How hard a game is pricing? Learn from my example.
Many years ago, I ran a manufacturing company that supplied a number of large U.K. and U.S. retailers. Our customers beat us up all the time on pricing. Sometimes I gave them breaks, mostly out of fear. Eventually, in the recession of the early 90s, I had to close the business. A year later, I ran into the buyer for our largest customer. She told me how sorry she had been to see us close, because she had been unable to find a product similar to ours at a similar price. All of her alternatives were much higher-priced.
She was trying to be nice, but I went home that day knowing I was a fool. By allowing customers to push me around on price, I had been leaving money on the table--money that might have kept the business alive. I had priced myself into an early grave.
If you don’t want to join me there, you need to take a hard, hard look at pricing. Pricing is where the rubber meets the road – where your internal costs smack up against customers’ willingness to pay. Marketers love to talk about the four Ps: product, pricing, promotion and placement. That makes price one of four elements in the overall mix. That’s a fine way to think about marketing, but not about pricing.
If your business needs to make a profit –and most do-- the price per unit sold times the number of units sold has to be greater than the total costs, fixed and variable, of running that business. That’s it. In this simplified but realistic view of the world, the CEO knows a good deal about his or her cost structure but much less about the real customer demand. The trick is to turn the dial on pricing to see if you can make the inside and outside realities line up.
The inside reality
This is the actual cost structure of your business. Sure, you know how much it costs to provide your goods or services. That’s just the start. To really understand your cost structure, ask yourself these questions:
- How much variety is there between customers in terms of what they cost you? I bet some of your customers are cost hogs and others are wildly profitable.
- How do your costs vary with volume? Once you’re up and running, how much does it cost to make an additional unit? For a software company, each incremental copy of a piece of software costs a negligible amount to produce. Or does the 10,000th widget cost you almost as much to make as the first one? That’s the problem auto manufacturers often have to deal with.
Once two or more of your direct competitors have made a big improvement in costs, you have to match them or you are no longer viable. Price can cure many ills, but it is the rare company that can use price to cover for an uncompetitive cost structure.
The outside reality
Now you need to do a 180-degree turn and forget entirely about your cost structure. Instead, step into the customer’s shoes. What is your product worth to them? The customer doesn’t know what it costs you to make a product, doesn’t need to know, and sometimes doesn’t even care. What matters is the perceived value of your product and how much someone is willing to pay for it. More precisely, you want to figure out how many customers you’ll lose for every percentage point increase in your price.
It sounds easy enough to find this out, but unfortunately everyone you are dealing with will want to lie to you. Science fiction writer Robert Heinlein once wrote that everyone lies about sex. Well, in business, everyone lies about price. Your customers want to pay as little as possible, so they are not going to tell you what they will really pay. If your sales team is paid on commission, they see lower prices as a way to get deals closed. They don’t suffer (at least not right away) if the business loses money. They too will lie.
Your only option is to continually push the limits on price, testing the customer and monitoring the result. You have to find out what the real “walk away” is. If you’re selling to consumers, there are a myriad of ways to do this, using marketing, A/B testing, focus groups, graduated pricing schemes and even Groupons. If you’re selling to businesses, you have to be willing to push the pricing to the point that you will indeed lose some deals. And when you do lose a deal, you need to understand the real reason why you lost it, and not just automatically chalk up the outcome to price.
Finally, sometimes there is pricing version of the Hail Mary pass. If you have a business that is losing money, then the last step before giving up should always be to raise prices. This is the no-lose, last-ditch play. If it works, then you know your pricing was naïve, and now you’ve fixed it. If it doesn’t work, then you know that the world does not value your product enough to pay the costs required to produce it. You don’t have a business, but at least you know why. Don’t wait until it is too late.