Maximizing the profitability of your business starts with a well-developed, value based pricing strategy. This is done by creating, understanding and quantifying the value that your product brings to the market. While pricing is one of the four components of the marketing mix (product, promotion, place and price), it is often given the least attention yet has the most direct impact on profits.
Now last month I showed how discount pricing can be detrimental to your profits. I will now show you how value based pricing can make a positive impact on your profitability.
Setting the correct price is both an art and a science. Many owners will go the route of cost led pricing in which they take their cost of goods and mark it up a certain percentage. This method is way too automated and does not take into account some of the intangible elements that create the value of the product. Also, it tends to underestimate profit margins as you try to forecast your sales (this will have to be discussed in another article)
To demonstrate the art and science of pricing, let’s look at two pairs of Nike basketball shoes.
The Nike Men’s Air Jordan XX Laser Basketball Shoes retail for $249/pair while the Nike Men’s Hyperflight Max basketball shoes retail for $179. If you were to compare the material that is used for both pairs of shoes, you would be hard pressed to note any significant differences, yet the Air Jordans are priced 40% higher than the Hyperflight.
So, why the big difference in price? To put it simply, it is the name behind the shoe. Even though Michael Jordan has been retired from basketball for 11 years, he is still considered to be the best that ever played the game and apparently commands an additional 40% in the price of a shoe with his name on it.
How did Nike determine what the Jordan name is worth? I don’t have any firsthand knowledge of how they made this determination, but this is the process that most companies use.
The Art of Pricing
- Conduct surveys- Assess the perceived value the Jordan name has and determine “brand awareness.”
- Conduct focus groups- Gather a sample of consumers who fit the target market and get first-hand reactions and other responses to the name, look and feel of the shoe, gauging its value. (Price does not typically come up in these focus groups as most people will always want to pay less. So, this is not a good question to discuss)
- List brand differentiation
- Anticipate demand based on a supply, quality, brand awareness and price level.
The Science of Pricing
- Consider the cost of past investment into the development of the shoe
- Consider the cost of the shoe contract given to Michael Jordan
- Consider the cost of future shoe contracts (future investment)
- Consider the cost of future shoe development (future investment)
- Consider direct marketing costs
All of the above points have a value that is factored into the price of the product. You probably understand why I considered the cost of past investment, but may be wondering why you should consider the cost of future investment as a determining factor in the price.
Will You Make a Profit?
After establishing your price, multiply by the anticipated volume demand and see if you will have enough left over after cost of goods, salaries and expenses to allow for a pre-tax profit sufficient to invest into future innovation of the brand and brand extensions. In the case of Nike Air Jordans, if they don’t have sufficient pre-tax profit to pay for future shoe contracts to Michael Jordan and/or future shoe development, like design and prototyping, the brand will ultimately die due to lack of capital.
Profit Needed for Re-investment
The same would go for your business. If you do not account for what it will take to re-invest into your business, the quality of your product/service will ultimately suffer, which will affect its value, thereby driving your price lower.
So you see, there are a number of factors that go into price setting. Some are quantifiable and others are not. At the end of the day, you gather all the information and make an educated guess. Yep, I said it, make a good guess. This process is not fool proof, and even the best marketing professionals get it wrong on occasion. But even if you get it wrong, by going through the pricing exercise, you will know what it takes to have a profitable brand. Then, with some minor price adjustments, you will get on the right path.
Now that you know how to set your price, next month, I will walk you through a pricing scenario and adjustment (continuing last month’s example) that will show you how to evaluate the future profitability of your business.
If you want me to use your business as an example illustrating pricing and profitability for a future article, e-mail me at [email protected].