Chapter 2

Why Most Companies Stink at Pricing (and How You Can Do Better!)

Pricing is a specialty topic in marketing—one with very few practitioners. You can get a doctorate in marketing (like I did) without ever taking a course on pricing. That’s because most marketing professors don’t know enough about the topic to be teaching it. There’s an annual pricing conference for academics and there are typically only 30 to 40 of us there each year—and that includes a number of professors from outside the United States.

Most people with specialized pricing skills are working in or have their own pricing consultancy. You can find me and the other pricing consultants at PricingSociety.com under their Pricing Experts Directory. Other pricing specialists work at very large companies and multinationals that can afford their own in-house pricing staff.

If you’re a new, small, or medium-sized company, this means there’s nobody who can give you the pricing help you need. Not unless you’ve got an extra $30–$250K you can afford for a consultant.

What can you do on your own? You can buy a book on pricing and hope to learn what you need from it. The best all-around book on pricing strategy is The Strategy and Tactics of Pricing by Nagle, Holden, and Zale. If you can take the time, I recommend it. I even use it when I teach pricing. However, it can be pretty rough going for a newbie. I was already a pricing specialist when I first read it, and it still took weeks of my time and most of my focus to process it. And it has an academic focus—which means it doesn’t give any of the quick answers business owners and marketers need.

Also, ask yourself what your goal is. Do you want to learn to become a pricing specialist? Or do you just want to price your products for maximum profit and then move on to the million other decisions you need to make?

Buying this book is a smart alternative. It won’t give you the all-around knowledge you’ll get from Nagle and Holden’s book. However, it will get you through your pricing decision in a day (if that’s all you have) or a week (if you can spare more time for a better decision). And it will leave you with a much better—more profitable—price than your competitors.

The “Myth” of Creating Demand Curves

One of the biggest headaches you’ll get from a textbook on pricing—and also in blogs and articles on pricing that are, in my opinion, worthless—is they will tell you to create demand curves to capture the price elasticity of demand.

In normal English, that means you are to track how many units you can sell at different prices—so you can find the most optimal price. Well, duh! If you already know that you can sell 6.5 percent more units at price “A” and 4.3 percent more at price “B,” then your decision is easy. You just calculate the profits and total sales at each price and your decision is made for you.

Just one teeny problem with this: It’s worthless advice for almost everyone. You’d first need to:

  • Offer your product or service at 15–20 different prices to see how many sell.
  • Offer each different price for long enough to get at least 40 sales for each price (so the results gain some statistical reliability).
  • Offer all 15–20 different prices at the same time (otherwise your results could be skewed by a time variable).
  • Keep people from finding out about all these different prices—or they’ll skew the test results (hard to do especially with services).

Because you’ll not be able to do all the above, and will therefore cut corners trying, the data you come up with will likely be wrong. That means no matter how impressive your demand curve charts look, making pricing decisions on them would be ill advised.

Businesses that have been selling the same product for ages at lots of different prices might be able to create demand curves. But they would be comparing sales at price “A” six months ago versus sales at price “B” three months ago. I wouldn’t trust there’s been no change in product demand for price “A” in six months, and you shouldn’t either.

Forget demand curves! With this book you won’t need them.

How Your Competitors Are Setting Prices

There is some question as to whether cost-plus pricing or competitive pricing is the most prevalent.

Nagle and Holden (2002) say cost-plus pricing is the most prevalent. This strategy adds up your costs then tacks on an extra percentage of the total for profits. Use of this (generally terrible) strategy is often the result of the pricing decision being left to the finance department or to an entrepreneur who doesn’t understand pricing.

Noble and Gruca (1999) found competitive pricing was used by three times as many companies they studied as any other strategy. They define competitive pricing as trying to match or come in close to the prices of the competing products already on the market.

If you had to pick one of the two above, pick the second one. Match-your-competitors pricing will lose you less than cost-plus.

But why use either?

If your competitors are small to medium-sized companies, they’re likely using one of these false strategies already. So you can gain a substantial advantage over them by using better strategies. If your competitors are large companies, well, you’re already at a disadvantage. You don’t want to increase it!

Cost-Plus Pricing

What is cost-plus pricing? It is a price that includes your costs plus a fixed percentage (15 percent or 50 percent—whatever your target is) for profits. Example: You need to price a new product that costs you $85 for materials. You estimate it also needs to cover $15 of your overhead. So your total costs are $100. You want to make 15 percent profit, so you price this product at $115.

Sounds great, right? You cover your costs. You get a guaranteed 15 percent profit. What could be better?

Actually, almost any other pricing strategy is better. Cost-plus pricing should be used only when you sell custom products. If you build custom houses, then you need to use cost-plus pricing. Using this strategy for any other situation is throwing away money.

