One of the most important issues growth and middle market companies face is how much to charge for their products and/or services. CFOs play a critical leadership role in this strategic and tactical focus. Pricing strategies impact every aspect of potential growth and financial success in every business. Pricing strategies need to be examined on an ongoing basis to determine if overall objectives are being achieved. CFOs support pricing strategy by implementing and monitoring proper value-add operational and financial analysis and benchmarks to enhance and enable well-defined company growth and profitability goals for critical and sound pricing policies and practices.
Factors that CFOs need to be considered in sound pricing policies include:
- Positioning – How are we positioning our product in the market? Is our pricing going to be a key part of that positioning? Is our pricing consistent with the positioning? Do our customers really hold strongly to the idea that they get what they pay for?
- Demand Curve – How does our pricing affect demand? Have we done the basic market research to find this out, even if it’s informal? Is the best long-term prospects for our business a model based on high volume with lower per unit gross margins or low volume high gross margins? How does our pricing strategy impact this strategy?
- Cost – Do we truly understand the mix of fixed and variable costs associated with our 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.
Setting pricing policies begins with defining your company’s objectives as to what the company wants to accomplish.
- 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 economies of scale. For a well-funded company, revenues may be 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 with the goal of eventually reaching targeted profitability.
- Maximize quantity – There are a couple of possible reasons to choose this strategy. It may be to focus on reducing long-term costs by achieving economies of scale. This approach might be used by companies that are well-funded by its founders and other 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.
There are a number of methods companies utilize to establish pricing. The following are some of the more common approaches:
- Cost-plus pricing – Set the price at your production cost, including both cost of goods and fixed costs at your current volume, plus a targeted 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 unit price should be $385 ($250/(1-35%)).
- Value-based pricing – Price your products based on the value it creates for the customer. This is usually 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 policy to always understand your value proposition to your customers.
- Psychological pricing – Ultimately, you must take into consideration the 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 growth and middle market company. During your CFO search, remember that highly-skilled CFOs add significant value to their companies by proactively working with every aspect of the business to enable management to clearly understand cost drivers, areas of potential margin enhancement and impacts of activities to grow revenues. CFOs who can successfully deliver this significant value-add understand the critical link between finance and operations. Harvest CFOs are highly-skilled at linking finance and operations to align pricing policies with the company goals toward improved profitability.
