Markets are efficient. Margins are lean. Customers are sophisticated. The competition never sleeps. How then do you price for maximum profits?
Let's start by looking at the relationship between price, volume and profits.
Price affects volume, and hence profits. This is obvious enough. But it pays, literally, to know how changes in price would trickle down to affect profits. Let's say you raised a price by 3 percent. If your volume stays put at previous levels, that 3 percent increase goes straight to your bottom line. If volume falls, you may still see an increase in net profits. How? Because as your volume decreases, so do your variable costs.
In general, the larger your variable costs in relation to your fixed costs, the more likely it is that a small drop in volume will still result in higher profits. Testing various price levels and the attendant profits will tell you how far you can raise prices before profits suffer.
Price and value. A price increase cannot occur successfully in a vacuum. Every time you increase a price, your customers start looking for options that will reduce their dependence on you. So you will need to modify your marketing and sales efforts to convince customers that you are still the best choice for them. You could do this by raising the level of your customer-related activities in ways that don't increase incremental costs.
Perhaps you could bundle services, or give the customer more control over scheduling, or focus your sales and service efforts on your more profitable accounts, or simply do a better job of re-positioning yourself against your competitors.
A good example is the pricing history of Lexus' LS400 model, which was priced at $35,000 at its introduction in 1989. Its competitors had products priced several thousands higher. Lexus established itself as a terrific value for the money, outclassing its legendary rivals in every way. With its "value proposition" secure, it began raising prices, so that by 1996 it cost upward of $50,000 to buy an LS400 – a 43 percent increase in seven years.
Know Your Customer. The key to raising your prices, then, is to understand the value of your product to your customers. Find out how customers use your product, what problems it solves for them, and how it affects their P&L. Try to put a dollar amount to the benefit they gain from it. Know what it would cost the customer to buy from one of your competitors. Or to do in-house, what you're doing for them. Or how not buying your product at all would affect their business.
Most customers will not readily part with information that would answer the above questions. However, through skillful research using focus groups, conjoint analysis of your major customers' preferences, qualitative and quantitative analysis of past buying behavior, insights from your sales force, and knowledge of your customers' businesses, you can understand the value and, hence, how much a customer would be willing to pay for your products.
Admittedly, this method of arriving at a price requires a lot more time, money and judgment than a "cost plus margin" method based on cost and volume data that are readily available. But the resultant understanding of your customer's needs will tell you what you need to do to increase your value – and price – to the customer. Your profits will then depend on how well you can reduce expenses while maintaining the market's perception of your value, or by how successful you are at enhancing your value and raising prices accordingly.
An alternative to the value-oriented approach is to price your products as dictated by the market. Your competitive situation may force you to do so. To drive profits, you will need to devote more of your attention to controlling costs and/or building volume.
Managing your prices takes a lot of hard work. Done right, it can prove to be the difference between survival and prosperity.