Factors to Consider When Developing a Pricing Model

Types of Pricing Models · Cost-based pricing. Costing out your price which essentially take all costs into account and the desired profit, and the total of these ... 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AbouttheBook Asolidpricingprocesswillenableyoutodifferentiateyourpricingacrossdistinctmarketsegments.Unfortunately,themostcommonpricingstrategiesareoftennotaverygoodapproach.InasurveyofitsmembersbytheProfessionalPricingSociety,30percentofrespondentssaidtheypricednewproductsbymirroringtheirnearestcompetitors,andanother22percentsetnew-productpricestorecovercostsandtackonaprofit.Only18percentsaidtheydidcustomerresearchtodeterminethevalueoftheproductorservicetopotentialcustomers. Higherprofitabilitytargets,greatercompetitivepressures,andtheemergenceofnewtechnologiesareallimpactingacompany’sapproachtopricing.Whyisapricingmodelimportant?AMcKinseystudyfoundthata1percentchangeinpricecouldresultinan8.6percentchangeinprofitability.Thecompanyfoundthatpricingcanhaveagreaterimpactonthebottomlinethanjustreducingcosts.Forexample,a1percentimprovementinfixedcostsgeneratesonlya1.7percentincreaseinoperatingprofits,whilethesame1percentimprovementinvariablecosts(includingrawmaterials,labor,etc.)begetsa5.9percentriseinoperatingprofits. Asaresultmanyorganizationshaveaskeduswhatfactorstouseindevelopingamodelthatisrightontarget. APricingProcessPaysOff Otherresearchsuggeststhatyour pricingprocesscanincreaseyour company’sprofitabilityfrom25%to75%.Mostcompaniesdon’thaveapricingprocess.Pricingistreatedmorelikeaneventthanaprocess.Whateverpricingmodelyouselect,accountforthesefourelements: Welldefinedstandards.Establishallowablediscountrangesandotherstandardstoensureaccountabilityandcontrolandfacilitatedecisionmaking. Clearperformancemeasures.Determinewhatkeyindicatorsofpricingperformanceyourcompanywilluse,suchaspercentageofvolumesoldatadiscountortherateofcompliancetothevolumediscountstructure. Investinpricingoptimizationtoolsthatwillhelpyoufindtheoptimumvolumeandmargin. Establishrewardsfocusedonmarginratherthanrevenue. DevelopaPricingStrategythatCommunicatesSolutionValue We’vebeeninvolvedinafewpricingstrategyandmodelconversationslatelymostlyaroundthequestion,“Whatistheidealpricingstrategy?”Almosteveryconversationcoversthesebasictenets: Developastrategythatwillcapturethevalueoftheproductorserviceforaparticularcustomerorcustomersegmentwithoutputtingthebrandatrisk. Makesureyourpricingstrategytakestwomarketingactivitiesintoaccount: priceformulationandpriceexecution. oThepriceformulationisthedevelopmentofthestrategy,tactics,guidelinesandpoliciesandshouldbedrivenbypricingobjectives,productioncosts,customerdemand,competitivebehavior,andenvironmentfactors(suchaspriceregulationsandthestateoftheeconomy). Deriveyourpricingobjectivesfromyourcorporateobjectives.Ifthecorporateobjectiveistoincreasenetprofitsby10%peryearoverthenextfiveyears,thenastrategywillneedtobedevelopedtoincreaseprofitability.Thestrategymightbetogrowmarketsharebyintroducingnewcustomer-requestfeaturesintoaproductwithapricingobjectivetomaximizeprofitforthisnewproduct. Youwanttodevelopastrategythatwillcapturethevalueoftheproductorserviceforaparticularcustomerorcustomersegmentwithoutputtingthebrandatrisk.YourpricingstrategyshouldtaketwoMarketingactivitiesintoaccount:priceformulationandpriceexecution. Thepriceformulationisthedevelopmentofthestrategy,tactics,guidelinesandpoliciesandshouldbedrivenbypricingobjectives,productioncosts,customerdemand,competitivebehavior,andenvironmentfactors(suchaspriceregulationsandthestateoftheeconomy).Thepricingobjectivesshouldbederivedfromyourcorporateobjectives.Ifthecorporateobjectiveistoincreasenetprofitsby10percentperyearoverthenextfiveyears,thenapricingstrategywillneedtobedevelopedtoincreaseprofitability.Thestrategymightbetogrowmarketsharebyintroducingnewcustomer-requestfeaturesintoasolutionwithapricingobjectivetomaximizeprofitforthisnewoffer. TypesofPricingModels Beforefinalizingtheprice,use avarietyofdifferentmethodstocalculateyourprice.Commonapproachesinclude: