Product pricing is a core issue facing all companies. A business needs to coordinate pricing decisions with product development, production, distribution, and promotion. Therefore, much of the information collected for other marketing aspects will contribute to pricing decisions.
Pricing is a signal to customers about product positioning and quality, and thus a careful analysis is necessary before price levels are announced in the marketplace. Manufacturers and distributors of social goods have a particularly challenging time when trying to set prices. Often, these organizations are nonprofits whose social mission is focused on reducing health and pollution problems among the poor. The ultra poor, or the poorest people in low-income markets, cannot generate enough income to afford even basic foods and have little to no assets or savings. Determining a “profit maximizing” price seems coldhearted, considering that these populations are barely surviving.
When setting prices, it is important to carefully balance the tradeoffs between price, volume, profitability, and access. Low prices will generally result in high sales volume, as a greater percentage of the population can afford the product. However, for the organization to stay financially solvent, it is important that the prices be high enough that the organization can generate a small profit, which can be further re-invested into the business. For the ultra poor who cannot afford your goods or services, consider promotional pricing tools (such as coupons and vouchers), but be aware that giving products away for free can often damage the manufacturing, distribution, and retail ecosystem surrounding the product. Read more about pros and cons for non-market based distribution plans and how organizations like Acumen Fund are tackling this issue in their fight against malaria. Remember that the purpose of strategic pricing is to price more profitably by capturing more value, not necessarily by making more sales. An easy trap is focusing on volume of sales, which leads to pricing at whatever buyers are willing to pay, rather than what the product is really worth.
Why Cost-plus Pricing does not work
Most companies rely on cost-plus pricing, where the firm calculates the cost of producing the product and adds on a percentage profit margin to reach the selling price. While cost-plus pricing is the simplest way to set prices, in practice it is a blueprint for mediocre financial performance. The problem with cost-plus pricing is that it is impossible to determine a product’s unit cost before determining its price. Why? Because unit costs change with volume. From the laws of supply and demand, a low price will drive high sales volume. But fixed costs (rent, marketing costs, administrative overhead) will remain the same regardless of volume. Because cost-plus pricing allocates fixed costs across the number of units produced, as sales increase, the fixed costs per unit fall. A manager evaluating pricing may look at the lower fixed costs per unit and decide to lower prices, thus driving the same cycle (lower prices, more sales, lower fixed costs per unit). The same “death spiral” is true in the opposite direction, where a decline in sales would lead to higher fixed costs per unit, thus kicking in a higher price – even though raising prices would result in even fewer sales in the future. Cost-plus pricing is a reactive strategy that allows managers to cover cost and profit objectives. Smart managers should price proactively and acknowledge that pricing affects volume, that volume affects costs, and that pricing strategy is in part about effectively managing the utilization of fixed costs.
Why competitive pricing does not work
Another popular pricing methodology is competitive pricing which benchmarks prices of similar competitor products and tries to add a slight premium or discount depending on the product’s feature set and your positioning strategy. However, this can be challenging as competitor’s products may not be a one-to-one match to your product and it can be difficult to get accurate pricing data. When your pricing strategy is based on competitors, it is more likely that this leads to price wars. A price war is a state of intense competitive rivalry where one competitor lowers its prices, then the others will lower their prices to match. If one of the competitors reduces the price again, a new round of reduction starts. In the short term, price wars can be good for consumers who can take advantage of the lower price. However, price wars are often damaging to the companies involve as they reduce the profit margins and can eventually put one of the companies out of business.
Qualitative Pricing Method: Willingness to pay
Different customer segments will have different willingness to pay for your product or service. Affluent segments may demand advanced features and aesthetics that may be out of the range of lower income segments. To determine the appropriate price range within which the customer is still willing to pay requires specific pricing research with your target customer.
Quantitative Pricing Method: Conjoint analysis
Conjoint analysis is a marketing technique that can discern the hidden values that customers place on product features. Every customer making choices between products and services is faced with trade-offs. For instance, is high quality more important than a low price and quick delivery? Or is good service more important than designs and looks? Conjoint analysis helps businesses understand precisely how markets value different elements of the product and service mix so that product development can be optimized and aspects such as pricing tuned to customer’s willingness to pay for specific features. The basic approach is breaking down a product into groups of features and then providing customers with a series of choices among various feature sets to understand which they prefer. Replicating the study with more customers will help in segmenting the target population by their primary motivators (e.g. price, brand, color) and aid in tailoring marketing messages for each target segment.
