An Imprecise Approach to Pricing

In many years of working with business teams, I have seen them spend countless hours making their pricing analyses more and more precise. More and more insights and analytics are demanded, assumptions questioned and tested, and often results are nonetheless doubted in the end. Not to mention that slow action hurts performance in many industries. I propose that the solution to this is not intuitive — to get at a higher quality answer, the prescription is ironically to be less precise and flip the analysis around to spend more of the value-added time of your decision-makers actually discussing the current context of the business and its future. Let me explain with an example.

An Example

The team can spend a lot of time debating what the 5% price drop will mean to sales volume. Hopefully it goes up with the price reduction (does not always happen…that’s a story for another day!). Let’s say some on the team argue volume will increase at least 25%. Others may be more dubious and expect something like 10%. How do we decide? More studies of price elasticity of demand? Conduct a survey? Hire a consultant to help us draw the demand curve? I would advocate for a simpler, faster approach. Instead of determining or pinpointing the new resulting total margin, let’s instead focus on what the decision criteria for this pricing change should be — in this case, assume we want net margin ($, not %) to improve. Since margin is 50% less at the lower price, in order to improve margin, we need to double unit sales. In many cases, as in this one, no one was arguing that would happen. The debate was in the 10–25% range. We just made our decision without any need for “further study” or time-consuming and expensive analytical exercises.

Here is a summary of what we just discussed.

Some Caveats

Note that we have finessed over the issue of fixed costs. In many cases, we have relatively fixed costs for certain items. For example, we don’t need to build a new factory if volume increases only 10%, and then in effect we can “spread” the fixed costs over more units. Or we don’t need to change overhead function staff levels just because volume fluctuates at the margin. That complexity does not break this approach; in fact, it simplifies it by making the analysis much more straightforward than if done in a more traditional way.

Another scenario

The Result

What can management then spend time discussing instead? How about why our margins are only 10%? Is that good in this high-end market? What can we do to lower costs? Should we price in a more premium fashion? We learn a lot about what our cost structure means for our pricing flexibility when we look at it this way.

A Multi-Price Presentation

Let’s look at our series of prices to be analyzed and in each case determine the required minimum volume change.

Now we can look anywhere along the curve and ask the much simpler question: at that price, would the volume increase be above or below the line?

Substitution

Finance professional passionate about technology and building scalable processes

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