Cost-basedpricing.Costingoutyourpricewhichessentiallytakeallcostsintoaccountandthedesiredprofit,andthetotaloftheseareusedtosettheprice.Whenusingthismethod,itisimportanttoaccountforbothindirectanddirectcosts.Directcostsarethoseyouincurwhendeliveringyourserviceandtypicallyincludelaborandmaterials.Indirectcostsarealltheothercostsnotaccountedforinyourdirectcosts,andincludethingslikerent,insurance,phoneandutilitybills,andofficesupplies.Theseindirectcostscovereverythingyouneedtokeepyourbusinessoperatingeveryday,whetherornotyoumakeanysales. Competitive-basedpricing.Inthismethod,beforeyousetyourpriceinvestigatewhatpricesyourcompetitorsarealreadygetting.Iftheirpricesaredifferentforthesameoffer,trytounderstandwhy.Ifhigher,whataretheyofferingtojustifytheprice?Ifthey’relower,isitbecausethereisaqualitydifference,acostdifference,orsomeotherreasontheyareabletoofferalowerprice?Ifyoucan’tjustgotothestoreorawebsitetodocompetitivepricing,hereareafewotherwaystogathertheinformation.Asksomeofyourbestcustomersiftheywillsupplyyouwithapricesheetfromcompetitors.Askyourtradeassociationiftheymonitorpricingamongthetradeandwhatinformationtheyhave.Interviewpeoplefromthecompetitorforjobopenings. Position-basedpricing.Thismethodaccountsforhowyouwanttobeperceivedinthemarket.ThinkFordtruck,nowthinkToyotatruck.Differentperceptions,differentpositioning,differentpricing.Ifyoudecidetotakeapremiumpriceposition,youwillmoreexpensivethan2/3oftheothersimilarproducts/servicesinyourcategory.Abudgetpricepositionsuggeststhat2/3oftheothersimilarproducts/servicesinyourcategorywillbemoreexpensivethanyou.IfyouchooseMiddleMarket,yourprice(s)shouldfallwithinthemiddlethirdofallpricesinyourmarket.Acommonpracticeistosetapricelowandthentrytoraiseitovertime.Mostpricingexpertsbelievethisisaterriblemistake.Oftentimesyoucannotrecoverenoughofyourinvestmentifyousetyourproductcosttoolow,potentiallyendangeringyoursurvivability.Inaddition,settingtoolowapriceleavesyounoroomtonegotiate.Ittakesverydeeppocketstousethisstrategy.Italsopotentiallysendsamessagethatinsomewayyourproductisoflowerqualitythanthecompetition.Ifafteryou’vedoneyourhomeworkandareconsideringtwopricepoints,choosethehigherone.Thiswillpositionyouashigherqualityandwillensureadequateprofitabilityfromtheget-go.Andshouldyoumeetresistanceatthisprice,youcandiscountdowntoanacceptableprice. Value-Basedpricing. Value-basedpricingisbasedonunderstandingthattheoverallvalueofanofferingtoanyonebuyer FactorstoIncludeinYourPricingModels Whatfactorsshouldgointobuildingyourmodel?Marketandcustomer-centriccompaniesshouldaccountforthefollowingwhenbuildingapricingmodel Customerbehavior,expectations,relativesizeofexpenditure,price-qualityperception Competitivebehaviorandsubstitutes(theavailabilityofalternatives) Value-yoursolutions end-benefit(therelativevalueorneedfortheproductorservice)anddifferentiators(thespecialfeaturesorservicesthatdistinguishtheproduct) ConsiderationsforPricingNewProducts AccordingtoMcKinseycompaniesconsistentlyunderchargeforproductsthinkinglowerpriceswillresultsinaquickgrabformarketshareorreturnoninvestment.Theirresearchsuggeststhatasmuchas80to90percentofpricesfornewproductsaresettoolow! Manycompaniesforgoconductingaprice-benefitanalysistodeterminenotonlywhetherpricebarriersmightmakeproductsunfeasiblebutalsoasawaytodeterminewhichattributescustomersaremostwillingtopayfor.Insteadtheyemployacommonapproachtopricingknownasincrementalpricing,whereexistingproductsareusedasareferencepointforestablishingthenewproducts’price.Theincrementalapproachoftenunderestimatesthevalueofnewproductsandwhilethisapproachmaycreatedemandforanewproduct,potentialprofitsarelost. Hereareimportant considerationsfordevelopingyourprice. Isyourproductame-tooproduct,thatis,doesitreplicateothersinthemarketoroffersmallimprovements?Ifso,thenincrementalpricingapproachesmaycomeclosetotheoptimalprice.Justareminder,incrementalpricestendtofocusonthelowerendofthepricerangeso,it’sverylikelyyouwillleavemoneyonthetable. Doyouknowthepriceceiling?Establishaceilingbeforedeterminingyourprice.Thisisjusttheoppositeofincrementalpricing,thefocushereisondeterminingthehigherendofthepricerange.Todeterminethepriceceilingrequires thatyouhaveafirmhandleonthe product’sbenefits valueitcreates sizeofthemarket competitivelandscapeand degreeofmarketdemand De-RiskSolutionPricingDecisionsviaResearch Bewaryofrelyingtoheavilyonyourinternalperceptions.Marketresearchismostlikelygoingtoneedtobedonetoestablishapriceceiling.Besuretoavoidbuildinginabiaswhenyoudoyourresearch.Askasmanyopenendedquestionsaspossibletogainanunderstandingofyourcustomers’economics. Haveyouassessedtradeoffsandbenefits?Deployconjointanalysisandperceptualmappingtoassesshowmuchvalueeachbenefitofferstocustomers.