Consulting firms sometimes help optimize pricing. You have to be very careful in this sort of project because a small change may have a huge impact both on the top line and bottom line. Analyzing changes in pricing is not easy as you have to take into account the relations between the products and the long-term impact on customer behavior.
In this post, I will show you the main concepts you have to know to be able to do consulting projects.
3 Approaches to Pricing.
There are 3 main approaches to price setting. We will discuss how they differ when you use them, and what are the pros and cons of every approach.
- Cost-plus pricing, In this approach, you first calculate the cost of producing, delivering, marketing, and selling the product or the service After that, you assume the margin you want to earn (as a percentage or per unit). You use the costs and the assumed margin to calculate the price for the customer. This is the traditional approach that has been used heavily till the beginning of the century.
- Competition-Based Pricing. In this approach, you mainly look at the price of already existing products offered by your competitors. The price may be at the same level, below current competitors or above them.
- Value-Based Pricing. In this approach, you disregard costs altogether. You estimate what value your product or service generates for your customer. This is done usually in money. Based on that, you determine the prices of the product/service. Since the same product will have different values for every user, the price should also differ for them.
Below is a short video with an example of applying those 3 approaches.
In most situations, you will use a mix of competition-based and value-based pricing. Luckily the majority of firms are still using cost-plus or competition-based pricing so you can shock them with how smart you are by showing them a few tricks value to apply value-based pricing
Value-Based pricing can be implemented in many different ways. Below are the usual suspects:
- Similar products with different price points. You have come across it many times, in the store. Just check how diversified the price of ketchup can be. Inside you have the same product, but the price difference can be huge. Quite often, you have a different brand or package to justify the price difference. The same goes for clothes and shoes.
- Basic products with potential paid upgrades. You can also offer a basic product at the same price but give people the option to upgrade the product so it fits their needs. People with low value will stick to the basic product. People that attach high value to the product will upgrade it. This principle is used for example when it comes to cars or plane tickets.
- One price but discounts for specific groups of customers. You can also offer the same product at seemingly the same price but on top of that have a set of discounts that change, adjust the price to the customer. You can have for example discounts for buying more or being at a certain age group (e.g. in public transports students can pay 50% of the price paid by adults).
- Use value metrics to estimate the price (i.e. SaaS). One of the best ways to implement value-based pricing is to define it based on the value that the customer gets. Many Software firms will charge you per result achieved. For example, Shopify charges firms for using their software to run e-commerce as a percentage of the sales generated by the customer. In this way, the firm that sold more using software will pay more. This principle is used also by some universities in the USA. Instead of paying fixed tuition, you can choose to pay a certain percentage of your salary. In this way, students that will earn more will pay more.
- Dynamic Pricing (i.e. Airlines). In Dynamic Pricing, you set flexible prices based on current or forecasted demand. In other words, there is a big fluctuation in the prices. So, if you buy an airplane ticket 3 months ahead of time you will get a much lower price than the person buying the very same ticket 1 week before the scheduled trip.
- Multiple prices for the same products (i.e. e-commerce). Some firms by definition show different prices to different customers. For example, if you buy a product on e-commerce and you came via a price comparison tool or Facebook ad, most likely you will see a lower price than if you directly entered the site. The underlying assumption is that a person using a price comparison tool is more price-sensitive and therefore the value this customer gets from the product is lower than the person who is directly entering the online store. You can also see this principle if you abandoned the purchase. Many e-commerce stores will send you an email urging you to continue the purchase. Sometimes, they will attach a discount or a lower price to be more convincing.
Price Setting Techniques firms use.
So, we have discussed briefly the approaches. Now it’s time to talk about price setting techniques. Most firms will use different price-setting techniques for addressing different issues. Have a look at the main techniques and after that try to guess which approaches are used by Apple, Zara, and Amazon.
