Most companies set prices to optimize profits at similar
selling volumes. In either price-elastic markets or where
marginal costs are low, that is a mistake.
Further, many companies look only at their own prices
rather than what it costs a customer or end user to acquire
and employ the offering. While not every offering can be
vastly more attractive at a lower total cost to the
customer or end user, many will. Companies need to vastly
increase their testing to identify opportunities to expand
volume profitably through changed pricing structures.
With a pen you can change your profits by adjusting your
prices. That's a lot easier to do than finding and
implementing a lot of subtle value improvements at the same
price.
Do you know what price adjustments you should make? A
spreadsheet can tell you the profit impact . . . if you
know what the volume effects can be. But you know that most
of your volume estimates will be way off the mark.
To overcome those potentially expensive errors, you need to
test new prices first. But you already test prices. What's
different from what you have been doing if you are to
create an improved business model?
You now sell a product at a dollar a unit. You want to find
ways to increase your profits from this product. Normally,
you would test a slightly higher price in one geographic
market to see how it goes. That price might be $1.05. Your
average cost is $0.80 for the product.
If the sales stay about even with what you expect, you will
probably make that price increase in all territories. That
apparently profitable change in price could be a major
missed opportunity, but you'll never know it.
Consider an example to help illustrate other ways to think
about changing prices.
Let's consider an alternative that you probably didn't
test. Because it would only cost you $0.25 (the marginal
cost of the product) to sell more of this product, you
decide to sell it at $0.80 instead. If the volume you sell
increases by at least 50 percent, you make more money.
If you don't have to invest in more equipment or working
capital and you are the low cost producer, this is a better
deal because competitors will have a harder time making
inroads against you in the future and you have just
increased your relative cost advantage. If you are a high
cost producer, all that may happen is that you will set off
a price war that you will lose.
The competitors may ignore your test, which will make the
test results misleading. But they will not ignore a full
roll-out.
Now, consider a second alternative that you probably didn't
test. The product's price stays at $1.00 for the volumes
purchased in the last year, but for increased purchases
above that level the price is $0.70. If total volume
increases by at least 15 percent, you make more money.
Again, if you don't have to invest more to make this money
and you are the low-cost producer, you are ahead. The price
war risk is much less if you are not the low cost producer.
Then, look at what else these customers purchase. Maybe
they need another product to go along with this one. The
other product costs $0.10 and sells for $1.00. In this
test, you price the first product at $1.00 on existing
volumes, and the increased purchases at $0.40. If the
purchased volumes of both products go up by at least 5
percent, you make more money before considering required
changes in investments.
If customers need both products, you also should consider
how price elastic the first product is versus the second
one. You may make more money by cutting the price of the
second product for incremental volumes and holding the
price of the first product.
Now, all of this evaluation could easily be faulty. Why?
Well, the customer may simply be storing the product in a
warehouse somewhere and there is no real increase in
consumption.
This would occur if the benefit of the better prices solely
went to increase profits of the customer, and you already
had 100 percent of that customer's business. If you were a
small market share competitor, the strategy of one of these
price reductions might be the right one. If you were a
large market share competitor, it is less likely to work
well except in the two product example.
Instead, you could aim your incremental price reduction at
the end user. This might mean that you offered a rebate to
consumers who haven't tried your customer's product before
and are likely to find your product desirable. Or you might
share the cost of free samples for new accounts that your
customer has not done business with before. Depending on
whether or not the end user was more or less price elastic
than your customer, this would or would not be a good idea.
Imagine that we are talking about services instead. In
many cases, the extra cost of supplying more services is
extremely low (such as more hours of connection time to an
Internet Service Provider). In this case, the price of the
extra service might be $1.00 and the cost of providing more
might be $0.01. In many cases, one service also affects
the usage of another service. In such a case, the correct
price to optimize profits (before considering increased
investments) could be vastly lower than where it is today,
assuming that you could supply all of the demand that was
stimulated. Done quickly, competitors might not be able to
respond at a time when they are out of capacity, and you
might also grasp large relative improvements in average
costs at the same time.
Do you still think that keeping the current pricing
structure and testing small increases is the way to go? I
hope not.
Copyright 2008 Donald W. Mitchell, All Rights Reserved
----------------------------------------------------
Donald Mitchell is chairman of Mitchell and Company, a
strategy and financial consulting firm in Weston, MA. He is
coauthor of seven books including Adventures of an
Optimist, The 2,000 Percent Solution, and The Ultimate
Competitive Advantage. You can find free tips for
accomplishing 20 times more by registering at:
====> http://www.2000percentsolution.com .
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