(Conjointanalysisexaminesthedirecttrade-offsamongcompetingproducts.Perceptualmapping,whichassessesthebenefitsofdifferentproductsthatmaynotbedirectsubstitutesforoneanother,seekstoidentifythebenefitsthatnootherproductoffers). Doyouknowtheactualcostofyourproduct?Anaccurateanalysisofcostsperunit,plusamarginrepresentingaminimallyacceptablereturnoninvestment,revealsanewproduct’slowestreasonablepricelevel.Whenyoudothisanalysisbesuretoaccountforallcoststhatshouldbeallocatedtoproducts;includingR&Dexpensesassociatedwithaproductcategoryandgoodwilllinkedtoacquisitionsthatleaddirectlytonewproducts. Doyouknowthesizeofthemarket?Similarresearchisneededtogaugethesizeofthemarketormarketsegmentsforvariouspricesatandbelowtheceiling.Estimatingthesizeofamarketatvariouspricepointsclarifiestherangeofpricingoptions,suggestswhichpricemodelstouseatanypriceandvolumepoint,andincreasestheaccuracyofestimatesofprofitabilityalongthespectrumandoftheunit-costcalculationsneededtodefinethepricefloor. Whereistheproductinthelifecycle?Isthisaproductaimedatearly-adoptersorthelatemajority?Earlyadoptersmaybewillingtopayapremiumenablingyoutocapturetheextravalue. Whatimpactwillthenewproducthaveonyourexistingportfolio?Itmaybeimportanttoestablishahigherreferencepricetomanagecannibalization. Onceyouhavetheanswerstoabovequestions,youarereadytoformulateaprice.Whenyouestablishyourreleaseprice,youaretellingthemarketwhatyoureallythinkyournewproductisworth.Indoingsoyouarecreatingareferenceprice.Bewaryofestablishingtoolowareleasepricewhichwillcreatealowreferenceprice.Alowreferencepointgenerallysignalsacompanyistargetingmarketshare.Thisstrategyisknownaspenetrationpricingandoftentriggersaresponsefromcompetitorsresultinginpricewar. Itmaymakesensetoundercutthecompetition,butthisshouldbeaveryconsciousstrategicdecision,notanoutcomeofpoorpricing.Iftheproductistargetinganeworunderdevelopedmarketandifthetargetcustomersareparticularlypricesensitive,thecompetitionisweak,andyoubelieveyoucanquicklybuildapresenceandestablishyourselfasthemarketleader,thepenetrationpricingmaybeappropriate.Beadvised,thisisariskystrategyandyoucanultimatelyendupforfeitingprofits.Ifthecost-toserveisgoingtodeclinerapidlyandthedemandisgoingtorisesharply,thenmarginsmayriseovertimeenablingyoutocaptureprofitsusingthisstrategy. Ifyoucan,weadviseestablishingahighreferenceprice,whichgenerallysignalsacompanyistargetingprofits.Highreferencepricestypicallygeneratefewifanyimmediatereactionsfromcompetitors.Ratherthanofferingtoolowapriceortoomanydiscountsearlyintheproductslife,considerwaystooffersamplesortrialstospeedupmarketpenetrationwithoutimpactingtheperceptionofvalue.Standarddiscountsorrebatesareusuallyamistake,however,sincetheydocutitandalsoprovokedoubtsabouttheproduct’sbenefits. MakeSureYourPricingStrategyImprovesYourBottomLine Priceisallaboutthebottomline.Keepthesefivefactorsinmindwhenyoubuildyourpricingmodel. Customerbehavior:Asamarket-centriccompany,takecustomerbehaviorintoaccounttobuildyourpricingmodel. EndBenefit:Whatisthetherelativevalueorneedforthesolutions. Differentiators:Thesearethespecialfeaturesorservicesthatdistinguishyoursolutions Substitutes:Thisaccountsfortheavailabilityofalternatives. Priceexpectations:Whathasbeenhistoricalandcompetitivepricingforthistypeofproduct/category.Alsoconsidertheprice-qualityperception,relativesizeofexpenditure,anysharedcostsandthebehaviorsyourcompetitorsarelikelytotakeinreactiontoyourpricingstrategy Onceyouhaveformulatedthepricingmodel,yournextstepisto addresspriceexecution,whichinvolvescapturing,configuringandinstitutionalizingthestrategy. Let’stalkifyouneedhelpdevelopingyourmodel. Sharethis:ClicktoshareonTwitter(Opensinnewwindow)ClicktoshareonFacebook(Opensinnewwindow)ClicktoshareonLinkedIn(Opensinnewwindow)ClicktoshareonReddit(Opensinnewwindow)Clicktoprint(Opensinnewwindow) Commentsareclosed. 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