Pricing: The strongest profit lever

Cost optimization and control are again in the focus of many firms. But we must not forget that the biggest lever for higher profitability is actually pricing.

What is pricing and why is it important?

Within classic marketing theory, the concept of 4-Ps as described by McCarthy, price is one of the four key aspects to look at: 

  • Product 

  • Price 

  • Place 

  • Promotion 

Amongst those four, price has however a unique position because it’s the only aspect that has a direct connection to a company’s financial result. It is included in the well-known equation for the calculation of profit: 

Profit = Price x Volume-Costs  

As companies endeavour to maximize profit, they have extensively looked for ways to improve volume, e. g. by creating more sophisticated advertising or more clever communication, product design, new sales channels, etc. Also means of reducing costs have been exploited to a large extend thanks to the movement of lean management that gained popularity in the second half of the 20th century. 

Price, however, has been overlooked in many cases, though star-investor Warren Buffett highlighted its importance: “If you are able to increase prices without losing sales, you have a very good overall business model. And if you have to pray before prices are increased by 10 percent, you have a horrible business model.” 

Compared with cost and volume, price is actually the superior lever on profit as figure 1 shows. While a 1% improved variable costs (previously 40%) lead to a 2.6% profit increase, 1% improved fixed costs (previously 45%) lead to a 3% profit increase and a 1% volume increase lead to 4% profit increase, a 1% higher price leads to a profit increased by 6.7%.

Pricing Maturity across companies

Companies can generally be grouped by their maturity level: 

While very basic pricing rules such as one margin across all products are hardly applied anymore, we still see today many companies using Cost Plus Pricing, where a fix margin expectation is slightly differentiated applied on top of COGS (Cost Of Goods Sold). The more sophisticated approach of Competitor Pricing also involves the prices in the marketplace as an external reference. However, both methods have shortcomings as they assume that one price fits all customers and that competition has set their prices cleverly. 

Value pricing, however, allows to capture more of the value the product delivers to customers and consequently what they would be willing to pay in exchange for the product or service they receive. So, in this case, prices vary and there is no longer a 1-to-1 connection between product/ service COGS and price. 

Intelligent pricing takes this idea even further. Thanks to big data and sophisticated algorithms, many influencers or value drivers on prices can be modelled and prices vary constantly, always aiming to best steer supply and demand along smart revenue management systems. While this level of maturity may not be aspired to be achieved by all companies, the differentiation of prices based on customers willingness according to customer type, time, location and other factors can help any company to increase profits.

The connection of Value and Price

As previously stated, price is what is paid in exchange for a certain good, product/ service. But as customers value things differently, prices may also be different amongst customers. As Peter F. Drucker famously stated: "Customers don't buy products, they buy the benefits that these products and their suppliers offer to them." 

Hence, if a customer benefits from a product more than another customer would, they are likely to pay a premium. If a customer has a particular issue that the product solves, and another doesn’t have the issue, or is not bothered so much by it, the first customer would be willing to pay more for the same solution as it does more to him. 

Value is however an abstract concept that needs to be analyzed carefully. But there are many different possibilities to do so: 

  • Internal 

  • Cost simulation 

  • Customer Benefit 

  • External 

  • Observed preference 

  • Expressed preference 

First, it’s possible to differentiate between internal and external sources for gathering information regarding value. Internal methods would include cost simulations, e. g. conducting a make-or-buy analysis from the customer’s point of view, so that prices can be placed just below the customer’s cost to produce it internally. Also, the customer benefit estimated based on calculations performed on existing sales data, or by asking experts, like the company’s salesforce. On the external side, one would differentiate between what the customer says he intends to do (expressed preference) and observing what he really does (observed preference). While the expressed reference is captured via survey, the observed preference may be derived through market data or even experiments. 

To make first steps into the direction of value pricing, an internal assessment, e. g. through expert interviews, is a solid starting-point and proves to be meaningful for many companies. Typically, this is followed by quantitative methodologies such as A/B experiments (e-commerce), conjoint methods (new products) or analytics-powered transaction data analyses (B2B firms). 

Demmelmair, M. / Baier, M.