why pricing is crucial
In our preparation journey to management consulting we all stumbled upon some sort of pricing framework, such as value-based pricing or price-based costing. However pricing is one of those areas where it can be very risky to employ a ready-made framework without an in-depth understanding of the customer dynamics. In all pricing scenarios the value at stake is generally very high as decisions reflect themselves straight into a company’s bottom line. In the paragraphs below we’ll show you a method to pinpoint the decisive factors in every pricing problem and identify the best decisions based on the client’s priorities (no ready-made frameworks here).
In all pricing decisions there are three critical data points we could use to come up with a potential price:
- Competitors’ prices: The idea is establishing prices based on how much competition charges. This implies the competitors exist and they sell a comparable product.
- Company’s costs: In order to make a product, the company has to incur a cost. Potentially this could be the starting point of pricing the pricing decisions. However, as we’ll learn, this should never be the case.
- Value added: Products usually aim to add value to customers, a generic concept which could come in terms of time, convenience, or money. However, for the purpose of pricing analyses, value should always be translated in economic terms. It is essential to bear in mind that different customer segments may attribute different values to a product, implying that the company could potentially charge different prices to different customers reflecting different value added in economic terms.
HOW TO PRICE A PRODUCT?
In order to understand in depth the thinking behind pricing, we’ll examine two cases and then derive general rules.
CASE #1: Duscraft, a fuel-efficient plane
Duscraft has just created a new airliner comparable in size to Boeing 737/Airbus 320 but with a significantly lower fuel consumption. Everything else, including maintenance costs is similar to its Boeing and Airbus competitors. Current prices for a Boeing 737 is 25m$ and for an Airbus 320 is 26m$. Considering that an aircraft usually lasts for 20 years and yearly fuel cost is 500,000$ for a Boeing 737, 400,000$ for an Airbus 320, and 300.000 for a Duscraft, how much should Duscraft charge for its aircraft?
CASE #2: Surinoco S-100, a mass-market phone
Surinoco is a Chinese supplier of while label mobile phone for the main European telecom operators. It has recently created its first branded phone, the S-100. The phone has similar characteristics to other mainstream mobile phones (whose price ranges from 60$ to 70$) and appeals to the lower end of the market. How would you think about pricing the S-100?
a FOUR-step approach to effective pricing
step#1: ESTIMATE THE CLIENT’S BEST ALTERNATIVE
Since we live in a market economy, we expect consumers to act rationally based on comparing our product with the ones of the competition. Therefore the starting point of our pricing decisions should be understanding what our client would choose if our product was NOT on the market. We identify the best alternative by estimating total costs the client has to incur by using different products. Here our focus should be the total cost of ownership (including acquisition price and running/maintenance costs), not only the acquisition price. Let’s see the application of this criteria to the above examples:
Total running costs (B-737): 500,000 x 20 + 25m = $35m Total running costs (A-320): 400,000 x 20 + 26m = $34m
Therefore the best alternative is the Airbus 320 as it has the lowest total running costs.
As you noticed we did not include maintenance costs, but for a reason: they are the same for all the three aircrafts and so adding them to all the 3 equations would not make a difference.
Total running costs (competition) = acquisition price: $~65
This assumes negligible running maintenance costs
STEP#2: ESTIMATE THE VALUE ADDED VS. THE BEST ALTERNATIVe
When pricing a product the main question is understanding how much value it adds to customers. The concept of value added is especially relevant for products that are somehow innovative and not commoditized. The key question is: does it add value compared to what? Additional value added should not be computed with respect to not using any product at all, but rather on using the best available alternative. For example, if we are dealing with a new fertilizer improving the quantity of a given crop, the value added would be given by the additional yield vs. the best existing fertilizer, not vs. not using any fertilizer at all. Once we estimate the value added, we should also estimate which share of this value we should charge to the customer. Let’s see the application of this criteria to the above examples:
Value added vs. best available alternative (A-320): (400,000-300,000)x20 = $2m
In this case there is no significant value added with respect to competitors, since the product is commoditized and aligned to competition
STEP#3: ESTIMATE THE SHARE OF VALUE ADDED to be REFLECTED IN PRICINg
Theoretically almost all the value added vs. the best alternative could potentially be charged back to the client as a higher price, i.e. if the client is a rational, utility maximizing individual she should be willing to pay the price for the best alternative option (STEP #1) plus a sum just marginally lower to the total value added (STEP #2), as shown in the Duscraft case below:
Willingness to pay: Best competitor's price [A320] ($26m) + value added ($2m) = ~$28m
This way the benefit from our new product would be almost entirely cashed in by the company. However, even if the client should rationally accept an agreement like this, it is unlikely that he will, for various reasons, such as:
- Switching costs to a new product
- “Risk” in adopting a new, relatively unknown, product
- Likely lower level of trust
For the above reasons, in order to incentivize the client to buy the new, innovative product, the company may decide on a more equal split of the value added, such as charging
Best competitors price [A320]: ($26m) + value added ($2m) x 50% = ~$27m
This way the value added would be effectively split equally between the company and the client, i.e. the total running cost for the client of using our plane would be 1m lower vs. using the best alternative (A320):
Total running costs (A-320): 400,000 x 20 + 26m = $34m Total running costs (Duscraft): 300,000 x 20 + 27m = $33m
There is no formula for share split of the value added as it depends on a series of “soft” factors. It is however an essential concept to keep in mind.
Looking at the Surinoco case there is no added value vs. competition and therefore the only applicable reference point are competitors’ prices.
STEP #4: CHECK COSTS
Some companies in the past based their pricing on costs. Some still do it now, but this is pure nonsense. You should base prices on what customers are willing to pay, based on competitors’ prices and value added. So, what is the role of costs? They should be checked before launching a product, to ensure that the price estimated in STEPS 1 to 3 exceeds the cost. However, they should not be treated as the starting point, but as a final check in the decision of whether to commercialize a product.