A price is not just a number on the label, it includes all the elements of your business model, which in influences in its turn.
Warren Buffett said that The single most important decision in evaluating a business is its power to set the price by relying on the market and its customers without losing business. Let's see an example to understand why this ability, this power to set the price means so much.
Short case study
Let's say we're talking about Maria, a fictional entrepreneur, with real numbers, and the numbers are as follows: Maria produces a premium scarf in her workshop for 50 euros. That's her cost of production. The fixed cost of her workshop for one year is 20,000 euros.
Maria currently sells 1000 pieces for 100 euros each (final price), her annual profit being 30,000 euros. At the end of the year, she wonders how she could get more. A simple and powerful answer for her may be precisely the price. Maria is considering two scenarios:
In the first scenario, she increases the price of her product to increase her earnings.
In the second one, she decreases the price to increase the number of customers.
In the first scenario, let's say she decides to raise her price by 20%, with the risk of losing some of her customers. With a 20% increase, she would have to sell at least 715 units to make sure this year she will be left with at least the profit she obtained last year. So she can afford to lose somewhere around 30% of her customers.
If she drops her price by 20%, Maria will have to sell almost 67% more (i.e. 1167 units) than last year to be left with the same profit. The question Maria should ask herself is "If I make this price change, what is the most likely consequence?".
But what the pricing power means is the following. Let's say Maria can raise the price by 20% without losing any customers. In this situation, her profit would be 50,000 euros, so a consistently higher profit than last year. In the second scenario, if Maria decreases the price and the market is not elastic, she will not see any reaction to the decrease, and her profit will drop to 10,000 euros if she does not sell more units as a result of the price decrease. In order to catch up with the price increase, she would have to sell 2330 units to make the same profit of €50,000 at the new lower price. The differences you have to take into account are quite big, because the price, together with the volume and the cost, are the 3 factors that determine what you are left with at the end, what profit you have at the end of a business year. Of the 3, the price is the strongest factor, both in a positive sense and in a negative sense. Let's not forget that profit is mandatory, it is what gives us a sense of security and guarantees the survival of our business, including in unexpected situations.
Factors affecting price
First and foremost, we have the customer, with their wants, needs, expectations and resources. We need to answer questions about what the customers wants, what solving a problem means to them, and what they stand to gain or lose if they don't solve it.
Of course, we also have to think about what resources they have available. In economic terms, this is called price elasticity, i.e. how much the customer reacts to a price increase or decrease.
Elasticity is a good, useful concept which helps us mathematically calculate how many customers we could gain or lose as a result of a price change. It has nevertheless a small disadvantage, namely that we need data, a history of the business or a similar business, but once we have that, we can calculate customers’ reaction to our prices and to the competitors’ prices. Therefore, if you have a business, I recommend that you keep detailed records of your price and volume changes.
Secondly, we have the product or service you're selling. On the one hand, it has an intrinsic value, its economic value, for example, what savings or financial gains it can bring to the customer.
On the other hand, it has an intangible value that brings benefits such as comfort, safety, speed or time saved. Beyond these things, there is another layer to consider: the value you communicate and the value the customer perceives.
Of all these elements, the perceived value is the most important in attracting and retaining a customer, regardless of the price changes you make.
And then we have the price layer. It tells you how you position yourself on the market, what your price says about you. Do you have a luxury price, a premium price, or a low-cost price? Price is already a communication tool and you have to be careful what you say about your product because that is reflected in what you are saying about your price.
It's important to understand and maybe even control what the customer is comparing you to in terms of price, which benchmark they have when they see your price. Are they comparing you to a coffee, to a beach holiday or are they comparing you to an important and powerful competitor?
Also, setting pricing packages and keeping in mind the differences between certain customers is a very important strategy to make sure that you attract every possible customer that can bring you income. All of these things, the interaction between the customer and your product, happen in a context. A market, a place, a moment, a setting where you communicate with the customer, present your product and tell them what the price is. Whether it's online, or on the shelf, whether you're there or not when they decide whether to buy or not, whether they are in a hurry or have time, whether they are relaxed or stressed... all these factors determine the customers’ willingness to pay. You need to understand these factors and change the context if necessary, so that they are more willing to pay the price you have to ask. Of course, part of this noise is represented by the competition, what others are offering and any other distractions the customer is subject to and all those mental pockets where the customers keep their money by categories. You need to understand what pocket they will take the money from to pay for what you are offering and what else they have to pay out of that same pocket to figure out who your real and perhaps unexpected competition is.
Where do you start when you want to change the price of your product or service?
The first step you need to take is to decide what you want from the new price, what your goal is. Ideally it should be figures and profit related.
The next step is to imagine how you can get there, what the scenarios that can get you there are. A scenario can be a simple price increase or decrease, or a campaign, the creation of bundles, or it can be a change in pricing strategy altogether.
After calculating the impact of every scenario on your profit, the next step is to see which suits you best, which one can get you there, and how much the customer is willing to pay in this new scenario. You can do this assessment using the thinking structure from earlier (customer-product-price-context) and see what changes you can make in any of these elements to make the customer more willing to pay.
When making big changes, a price test can't hurt. Testing can take many forms, from launching a temporary campaign or doing a crowdfunding project, to having a group of old or completely new customers experience your new price in a safe environment. There is one thing you should bear in mind here: when you test your price, it's better not to tell the customer that it's a price test and let them interact with the product as a whole with the price in front of them, so that you can understand which the perceived value is and how the new price affects that perceived value. Usually, if you ask about the price first, people will lose sight of certain aspects of this interaction.
Finally, we want you to remember that a price is not just a number on the label. Price is affected by all the elements of your business model, and, of course, it affects all of them in its turn. Once you understand these connections, you'll be much better prepared to make the pricing decisions you need to be profitable and grow your business.