Articles

Understanding pricing

In market research, pricing on February 8, 2013 by sdobney

We run seminars on pricing research and one of the interesting things we find is how price means different things to different people in the audience. Finance/accounts have a different view and use of price than marketing people, and both have a different view to econometricians and OR specialists. For things like pricing research these different perspectives can get confused and we lose track of the fact that when setting a price we are assuming that not everyone will buy.For finance people price is easy – it’s what people pay and therefore it drives profit. If you cut price by any amount, the effect on profit margins can be huge, so financial people like to set prices as high as possible and avoid making price cuts if at all possible (except to clear out unwanted stock). Sales people on the other hand are keener on cutting prices because it facilitates the deal. More deals and a bigger bonus. Consequently there is an inherent tension between the finance team and the sales team – but both would recognise a good salesperson as someone who can make sales at the maximum price.

Marketeers in our pricing seminars tend to look at price as part of a positioning package – so are we perceived as being high price or low price and how do we stack up against the competition. Price is a marketing variable (one of the Ps) where we just need to know what the customer would like to pay and set the price accordingly. Price is seen as disconnected from profit. Now obviously this is a caricature – senior marketeers are much more savvy than this. However, we do still find we get the odd brief asking for pricing research based on qualitative research and what people want to pay (answer they don’t want to pay, and they don’t like complex pricing, or hidden charges – but this doesn’t tell you how to maximise what they would pay).

For econometricians and OR specialists, price is much more interesting. They assume that some people will pay, but that the number of people willing to pay at a given price declines as the price increases (for some goods the reverse can be true for prices that start too low). The question is then not what people are willing to pay, but what at what price do you achieve the maximum revenue, or profit. This is usually dressed up in technical language about price elasticity. The principle is simple though – we assume that if you are willing to pay $10 for something, you’re also willing to pay $9 or $8 or $7 for it. Then for any price we can say what the demand for the product at that price would be – say 40% of the population would pay $10. If the population is 10,000 people then the potential revenue is 40%*10,000*$10 or $40,000. Now consider the price at $9. All those people (all 40%) who would pay $10 would still buy if the product was $9 but we have some additional people who would pay $9 but not $10. So say our percentage willing to pay $9 is now a total of 45%. What’s the revenue? 45%*10,000*$9=$40,500. In other words, in this case bringing the price down by $1 increases the potential revenue. If we know how many people would buy at each price point, then we can generate a revenue curve and that revenue curve has a maximum point. (Also note that the population is a fixed number, so we only need plot percentage*price to see the curve).

From this we can see if increasing or decreasing the price offered will have a positive or negative effect on potential revenues. You can also see that this is very quantitative – it’s not possible to do this analysis in a qualitative sense. We want to know, not whether people like or don’t like the price, but at what price we can maximise revenue/profit. I’m sure lots of people would like Apple to bring their prices down, but those it might increase market share, it may also have the negative effect of actually reducing revenues.

Consequently price is really a trade off – econometricians view price has having a negative utility value. The question is how do you balance the positive items of the product/service against this negative utility value.

There is also a hidden trick in that maximising revenue may not maximise profits. The reason is that the revenue maximum can be different to the profit maximum, particularly if you have fixed or lumpy costs. The easiest way to see this is to consider selling $10 bills for $9.90. Demand will be high, so you’ll maximise revenue, but you’re taking a loss on every sale.

This still doesn’t complete the picture though. Though you can see what price will maximise profit (aka a skimming strategy), the business still might choose to set a price to aim to maximise market share (aka a penetration strategy) as gaining market share, particularly in a new market can be more important than short term revenue. There are various benefits that products get from being perceived as market leading than help with aspects such as distribution. Also for some areas such as technology sectors like selling ink-jet printers, the profitable income comes after the sale so market share is key. Also in technology markets the cost of production falls according to volume, so having the leading volume in the market, can lead to having the lowest production costs increasing profits not from the prices side of the equation but from the production side.

Price is not just a question of what the customer wants, it’s also about what the business is trying to do and what the impact of pricing decisions will be on aspects like volume, revenue and profit. For more information and advice on pricing research, see our main website www.dobney.com

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