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Pricing Strategy

Pricing Strategy

This is part 1 of a 5 part series on Pricing Strategy – Part 1.

A fundamental aspect of your business is figuring out what price to charge customers for your product. In previous editions of the Data Driven Daily, we assumed you had already determined a price in order to talk you through metrics related to your revenue, like Customer Lifetime Value. For the next two weeks, we’ll take away that assumption and talk more deeply about how you can use data to create a pricing strategy for your business.

Before we do that though, let me introduce myself. I’m Doug Mitarotonda, the VP of Analytics at Outlier, and I’ve been working on pricing my whole career. I started by creating an auction to sell carbon dioxide emission allowances, then designed residential electricity rates for utilities, and most recently helped sports teams and live entertainment promoters price their tickets.

The most important thing I’ve learned through all of these experiences is that pricing should be thought of as a continuously evolving strategy. Because of your company’s objectives, and the competitive environment in which you operate, change over time, your pricing needs to adapt strategically as well.

These next two weeks, we will dig deeper into pricing concepts that will help you become a more profitable business by answering the following key questions:

  • What inputs should you consider when coming up with a price?
  • How do you measure your customers’ response to price changes?
  • How do you maximize revenue for each customer segment?
  • When does it make sense to discount or promote your product?

In response to each question, I’ll spend one day talking about the theoretical aspects and then the next with a concrete example using a hypothetical company, Doug’s Desserts (because I love baking!). This hypothetical company sells its baked goods online and also has an online subscription service that provides customers with recipes and tips.

There will always be some art to creating a pricing strategy, but by the end of this series, hopefully you will feel more comfortable identifying the right data and tools to use to inform your pricing strategy. If you have any questions along the way, please drop me a line. I’m here to help.

Recipe of the day: Cook’s Illustrated Blueberry Scones (free trial / subscription required; I do not receive any compensation for this link)

Pricing Strategy: Pricing Inputs Theory

This is part 2 of a 5 part series on Pricing Strategy – Part 1.

Today we will focus on the inputs you need to inform your pricing decision. When you first sit down to try to determine how to price your product, there are a number of different inputs you can use to narrow in on the optimal price:

  • Cost of goods sold (COGS), plus a margin
  • Target revenue divided by the number of expected customers
  • Price of your competitors
  • Value of your product to your customers

Let’s consider the strengths and weaknesses of each of these to understand where they should fit into your pricing strategy.

Cost of Goods Sold (COGS), Plus a Margin

This is one of the most straight-forward and easy-to-calculate ways to think about pricing. You have fixed and variable costs of producing your product, so as long as you cover your variable costs in the short-run (and can find a way to cover your fixed costs in the long-run), you are in business! You’ll still need to test whether customers are willing to pay you enough to cover your variable costs, but knowing how much you need to make per unit helps you understand the price you need to charge to stay in business. But if customers are willing to pay more than your costs, you’ll be leaving lots of money on the table!

Target Revenue Divided By the Number of Expected Customers

Another relatively straight-forward input is to identify a target revenue goal and divide it by the number of anticipated customers, thereby yielding the amount you should charge per customer. This metric is easy to calculate as your revenue and customer targets are based on your company’s current strategic goals. Revenue and customer targets can help you aspire to a goal, but you won’t know if any / enough customers are willing to pay your calculated price or if you are underpriced relative to their willingness to pay.

Price of your Competitors

Knowing the price(s), and related product offering(s) associated with the offered price(s), of your competitors helps you understand your market, particularly how much customers are willing to pay for a similar product or service. This input can serve as a benchmark for your product and should be easy to measure as most pricing for SaaS and e-commerce companies is available on their websites.

However, your product is differentiated from your competitors’ in important ways that affect its price. Or, in some cases, you are developing something new and there are no direct competitors. Plus, you don’t know that your competitors have thoughtfully set their prices in a way to maximize their revenue. For all of these reasons, using your competitor’s price as the only input in your pricing strategy is a bad idea.

Value of your Product to your Customers

Keeping in mind how much value your product is providing to customers is key when developing a pricing strategy. This cost / benefit analysis is certainly what your customer is asking herself / himself consciously or subconsciously as she / he decides whether or not to buy your product! Thinking about pricing in this way gives you a realistic view of what people think of your product and how much they’re willing to pay to benefit from it. The input you get about the value of your product has the added benefit of helping you determine which features are the most valuable or new ones that need to be added.

