Basic price setting for products

Optimal pricing is crucial for achieving a good margin, profit and ultimately, company growth. For many companies, at least one of these factors is a main goal. To set up the right price of your product, you can use this simple formula:  

Profit = Price x Volume – Total Costs

Basically, you look at how much your business costs to run and after that you determine what the price for the expected number of products you will sell. Most companies first determine the cost of running the business. For that, most businesses use the following formula:

Total Costs = Total Fixed Cost + Variable costs

As you can see, the total costs are based on two factors. Fixed costs are not related to the number of products a business sells, for example rent, machinery, web shop costs or certain marketing promotions. Variable costs are costs based on the number of products a business produces, for example, packaging, commodity or sending costs.

Many companies start with calculating the costs and then calculate how much they need to sell for which price to obtain a profitable business. Because of this, many businesses follow a cost-plus pricing model, which first determines the costs and then determines the price of the product on a certain margin target they want to obtain.

This is good (in some cases), but for many companies, this is not how you set the optimal price. Most companies should shift their focus from costs to price if they want to increase their profits. But why?

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Focus less on cost if you want to set the optimal price

According to Simon & Kucher, a 5% price increase without volume loss and average margins can easily lead to a profit increase of 30%-50%. Normally companies focus on cutting costs or increasing volume to generate more profit. But no matter how much you focus on these two factors; at a certain point you have reached all potential. But why is this? And what should you do next?  Let’s look at the profit formula again:

Profit = Price x Volume – Costs

As you can see, Price is the multiplicative factor, but according to most consulting companies, companies pay the least attention to this factor. While in fact, it has the biggest potential for profit gains. Let’s explain that with the following examples. In one case we increase the price with 10% and in the other case we decrease the cost with 10%:

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As you can see, a 10% price increase is 2x more effective as a 10% cost decrease. Of course, this is a simplified situation and formula, but the principle is clear. Price increases are more effective than cost decreases when volume stays the same.

A blunt 10% price increase could be beneficial for companies that operate in a niche market, or which are much higher valued than competitors. Examples of companies that can increase their prices easily without losing (a lot) of volume are Apple, which has relatively expensive smartphones. Or pharmaceutical companies that have patents on products. These companies can sell based on what the consumer value the product, without losing volume.  

However, many companies operate in a market which is competitive, without having the luxury of being a known as a premium brand without alternative brands. Therefore, to fully optimize their pricing, companies should consider price elasticity of demand. Basically, the change of consumption in relation to a change in price. Mathematically known as: Price elasticity of demand = % change in quantity demanded / % change in price.

In principle there is a negative relation; if a product gets more expensive, the product will be less demanded. If competitor prices stay the same. However, taking this into account a price increase for a price sensitive product can still be more effective than a cost decrease. Let’s say that if your product increases 10%, 3% of the customers decide to not purchase your product anymore. How would that play out? Let’s incorporate it:

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Again, a price increase with a slight volume decrease can lead to a higher profit than a cost decrease. Let alone if you combine a cost decrease with a price increase…

You may now think that this is only a theoretical example and that this can never work in reality. Let us show you how one of our clients could increase a product price with 10% to increase his gross margin with 29%. Resulting in an increased profit of 10.000 euros per month!

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For every company and every product these factors will be different and there is no one-size-fits-all solution for pricing. However, based on these principles there are pricing strategies that are best fit to certain business situations.

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Set the optimal price – from simple to complex business situations

Based on the profit formula: Profit = Price x Volume – Costs, there are certain pricing strategies that fit in certain situations.

Let’s say you are starting a new business and you can only determine the costs of your product then the best strategy for you is a cost-plus pricing model or a competitor-based pricing model. These two strategies are useful if you know your costs.

Let’s say you have a good-selling product on the market for some time and you do not have a lot of competition. Then you start thinking about a customer-value based pricing model or a premium pricing model. Which focus on selling the product for the price that customers value it and making it feel premium to the customer.  

Let’s say you are in a very competitive market with some established competitors, but you already have a good market share. Then you should investigate the price elasticity of your product and the prices of the competitors. This should ideally be done by looking into the data that is available to determine the right price for your product which leads to the most amount of profit.

Do you want to be a pricing superstar? Then you should consider dynamic pricing, which is the practice of automated variable pricing for a product of service to anticipate on changes in the market condition. This pricing strategy is very data driven and uses data of different sources such as competitor prices, price elasticity, weather, stock available and or other factors to determine the optimal price. This is the ultimate strategy for optimizing profits.

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Conclusion

There is no one-size-fits-all solution for optimal pricing. It very much depends on the situation you are in as a business and how much data and knowledge you have about the market. However, many businesses should focus on increasing their prices since a lot of profit and value can be obtained. If you want to optimize your pricing to be ready for 2022, SYMSON can help you out.

SYMSON helps companies with their pricing by automating mundane tasks and giving advice on how to increase margins and revenue. To never lose margin again with the help of pricing.

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