- Market Metrics Inc. - http://www.marketmetrics.ca -

Why setting the right price is so important

“If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business.
If you have to have a prayer session before raising the price by 10 percent, you’ve got a terrible business.” 
Warren Buffet

A while back I was working with a software company and we were discussing the price of their new product. I thought that their proposed pricing was too far below industry average and could be raised a little. It’s an age-old dilemma -– do you price lower for market penetration (growth) or higher for profit? What’s the optimum?

Of course, the point is that price will impact volume. If you want to develop a larger customer base so that you can maximize revenue from support and software upgrades, lower prices might be better. But if you wish to maximize profits from greater product sales revenue, higher prices might be better.

Although this brief explanation may sound simple, setting a price isn’t a simple process at all — it depends on many factors, including your business goals, the competition, and your target customers’ buying behaviour.

We reviewed different pricing models, and I had prepared a forecasting spreadsheet so we could plug in the client’s pricing assumptions and see what the impacts would be on the customer base and various revenue streams (product sales, support sales, distributor sales, distributor commissions, etc). These revenues were then compared to the targets that made the business case work for the client and their distributors.

But here’s what really got the CEO’s attention.

Consider a product with an average selling price of 395 (dollars, thousands of dollars, millions of dollars, it doesn’t matter). Raise the price by 1% and it goes up to 399. If you have any pricing power at all, chances are this price difference won’t deter buyers.

And if it doesn’t increase volume (except for ultra-pricy prestige products, a higher price rarely increases sales volume!) it won’t increase your production, fulfillment, support and other operational costs. That means that extra 1% is profit that goes straight to the bottom line.

The median profit as a percentage of revenue for Fortune 500 software companies was 16% in 2009. Add one percent and it goes up to 17% — 6.25% more! So, in this scenario, a 1% price increase yielded a 6.25% increase in profit.

I had a professor in business school who used to say that pricing is the single most important marketing decision. This is a big part of the reason why.

Once you’ve got your pricing strategy in place, don’t be afraid to consider keeping your manufacturer suggested price (MSP) a tad higher than you might be inclined to. While raising a low price is hard, it’s easy to discount a higher price a bit more or reduce your price in the future. In the mean time, even a slightly lower price can sacrifice a surprisingly amount of profit.

This concept also demonstrates the connection between branding and pricing. Strong brands often command price premiums of 10% to 15% above their competitors. Now that’s pricing power!