Optimal Price Setting

December 03, 2016

Optimal pricing experience

Value pricing, not cost-plus 
If you ask companies how they set their prices, chances are they will say value pricing! But if you take a closer look, cost-plus pricing is really what they are using: add your target margin to costs and you have a price. In true value pricing, the mark-up depends on how much the customer values the product. This value differs hugely, but it’s almost always measurable, which is why value pricing has such enormous profit potential. For example, a metallic finish on a car comes with a high mark-up despite minimal manufacturing costs. In the US, a stamp for a two ounce letter (57g) costs 45 percent more than a stamp for a one ounce letter (28g), although the costs are nearly the same. It’s all a question of value. But measuring customer value is borderline impossible when there is a high number of products, e.g. thousands of spare parts. That’s when you need a system. Spare parts, for instance, should be grouped by various criteria such as safety relevance – their price is then higher or lower depending on the group they are in. So true value pricing is actually always possible.

Analyze the current margins of your products: Minor deviations are a clear sign that you are using a cost-plus approach. Ensure that true value pricing is used, even if it’s a lot of work.

You MUST know your price elasticities 
Price elasticity is a tricky topic: Some companies don’t fully understand it, others see it as an abstract concept. For decades now though, one thing has remained true: If you don’t know your price elasticities, you won’t be able to set an optimal price, especially for new products. The problem with price elasticities is that they vary strongly depending on the product and situation. There is never one constant price elasticity. But at least, the methods for measuring it have improved greatly over the years. And yet many companies choose not to measure price elasticities, thereby missing out on considerable profit potential – as history has shown. When Mercedes launched its A-class in 1997, it planned on offering the car for DM 30,000. After thoroughly analyzing the price elasticities, costs and production capacities, we recom­mended a price of DM 31,000 – which ultimately generated added profits of DM 150 million per year.

Establish the importance of price elasticities in your organization. Conduct an elasticity analysis before launching important products or changing prices, and continuously use these results for simulations and to assess business cases.