Is the price right? More science than you think

"Price is what you pay. Value is what you get." - Predictably wise words from the Sage of Omaha himself.

These words from Warren Buffet are a great reminder for many growing businesses to make sure that sufficient time is invested in getting the price for goods or services correct.

Of the many areas in which we spend time working closely with management teams, frequently top of the priority list is a detailed review of pricing. Clearly there are many drivers that are used as starting points, but in our experience there is a tendency to allow what it costs to deliver that good or service to over-influence pricing decisions rather than in our view the only critical question of what value is being delivered and hence what ‘should’ you charge.

Once you have a reasonable understanding of what a consumer ‘should’ pay, what it costs to deliver the good or service is highly relevant as at a basic level it helps define the ultimate capacity of the business to deliver profits but it is in this that cost is relevant not in pricing decisions.

Whilst there is clearly merit at times for more tactical decisions on price such as penetration pricing more frequently called land grab, it is critical in our view to do that from a basis of understanding of at what price a consumer receives value.

If the price is set too far below perceived value, the company will leave money on the table and compromise its ability to succeed profitably. If set above received value, even if initial take-up is good, customer retention numbers will be poor as will the vital word of mouth endorsement that can be a powerful driver of growth in many developing businesses.

There is an often-held belief that in some areas pricing is ‘more of an art than a science’ and, particularly in the area of truly revolutionary products where there are few if any relevant comparators, it is harder. But, as described below, there is in most cases some relevant ‘science’ to help guide pricing decisions.

Our recommended starting point involves two main principles, first, respect pricing history but don’t be dominated by it and second, invest the time and money in developing as much science as is reasonably possible.

More on pricing:

The first goes back to the starting point of delivering value. It is understandable to be nervous about a significant change in pricing but ultimately if the consumer is receiving value they will be accepting of change – albeit too radical a move all at once would be difficult to implement. However, the importance of losing the constraint of history is it allows a thorough review of all elements of pricing including not just level but structure.

Levels of complexity vary according to product/service type, but the balance between: upfront fees versus ongoing fees, fixed versus variable, deposit versus fee, etc can significantly change the economics for the company whilst frequently not worsening and even improving perceived value.

Developing ‘science’ is principally about two elements. One is rigorous analysis of all available data on how customers currently interact with the company (and in many cases improving systems to ensure all relevant data is captured) along with a detailed understanding of the alternative offerings by its competitors or substitutes.

Customers can provide enormous insight into how and what they value in a product or service through demonstration of how they consume it. The other is creation of data and its subsequent analysis through carefully tailored primary research of both existing and target customers. A favourite without being too technical is conjoint analysis which can provide sometimes surprising insights into how customers see alternative pricing structures and hence value.

One particularly striking example was at Streetcar (now Zipcar), the UK-based car sharing club. Detailed research and statistical analysis helped us understand which levers of pricing members were most sensitive to and which they were least. This helped management to revamp the pricing structure to a model that better optimised profitability and member satisfaction. The result was a 70 per cent increase in contribution per member with no negative impact on churn.

Armed with the best possible understanding of the value a customer places on a company’s product or service and their view of alternative ways of charging provides an excellent starting point to developing the correct pricing architecture. Whether the company can deliver it profitably at that level is an equally important but different question.


Johnny Hewett

Johnny Hewett has been chief executive of private equity firm Smedvig Capital since founding it with Peter Smedvig in 1996. Prior to Smedvig Capital, he spent three years at Bain & Company, working...

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