If you’ve ever been involved in setting up the pricing strategy for a product or service you know how challenging the task can be. Charging too little might have a disastrous impact on profitability, while charging too much might leave you with no customers.
The classic demand curve shows that a lower price results in more units sold, and vice versa.
In reality, finding an optimal price is not that simple, as many trade-offs are required.
In Search of the Optimal Price: Maximize Profits or Market Share?
The optimal price is the price you are able to charge your customers that ensures maximum profitability for your business.
A question that is asked a lot is: what should be the goal of our pricing strategy? Maximize profits or capture market share?
Ideally your goal should be profitability. Contrary to popular belief, a business with dominant market share is not always profitable.
If your goal is to increase market share, your first temptation will be to slash prices, to a point where profitability and brand building initiatives such as advertising and new product introductions might be put on the back burner.
Not a wise long term strategy.
What “Too Expensive” Really Means
A business deals with a mix of customers: some who are willing to pay more for your product, some who are happy with the current prices, and some who think your product or service is too expensive.
The words “Too Expensive” cause a lot of frustration, especially among sales people who are quick to pressure management for lower prices as soon as they hear them.
But in most cases, at least in the developed world, too expensive doesn’t mean “I can’t afford it”. What it really means is “the perceived value the product delivers is not worth the price charged”.
Let me give you an example.
A friend of mine drives a luxury car but doesn’t subscribe to cable TV. Instead, he’s using an over the air antenna and is very happy.
His argument for cutting the cable was “it’s too expensive”. What he really means is not that he can’t afford it, but for the amount of TV he watches, paying for cable doesn’t make sense.
In developing countries, people often complain about the price of food and other everyday necessities. The same people will be happy to show you their latest smart phone, or piece of designer clothing.
Some Factors That Affect Your Pricing Strategy
The goal is to find the right the right balance between the price you charge and the quantity sold. The relationship is not linear. Here are some factors to take into account in your search for the optimal price:
Fixed and variable costs– the obvious first step is to account for all the costs associated with the product or service being marketed. Most established businesses have pretty good systems in place to track fixed and variable costs, however new businesses might experience lower than expected profits due to costs that were not anticipated.
Availability of substitute products-if consumers are able to find alternative products that satisfy the same need, your ability to charge a premium price for your product decreases substantially.
Brand image-there is a direct relationship between how a brand is perceived in the marketplace and its pricing strategy. Many great products fail to gain market traction because they are marketed under the wrong brand.
Volkswagen Phaeton had features comparable to the Mercedes-Benz and BMW models, and was priced accordingly.
Sales fell short of expectations not because of the lack of features or marketing efforts, but simply because luxury consumers could not associate the Volkswagen brand with “premium”.
Level of product differentiation– companies who offer innovative and differentiated products are in most cases able to enjoy comfortable profit margins and should charge a price premium. A higher quality product is most costly to develop and produce, so the higher profits could be used to offset some of these costs and deliver sustainable innovation.
Level of competition in the category-as a general rule, the more competitive a category is, the greater the pressure or price and profits.
Demand seasonality-if most of your sales occur during a specific time period, your prices will have to be adjusted accordingly.
Market segmentation-a valid strategy to improve profitability is targeting distinctive customer groups, such as residential and business customers. Generally speaking business customers are willing to pay more for a particular product that might be only slightly more costly to produce than the equivalent consumer version.
Ability to offer complementary products-these are products that is sold and used with another product. Examples of complementary products are printer cartridges, or razor blades. Complementary products are highly profitable as they enhance the core product or make it fully functional.
Go-to-market strategy-if you design your product to appeal to a lot of consumers (mass market) the price you will be able to charge is typically lower. If you adopt a niche market strategy, which usually involves a certain level of product innovation, will attract consumers are who are willing to pay more.
As you can see, understanding the demand curve for your product or service is key in determining the optimal price. A sound pricing strategy also requires a thorough analysis of your business capabilities and good understanding of the competitive environment.