Recently we wrote a blog post, “Don’t Make This Mistake When Value Pricing,” about the mistake of using a value calculator to set price. Interestingly, the ideas in this post sparked a spirited discussion in one LinkedIn group about all kinds of issues related to pricing. One of those issues was how exactly pricing should be set (another issue was who should set price, sales or marketing, which we will address in another post).
First, let’s examine some of the negative effects of both high and low pricing.
Pricing Too High
Pricing too high has at least four negative effects.
- You might discourage customers who are on the fence from buying from you because your price is extracting too much of the value you created.
- You might encourage competitors to undercut your price.
- You’ll fail to gain market penetration.
- Your sales cycle will get lengthier and closing deals will become more difficult, which means the cost of serving your customers will go up.
Pricing Too Low
Pricing too low also has negative effects, for different reasons. When you price too low you trade whatever market share you gain for lower margins, which means you’ll have less money available to serve the customer and also less money to develop new features and capabilities. Although you might grow your total sales with lower pricing, you’re not optimizing profitability because you’re limiting your ability to improve your offering and sustain growth over the long term. (For some related thoughts on this topic, see our previous post, “How to Stop the Price Discounting Spiral”).
The Goal of Pricing: Maximizing Profitability
The goal of pricing is not to achieve target market share, obtain a desired margin above your costs, or follow the price set by competitors. The goal is to maximize the long-term profit of your offering, based on whatever value your offering provides to customers.
In other words, pricing should not be driven by any constraint except one and that is: what is the price that will deliver the highest profit over the life of the offering? If that price is in the middle of the pack, then that’s the best price for you. Similarly, the highest or lowest price might be the right answer.
Of course, that is easier said than done. To predict the price that will deliver maximum profitability, you need to take into account such factors as:
- How differentiated is your offering?
- How sustainable is your differentiation?
- What alternatives do your customers have to solve the problem?
- Do you really deliver as much value as you believe you do?
- How price sensitive are customers (how steep is the demand curve)?
- How will competitors react to your price?
- Will your price cause competitors to enter or exit the market?
- Will your price encourage customers to find new, alternative approaches to solve the problem?
Of course, the answers to these questions are not always readily available. Even though your goal should be to maximize long-term profitability, it’s often hard to do since the required information is sometimes imperfect. I’d argue that the answers to the first two questions above (how differentiated and how sustainable is your offering) are the most important and should be the focus of your analysis. If you get those right and fill in the rest with the best information available, you will be well on your way to setting the “right” price.
How do you set price? Share your thoughts in the comments section.
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[Image via Flickr / David Muir]