When the analysis is carried out to improve the results of an organization, in most cases the improvement of the results is associated with the reduction of costs or the increase of sales… But a great forgotten in these situations is the policy of prices. This is a big mistake and this is one of the elements with the greatest impact on the income statement.
But you, the reader, will surely think of your inability to maneuver with your pricing policy. Elements that have been introduced into the day-to-day of companies in recent years such as the crisis, globalization, installed overcapacity, greater market transparency and greater customer power lead to a continuous drop in prices, which seems to be little or nothing we can do about it.
Among managers, it is common to hear “I am in a commodity market. The price is set by the market and we have to follow the lines set by the market ”. That's true?
In the experience with our clients, we find cases in which the pre-tax profits have been improved by 5-7 points thanks to a correct pricing policy in relatively short periods (around 6 months). In this way, excellent price management can be a competitive advantage and a way to differentiate yourself from your competitors.
In addition, it must be taken into account that the impact of prices is around 4 times greater than -for example- the reduction in personnel costs, that is, that the impact on the income statement of 5 points would be equivalent to a reduction of personnel costs of approximately 20 points. This justifies the great importance of pricing policy.
Among the reasons that make it understandable why price management is undervalued are the following:
- The pricing policy is not understood as a strategic aspect for the company and other elements are more valued to improve profitability such as increased sales or reduction of personnel costs There is no clear methodology for managing prices in each one of its phases: analysis, planning, definition and control.There are no specific managers or the necessary resources for the correct management of prices.There is no clear vision of the cost structure, perception of value and price policy, both its own and that of the competitors.
Price calculation methods
In a brief way, different methods for calculating prices will be developed. This is a brief explanation to give an overview in this regard, although there are a large number of methods and variants, but they escape the objectives of this article.
One approach is simply to define "cost + margin", that is, the cost for the product / service is calculated and a certain profit margin is applied to it, thus obtaining the sale price of the product. In this case, the most complicated thing is to define the profit margin since it is the one that will determine the entire price structure.
Another approach is to analyze how much consumers are willing to pay for the product / service and set the price according to the perception of value by the customer.
In this case, the most complex part is the collection of customer information, since for practical purposes it is often complex to obtain this information in a clear and reliable way.
Another method is the setting of prices based on the pricing policy of the competitors and the competitive position in the sector. In this case, the company estimates what the price of the competitors is and then positions itself above or below them based on its competitive position with respect to them.
In addition to these elements, other elements appear at the time of pricing such as alignment with the strategy, prices based on the desired profit, brand positioning, etc.
The four pillars of pricing policy
In order to perfectly define the pricing policy, the following four pillars are essential:
- A strategy, processes and organization that consider the pricing policy as a basic element in the company's results.
Price management must be systematic and strategic and not viewed as an art left to chance at the hands of sales people.
Like other elements of the strategy, the pricing policy must be perfectly defined and aligned with the rest of the company's strategies and policies. In this sense, it is very common to see companies that do not have a perfectly defined pricing policy with the same clarity as other company policies or strategies.
Likewise, processes and organization for price management must be clearly defined in each of its stages: planning, analysis, definition and control. Clearly, the functions, responsibilities and competencies for each of the positions related to these processes must also be defined.
- An activity-based costing system
The cost system must allow to know both individual costs as a function of volumes and must have perfectly defined the concepts of fixed and variable costs.
Although not in all cases a price policy based on "cost plus margin" is chosen, a correct definition of the cost system is essential to be able to analyze in depth the position at all times as well as the policies and strategies both at the level of operating prices and at the level of strategic positioning.
In this sense, elements such as the "target price" are essential on many occasions associated with price policies in order to be competitive, focusing on areas that add value.
- Understand that each client has different needs and attitudes and therefore - potentially - different prices.
It is obvious that each customer (or segment) has totally different attitudes.
Segmentation can be done based on a multitude of parameters such as turnover potential, areas, channels, etc. Or by concepts related to their behavior, segmenting into categories such as "price mercenaries", "convenience seekers", "quality seekers", and so on.
A very common case is to use the volume discount, defining better prices for the most important customers (those with the largest current and / or potential purchases). But even in these cases, it is very common that when the correlation between the size of the customers and the prices is analyzed, it is found that - although it may seem incredible - there is usually no clear correlation between the size of the customers and the prices, finding in this way three situations:
- Customers with a discount in line with the volume of purchases they make. You could say that this case is correct.
- Customers with a discount greater than that stipulated for the volume of purchases they make. It could be said that in this case, the client has a lower price than she should and therefore she is not making money with her. For practical purposes it is common to find 30-40% of customers in this situation.
- Customers with a discount less than the one stipulated for the volume of purchases they make. It could be said that in this case it is the most favorable situation for the company, although for practical purposes it is the most difficult situation to find.
Only by normalizing these types of situations are very important impacts on the income statement achieved.
- Perfect identification of the perception of value by customers and the differential (positive or negative) compared to competitors and their prices.
"There is a direct relationship between the perception of value by the customer and what they are willing to pay for a certain product and / or service." Therefore, it is necessary to have a deep knowledge of the pricing policy of competitors as well as the perception of value that customers have of both our offer and that of the competitors.
