How to Price for Profitability

Pricing strategy is crucial to any business’s profitability. Optimal pricing can increase revenue and help a business’s bottom line, but it is a tricky exercise. Prices that are set too high or two low can affect sales volumes, restrict profit margins, cause cash flow problems and stunt business growth. It can also misrepresent your brand image and make your business less competitive in the marketplace.

A 1992 study by McKinsey & Company strategists Michael V. Marn and Robert L. Rosiello reports the effects of volume and price on profit. They found that a 1% improvement unit in volume led to a 3.3% increase in operating profit, whereas a 1% improvement in price increased operating profit by 11.1%.

The importance of price as a factor of profitability appears to have increased over the decades. In 2011, researchers Andreas Hinterhuber and Marco Bertini reported a 2% price hike increased operating profitability by 14% for top earning-companies in the US. They argue for a value-based approach to pricing for profitability – and we look at their reasons why.

 

Pricing strategies

Businesses can approach pricing with one of three approaches: cost-based, competition-based and value-based.

Cost-based pricing involves adding a target profit to the cost of a product in order to determine a selling price. Competition-based pricing considers the larger ecosystem that houses a product or service, paying particular attention to prices set by competitors.

Value-based pricing, however, takes into account the willingness of a customer to pay for a product or service, as well as customer price elasticity.

 

Value-based pricing

Hinterhuber and Bertini present the case of a large European supermarket chain looking to label a type of yoghurt with health benefits. Faced with a cost of €1.29, the company sought to sell the product for €1.99, giving it a healthy markup while remaining competitive against a branded product which was priced at €2.99.

Surprising research results reported that the health benefits of the upcoming product were valued at around €0.30. However, the absence of an established brand set the product back by €0.50. After taking into account other factors, Hinterhuber and Bertini recommended that the company sell the product at €2.49 – and enough customers were willing to pay this price – so that profits increased sixfold.

 

Value-Based Pricing – Obstacles and Solutions

Despite the benefits of value-based pricing, Hinterhuber and Bertini found that it was not a popular approach, with 80% of companies pricing products based on cost or competitor prices. Determined to find out why, the pair interviewed executives worldwide to determine the top five perceived obstacles that these executives had to value-based pricing.

Obstacle 1: They don’t have the tools to measure customer value with confidence.

Solution: Hinterhuber and Bertini suggest obtaining rigorous, empirical tools to measure and track customer value. These include conjoint analysis, expert interviews, and other forms of asessments to help businesses understand customer value.

Obstacle 2: They struggle to communicate the value of what is being offered.
Solution: Rather than providing product features and technical characteristics, which are relatively quantifiable, businesses should focus on communicating how key features of their products can benefit customers or clients.

Obstacle 3: Poor market segmentation thwarts attempts to fully understand customers.
Solution: Despite the wide variety of methods used to segment customer bases – such as age, gender, income type, business size and more – many businesses are still scratching the surface when it comes to understanding these segments. Instead of using generic categories in segmentation, businesses should focus on customers’ needs first and foremost.

Obstacle 4: Motivating their salesforce to sell based on value.
Solution: A business should have clear guidelines and systems in place in order to motivate its sales force to focus on the value, rather than price, of the products offered. At Smart Currency Business, we remunerate our salesforce on customer satisfaction and retention, rather than on commission. This means that our traders are more motivated to help customers get the most that they can out of a transaction.

Obstacle 5: Lack of senior management support.
Solution: Senior managers also have to buy into the concept of selling based on the value of a product. They need to recognise the importance of quality over quantity when it comes to market share, and motivate their teams accordingly.

 

Promote Benefits, Not Prices

Different businesses may require different approaches to pricing. However, value-based pricing has a significant influence on profitability. Customers should be encouraged to pay prices that they are comfortable with given the perceived benefits of a product; this allows both the business and the customer to profit from a sales transaction.