The basics of pricing

The pricing of the products in a company ranks among the tasks with the strongest influence on profitability. If you are operating on a 10% margin, increasing your prices by 5% leads to a profit increase of 50%! That is, if your customers are not running away, which is of course the most important issue when treating pricing issues. The propensity of your customers to run away when you increase prices (or to come back, when you decrease them) is described by the demand curve.

The demand curve tells you which demand to expect at a given price. Though the demand curve represents our intuition of the sales process well, it is a highly abstract concept and has never been measured in real life. We are lucky if we can boast the knowledge of even only a few "price points" as in the graph on the left. In such cases we can estimate a demand curve using a regression. The point of course is, if you know the demand curve, and your costs (which is also not self-evident, but let's assume you do), you can do the little exercise depicted in the graph on the right and calculate the profit optimal price of your product.

Since the demand curve is such an elusive concept, we often content ourselves with estimating just the slope of the curve in the area near our current price. This appropriately describes the mentioned propensity of our customers to react to (small) changes in the price. This price elasticity e is defined as follows:

If you increase your price by x% the demand decreases by e*x%.

[Experts would say that the elasticity is (minus) the slope of the demand curve, if we plot the log(demand) by the log(price).]

Now an interesting (and simple) result is the following: Assume you did everything right, and the price of your product is optimal. Then the operating margin you make with this product is just 1/e !

1/e = operating margin

This is the quantitative version of the intuition, that high competitive pressure results in low margins as well as low competitive pressure results in high margins.

So, what methods are there to measure price elasticities? Assuming for the moment, that the product in question already exists a while, there are several "empirical" methods:

• Direct price testing (B2C)
• Profitability benchmarking (B2B)
• Lost order analysis (B2B)

Direct price testing means that you look at the effects of price movements in the past. See the presentation on how to measure marketing effects [pdf presentation] for a way how this could be done. Lost order analysis is the same idea applied to a B2B context: At which price levels did you pass the order, and at which price levels did you fail to pass it?

Profitability benchmarking compares your product to similar products in your portfolio. The issue is to know which products are to be considered as being similar. We treat this in more detail in our [pdf presentation] on benchmarking.

The situation is different, when you have a totally new product. In this case no price history exists, and in the case of true innovations you also cannot easily compare your product with other already existing ones. So you're probably stuck with having to do a market research to test customer response to your new product directly, e.g. via a conjoint analysis.

An overview of some of these pricing methodologies is [here (pdf)]