How most businesses price and why these methods are wrong
Having worked with hundreds of businesses and business owners over the years, the mechanics of how most prices are set can be boiled down to just four main methods. We need to explore each of these so that we understand them, and to explain the weaknesses in each method. Having done this we then consider the only critical element of pricing, which is to better understand the value your customers place on what you do.
This chapter considers four principal pricing strategies, and then the only one that really works:
And most importantly:
Cost plus pricing – the fundamental flaw
The flaw in cost plus pricing
The most common method of setting prices is to take cost price and to add a set percentage mark-up. This does not work.
Cost plus means adding, say, 30 per cent, 50 per cent or even 100 per cent to the cost price of what a business buys or makes to set the price at which they sell. There are many complex ways of doing this, but they all have the same flaw.
CASE STUDY Smithfield Clothing
Mr Smithfield ran a small business that sold outdoor clothing. At a meeting he complained that he had been extremely busy over the weekend, and when I asked him why, he told me the following:
For many years he bought stock from a key supplier. His volume of sales had grown so that he was now buying much more from them, so he decided re-negotiate the cost of all his purchases, based on these higher volumes. He was delighted to say that he had managed to negotiate a 15 per cent discount off all of his current purchases.
This was a great result, but didn’t explain why he had been so busy. He continued to explain his pricing method:
He took the cost of each individual item he sold and doubled this to set the selling price. For example, an item that cost £10 would be priced at £20 giving a gross profit of £10 and a profit margin of 50 per cent.
Having been successful in negotiating a buying discount, the cost price of all of his stock had reduced by 15 per cent. For example, the item costing £10 now only cost £8.50 and hence was sold at £17. He therefore explained that he needed to re-price all of the items that he purchased from that supplier. That was why he had been so busy.
The mathematics makes sense to me, but the logic of this pricing method is completely flawed. So I worked through the example he had used to show him that where he used to make £10 profit, he now only makes £8.50 – although it remains a 50 per cent profit margin, the same item now generates £1.50 less profit than it did a week before. It is pretty simple when you think about it. He had passed on all of the discounts he had negotiated because his buying price and selling price were directly linked, so as his buying price fell, so did the profits.
While this example stems from those with a rigid formula with selling prices linked to cost, it happens more frequently where businesses have established what they regard as normal profit margins. Another business – Wholesale Equipment Supplies Limited (WES) – had a buying team focussed on negotiating better buying prices from all of the suppliers that they used. However, the company had established what they regarded as normal profit margins on everything it sold. Every time they negotiated a discount on the buying price the frontline salespeople gave it all away to the customer by increasing the discount on the selling price. (Chapter 10 covers this point.) So although they did not have the rigid formulaic approach adopted by Mr Smithfield, they informally adopted the policy of a normal profit margin, and ended up with the same problem.
It really is quite simple. If the customers valued the item at £20 last week, that does not change based on a lower cost price to you! If Mr Smithfield’s customers were happy to buy the pair of waterproof trousers for £20 that is because they believed that the trousers were worth that much. The fact that the cost had reduced by 15 per cent had no impact on their perception of this value, not least because the customer didn’t even know what the cost price was before.
Interestingly, what often proves this point to businesses is to consider the opposite situation. Just consider for a second what most business owners would do if their cost prices suddenly went up 15 per cent.
When another company, SE Limited, were unfortunate enough to have a price increase of 10 per cent imposed on them by a major supplier, it was greeted with a moan from all the frontline people saying, ‘We can’t possibly pass that on to our customers, they would all leave’. Many times that argument was accepted and some of the price increases were absorbed by the company, at least in the short term. So if the logic of a link between buying and selling price doesn’t work when cost prices go up, then why would it work when they go down?
The vast majority of businesses I have met would probably take a similar view that they couldn’t pass on all of an increase of that size straight away. They have therefore accepted that the value to the customer and the cost to them are unconnected issues, yet when cost prices reduce they often feel obliged to reduce their selling prices and sometimes, like Mr Smithfield, or SE Limited, they deliberately reduce them.
Later chapters look at the setting of prices without connection to cost, based solely on the value to the customer, and there are a number of techniques for managing the internal reaction of any frontline people.
Businesses that use any formula to link buying price to selling price often end up accidentally passing on all the discounts they have gained to their customer, thereby reducing their own profits.
Ouch!
Undercutting competitors – it simply cuts your profits
Many businesses deliberately set their prices at a level they think is just below that of their main competitors. They do this in the expectation that this will attract new sales from those competitors or win sales where customers are choosing between them.
