Pricing is a critical task that all businesses manage. However, there are many different ways to approach the pricing requirement. In simple terms, price = cost of inputs (or raw materials) + profit margin. Costs include personnel expenses + non-personnel expenses (IT, accounting, compliance, insurance, Infrastructure…); while margin is dependent on your profit and return on investment requirements. Companies run into problems when they disregard the math, and do not understand the returns they require.
An incorrect approach could jeopardize your business and have dire consequences. Several popular strategies include –
The low price option in the market – This strategy requires your material costs to be substantially lower than competitors in the market, on an ongoing basis. Your business processes must be very efficient. Inefficiencies cause waste, which have a cost and add no value. A short-term dislocation in costs will make this approach damaging to your business. The goal in business should never be to become the low cost provider; but to become the most profitable provider.
Discounting – This strategy is used by companies in an attempt to garner new business from competitors by offering a discounted introductory price. The goal is to provide an incentive to the client, to make a change and try your product/service. However, once you provide a discount, it is very hard to remove it. You will risk your clients moving to another competitor when your discount ends, as they will not appreciate an increase in costs. Consider the approach of mobile phone companies and cable TV providers. Each provides a discount for new customers to migrate to their service, if the customer agrees to stay with the provider for a certain amount of time. But once the Agreement term expires, customer attrition is high. The only time this approach will work is when the cost of converting to a new provider is high. Customers will change providers unless the penalty for changing is greater than the cost of staying.
Selling certain products/services at a price below costs – For this strategy, a subset of your products/services is sold at a very low price, while other products/services are premium priced. The assumption is that your clients will come for the low priced products/services; and additionally purchase other items which have a higher price. But problems will occur if your projections are far off the actual results. A situation was reported in the Wall Street Journal where Staples Inc. offered the State of NY (government agency) a promise to offer some items for one penny in exchange for the state’s office supply business. “Staples delivered penny items with a list-price value of $22.3 million in the contract’s first few months, for which it was paid $9,300…” (07.23.2014 – WSJ “When Staples Offers Items for a Penny, New York Buys Kleenex by the Pound”)
Relationship pricing – With this strategy, businesses offer an across the board price reduction to win large contracts. The base price is reduced only for this client. But, I have seen profitable relationships become unprofitable when this approach is not monitored and modified continually. This approach will work in the first year once prices are set. However, if you have agreed upon a very low margin and the period between dates of re-setting prices is long, a relationship can quickly become unprofitable. For example, if you provide a fixed fee to your clients, you are assuming risk associated with price increases, which you will need to absorb until the fee is adjusted.
“…in general, corporations that hire real-estate companies to operate their facilities have been leaning harder on costs and are moving toward fixed-price contracts; under a fixed-price contract, the real-estate company must deliver its facilities management services within the price of its bid or absorb any cost overruns.” (04.14.2014 – WSJ “Cushman & Wakefield Scores a Big One: Citigroup Contract”)
The solution to competing on price is to compete based on value, i.e. a value proposition. In a world where most products/services are offered by multiple providers, clients need a reason to trust you with their business. “The reason I use XYZ Inc., for my needs is that I am assured that they will provide me with –expert sales support that is knowledgeable and committed to providing a high level of customer service; a full menu of products/services that allow for one-stop shopping; a great brand reputation and presence in the market; and, they have the ability to deliver on promises, i.e. follow-through.
Customers/clients will be less sensitive to price if they understand the benefit of working with you, i.e. understand the value proposition you offer. Additionally, satisfied customers will generate repeat business and be a source of recommendations for new business.