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Confessions of The Pricing Man

By: Hermann Simon

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Peter Drucker once said the following:

“Profit is a condition of survival. It is the cost of the future, the cost of staying in business.”

As you'll learn in the following 12 minutes, pricing is one of, if not the most, important driver of profits. Yet it receives very little attention.

Hermann Simon, one of the world's most foremost experts on pricing, wants you to change that. He makes a very compelling case.

As he points out early in the book, excellent pricing drives profits, and profits are what your business needs to survive.

What Price Actually Means

Simon has been asked thousands of times over the years what the most important aspect of pricing actually is.

If he needs to give a one word answer, he says that pricing is "value." If he needs to elaborate, he says that pricing is "value to the customer."

In essence, he is saying that the price a customer is willing to pay, and thus the price a company can and should charge, is always a reflection of the perceived value of the product or service in the customer's eyes.

This means that managers and business leaders essentially have 3 main tasks as it relates to price:

Create value. This is where product creation and innovation come in.
Communicate value. This is how you influence your customer's perception of the value you create. It includes your unique selling proposition and your brand.
Retain value. This is about what happens after the customer buys your product or service. Expectations about how long value will last (and your ability to deliver on that expectation) has an outsized influence on your customer's willingness to pay the price you've set.

The Relationship Between Price And Profits

Most people know that if you increased your price and volume stayed the same, your profits would go up. But most people (including some really smart business people) don't know just how much it could impact their bottom line.

Most companies in the world operate at margins that are between 1% and 3%. An industrial company with margins above 10% would be far above average. Of course, there are exceptions to this rule like Apple - but even their net margin stood at 21.6%. And, to drive the point home that most businesses are not like Apple, Simon points out that if the average company were as profitable as Apple, we'd live in a utopia beyond our ability to imagine.

To give you a concrete example, if Sony raised their prices across the board by 2% without seeing any drops in volume, it's profits would increase by 236%. Walmart's profits would increase by 41.4% with the same 2% increase in price.

While you'll have to run the numbers for your own business to see what the impact might be, it's clear that price is one of the most powerful tools you have at your disposal to make more money.

Most people look to improve their marketing and sales efforts when they want to increase their bottom line. Pricing has two advantages over sales and marketing:

Price changes usually can be implemented very quickly. Developing a new advertising campaign and waiting for it to have the effect you are looking for could take months or even years.
Price is the only revenue driver that you can employ with no upfront investment.

Different Ways To Set Prices

There are 3 different approaches you can use to set prices. One of them is the right way.

Using Costs to Set Prices

Many people use a "cost-plus" approach to setting their prices. There are a number of problems with this approach, even though it sounds like a reasonable thing to do. Here are two of them.

First, it has nothing to do with your customer's willingness to pay. Second, even if it did, your customers don't know what your costs are, so they couldn't make their decision that way even if they wanted to.

Following The Competition

This means that you set your prices based on what your competitors do. This also sounds like a reasonable approach, and is probably the easiest path to take. But, it also has a number of problems associated with it. The most important being that it's almost never the best way to set prices to optimize profits.

Market-Based Price Setting

The third and best approach to setting your prices is to take the market-based approach. This means understanding what your demand curve looks like, which is like a graph that shows the number of sales you would make at various prices, with volume on the Y axis and the price on the X axis.

In general, when the price goes up the volume goes down, and vice versa. The goal with the demand curve is to find the price where you maximize revenue and profit.

There are four ways you can go out doing this:

Use your expert judgement. You can start to get a handle on your demand curve by asking yourself and your team how much volume you would lose if you increased your prices by 10%. Keep asking for different increases or decreases and you'll end up with an approximation of your demand curve which will help you make pricing decisions.
Ask your customers directly. This would be a more accurate way to do it, and you could use your email newsletter and a simple survey to accumulate large numbers of answers. However, be careful with this approach because just asking the question usually makes customers more sensitive to price.
Ask your customers indirectly. In the pricing field, an approach called conjoint measurement was created to get customers to make tradeoffs between price and value. They are shown many variations of products and price, and are asked to rank order their preferences. You'll probably want to hire an expert like Simon if you dig into this level of detail.
Use price tests. This is the most accurate way to get your answers because all of the other approaches are thought experiments. As behavioural science tells us, there is a large gap between what people say they will do and what they will actually do. Luckily, digital technology makes it fairly easy to run A/B tests and find out the actual answer to "how much does demand rise/fall based on different price points?"

