I recently read a blog about pricing strategy at EBN Online, Set Pricing for Customer Loyalty & Long Term Profitability, in which the 3rd recommendation is “remove complexity” from your pricing. That is not the first time I have heard or seen that recommendation, and we have had clients ask us to help them remove complexity. Our advice is – be careful about simplifying your pricing, and make sure you model the possible outcomes, because it can result in lower profitability.
We like to remind clients and others that pricing has greater leverage on their profitability than any other area. The graph below demonstrates that a 1% improvement in price increases operating income more than a 1% increase in volume or a 1% decrease in direct costs or overhead. Each industry looks a little different, but in all cases, you get the most leverage from price. The counter argument we hear is “It’s much harder to get 1% in price, and if we can lower our costs while keeping prices steady, we will be more profitable.” We think there is a low likelihood of simplifying your prices to lower the administrative cost while maintaining the same revenue and overall average price. Here is why.
Each customer is unique and the amount of value they place on a product or service can also be unique. There are a number of factors that affect each customer’s estimate of value, including:
- How well the product or service works in their organization and addresses their specific needs
- The amount of time they have to investigate alternatives
- The cost and availability of alternatives
- The quality/ durability of the product or service compared to available substitutes
- The amount of physical space needed to store the product
- The ease of ordering, buying, receiving, and paying for it
- The reputation of the selling company
- The responsiveness of the sales person
- The working capital that is either tied up or avoided by buying from a particular seller
- The bargaining power of the buyer
There can be more factors, but the point is these factors are not the same for every customer and every situation. That means the value will not be the same. If you try to set a single price or just a few price levels, the customers whose value is lower than your price will not buy from you. To avoid losing those customers, your simplified pricing will have to have a relatively low price to reach the broader group of customers. Let’s look at a hypothetical example:
In the first chart below, we can see that as the price of the product increases, the demand decreases. At each increase in price a number of customers become unwilling to buy. So a company that wanted to have a single price and maximize their profit would set their price at roughly $4.00. With a variable cost per unit of $2.65 their margin would be approximately 34%. They would lose some customers on the left side who are unwilling to pay $4.00, but this would maximize their profit.
Now consider if that same company could identify the amount each customer was willing to pay, and they could manage a structure that offered each customer a price equal to their value. They would be able to capture all the customers willing to pay $5.00 and each price point below that, and they would accept all business above their $2.65 per unit variable cost. As you can see from the 2nd chart, profit is much higher under this structure.
Of course it may not be possible or practical to identify the value placed on your product or service by each customer, but as you can see from the graphs, it could be worth a substantial amount of money to be more granular in your efforts to identify value. Grouping customers into several segments of similar value is a logical step. Conversely in B2B environments we regularly see products and services sold at a wide variety of prices and companies looking to reduce the administrative costs associated with managing all those prices. Before making that decision, it is imperative to model the impact on your P&L. If the cost you save by reducing the administration is not greater than the incremental margin you earn by charging differentiated prices that reflect the variety of customer values, don’t do it. In our experience it is usually well worth the effort to manage the complex pricing structure.
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