Obviously, the customer is not willing to pay more for the same, that is, there is a direct relationship between the perception of value by the customer and what they are willing to pay for a certain product and / or service. Based on this concept, which is essential to understand and define a correct pricing policy, three elements are basic:
- In-depth knowledge of the perception of value of customers for each of the products / services offered by the organization itself Deep knowledge of the portfolio of products / services of competitors as well as the perception of value of customers for each of them.Knowledge of the pricing policy of competitors.
It is true that it is often complex to know in depth the perception of value by the client both of our products / services and of the competitors, and for this, research techniques must be used at a quantitative or qualitative level in a sufficiently structured way to reach quality conclusions.
In this sense, it is common to find cases in which one's own price is compared with that of another competitor who is actually offering a product / service that is not comparable with his own, since the perception of value by the customer is totally different and is done an analysis without introducing that variable, thus reaching erroneous conclusions.
In fact, depending on this parameter, for practical purposes we would find three situations:
- That a product / service is offered at a lower price than the perception of value that the client has of the same (and of the competitors) so that they would be losing income from it. That a product / service is offered to a price aligned with the customer's perception of value of the same and compared to competitors so the pricing policy would be correct Offering a product / service at a higher price than the customer's perception of value of the same (and the competitors) so it would be in an unsustainable situation in the long term, since sooner or later the client will have market information and will perceive that he paid for the product / service more than he should with what - surely - the customer will feel "cheated".
"Both the value perceived by the customer and their purchase drivers lead us to lower prices in cases where they are not necessary"
In fact, on many occasions, not having direct contact with the client and a perfect knowledge of both the value perceived by the client and their purchase drivers, lead us to lower prices in cases where they are not necessary as well as not capturing customers who are demanding a lower price and are unknown to us.
For this reason, it is common to find cases in which due to the lack of efficiency in the marketing and / or sales activity, a company has almost all the «price mercenaries» as customers whose main inducer of purchase is the price, with which leads to a situation of very low returns.
Practical advice on its use
But the pricing policy is a complex concept since it is necessary to align both the value proposition to the customer, the costs of the product / service and the company's strategy.
Regarding the perception of value, the customer is really willing to pay based on it and not at a price based on a cost plus a previously defined profit margin. Therefore, many factors have to be taken into account. In this section, four important concepts will be discussed when defining the price policy:
- Concept of fixed cost versus variableCommodity and «decommoditization» Mix of productsThe brand
Each one of them is developed below.
Fixed vs. variable cost
The concept of fixed versus variable cost is basic in the definition of pricing policies since they define radically different scenarios. Let's imagine a certain product / service for which pricing decisions are being made, what is more interesting, selling 500,000 units for 100? (case 1) or 600,000 units at 90? (case 2)? The following example shows both cases reaching interesting conclusions:
| Variable cost | Fixed cost | Sold units | Sale price | Total cost | Benefit | |
| Case 1 | 10 | 1,000,000 | 500,000 | 100 | 6,000,000 | 44,000,000 |
| Case 2 | 10 | 1,000,000 | 600,000 | 90 | 7,000,000 | 47,000,000 |
With which it comes to the conclusion that pricing policies cannot be proposed without taking into account demand and both fixed and variable costs.
Commodity and "decommoditization".
Also for practical purposes it is very important to assess the value proposition for the customer and the concept of "decommoditizing", that is, trying to make something not a commodity. Note: A commodity is a product without differentiation from others, so there are products in the market whose perception of value by customers is the same. For example, water is a commodity since water is water and there are no important differential elements between some products and others.
In commodities, the basic elements of differentiation are price (in most cases) and service, so the pricing policy (with low margins) is basic in this type of product / service.
If you do not want to compete for price in markets with low margins, you can strategically tend to "decommodify" by adding value-added services to the product itself and thus be able to enter higher margin markets.
Product mix
When defining a pricing policy, the profitability of the product / service mix must always be considered, since at a given moment the profitability of a given product can be sacrificed in favor of the profitability of the whole.
This is a very important concept in products / services where sets (mixes) of products / services are purchased, since the profitability of certain "reference" products can be sacrificed (and that the customer may compare to make the purchase decision) versus to the profitability of products / services that have to be bought together. This is a very common case in large stores.
The brand
The brand is clearly a strategic element in a company and also has a direct influence on pricing. In addition to being a basic element of "decommoditization".
In addition, in the case of the brand there is a very interesting two-way phenomenon and for which the brand positioning cannot be considered without thinking about the price or the opposite reasoning.
The importance of pricing must be recognized as a tool to differentiate a product or service from competitors, since the price signals its quality and exclusivity, just as the brand must be taken into account in order to define a certain level of prices or other.
In this sense, the strategic reflection of whether it is more interesting to position itself in a high segment with a relatively high price and a well-positioned brand (with a high communication budget) or to position itself in a lower segment, with a lower price and with a weaker brand positioning (lower communication budget). In any case, you have to define the scenarios and make decisions based on the different strategic factors.
As a conclusion about pricing policy, to say that it is a basic element for the profitability of the organization, since many times the reasons for the competitiveness or not of an organization is directly proportional to the suitability of its pricing policy.