Should You Price High or Low

Once you've determined your demand curve and how much people are willing to pay for your products/services today, it's time to make a decision: which pricing approach is the best for you to take moving forward.

There are 3 main categories to choose from.

Low Price Strategy

This is where you price your product as low as possible to capture as much volume as you can. Thus, the focus of your business is around driving down the cost to produce your products and creating efficiencies.

You probably already know this, but there is only room for a couple of low-priced players in any market. If you are going to choose this approach and be successful with it, here are the factors that will help you do so:

Begin with a low-price strategy from day one. Many times it requires a new and innovative business model.
Be extremely efficient in managing both costs and processes.
Guarantee adequate and consistent quality.
Focus on your core product and don't do anything that isn't absolutely required by the customer.
Have a high-growth and high-revenue focus. You'll need to make up your lack of margin with volume. Economies of scale are your friend.
Be tough and forceful in your purchasing.
Have little debt. Instead, rely on self-financing or supplier credit.
Exercise strong control over the entire value chain.
Focus your ads on price.
Don't mix your messages: Almost all of the successful “low price–high profit” companies stick to an “everyday low price” strategy.
Understand your role. Most markets have room for only a small number of “low price–high profit” competitors, often just one or two.

Luxury Goods Pricing

On the other end of the spectrum are luxury goods pricing companies. This is where there is little connection between the cost of production and the prices you set.

If you are going to choose this approach and be successful with it, here are the factors that will help you do so:

Ensure your product delivers the highest level of performance. This goes for every dimension of your business, including the materials you use to the way you distribute your product.
Ensure your product can deliver the prestige effect.
Set your prices high because price is a quality indicator for luxury goods - the more it costs the more it must be worth.
Keep your volume and market share within strict limits. If "everybody" has your product, you've lost the luxury game.
Avoid discounts and special offers like the plague.
Hire top talent in every part of your business. Every employee is an extension of your brand.
Keep control of the value chain. There's no room for B players.
Understand that the primary factor in price setting is the customers’ willingness to pay. There is little or no connection to the "value for money" equation.

Premium Price Strategy

Finally we have the premium pricing strategy. This is where there is a direct connection between the value you deliver and the prices you set. This is where you try and create the optimal value in your market place, and share some of that value with the customer.

In other words, you create a product that generates more value for your customers than the competition's product, and thus also charge a higher price.

While it's almost impossible to give a general answer to the question of how much more a premium price is to a "normal" price, there are a number of considerations to keep in mind as you pursue a premium price strategy:

You must provide superior value.
The price to value relationship is your competitive advantage, unlike low-cost or luxury where the price is the deciding factor.
Innovation is the foundation of your growth - you must continuously be searching out new value.
Creating a consistently high level of product and service quality is a must.
A strong brand is a must. Your customers need to understand what you stand for.
A strong communication program is a must. Your consumers need to hear your story if they are going to understand your differentiated value.
Shy away from special offers. Premium pricers offer discounts very infrequently.

Which price strategy is best for you?

For most companies the best strategy for creating strong profits is to use a premium pricing strategy. There's certainly room for a couple of low-price and luxury producers in every market, but the high percentage play is to choose the premium route.

Specific Pricing Situations Explained

Now that we've covered pricing in general, let's move on to some of the more specific applications, and how to drive the profit needle even further.

Price Differentiation

Sometimes it makes sense to create different prices for different people, or for different situations. Here are a few ideas to get you started:

Price bundling: you can often maximize profit by packaging together several products and charging a total price less than the sum of the individual products. If you've bought a car recently, you've seen this in action.
Price unbundling: in some situations it might make sense to do the reverse - unbundle what used to be packages into separate product lines.
Volume discounts: there are two ways to give volume discounts - one where the discount applies to the entire volume purchased, and another where the discount applies to the incremental volume. The incremental approach almost always leads to higher volume.
Skimming: this is where you decrease the price of a previous version of your product when you release a newer version. Apple has used this approach with great success.

Pricing In Crises

Often times you'll find yourself in a crisis where you need to make price cuts in order to survive. If you do, make sure you do it intelligently by keeping the following in mind:

make sure you use price-oriented advertising and additional communication to drive the desired increase in volume;
consider offering additional goods or services instead of lowering prices;
consider that maybe an increase in price is the right approach, like Panera successfully did in the 2008 financial crisis.