the right distribution mode.

Such pricing scheme captures more value, but can be risky as we may accidentally erode our margins, e.g through loose discounts policy. It’s also critical to create clear, but also strict internal procedures. You may want to communicate the pricing policy in CRM or implement it directly.

Value-based pricing

Crème de la crème of pricing strategies. As shown on Porsche example, it captures maximum value and it’s the most impactful among all strategies. Overall, it comes to the topic of “willingness-to-pay” – how much value do I bring to the table, so my customers want to pay for it?

Ultimately, it answers a simple question – what is the value my offer? It allows for better product creation as we develop only what is wanted and mentioned specifically. We also, similarly to Porsche, produce massive level of insights about our customers. It’s a valuable knowledge you can use for other activities, e.g. brand positioning or viral campaigns.

On the other hand, it’s easier said than done. Value-based pricing requires few more advances skills that allow you to properly calculate WTP and tackle the right pricing. Rome was not built in a day, so wasn’t your pricing capabilities. Some things (like Price Sensitivity Meter survey) you can run relatively easily, but others require more sophisticated toolkit and methodology (e.g. Conjoint Analysis).

How to start thinking of pricing?

Even considering above, you can simply start asking: “how much would you pay for it?”. It should be enough. Also, you’re not alone as we will cover the topics here or you can always shoot me an e-mail here: maciejwilczynski24@gmail.com

There are few books, you can use the ones from the links provided in a content, but I will also create a separate post with that and link it here. Personally, I think that pricing is one of the hardest parts of business and companies need to prepare for it. Doing it right may skyrocket your business, but there is always a risk of screwing things up. I strongly recommend to do the research and increase your knowledge on that.

Pricing is an extremely important, but also highly interesting subject, which combines economics, management, finances, psychology, statistics and technology. It’s a challenge to grasp the knowledge, yet value generated is extremely high. Are you willing to pay the price?

Questions to think:

1. Did I consider importance of pricing before?

2. Does my company understand customers willingness-to-pay in product development process?

3. Which pricing