Margin-based pricing sounds great in theory — it predetermines profit for a specific product by setting a definitive goal for the difference between price and cost.
Unfortunately, the reality is that margin-based pricing creates a host of potential issues for the simple reason that determining price involves many more factors than just cost. Margin-based pricing ignores these other variables, simplifying the process but weakening your results.
To give you an idea of how margin-based pricing can negatively affect your bottom line, we’ve outlined its four biggest evils.
- Emphasizes Costs, not Value
Margin-based pricing relies on two major variables—cost and desired markup. It disregards a third variable—the value you create for the customer. This third factor determines what your customer is willing to pay, so margin-based pricing risks one of two undesirable outcomes:
- You arrive at a price higher than the value you create for the customer and lose the transaction and any associated profit
- You arrive at a price lower than the value you create for the customer and win the transaction, but leave profit on the table
Moreover, margin-based pricing, by ultimately depending on costs, means your prices may change even when the value you deliver the customer does not change or, alternatively, keep your prices flat even when the value you create for the customer changes. Either results can produce a disconnect between your price and the value you create for the customer, ultimately putting your profits at risk.
Take a step back for a moment and consider why your customers chose your company as a vendor in the first place. Most likely, it isn’t because you’re consistently the least expensive option out there (which is a difficult position to maintain anyway). What else are you offering them? Bundle these benefits into a value communication to your customers consistently and often. Weave them into your brand’s message, and make sure customers understand they are included in the price, in addition to the tangible product-based elements of your offering.
- Assumes Your Customers Are Clones
Are you treating your customers like the exact same person? You shouldn’t be. When you assume the same price fits all of your customers through margin-based price management, you create three major pricing potential issues for your company:
- Tailored Value Propositions are impossible to create, creating a crater-sized hole in your pricing strategy.
- You sacrifice increased margins from customers willing to pay more due to incremental value you create for them.
- You run the risk of losing customers who draw the line at a specific price point.
A more profitable pricing strategy takes these scenarios into account and plans for each of them. For example, when you outline value proposition to your customers across their various buying situations, you understand that one size doesn’t fit all. Your customers exist in different markets, seek different products, and find different things appealing in different situations. Do a little research to determine what matters most to specific customers, and use this data analysis to properly segment them into groups (“pricing segments”), each with their own designated pricing strategy.
Also consider segmenting your customers into groups defined by price responsiveness. We all have customers who don’t balk at incremental price increases either out of loyalty or an accommodating budget. And we all have those customers who pinch pennies and demand answers at every tiny price increase. This is not taking advantage of the customer – it’s a practicing a subtle yet powerful form of value-based pricing.
Instead of having pricing for all customers ebb and flow with input costs, set a profitable price for each customer segment and then do your best to hold it there. Most customers will appreciate the consistency, and your team will most likely save on the resources and time that accompany negotiation around constantly-changing prices. Of course, if there are massive changes in input costs, customers will likely be aware of this and you should temper your approach in these situations accordingly.
- Assumes Your Products Are Clones
Margin-based pricing also has the evil tendency to lump all of your products together as it does with your customers. Many companies employing this strategy set a margin goal for huge groups or — gasp — every single one of their products.
For example, if your company carries a standard 5 pound bucket as well as a non-standard 4 pound bucket, it wouldn’t make sense for you to charge the same price for those products, even if the costs for them might basically be the same. A non-standard product in inventory immediately gives it a higher value than other similar products, and you should be passing on this premium to your customers in the form of a higher price. After all, the 4 pound bucket has a slower product velocity, and you’re creating value for your customers by keeping it on your shelves.
For effective product segmentation, start with taking stock of all of your products and their implied value to your customers. Then segment these into smaller groups and price them accordingly. To enhance your price performance for even better profits, build upon this and a customer segmentation strategy to determine effective pricing for specific products within distinctive customer groups. This can get complicated quickly, so having an intuitive and effective business analytics solution to help you juggle, organize, and properly analyze all of your data is key.
- Relies on Volume for Profit Improvement
The last evil on our list is narrowing focus on growth to volume alone.Businesses have five levers to improve profitability: price, cost, customer mix, product mix, and volume. Margin based pricing takes the first four out of play completely. Prices are dictated based on a set margin percent, and costs gains are immediately passed through to customers, eliminating those levers. Margins for all customers and products are set to a single rate, so you have no ability to improve customer or product mix. This leaves you with volume as the only lever to improve profitability. Why would you want to adopt a strategy that limits you to only one lever to improve performance when you could have five levers?
Moreover, businesses that focus heavily on volume to drive growth usually end up having to cut prices to reach their goal. This, in turn, often triggers price wars and put companies on a downward spiral that’s difficult to stop. By focusing solely on volume, your company relinquishes control over your profits.
Change direction by using all five profit levers — price, cost, customer mix shift, product mix shift, and volume — in tandem to find the quickest and most sustainable path to profit.
Brilliant oroginal by : Chris Sorrow June 2, 2015