There are a number of issues with this, some of which are dealt with in other chapters. However, the fundamental problem with this strategy is that there is always someone else around the corner prepared to do what you do for less money. The ability to be the cheapest and still make a profit is really a preserve of organizations with incredible scale and who sell such huge volumes that the elusive economies of scale are a reality. This would include the likes of Tesco, and ASDA/Walmart. This is a perfectly legitimate business strategy, but it is simply impossible for the small owner-managed business or even those with tens of millions in turnover to achieve. However, I just want to focus on the accuracy of the data to support the argument that undercutting competitors is a viable plan.
It is crucial to engage the frontline people in generating ideas to support price increases. However, there is often a barrier where they complain, ‘We can’t put our prices up as our customers will just buy from competitor XYZ who are cheaper’. They then underline this by saying how their customers often make that very point during negotiations.
My simple challenge is to ask, ‘How do you know what XYZ are charging?’ Their answer in most cases is that their customers tell them.
What we find is that the decisions on price are made almost entirely on anecdotal evidence. What’s worse is that the hearsay is biased as the customers clearly have a vested interest in persuading us to keep prices low.
It is critical to gather the facts on what prices are actually being charged by the business’s main competitors. This is pretty easy, you can do it with a few simple phone calls, online research, or even a mystery-shopper programme to actually go and buy a range of core products. I have seen this done in businesses to identify pricing inconsistencies across various branches, and to prove to the business owners and managers that what they think is happening within their business is not what is actually happening at the sharp end dealing with customers. In every single case the estimates or expectations of the business based on their informal customer feedback are way out of line with the actual prices that their competitors are charging. In short, the assumptions and the facts don’t tally. The other advantage of such a research programme is that it yields information on competitors’ marketing activities, account opening procedures, selling propositions and standards of service, all of which help to establish the comparable value delivered by each business.
Like many issues within this book, a key part of the problems businesses encounter is because they make decisions based on flawed information, whether biased, anecdotal or simply inaccurate.
Setting prices to undercut your competitors makes no comparison of the difference in the value delivered by them and by you, and secondly, it is more often than not simply based on incorrect anecdotal evidence. Get facts or lose profits.
Ouch!
Last year’s pricing plus a bit – the bit is never enough
The next most common pricing approach is to take last year’s pricing plus a bit as a simple pricing model. Almost always this bit is the underlying rate of inflation, but it can be any arbitrary small percentage uplift. Sadly, it can also in reality be last year’s pricing less a bit, but after reading this book that should not happen in future!
The problem is the same as with the cost plus approach – the price charged is not linked with the value to the customer.
If you increase your selling price based on, say, the increase in all prices that form the country’s inflation rate, it assumes that there is value inflation in the marketplace; ie just because inflation runs at 3 per cent, does a customer feels the item is worth 3 per cent more to them a year on?
The inflation rate includes price increases that are to a great extent not optional increases such as energy costs, food, etc and it therefore doesn’t reflect an increase in the average customer’s recognition of value. This is even truer when price inflation is running ahead of wage inflation. Consumers are less willing to simply accept that prices go up by inflation if that isn’t reflected in their pay packet.
CASE STUDY Bright Sparks Limited
A large electrical contractor business had a policy of increasing prices once a year based on the underlying inflation rate. This was for many years a 3 per cent to 5 per cent uplift, and it was broadly accepted by customers.
However, over a short period, two things happened. First, a large element of their cost is the installation of electrical cables in various sizes and grades. A high-cost element of these cables is copper, which saw a surge based on a worldwide shortage of the material. Consequently, while inflation overall was running at around 3 per cent, the price of their largest raw material jumped over 10 per cent in a single year. Their annual inflationary increase just didn’t keep up with underlying costs, and rapidly ate into their profits.
Bizarrely, they had the opposite impact over another two-year period, where wages experienced a freeze in the market based on high unemployment and pressure on jobs, while underlying inflation continued at around 4 per cent. When the company tried to add on the usual inflationary uplift, many of their customers wouldn’t accept it based on the freeze in wage costs.
Inflation is perhaps the most common component of a last year’s pricing plus a bit approach, but it is simply not linked to the financial realities of any business in the short term. It only works if customers’ appreciation of what you offer inflates in the same way. Recent economic difficulties have clearly shown that value inflation doesn’t exist, as many businesses have not been able to raise prices at all despite an underlying increase in their own costs shown by the inflation rate.