Two Ways This Strategy Can Make You Lose Money

The “guaranteed” profit from cost-plus pricing can actually lose you money. You could be throwing away profits, or you could actually end up selling your products for lower than your costs! Here are the deadly duo of ways this strategy will hurt you:

1. Because your “variable costs” really do vary
Variable costs are just that: variable. They depend on how many you buy. In the previous example, your $85 for materials depends on the quantity you order of each. Let’s say you projected you would sell 500 products every month. So you order 1,000 (two months’ worth) of materials for those products at a time for a total cost of $85 each. What happens if you find you can only sell 250 each month? The next time you order for two months, you’ll only order 500. So the vendors will charge you a higher price. Your actual price might come out to $100 each instead of $85. With your $15 of overhead, your actual costs are $115 instead of $100.
  • In this example, you set your price to get a “guaranteed” profit of 15 percent. You thought your costs would be $100, giving you $15 profit for each item you sell. But since you’re only selling half as many as you thought you would, your costs are $115—so you’re receiving zero dollars of profit for each item.
  • What happened to your “guaranteed” profits? Gone. In fact, you could even end up losing money on each item you sell with this pricing strategy.
  • If this is a new product you’re offering, you really can’t know how many you will sell. You can do the best marketing research in the world and still be terribly off in the number of units you sell. Think of the Wii introduction—where backorders went on for months! They did extensive research on demand, only to be terribly wrong. Think of Segway—which thought hundreds of thousands of us would be scooting around town on their machines. Since you really can’t know what demand will be, cost-plus pricing will not give you the “guaranteed” profits you expect.
2. Because you haven’t accounted for consumer perceptions of value
Suppose you guessed right about the quantity you would sell. So you got your planned 15 percent ($15) profit on each item. That’s great, right? Should you be celebrating? Not necessarily! You might just have cost yourself thousands and thousands of dollars.
How? What if the people who wanted this product and bought it at $115, would have been just as willing to pay $130? You could have had double the profits you’re actually getting for each item. You just cost yourself—or your company—a lot of money. And you will continue to lose that money until the day you learn how to set a better price.

Match-Your-Competitors Pricing

Planning to match your competitors’ prices is recommended only in two, frankly unlikely, sets of circumstances:

1. When your new product is almost identical to the competitor products already being sold
2. When your new product has very little advantage over competitor products and the competitors are pretty tame (e.g., when they don’t compete hard against each other)

Why are they unlikely?

1. Why the heck would anyone launch a product that’s not different or has little to no competitive advantage? Most people stick to a brand that works for them. To get them to try a different one requires a reason. “Me-too” products don’t provide a reason.
2. Very, very few markets have competitors who don’t compete. Most markets have competitors who are watching every penny change made by a competitor.

This is not to say you ignore competitor prices. Not at all! They are a wonderful source of free research for you. Reviewing your competitors’ prices tells you what your target customers are willing to pay for products with some similarities to yours. You don’t have to guess they’re willing to pay those prices. Your competitors’ sales prove it!

The problem with pricing a new product relative to your competitors is that it doesn’t give you enough price “bonus” for your product’s advantages over the competitors. It also doesn’t account well for any negatives your product has relative to the competitors.

For example, suppose you create a new product that is 10 percent better than the competitors. What is that extra 10 percent of effectiveness worth to consumers? Maybe not a single penny more. Or maybe double or triple your competitors’ prices.

Want proof? Here are two examples:

1. Suppose you make soap. You discover something you can add to your soap that will make it clean 10 percent better. And you can prove it. The process will cost you an extra 10 percent in costs, so you want to get at least 10 percent more in price. Can you get it?
Ask yourself if you would be willing to pay 10 percent more for soap that is proven to clean 10 percent better. Most people wouldn’t. They feel the soap they’re using cleans well enough.
2. Now suppose, instead, you make anti-wrinkle creams. And you’ve discovered an ingredient that will reduce the appearance of wrinkles by 10 percent. But the ingredient will add 10 percent to your wrinkle cream costs.
Can you get 10 percent more in price for a 10 percent better wrinkle cream? We both know you can probably get 100 percent more in price for it. Maybe even 200 percent more.

The value of your new product has no basis in your costs or the degree of improvement over competitor products. The value to your customers is in the degree to which they want your new advantage.

Matching your competitors’ prices doesn’t capture the true value to consumers of your product’s specific benefits. Nor does it recognize your product’s disadvantages compared to competitors.

Both of these can cause the value of your product or service to differ substantially from your competitors. So matching competitor prices could lose you the price premium you could have commanded (because you are underpriced for the value you deliver) and/or lose you substantial unit sales because you’re overpriced for your perceived value.

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