The pricing challenge: how much should you be charging, and how to arrive at the equation

A company’s pricing strategy can be a complex, frustrating and intricate maze for business leaders to navigate. Models, methods, equations and theories abound, and when it comes to deciding how much you should be charging, they all serve to challenge and optimise the status quo in search of greater margins or market share.

But how do companies deal with these challenges? Are pricing strategies based loosely on market rates, or are they entirely driven either by market rates or competitors’ pricing strategies? And is everything down to the concept described by economists as price elasticity?

First, it helps to look back at how companies typically arrive at their pricing strategy, and try and analyse those important ingredients – market forces, economics and gut feeling – as well as work out the often-dynamic proportions of those ingredients.

It’s also important to weigh those ingredients against the backdrop of your business strategy; are you after market share, maximising profit or trying to defend your existing market? Do you believe prices in your market are too high, and are you willing to exchange profit margins for market share?

The elasticity of demand

To start with – and this is where economics and market forces come in – smart businesses will usually understand and employ the concept of price elasticity. Demand and price elasticity refers to market characteristics where the price elasticity of demand is a measurement of the change in consumption of a product in relation to a change in its price. It’s a bit of a mouthful, I know, but in short, if a product or service is inelastic, it means that demand won’t change if the price goes up. Conversely, perfect elasticity means that demand will change dramatically with even modest changes in price. This is important to consider when looking at value-based pricing, discussed below, where customers’ varying sensitivity to price and quality or value will affect what strategies may suit your industry, sector and company profile.

To understand how an increase in prices doesn’t affect demand – inelasticity – we need look no further than the cost of commodities such as diesel and petrol, for example. Buyers – airlines, haulage firms, private motorists – rarely change behaviours according to fluctuations. They will keep buying petrol and diesel, and will make adjustments to accommodate these inelastic products. But that’s not the case for other products or services, where even minor fluctuations can cause a huge change in demand.

As economists have discovered, some goods or services are inelastic, some are elastic. So, it should come as no surprise to discover that this theory of pricing caught the attention of sales and marketing teams a long time ago. In fact, it could be argued – and often is – that sales and marketing teams exist to create or market certain characteristics of their particular product to establish differentiation from the competitor’s product. In short, they exist to create inelastic demand for their offering.

Value-based pricing

Traditionally, companies have dealt with pricing challenges by employing three principal approaches to setting prices: cost-based pricing, customer-based pricing, and competitor-based pricing. The first is based simply on adding a percentage margin to the cost of offering a product or service. The second is based on the relative elasticity of a product or service, or what a company believes customers are willing to pay. The third method uses a company’s competitor’s prices to determine its own pricing strategy, a method that’s often used to gain market share, especially in a price war.

This leads us to a fourth approach: value-based pricing. It’s certainly worth bearing in mind that, historically at least, successful business leaders have always been aware that the price customers are willing to pay for products or services is based less on cost, and much more on value. That’s to say, price is influenced by how much they value that product. In short, how much are they willing to pay?

The notion of testing what’s acceptable by comparing your product to the competition’s lies at the heart of any pricing challenge. And it’s one aspect that businesses have traditionally given the most attention to. Testing requires an intelligent approach, and strategies will vary depending on whether your product is customised, or whether it’s a commodity. After all, speculation in a commodity market can dramatically affect prices. The relationship between the price a company charges and the volume of products it sells is an easy one for business leaders to establish.

How to be a winner in the price competition

The the difficulty arises when you start dealing in increments. For example, it’s often difficult for management, as well as sales and marketing, to establish exactly how much any nominal price increase may affect sales. This is where price elasticity is crucial once again. Price rises could result in a drop in sales as customers flock to competitors. But what if you’re missing the opportunity to increase profit margins by charging more?

In many ways, this is not only a successful strategy in many industries, it’s also a winning strategy in the event of a price-war situation. Why? Because this particular strategy helps avoid a race to the bottom, where brand value and profit margins are eroded mercilessly. Price competition can emerge as the smart move in certain scenarios, but it’s crucial that business leaders can clearly see what they’re aiming to achieve. For example, if your company has good intel on a competitor’s resources, pre-emptive or even retaliatory cuts can show you mean business.

In addition, if intelligence shows a cost advantage and your resources are greater than your competitors’, engaging in a price war might be the only way to wrestle a growing market of price-sensitive customers from your competitor, especially if you can take advantage of greater economies of scale compared to those available to your competitors.

This can be a canny approach, because most customers understand the difference between value and price. This crucial understanding – and therefore your chances of success – is even further enhanced when customers pause to consider the total cost of ownership, and what bearing that may have on a product they consume over a long period of time.

Because of this, marketers set out to identify and get across the unique value propositions that set their product or service apart from competitors, such as higher quality, utility, unrivalled customer service or enhanced features. Identifying customers’ varying sensitivity to price and quality can allow businesses to respond creatively to a competitor’s price cut without slashing their own prices.

Where successful businesses excel is in not allowing margin erosion without adding value to the product. Simply cutting prices without confronting the reasons behind the competition can result in a downward spiral of diminishing returns.

With that in mind, it’s crucial to create a pricing strategy, whichever one it is, that suits your company’s current situation, cash and other constraints. It’s often a complex mix of ideas and approaches against the backdrop of a fluid market, but it has to be reality- and strategy-lead.