Determining a tariff or a price for products and services is arguably the single most important strategic decision faced by a firm. Yet, many manufacturers and service providers today still forego profits due to a lack of focus on the critical marketing strategies affecting pricing. The theoretical price point at which the maximum profit is achieved is known as the optimal price. This might not always be knowable with absolute accuracy in practice, although it may be approximated very closely.
Organisations use various methods in arriving at a selling price. Typically, in a small company, the owner sets prices. In larger companies, pricing is the responsibility of product and division managers. Nevertheless, they are still typically constrained with pricing objectives that are set by senior management.
Regrettably, these commonly-used approaches are not the most profitable ones to organisations. It is important to set the correct price not only to maximise returns, but also to strengthen sales and accurately reflect customer perceived value. Setting the ideal price cannot be solely based on costs or the competitor’s pricing decisions, but should also be focused on identifying the real value that customers are getting from the company’s products or services. Marketing academics argue that any pricing method that does not consider market demand, competitors’ prices and customer perceived value are unlikely to lead to an optimal price.
A company’s pricing decisions are affected by both internal and external factors:
The company’s objectives such as survival, profit maximisation, product quality and market share need to be considered since these will influence pricing policy. Pricing decisions must also be aligned with the other elements of the marketing mix, such as the design of the product, promotion and distribution channel decisions in order to develop an effective marketing programme.
Costs are another factor which influence price. For some organisations the cost to provide a service or to manufacture a product is substantial. For others the cost of building an infrastructure is substantial whereas the cost of providing the service over that infrastructure is proportionally negligible. A for-profit organisation needs to ensure that an overall fair return on investment is achieved after all the costs incurred and risks involved are factored into its pricing policies.
The price elasticity of demand – the sensitivity of customer demand to changes in price – is an external factor that companies should consider when setting pricing policies since it will affect sales quantities, revenues and profits. One way of maximising profits or approximating profit maximisation is through optimal pricing policies.
This can be achieved by identifying the prices that the market is willing to pay and by charging in accordance with how such prices equate to sales quantities. Competitors’ costs, prices and promotions are other external factors affecting pricing decisions. Consumers will also compare various products and services with other companies’ similar and substitute products. Furthermore, when pricing its products or services, a company cannot determine its pricing strategies in isolation but must continuously monitor and benchmark with the competition.
For an overview of the theoretical and the practical aspects of the price setting process please view a presentation that our members of staff had given here.
Most organisations strive to minimise their costs, try to increase their sales volume to the highest-possible levels and apply across-the-board sales price increases as a means to increase profits. However, strategically managing tariffs and prices through segmentation, repackaging, brand differentiation and the like is usually the most effective means of improving profits.
Setting a price that takes into consideration customer sensitivity might seem to be quite a difficult task. In fact, this is the main reason why many organisations take shortcuts and usually adopt pricing models such as cost-plus. However, cost-plus might not be an optimal pricing approach since there is a huge revenue loss potential.
The aim of optimal pricing is to segment the market into distinct clusters that share similar characteristics, to package the product or service in line with these characteristics and to charge the customers within these groups what they are willing and able to pay. Different customers attribute different values and prices to a company’s products and services. Organisations can better understand the customer’s perceived value of its offerings through market research. Researching product demand and asking customers to judge different products or services with different features and prices will provide the required information that will enable the organisation to charge an optimal price. The objectives of optimal tariffing and pricing can be achieved through segmentation only if there are different price elasticises within the different customer segments.
The main pricing and tariffing mistakes that companies make include the following:
- Customers are not segmented into distinct similar groups;
- The same profit margins are set across all product lines;
- Companies tend to base their prices on a cost-plus model instead of customer perceived value;
- Prices are held constant over a long period of time, neglecting changes in the competitive environment, costs and customer tastes;
- Price changes do not take into consideration possible reactions from competitors;
- Companies lack internal commitment and procedures related to optimising tariffs and prices.
At Equinox, our tariffing and pricing team has the expertise to assist your organisation to maximise profits through optimal pricing strategies and tactics. Our team utilises various statistical models and techniques, such as discrete choice models and market research techniques. This will help you discover and understand the competition, internal cost structures and what customers value most so that superior pricing techniques will lead to greater returns on investment.