Compared to the other pricing inputs, product value is the most difficult to measure accurately. One approach is to conduct a market survey or talk to customers; however, customers are biased in their response by their desire to minimize their costs. As a result, they have little incentive to truthfully tell you exactly how much they are willing to pay for your product. Another option is to estimate the direct benefit of your product by, for example, estimating the time your customer’s employees save by using your product.

So, What Do I Do?

The most important data to have available when determining the price of your product is the value you are going to add. The other pricing inputs help to complete the pricing narrative but are not sufficient alone. For example, knowing your competitors’ prices shows that you are knowledgeable in your industry and gives you the opportunity to showcase why your product is better in order to justify the price you are charging. And when you know that the price you are asking will also cover your variable costs and put you on the path towards achieving your targeted goals, you know you have a viable business!

Tomorrow, I’ll give you an example of assembling inputs to form a pricing strategy for Doug’s Desserts, my hypothetical company.

Recipe of the day: Cook’s Illustrated The Ultimate Flourless Chocolate Cake (free trial / subscription required; I do not receive any compensation for this link)

Pricing Strategy: Pricing Inputs Example

This is part 3 of a 5 part series on Pricing Strategy – Part 1.

Now that we know what inputs we should consider in coming up with a pricing strategy for our product, let’s take a look at how that could play out with Doug’s Desserts, a hypothetical company that sells its baked goods online and also has an online subscription service that provides customers with recipes and tips.

Cost of Goods Sold (COGS), Plus a Margin

Doug’s Desserts has a number of costs associated with producing its baked goods, like chocolate chip cookies, that are mailed to customers as well as the online subscription service.

CostChocolate Chip Cookies
(per dozen)
Online Subscription Service
(per monthly customer)
Ingredients$0.75
Facility$1.00
Labor$2.00$0.75
Online hosting$0.25$0.25
Total$4.00$1.00

Suppose I want to make a 50% gross margin on each product. Then I would need to sell cookies for $8.00 per dozen and online subscriptions for $2.00 per monthly customer.

Target Revenue Divided by the Number of Expected Customers

At this point in my company’s life, my goal is to have $5,000 in monthly revenue and 1,000 customers each buying at least one dozen chocolate chip cookies per month, so I need to sell cookies for $5.00 per dozen to meet my target. I aim to have $10,000 in monthly revenue from 10,000 customers for my online subscription service, or $1.00 per monthly subscription.

Price of your Competitors

My local Safeway sells 50 chocolate chip cookies for $5.00, or $1.20 per dozen. But, the quality of ingredients and taste of my cookies is vastly superior to Safeway’s, so they are not a true competitor! This online review says that the best store-bought chocolate chip cookies in America are Tate’s, selling 14 cookies for $5.99, or $5.13 per dozen.

Cook’s Illustrated (my favorite place for recipes) sells their standard online membership for $34.95 per year, or $2.91 per monthly customer. But they have an entire test kitchen that they use to test hundreds of versions of each recipe, so their recipes and tips might be better than what I can offer. There are also lots of free options out there that make their money off of advertising.

Value of your Product to your Customers

Buying chocolate chip cookies provides my customers the benefit of saving their time from having to shop, bake, and clean-up, plus the delicious taste and quality of my cookies compared to their own (or my competitors). They have ingredient costs similar to mine, but presumably a little more expensive since I can buy in bulk. Let’s assume my consumers’ ingredients cost 25% more per dozen, or $5.00 per dozen. And let’s assume that each customer bakes two dozen cookies once per month, it takes two hours to shop / bake / clean-up, and that their time is worth $5.00 per hour. That means there is a time savings of $10.00 per two dozen, or $5.00 per dozen. So the total value to the customer is $10.00 per dozen (before considering the superior taste and quality of my cookies).

The online subscription also saves my customers time. Let’s assume two hours a month are put into meal planning, and my recipes / menus could cut that time in half. At $5.00 per hour, the value to my customer is $5.00 per monthly customer (before considering other benefits like impressing their family and friends with such delicious food).

Summary

Pricing InputChocolate Chip Cookies(per dozen)Online Subscription Service(per monthly customer)
COGS, plus margin$6.00$1.50
Target revenue$5.00$1.00
Competitors$5.13From $0.00 to $2.91
Value$10.00$5.00

The theoretical value that my products provide my customers outweigh the other inputs, so that gives me a good idea of how much I could potentially charge. But until I’ve sold my product and talked to customers, these values are a little fuzzy.

I’ll price my chocolate chip cookies at $7.00 per dozen, knowing that I’ll have work to do explaining to customers how far superior my product is compared to my competition. I’ll price my online subscription service at $2.00 per monthly customer because I am not sure yet if my value will exceed that of my competitor’s.

