Is It Time to Raise Prices?
Boost your bottom line by taking the guesswork out of pricing.
Ross McDonald
Scott Pasfield
SAM CALAGIONE OF DOGFISH HEAD CRAFT BREWERY: "When we add new products, we always add them at higher prices. So while our median price level has increased significantly, we can honestly say that we've never raised prices."
Scott Pasfield
MARC CENEDELLA OF THE LADDERS.COM: "From our point of view, we're charging only a fraction of the value we provide."
Every time he closed a sale, Kris Simmons kicked himself. That's because Simmons, president of Fire Eye Productions, a video production company based in Chattanooga, Tenn., knew he'd done it again: He'd set his price way too low. A client would ask for a quote, and Simmons would toss out a number based on some combination of his company's cash flow at the moment, his own fear of losing a customer, and what he'd begun charging when he founded Fire Eye four years earlier. "Basically, I'd throw a price out there and see what they'd take," he says.
From the outside, Fire Eye looked like a big success; Simmons was even nominated for the 2004 Young Entrepreneur of the Year Award given by Tennessee's small-business administration. But inside, the company was falling apart. Working 18-hour days to keep up with demand, Simmons had no time to make sales calls, which meant that cash flow was always erratic. He would hire employees, let them go when receivables dipped -- and then hastily hire them back when the work flowed in again.
By August 2004, Simmons was fed up and exhausted. He knew what he had to do. He had to raise prices. A price hike would mean he could work fewer hours, earn more money, hire employees, and buy new equipment. On the other hand, if he raised his prices too high -- and who knew how high was too high? -- he would risk alienating his longtime customers. If he lost them, Simmons knew, Fire Eye would not survive. "These clients are my bread and butter," he thought. "If I make them mad and they leave, then I'm in a whole different kind of bad situation."
There's no more important number than the one on your price tag, and nothing provokes a case of the cold sweats like the thought of raising it. After years of almost no inflation, relentless downward pressure from places like China and India on the price of almost everything, and comparison shopping at the click of a mouse, it's more competitive than ever out there. It's easy to see why fewer than one-third of business owners surveyed by the National Federation of Independent Business reported in February that they had increased their prices over the previous three months.
But that could be a big mistake -- especially today, which might be the best opportunity companies have had to raise prices in some time. In March, the consumer-price index rose 3.1% over the previous year. If you're holding prices steady at a time when they are generally increasing nationwide, you may be surrendering more of your margin than you need to. "This is a very important time for everyone to review their prices," says Brent Lippman, CEO of Khimetrics, a pricing consultancy in Scottsdale, Ariz.
On the other hand, you can't raise prices if you haven't set them appropriately in the first place. Ask entrepreneurs how they arrived at their prices, and once you get past the usual stuff about optimization, segmentation, and market conditions, you'll often hear things like "it was pretty arbitrary" or "we go by our gut." Unfortunately, the gut often gets it wrong. "Entrepreneurs tend to keep prices too low," says Reed K. Holden, founder of Holden Advisors in Concord, Mass., and the co-author of The Strategy and Tactics of Pricing, a widely used text on the subject. Robert J. Dolan, dean of the Ross School of Business at the University of Michigan and co-author of Power Pricing: How Managing Price Transforms the Bottom Line, agrees. "You're likely leaving money on the table," Dolan says.
How do you make sure that money ends up in your pocket instead? Every industry has a dynamic of its own, and it would be hard to find two businesses that take the same approach to pricing. Still, there has been plenty of recent research into how consumers behave, examining how they assign value to goods and services and how smart managers can alter those perceptions. These insights can be valuable for any entrepreneur, in any industry.
But before we get to that, a quick primer on the wrong way to set prices: Many business owners base their prices on their costs, adding in a certain profit margin on top. "They say, 'Hey, if I could get my costs, plus 20%, that's not a bad business," says Dolan. Well, it could be a better business -- if you could get a 40% margin. Others look at what their competitors charge and seek to bring their own prices in line or charge less. That may be your only option if your product or service is identical to that of the competition. But how do you know that your rivals know more about pricing than you do? And if you undercut them, you risk sparking a margin-killing price war. Then there are those who consult with customers before arriving at a price. But customers, obviously, have a powerful incentive to get you to keep your prices as low as possible. Setting prices based on what your salespeople report back can lead to similar problems. "Salespeople want to close deals, and they use price as a way of doing that," says Holden. "But that can be inconsistent with the real need of the business -- profitability."
Of course, you can't make smart pricing decisions without taking your costs, competitors, customers, and salespeople into account. But nearly all experts agree that making any of those factors the primary basis for your decision is a big mistake. Instead, the right price for a product or service should rest on one thing -- the value that a product or service provides.
When determining your prices, says John Gourville, a marketing professor at Harvard University who studies pricing, the first question to ask is this: How much would a rational consumer be willing to pay for your product, assuming the consumer had a perfect understanding of its actual worth? It sounds easy. But while most business owners spend a good chunk of their time touting the benefits of their products and services, "they haven't tried to monetize those benefits," says Brent Lippman. The first step toward creating a pricing strategy, then, is to do just that -- think through the benefits of your product and make a rough calculation of what you think they're worth in dollar terms.
Marc Cenedella went through this process in 2003, when he was setting subscription rates for his start-up, TheLadders.com, an electronic job-search service that lists only positions paying more than $100,000. Most career sites allow job seekers to search for free and make money by charging employers. Cenedella's strategy is different: He charges job seekers and lets employers list their six-figure positions for free. After many meetings with "way too much pizza," Cenedella and his team arrived at their value figure: somewhere between $10,000 and $40,000. Their assumption was that a job seeker who used their site would find a position at least one month faster than one who didn't. Since that job would pay $100,000 or more, the value of the company's service translated to roughly one month's take-home pay, or somewhere between $10,000 and $40,000, depending on the job.
