Pricing is an art and a science. There are many factors that a pricing manager factors in to arrive at a price that delivers the most value to the corporation. It is important to refrain from equating “most value” as merely “largest revenue”. Value to the corporation is a combination of many things including top and bottom line profitability, improved cash flow, simplification of policies, brand positioning, and customer loyalty.
The analytical side of pricing definition includes many tools including Pricing Optimization. The process uses historical data points of demand (sales) for various price and cost combinations. Optimizing pricing can deliver significant improvements in profitability and customer loyalty.
The process starts by understanding how price movements – up or down – impact the demand for the product. The magnitude of the movement of market demand is quantified and defined as the product’s Price Elasticity.
In almost all cases, when prices go up the demand for the product goes down. The only benefit is that each sale has a greater contribution margin.
Conversely, when prices go down the demand for the product goes up. But the contribution margin of each product sale goes down.
One of the most devastating errors in many businesses is believing that one must maximize either unit margin or demand. In our practice, we have come across many businesses that move large quantities of products with little bottom-line impact. Leaders of these companies wonder how come these large quantities of product sales do not translate to profits on the top, and much less, the bottom line.
The key to solving this apparent paradox is in maximizing Gross Profit. Gross Profit is a function of the number of items sold and their unit margin. Recall that both quantity sold and unit margin are affected by the sale price.
Gross Profit = Quantity Sold x Unit Margin
If we plot Gross Profit against Prices, we can observe the incredibly useful inverted U curve that easily demonstrates that there is a price that yields the maximum gross margin (profitability).
If the business’s tactic is to move gross profit using only low prices, they would select prices to the left of the optimum price. Unfortunately, this single-factor tactic does not take into account the larger effect of low profit per unit. As prices become lower and lower, the effect of low per-unit profit is insurmountable. This is a very common situation for many businesses.
On the other hand, if the business’s tactic is to move gross profit through high prices, they would select prices to the right of the optimum price. Unfortunately, this tactic neglects the effect that higher prices have on demand. And while each sale carries a high per-unit margin, the effect of modest sales yields a low gross margin.
The solution is obvious. Find the price that yields strong demand (not the maximum demand) while ensuring a healthy per-unit margin (not the maximum per-unit gain).
As a pricing manager with over 20 years of experience, my approach with entrepreneurs and business leaders is to go over this fundamental concept before engaging in any analytical work. Once this basis is covered, the work entails extracting historical sales figures with their associated per-unit prices and costs.
Our algorithms build the necessary models to compute the price optimization table or curve.
An extremely productive effect of this analysis is helping clients shift their focus to negotiating better per-unit costs through strategic partnerships with suppliers or distributors. Improvements in gross profit have ranged between 4% to 12% for key product categories.
If you want to know more about our services, contact us at solutions@vectoraldata.com
