An Imprecise Approach to Pricing

An Example

Let’s assume we manufacture cars. We have a high-end offering priced at $40,000. The margin we earn on each sale is $4,000. Our marketeers are telling us that we are not price-competitive, and that we need to lower price to $38,000. Costs will not change, so our margin would change to $2,000 per vehicle. What’s the right decision here?

Some Caveats

I recognize that, in many cases, management will argue that driving revenue is more important even at the expense of a loss of net margin. Maybe it is to gain market share (which hopefully translates into long-term margin improvement). Maybe it is to “get more of our cars on the road” and hence to drive visibility of our brand. Whatever the reason, decide what your criteria are and focus on the decision, not haggling over the precise result or assumptions.

Another scenario

What if management wanted to look at raising prices? A similar discussion would follow to answer the question of whether we achieved the required minimum volume change to justify the decision. In this case, it turns out that any volume decrease of less than 33% meets the criterion. In other words, if volume “only” drops by 20% with the price increase, the company makes more money by indeed raising the price. If volume instead drops by 40%, the company earns less total margin with the price change.

The Result

Regardless of the specific criteria used, see what we are doing here? We are having our business leaders spend time discussing the market rather than anyone’s opinion about the demand curve (which is often ultimately unknowable with any certainty). We are also able to move much faster. I would argue this is even more valuable and important in fast-moving industries where prices can be tested. It’s harder to drop the price of a car because the decision is not easily reversible, but it is easier, for example, in digital spaces where individual, unique offers can be made to consumers.

A Multi-Price Presentation

What if we want to present a range or menu of pricing options? After all, we rarely are just evaluating in a binary fashion a single price point like we did above to arrive at a yes/no answer. We can walk through every potential price point and analyze the impact to margin and discuss what we think the demand curve looks like at each point. But there is a radically simpler way to visualize the pricing outcomes across a range of price points.

Substitution

For a future installment of this discussion, we can look at a more complicated example — where we are considering offering a new product, a lower-end option for $30,000. We would source less expensive parts so that the margin could still be positive. Management is faced with the product decision. We will need to consider what happens to demand for our premium product (i.e. the extent to which consumers substitute away from our premium product to our new product) and what levels of demand change we can tolerate there.

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Stuart Zussman

Stuart Zussman

Finance professional passionate about technology and building scalable processes