The right price should meet the requirement of the buyer and seller. If you hit the optimum price, the theory suggests, your customers will be happier, your profits will be higher, and your bottom line will be healthier.
In reality, pricing is far from simple. Setting the optimum price is one of the most difficult decisions managers ever make. Most companies are so bad at it that they leave money on the table.
Pricing is about more than setting prices. Pricing represents a strategy to increase sales volume at a profit while incorporating and communicating critical messages about the value the offering delivers to the customer. In general, most organizations fail to use pricing in such a disciplined fashion.
There are four pricing strategies that organizations typically employ. Let’s take a look at each of these.
1. Price to Cover Costs: Here, you set prices based on your costs and add a reasonable margin. It makes sense to do this because if you always price to provide a profit over your costs, you’ll make money. Right? Not necessarily. There are two problems with Price to Cover Costs. First, your customers don’t care about your costs. They care only about the value you deliver. By ignoring the value that you create for customers, cost-based pricing can keep prices lower than they should be, thus leaving money on the table and reducing profits. On the flip side, pricing to cover costs can actually keep prices higher than optimum, thus reducing sales. The second problem with cost-based pricing is that it allocates overhead and/or fixed plant costs into pricing calculations. Sounds reasonable until you consider that often those costs appear to be variable when they aren’t. If you have low utilizations, your allocations are going to be high, preventing you from dropping the price to increase sales and subsequently the utilization. Again, you either forfeit profits or sales. Sometimes both.
2. Pricing to Meet the Market: If you know that your costing systems inflate the true costs, maybe you use market-based pricing. Here, organizations let the market set the price. We hear about this strategy a lot and on the surface it sounds good. After all, we know that the market alone sets prices. Here’s the problem with Pricing to Meet the Market: We don’t sell to markets. We sell to customers. And customers, being unique, often surprise us by behaving differently than markets predict they will. They ask for a lower price, and we give it to them. In the end, market-based pricing is just lowering price to close a deal.
3. Pricing to Close a Deal: Now we’re on to something. Pricing to close a deal is what business and pricing should be all about. After all, if we can’t price to close a deal, what good is pricing? The process should work to provide us with a profit, right? Well, not really. When you price to close a deal, it provides customers with every incentive to negotiate for lower prices. These customers put salespeople through a meat grinder of price negotiations. The process, in turn, gives salespeople every incentive to respond with lower prices. It undermines their confidence in prices and leaves money on the table.
4. Pricing to Gain Market Share: In this strategy, prices are set low to gain share against a competitor. Again, this sounds like a good idea. We all learned that increasing market share leads to increases in profits. The reality is not that clear-cut. If you already enjoy high market share, it’s true you’re going to be more profitable. But, it’s more likely that you are not the market share leader. In that case, using lower prices to go after market share is risky. You can’t expect to catch your competitors by surprise. Even if you do, the advantage will be temporary. Most likely, the market leader will simply match your price. Lower prices eat into profits of both companies. Customers love a price war.