Setting Up Shop - Chapter 3: Setting the Price Right (PART II)
In Part I we touched upon the structure of a typical P&L and an example of impact of pricing on the beer category.
When it comes to pricing there are several broad approaches we can take that we will take a look at below. There are many pricing tactics when it comes to promotions, upselling, cross-selling etc… We won’t be discussing these today as they may be part of a broader Revenue Management discussion, which we might actually tackle at a later date.
Today we will look at the following three types of pricing approaches, what they mean, how they are implemented and what are the benefits, watch-outs and applications of each:
Cost based pricing
Value based pricing
Market / competition based pricing
Cost based pricing
Definition: Cost based pricing is the price of an item (physical, digital, non-tangible) where the cost of manufacturing / creation, distribution, marketing and other fixed costs is added together and an arbitrary mark-up margin is added to the amount.
Benefits: Predictable margin and profitability, ease of creation.
Watch-outs: We must make sure that we are able to truly identify all applicable costs to a sold item as missing an elements will directly eat our margin, which might be thin. This type of pricing doesn’t take into account market movements and might lead you to being overpriced versus the competition price and stop you in your tracks.
Applications: Commonly this type of pricing is used in inter-company sourcing, that apply handling margins or you will find it in the production of private label products by manufacturers for retailers where a purchase price is set after negotiations, making it effectively a cost based price deal. In the services industry some products might be priced this way whereby an overhead is charged to the cost of the people engaged on a project.
Value Based Pricing
Definition: Value based pricing is the price of an item or more usually a service that is derived from the total value created by the product sold to the customer
Benefits: Value based pricing is a great way for the supplier to on the one hand show that their price are purely merit and performance based, which can lead to your buyer feeling that you also have skin in the game, which you do, and which they like! Value based pricing is also one of the forms of pricing which can “open the lid” on the revenue that can be generated by services firms. You might imagine a parking lot video surveillance product that is paid for by how many wrongly parked cars are spotted.
Watch-outs: Value based pricing is often difficult to implement, especially in an industry or a market that isn’t used to such an approach. Some buyers will not be ready to accept that you take a percentage of value created and might lead to the perception of the product or service being overpriced. On the other hand some buyers might be enthralled by the idea of a service being paid only as a percentage of value created, which is initially great, however when the time comes to issue the invoice and be paid your buyer might become reticent to pay you such an amount.
Applications: This type of pricing is often used in consultancies in cost saving projects, in new growth projects, in recruitment projects etc…
Market / competition based pricing
Definition: Market / competition based pricing looks at the general willingness to pay by users of a certain product or service. Usually there will be several competitors in the market offering similar alternatives and a price will be chosen that is competitive to similar products in the market. In broad terms FMCG / CPG, consumer electronics and other mass user goods where there is healthy competition will be found in this category of pricing strategy.
Benefits: Pricing is already set up by the market and will give you an idea of what sort of revenue can be generated from a given market. “Clever” pricing and promotion can give you an edge and can even be modelled to predict what sorts of sales uplifts can be expected.
Watch-outs: There is clearly a limit to what a certain type of product can be priced at in these types of market, any breakaways are more difficult to achieve, but not impossible. As these markets tend to be demand and supply driven any move by a competitor in terms of price dumping to generate volume or share can lead the market in a detrimental spiral eroding value. In these markets managing a business is a fine balance between pricing, investing and maintaining cost under control - any abrupt and wrong move can wipe your margins out at a moment’s notice.
Applications: FMCG, CPG, markets where competition is flourishing and the market is driven by demand and supply.
Hopefully the above overview has given you a succinct overview of different pricing approaches that can be taken. If you would like to discuss your approach with us, drop us a line. We will be happy to assist!