One of the most important issues companies face is how much to charge for their products and/or services. Pricing strategies impact every aspect of potential growth and financial success. Pricing strategies should be examined on an ongoing basis to determine if overall objectives are being achieved. Having the proper financial benchmarks and well defined growth and profitability goals are critical to sound pricing policies and practices.
Factors that you need to be considered in a pricing policy include:
· Positioning – How are you positioning your product in the market? Is pricing going to be a key part of that positioning? Pricing has to be consistent with the positioning. People really do hold strongly to the idea that you get what you pay for.
· Demand Curve – How will your pricing affect demand? You’re going to have to do some basic market research to find this out, even if it’s informal. Is the best long-term prospects for your business a model based on high volume with lower per unit gross margins or low volume high gross margins? Your pricing strategies impact this strategy.
· Cost– Calculate the fixed and variable costs associated with your product or service. Variable costs fluctuate with sales volume whereas fixed costs remain essentially the same regardless of sales. Knowing your cost structure and the variable versus fixed components is critical for pricing strategies and also for business modeling to understand break-even point, forecasting and profitability at different sales levels.
The next step to define in your pricing objectives is what are you trying to accomplish with your pricing?
· Short-term profit maximization– While this sounds great, it may not actually be the optimal approach for long-term profits. This approach is common in companies that are bootstrapping, as cash flow is the overriding consideration. It’s also common among smaller companies hoping to attract venture funding by demonstrating profitability as soon as possible.
· Short-term revenue maximization– This approach seeks to maximize long-term profits by increasing market share and lowering costs through economy of scale. For a well-funded company, or a newly public company, revenues are considered more important than profits in building investor confidence. Higher revenues at a slim profit, or even a loss, show that the company is building market share and will likely reach profitability.
· Maximize quantity– There are a couple of possible reasons to choose the strategy. It may be to focus on reducing long-term costs by achieving economies of scale. This approach might be used by a company well-funded by its founders and other “close” investors. Or it may be to maximize market penetration – particularly appropriate when you expect to have a lot of repeat customers. The plan may be to increase profits by reducing costs, or to upsell existing customers on higher-profit products down the road.
· Maximize profit margin– This strategy is most appropriate when the number of sales is either expected to be very low or sporadic and unpredictable.
· Differentiation – At one extreme, being the low-cost leader is a form of differentiation from the competition. At the other end, a high price signals high quality and/or a high level of service.
· Survival – In certain situations, such as a price war, market decline or market saturation, you must temporarily set a price that will cover costs and allow you to continue operations.
Here are common pricing policies:
· Cost-plus pricing – Set the price at your production cost, including both cost of goods and fixed costs at your current volume, plus a certain profit margin. For example, your products or service cost $200 in variable costs (raw materials) and production costs, and at current sales volume your fixed costs come to $50 per unit. Your total cost is $250 per unit. You decide that you want to operate at a 35% profit margin. Therefore, your targeted price should be $385 ($250/(1-35%)).
· Value-based pricing – Price your product based on the value it creates for the customer. This can be the most profitable form of pricing, if you can achieve it. This pricing policy is based on the expected ROI to the customer. This requires additional analysis and in addition to being a sound pricing practice is extremely helpful in sales negotiations. For this method the business analyzes the value to the customer, such as cost reduction, increased revenues and profitability and then uses this data to create pricing based on the ROI or payback period to the customer. It is an excellent practice to always understand your value proposition to your customers.
· Psychological pricing– Ultimately, you must take into consideration your customer’s perception of your price, figuring things like product positioning, other popular price points and what would be considered “fair” pricing.
Sound pricing policies are critical in every business. Harvest CFO Consulting can assist you to understand if your pricing policies align with the company goals and improve pricing policies and practices.