Click here for a more detailed look at running a conjoint analysis using a statistical software program.
Multiple Price Points
In an ideal world, a company could adjust prices to tap into individual customer’s willingness to pay. An urban woman who works in an office and has adequate disposable income would pay more for the product or service than a poor farmer who can barely pay his children’s school fees. In reality, it is difficult to roll-out products at different price points within the same market. If a profit can be made from buying the product at the lower price and selling it to the more affluent demographic, then you can bet a budding entrepreneur will seize that opportunity. One way to avoid arbitrage is to re-brand and re-label the product for the two segments.
Short Case Study: PSI Malaria Bednets
Photo Credit: Valentina Buj/ CC BY SA
In Kenya, PSI has successfully promoted the sale of mosquito nets at different price points. Insecticide-treated nets are known to reduce the incidence of malaria, which is one of the leading causes of mortality for children under the age of five. PSI used multiple channels to distribute bednets, including private for-profit markets, not-for-profit nets with branded social marketing campaigns, highly subsidized or free nets through maternal health clinics, and free nets given in conjunction with national vaccination campaigns. PSI and their partners were able to create a tiered pricing structure by positioning the free nets with different packaging and product colors (blue versus the white nets sold in the marketplace). Read more about the case study here.
Short Case Study: Aravind Eye Care
Photo Credit: Aravind Eye Care System
Aravind Eye Care provides over 2,000 eye surgeries each year, serving the full range of socioeconomic levels in India. The poor, who come from the remotest villages in the region, receive free or heavily subsidized treatment while the hospital earns its income from the other half it serves: well-off folk who flock to Aravind for its reputation for excellence in eye care. The differential pricing has nothing to do with the quality of treatment which is the same for every patient, but with the type of lens inserted in the eye and the amenities provided. Nonpaying patients are given a basic hard lens and share a room with other patients where they get a mat on the floor. Paying patients can choose from a menu of soft lenses and other categories of rooms.
Getting rich patients to pay for the poor has worked exceedingly well for Aravind. Unlike other charities, the organization is not dependent on donors and makes enough money to be mostly self-financed.
Given the failings of the cost-plus model, it is critical to understand the value that your products creates for customers and translate that value into a price that customers are willing to pay. Conducting a conjoint study can help you understand the features that customers care about, but it’s also important to know how to effectively communicate that value. The content of value messages will differ depending on whether the customer benefits that are derived from the products are psychological or monetary in nature.
- Monetary value represents the total cost savings or income gains that a customer accrues as a result of purchasing a product. For example, the monetary value of a cookstove is the amount of fuel savings over the lifetime of the product.
- Psychological value refers to all of the other ways that a produce creates innate satisfaction for the customer. In the same example, a cookstove that is positioned as aspirational and modern may bring a sense of pride and prestige to the owner, or a sense of security due to its insulation and stability, which is less likely to tip and scald boiling water on the children in the household.
When the important value drivers for a purchase decision are psychological rather than monetary, it is best to avoid using quantified value estimates in marketing material, because value is subjective and will vary among individuals. As well, the less experience a customer has in a market or the more innovative a product, the more likely it is that the customer will not recognize nor fully appreciate the value of a product or service. Therefore, being proactive about educating and communicating the value of your product will be a critical part of the marketing process.
Karmali, Naazneen. Aravind Eye Care’s Vision for India. Forbes Asia Magazine, 15 Mar 2010. http://www.forbes.com/global/2010/0315/companies-india-madurai-blindness-nam-familys-vision.html
Nagle, Thomas, John Hogan, and Joseph Zale. The Strategy and Tactics of Pricing: A Guide to Growing More Profitably, 5th edition. Prentiss Hall.
Novogratz, Jacqueline. More than one approach needed to fight malaria. Acumen Fund, 20 Aug 2007. http://blog.acumenfund.org/2007/08/20/more-than-one-approach-needed-to-fight-malaria/
Tilson, Dana. The Social Marketing of Insecticide-Treated Nets (ITNs) of Kenya. PSI. http://gwumc.gwu.edu/sphhs/departments/pch/phcm/casesjournal/volume1/commissioned/cases_1_12.pdf