In some markets, there is even value deflation as increased competition or improved technology drive overall prices down. The cost of making a digital camera model ABC1 may not change much when model ABC2 and ABC3 are launched, but its value in the market will almost certainly fall if these newer models have higher megapixels, faster shutter speeds or simply extra features that the old one doesn’t. Adding a small percentage to reflect inflation ignores the fact that your actual costs may have gone up well ahead of inflation, meaning that profitability will still fall.
A customer’s appreciation of value doesn’t change just because inflation means that your costs do. So don’t expect to be able to pass on your higher costs without increasing the value you offer.
Ouch!
Even if you had done a great deal of thinking and research when you originally set your prices, when you adopt a last year’s pricing plus a bit approach these prices will very rapidly detach from the value the customer sees and thus become nonsense.
Best guess pricing – it’s just a stab in the dark
By this term I don’t mean randomly plucking figures out of thin air, rather a decision based on what price to charge that doesn’t link itself to cost price, to what competitors charge, or to whatever was charged the previous year, and certainly not based on proper market research or financial analysis. It is simply based on judgement, instinct or to perhaps be more accurate, an educated guess!
Many professional firms, such as lawyers, have now been forced into fixed price agreements rather than the traditional rate per hour. They need to look at the work required, estimate how many hours this will take and what level of team member the work will require, and then calculate a fixed price for the customer. By necessity this will require a judgement based on experience. Similarly, a plumber may use his experience to set a price at say £500 for a boiler repair job. The issue is that although these appear to be based on a calculation of the work needed, they eventually are simply an educated guess based on historical experience.
Many will have set pricing for a job, which is the same for all customers in all circumstances, hoping that they are right more often than they are wrong.
The key point is that these prices are not set based on a carefully thought through decision-making process to establish the right price or the market price, just a finger in the air based on experience of the market. This is absolutely not value pricing, described below.
CASE STUDY The Friendly Lawyers partnership
Working with one law firm, all the lawyers were asked to provide an estimate of the fees they would charge based on a clear brief of the client’s problem. This was, for example, a debt dispute for lawyers in the commercial team and a divorce for lawyers in the family team.
Although the paperwork was standard, the range of potential fees indicated was staggering. The highest figure was roughly double the lowest on most areas we looked at. This showed a huge inconsistency between individuals and across departments. They may all start with the same broad view of the work involved, the same rates per hour for the individuals needed on the task, but depending on many other factors the proposed price varied greatly. This is due to factors such as each lawyer’s current workload and hence keenness to win the job, their personal experience of delivering that particular service, and whether they think they are in a competitive tender situation. There may simply be a confidence variance between individuals, with some naturally more bullish on fees than others.
Slight variations are understandable, but leaving lawyers to individually set prices showed variations between £5k and £10k for the same work. One solution was to set guide prices for all services, and to insist on peer review before doing any quote. This improved consistency and enabled partners to talk each other up or down as appropriate.
You cannot simply set prices based on experience and judgement as this is fundamentally flawed by the human element. Personal experiences and individual characteristics, such as confidence, overshadow the importance of research and facts.
Ouch!
So how should businesses set their prices?
Value to each customer – the only pricing strategy that really works
In a perfect world you would set a unique price for every single customer based on the value to them of each individual product or service you provide, and at that specific point in time. That is value pricing.
This would take into account factors such as their ability to pay, so you might charge more to those customers who can afford it and less to those who can’t. Now that is not just the fact that they have the money to pay, but actually that our perception of value is distorted by our financial situation. I would never think flying first class was value for money when I have to work as hard as I do to pay for it, but if I won the lottery and had £5m in the bank, I may well decide to fly first class. The product hasn’t changed, the value on offer is the same, but my perspective on it has changed. So should the supplier charge more just because I can pay more? We might also consider the significance of the item itself at that point in time, so that if a customer is desperate and needed your product right then, the price could be higher than if they had time to shop around.
There are many readers who will struggle with these ideas. They would see it as profiteering or perhaps ripping people off. You can make up your own mind as you read through the rest of the book. You may want to consider, though, that every business should make a profit which reflects the effort and risk that they take each day that they open for business, and very few achieve this. This may mean that the business will need to seize opportunities to make very good profits on some transactions, and accept lower profits and perhaps even losses on other transactions, knowing that it will balance out over time.
The reality is, of course, that it is very difficult to have unique pricing for each customer, and therefore we end up having a more generic approach. Eventually this evolves into a one-size-fits-all pricing policy, where all customers pay broadly the same irrespective of circumstances. The problem with this is the same as we might have if we operated a one-size-fits-all clothing policy. In clothing we would need to have the largest size possible in order that everyone can at least wear it, however ridiculous it might look on smaller people. With pricing this simplicity of one-size-fits-all means that the prices are driven down towards the lowest prices that appease the most price-sensitive customers, and are way below the levels the top customers could and would pay.
