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.”
Hermann Simon points out that pricing is one of the most important drivers of profits. Yet it receives far too little attention. A great understanding of pricing will drive the profits that your business needs to serve
What Price Means
A question that has been asked to Simon thousands of times over the years. A one-word answer to this question is that pricing is “value.”, within a phrase, pricing is “value to the customer.” This means the price the customer is willing to pay, and therefore the company should aim to charge, is a reflection of the value of the product or service in the eyes of the customer. Simon then lays out the three main tasks businesses have as they relate 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) have an outsized influence on your customer's willingness to pay the price you've set.
Different Ways To Set Prices:
Simon explains three ways one can use to set their prices. Only one of them is the correct way.
Using costs to set prices.
At first this seems like a reasonable thing to do, however there are some issues with this approach. First, it does not factor in the customers’ willingness to pay for the good or service. Second, the customer does not know what your costs are, so their willingness to pay is not affected by your costs.
Following the Competition.
This means setting your prices based on the prices of competitors. This too seems like a reasonable strategy, however it also has its issues. The most important of which is that it is almost never the best way to set prices if your aim is to maximize profits.
Market-Based Price Setting:
This is the best approach to setting your prices. This method involves utilizing the demand curve. The demand curve is a graph which shows the number of sales one would make at various different prices, with volume on the Y axis and price on the X axis. Within this method there are four ways of determining your demand curve.
- The first way is to use your own judgement and the judgement of your team. Figure out how much volume would be lost by increasing and decreasing prices by 10%. Moving in both directions will give you an approximation of the demand curve and help you make better pricing decisions
- Second, you can directly ask your customers. Using an email newsletter or a simple survey, you can receive a large number of answers. With this method one must be careful of their customers becoming too sensitive to price.
- Thirdly, a business can ask their customers indirectly. An approach like this would generally involve an expert such as Simon. One method of doing this would be presenting the customer with many products and prices and asking them to rank their preferences to show how they make tradeoffs between price and value
- Fourth, the likely most accurate way is to use price tests. Because there can be a large gap between what people say and what they do, the previous methods can sometimes be inaccurate. There is digital technology which can be utilized to run tests which answer how much demand rises or falls based on different prices.
It is evident there are many different ways to set prices, and if business leaders which to maximize their profits, Hermainn Simon provides an essential guide to pricing.