This research gives me a good starting point on my pricing. Tomorrow I’ll talk about what you can expect to happen when you change your prices via the concept of the price elasticity of demand.

Recipe of the dayCook’s Illustrated Perfect Chocolate Chip Cookies (free trial / subscription required; I do not receive any compensation for this link)

Pricing Strategy: Price Elasticity of Demand Theory

This is part 4 of a 5 part series on Pricing Strategy – Part 1.

The price elasticity of demand is the way to measure the responsiveness of your customers demand for your product in reaction to a change in price. By understanding and measuring this metric, you’ll have a better idea of what to expect to happen to your revenue after making a price change.

Definition

The own-price elasticity of demand for a product is calculated as the percent change in quantity of a product demanded in response to a percent change in that own product’s price¹.

For example, if you’ve sold 100 units at $50 per unit and after changing the price to $55, you sell 95 units, then your own-price elasticity of demand is -0.5. This result is a unit-less (because it is measured in percentage changes), negative number (because changes in price move in the opposite direction as changes in quantity)² between 0 and negative infinity.

Interpretation

The most important aspect of the price elasticity of demand is how it relates to -1. If the price elasticity of demand is between 0 and -1, then the percent change in quantity is smaller than the percent change in price. You would make more revenue by raising price since the number of lost sales is made up by the higher price for the units sold. Because of this, when price elasticity of demand is between 0 and -1, it is called inelastic, because customers are not sensitive to your changes in price.

On the other hand, if price elasticity of demand is less than -1, then the opposite is true. You would make more revenue by dropping price since the number of new sales will make up for the lower price point. In this case, the price elasticity of demand is called elastic, because customers are sensitive to changes in price.

Measurement and use

There are a few ways to measure the price elasticity of demand using survey techniques, such as choice-based conjoint analysis or the price sensitivity meter. However, surveys need to be taken with a grain of salt due to a number of factors, such as the incentive structure and potential biases. The most accurate view of price elasticity of demand for your product is by making price changes to see how customers respond.

It is important to keep in mind that the price elasticity of demand is not typically a constant value for all consumers, at all times. You should estimate the price elasticity of demand for each customer segment and when demand shifts due to seasonal effects, for example.

Even if you don’t conduct surveys or change prices to compute the price elasticity of demand, there are many factors that influence it that you should always have in mind. In particular, products that have many close substitutes are highly elastic because it is easy for customers to switch to a cheaper option. Also, products that are considered luxury goods are highly elastic because if the price changes significantly, the customer can move on without it. These concepts reflect what should be a driving goal for your company – to create a unique product that is deeply ingrained into a customer’s life or workflow.

Tomorrow I’ll provide an example of how to use the price elasticity of demand for my hypothetical company, Doug’s Desserts.

Recipe of the dayCook’s Illustrated Quick Cinnamon Buns with Buttermilk Icing (free trial / subscription required; I do not receive any compensation for this link)

¹ There is a related concept of cross-price elasticity of demand, which measures the demand for one product in response to a price change of another product.

² In other words, increases in price cause decreases in demand, which is true the vast majority of the time. Because of this, you’ll often see the price elasticity of demand written as a positive number instead of a negative number. I personally don’t like that practice because I like having the negative sign remind me that prices and quantity move opposite of each other.

Pricing Strategy: Price Elasticity of Demand Example

This is part 5 of a 5 part series on Pricing Strategy – Part 1.

Today, let’s see how the price elasticity of demand comes into effect for my hypothetical company, Doug’s Desserts. I decided in an earlier example to price my chocolate chip cookies at $7.00 per dozen. Suppose that at this price, I’ve been selling 500 dozen per month, but I think I might be overpriced and can sell a lot more cookies if I lower my price a dollar. After dropping my price from $7.00 to $6.00 per dozen, I’ve started selling 750 dozen per month.

Plugging these values into the equation from yesterday, I find that my cookies have an own-price elasticity of demand of -3.5.

This means that demand for my cookies is elastic, which is probably not surprising because there are lots of close substitutes for my chocolate chip cookies and cookies, particularly premium ones, are not a necessity. Because demand for my cookies is elastic, this price change generated more monthly revenue for my business.

PriceQuantityRevenue
$7.00500$3,500
$6.00750$4,500

Next week we will continue the pricing strategy conversation by looking at tiered pricing, discounts, and promotions.

Recipe of the dayCook’s Illustrated Spiced Pumpkin Cheesecake (free trial / subscription required; I do not receive any compensation for this link)


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