- Price Points & Price Segmentation. In many cases, similar products are available at different prices next to each other in the same store. Those different prices we call price points. The firm does not decide about just one price of one product, but rather tries to find the optimal prices for a family of similar products. Below is an example showing how it works in the fashion industry:
- Complementary Product Pricing. Certain needs require the customer to buy a few products together to fulfill his needs. Those products we call complementary. A great example is a razor and blade, or Coffee Machine and Coffee or coffee capsules. When it comes to complementary products you can decide to price them jointly and lower the price of one product to increase the demand for the other product. The best example is what happened with consoles. Producers like Playstation and Xbox sell consoles at a loss because they know that they will make their money from the games once the gamer has a specific consoler. This model is quite often called the razor-blade model – thanks to the approach used by Gillette 🙂
- Price Bundling. In some cases, you want to bundle two or more products and sell them as one set. Usually, the bundle costs less than individual products. The products don’t have to be complementary or even connected. Usually, they have to be targeting the same segment. Producer of cosmetics, provider of mobile phone coverage, and others love this approach.
It helps you introduce new products and to earn money from your customer base. Btw check my short video showing how to estimate the value of the customer base.
- Unbundling Pricing. In some industries especially B2B the pressure on prices is so big that firms decide to unbundle their services and prices. The classical example that you have come across is … the chicken. Chickens were used to be sold mainly piece by piece. You could not buy a part of the chicken – just the whole chicken. At some point, the profits from selling chickens were so low that retailers started selling them piece by piece. Thanks to this tactic there were able to make much more money.
- Regular prices vs discounts. Price by itself is not that important. Only combined with the discounts they show you the picture that the consumer-facing. When it comes to discounts there 2 main approaches: everyday lower prices (now discounts just low prices) and high-low approach. In the High-low approach, you have a lot in fashion. They start with full price and after a few weeks, they start discounting to generate traffic to their stores. At the end of the season, fashion items are discounted by 70-90%. Every-day low prices are rather used in groceries. This tactic was heavily used by Walmart. More and more firms use a mix of both. For example, H&M uses ever-day low prices approach to basics and a high-low approach to other items.
- Price Changes in the Product Life Cycle. Many firms adjust the price of the product according to the life cycle. The best example is games. When they debut you pay a lot to play them. The same game in 1 year will be available at a 30% lower price and in 2-3 years at a 50% lower price.
- Price Discrimination. This is an old concept Price discrimination is an old concept that can fully be used thanks to technology. The idea is to show different prices to different people. In other words, to have ideal value-based pricing. As we have mentioned one of the ways to achieve that is Dynamic Pricing.
- Freemium / Free/ Free Trial. An interesting approach to prices is to have at least to some extent a free version of your product available. This is considered more of a customer acquisition tool than a price-setting technique. Still, you should not forget about this possibility. Free products are usually paid for by somebody else. For example, you use Facebook, Youtube for free. Those juggernauts get in exchange your attention (time) and sell it to the highest bidder (mainly firms selling products and services to individual consumers) by offering them the possibility to show individual ads. To sum up, the product is free for individual customers because the costs of the platforms are paid by advertisers. Freemium and free trial are a bit more complex. Therefore, let’s look at a short movie that will summarize the difference between those 3 approaches:
Other important concepts.
In pricing, apart from price setting techniques, you will use also some additional concepts that are worth learning. I will briefly go through them
- Price Elasticity. Shows how the demand will change if you move the price. It gives the percentage change in quantity demanded in response to a 1% change in price. By knowing the prices elasticity you can predict what will be the change in demand if you lower or increase the price. Price elasticity helps you decide whether the change in price makes sense or not.
- Price Perception. People don’t really know the prices of products. They have certain perceptions of prices that may not be in line with reality. The product may cost 100 but they may think it costs 70 or 150. That’s why in many cases it is more important to manage the prices perception rather than real prices. By Price Perception, we mean the price level perceived by the customer
- Price Awareness. If you want to influence Price Perception you should measure whether customers are aware of prices at all. Price Awareness is measured in the percentage of the customers that know roughly the price of the product. This will differ from product to product; from customer to customer. If there is little price awareness then the promotions you are doing are simply a waste of money.
That’s in short. For examples of calculations in Excel done during consulting projects check my online course Pricing for Management Consultants.
Make sure to download the presentation available below with details on the techniques that we have mentioned in this post.
I hope you liked it and if you have any questions please let me know.