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When It's Time to Raise Prices

Need to make more money from your customers? Here's why a price hike might be your best option.

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Internet music company Pandora is one of those businesses that can do well in the stock market just by not doing as badly as people expect. Revenue grew 58%, as was announced Wednesday, but losses more than doubled year-over-year. Now, most entrepreneurs don't have to worry about keeping stock prices up, but there's an important lesson to learn from Pandora's roller coaster: Sometimes you need to face the music and ask customers to pay more.

Why Pandora Is in the Red

The ongoing problem for Pandora is that even as it grows, with the active audience increasing 53% year over year, so do the music royalties it must pay. As a result, its quarterly earnings reports have shown a constant flow of red ink.

When the cost to provide goods or services is too high, you lose money. You have two choices: decrease costs or increase revenue. General and administrative costs are 12.6% of revenue. Marketing is nearly 30%--on the high side--but the company is trying to grow its revenue base. Product development (R&D) is 5.1%. That's just under 48%.

The real problem for Pandora is the cost of licensing music. The combination of cost of revenue and content acquisition expenses are 77.7% of its gross revenue. That's one brutal ratio and the key place to lower costs. Except, Pandora already negotiates with the board that sets royalty rates.

If it's not coming out of expenses, it has to get added into revenue. Add enough dollars into the till through higher prices and Pandora could take care of the acquisition expenses (assuming that they remain fixed) and still pay the other expenses, which now become a smaller percentage of revenue.

The Argument for a Price Hike

That's where the lesson comes in. Companies and entrepreneurs are often afraid to raise their rates, particularly if they perceive that they set them too low in the first place. There's that nagging question of whether people actually do like your product or service that much.

Why assume that they don't? I can't speak for other Pandora subscribers, for example, but the $36 annual fee is trivial. I could easily justify paying more to continue to get the music that I want. Price elasticity is a real economic principle, and there are times that consumer sensitivity won't allow you to charge more than a given amount.

But this isn't an absolute question. Yes, raising prices might drive away some customers, but that is fine if you bring in enough extra revenue from others to more than make up the gap. Have you noticed that a company like Starbucks will occasionally raise prices? It probably loses some customers but on the whole makes more money.

Instead of assuming that people won't pay more, why not do some investigation? Run a survey. Talk to your customers and see how price sensitive they seem to be. Try introducing a more expensive product line and watch the response. Raise prices in a particular promotion or at one location to gauge the reaction.

Do some testing and questioning and you may find that the only person afraid of higher prices is you.

IMAGE: Jack Flash/Getty
Last updated: May 25, 2012

ERIK SHERMAN's work has appeared in such publications as The Wall Street Journal, The New York Times Magazine, and Fortune. He also blogs for CBS MoneyWatch.
@ErikSherman




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