The overall critical objective is to set prices based on the value to the customer. Consider a new model smartphone for example. The cost to make this is around £120. If the manufacturer adopted a cost plus mentality they might double it or even treble it. If they adopted a last year’s pricing plus a bit approach, they might take the previous model price and add say 20 per cent for the uplift to the newer one. The manufacturer of course wants to get the best price possible and they do a lot of research to establish what the perception of value is within its marketplace. How does it compare to the alternative products customers could choose? Are typical customers spending business money or their own cash? Even down to some specific market research that would ask: ‘How much would you pay for a phone that did this?’.
Based on the information Apple gathered, they set the price at £500. This captures the early adopters that buy it because they must have the latest model, or the geeks that want the most up-to-date technology. As demand reduces, or newer versions are brought to the market, they will gradually reduce the price to sweep up more customers for whom the value perception may be lower. They absolutely never rely on just anecdotal evidence of what their competitors offer and at what price. They will know every detail of the alternative products, having researched them extensively in deciding where their own products sit within that very crowded marketplace.
Imagine a young man who ventures into a car showroom. In front of him is a shiny red convertible sports car. He wanders around it looking at all the gadgets opening the doors, putting the roof up and down, and examining all of the buttons and knobs. The salesperson offers him a test drive where he hears the roar of the engine, and feels the exhilaration of speed.
He gets back to the showroom and the salesperson launches into the sales patter covering all the features and benefits, optional extras and eventually the price and the easy-payment terms that are available.
Now, he will of course need to consider lots of issues before he can make a buying decision, such as whether he can afford to buy or to run the car. He will need to consider whether it is a practical option; ie whether he has kids or a dog to transport. He may also need to consider how it will be perceived by others; ie does it provide the image that he aspires to, and depending on his circumstances, whether his wife or girlfriend would approve!
Think back to the last time that you bought a car, and the wide range of issues that you considered, particularly for what is of course one of the most expensive purchases that any of us buy in our lives. You may have decided that the satnav upgrade wasn’t worth the price, but that the leather seats option was. What were all the questions you asked the salesperson when selecting the model and specification of the car you chose?
What I am certain of is that neither the young man looking at the red sports car, or you when you bought your last car, sat down with the salesperson and asked, ‘Can you tell me how much it cost the manufacturer to make it?’
There is a really simple point here.
The way in which you set prices requires a degree of thought and research that very few businesses invest in. How can you set prices that maximize the profit your business makes without research, analysis, testing and then training to react properly to the responses from customers?
For each of the options it is important to think about what you would do if circumstances changed, as in the cost plus example. If your cost price went up 25 per cent would you expect to pass this on, and could you? What if it fell by 25 per cent, would you drop your prices to match?
What if you aimed to be just under your competitors’ prices? If they dropped them by 25 per cent would you do the same? Could you? If they increased them, would you?
The customer decides the value of what you do. What you pay for an item, what competitors charge, or what you charged last year has no real impact on this figure.
Ouch!
The only true way to set your selling prices is through value pricing, which is establishing a value to each of your products for each of your customers and then pricing them accordingly.
What I see time and again are businesses that operate a pricing policy which is far too simplistic (to make it easy for them to calculate) and linked to some formula that ignores completely the value to the customer. To make matters worse, when the costs or competitors’ prices change, most businesses lack the courage to move their prices up when needed, yet almost always drop the prices in a blink when their costs or competitors’ prices fall. If you want your prices and profits to increase, you will need to tackle these issues.
As with most things in business, it is all about value for money. The cost price, what competitors charge or even economic factors such as inflation or interest rates may influence pricing decisions, but the value to the customer is the only real issue.
1 Consider how well researched your prices are.
– What methodology did you adopt in your last three price changes? Are there any examples where you have value priced?
– Where you have followed competitors’ actions, how well researched was your data?
– If you have used any of the four wrong ways to price, have your pricing team remove the option to follow these and to develop your own value-based proposition.
2 Plan out how you can gather research that will help you understand your options:
– Identify your top five competitors.
– Do some simple online or telephone research on a sample of products or services where you compete.
– Undertake a full mystery-shopper exercise.
– Pick some of your core products and track your buying and selling prices over the last five years. Look at the trends and set up a workshop to debate when and how the next price changes should be handled.
– Lock in Price Review dates for the next three years.