Do you like pricing new product or service offerings? For many of us, it’s a stressful decision. Too high of a price and customers won’t want the new offering. Too low and we feel as though we’ve cheated ourselves out of the real value of a truly innovative and valuable offering.
Frontrunners don’t simply stop at making a profit on a new product. They seek to optimize the profit potential from each offering within each customer segment. These companies avoid leaving money on the table through lost sales or underpricing by triangulating on an appropriate price.
By calculating three prices − the floor, the substitution price, and the customer value price− you can satisfy yourself that your initial price is optimal.
Floor Pricing For Your Product
You probably already use this method sometimes. It consists of the cost of your offering plus a minimum acceptable margin. Some firms use this approach all the time for pricing and it is effective at making sure that the company makes a minimum margin on each sale.
The floor prevents us from selling at a price that may be acceptable to the market, but not to our bottom line. The cost plus approach is flawed, however. It ignores the fact that individual offerings often do, and should, have different profit margins based on their uniqueness and intrinsic value. The cost plus approach also ignores the fact that an offering may be more valuable to some customers than others.
Substitution Pricing for Your Product
To address an offering’s value in terms of uniqueness and intrinsic value, frontrunners use the second approach: substitution pricing. You have probably given some thought to the substitution price in the past as well. Simply put, this is the price a customer could pay if they purchased another product or service. That includes the exact same product or service or one that provides similar value to the customer. At its simplest, this approach is like comparison shopping.
What can customers pay for ice cream at Kroger rather than Meijer? Adding a little complexity to the story, however, can add margin to your bottom line. If your ice cream is made from locally grown, organic ingredients and with unique flavors that cannot be purchased from your competitor, you should be able to command a price premium over the generic substitution ice cream.
Using this approach is especially helpful in avoiding overpricing an offering. If the exact same product is available from a competitor, it is less likely you can charge double for it. If, on the other hand, your product or service is unique, you are more likely to be able to charge a premium, provided customers value the organics and special flavors.
Customer Value Pricing for Your Product
Which brings us to our third approach: customer value pricing. The financially strongest companies price their products and services individually by customer segments.
Sticking with the aforementioned example, customers who have concerns about the environment, food safety, and health and fitness might all value organic, locally sourced ice cream more than customers focused primarily on prices. Similarly, customers that are into special flavors might attach a premium to unusually derived ice cream flavors. Combining both, in the ice cream market, can yield double or higher premium prices over nationally available options.
In some cases, you can calculate the premium. A leading maker of packaging materials priced a new offering by calculating the total cost of using their competitor. The labor to install the product and the actual purchase price of the product totaled $187 per truckload. There was also a significant indirect cost in that the competitor’s product took so long to cure that a dock was tied up for 30 minutes.
Since the company’s product cost about $12 per truckload to make, using a cost plus approach would have resulted in a selling price of about $16 per truckload. The company priced their product at $197 because they could demonstrate to customers that the reduced dock dwell time was easily worth the $10 premium.
Continuing to triangulate on a price that reflects the true value to your specific customers is a key factor differentiating the frontrunner from the pack.
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Editor’s Note: This article was originally published on Jul 18, 2012.