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Catching generated value: Pricing (I)

February 21, 2012 Leave a comment

With the tough competition currently present on every industry, it doesn’t become easy to run your own business with profitability. Your best chance is developing a true value proposition. If your product can save some money to the customer, why do not try to pick up a piece from this benefit?

When thinking up how to price a new product or service, there are many strategies available (see www.netmba.com/marketing/pricing). Most popular are cost-plus, value-based and psychological pricing. The win-win pricing is quite a mix of the previous ones.

Imagine you have developed a product that allows your customer to save some money with respect to the current situation. Then you must decide if establishing a fixed gross margin or find out how much is likely the market to pay for it, or even mix both strategies by setting the final price on a face-to-face negotiation. If you are running a set-up, these strategies could become quite harder due to your inexperience and your weakness as a new player.

Consider a consumer that pays 100€ for a 10 years product or service, including all the associated expenses he may incur into. Consider also that you are able to cover the same necessity for only 80€. Therefore you can set your price in the range 81€-99€ to both have a positive gross margin and mean a saving to the customer.

Contemplating a 50-50 share in the potential saving, both the provider and the purchaser would get the same profit. In this case, our gross margin would be 10€ and the price 90€. This involves a 10% reduction for the customer with respect to the original 100€ scenario while a 11% gross margin and 12,5% gross profit for us. The lower we can develop our product, the better the margin and profit goes, as shown on the following graph.

In a typical overcrowded scenario, the only way to gain some market share is by reducing prices through a cost and processes optimization. But this reduction frequently leads to less operative margins and consequently to profitability drop. The previous curves show that, since we are systematically catching from the customer some of the value our product is creating, our gross margin and profitability improve as the price goes lower, as well as our competitive position. Eventually we would be avoiding the frightening zero-sum competition.

As the 50-50 share shifts, the margin curve does as well. Any increase on our picked proportion of the saving would lead to higher margins and benefits but also to a lower value proposition. With an hypothetical product cost of 70€ and a 75-25 of the profit taken by the company-customer, the gross margin would be a 20% instead of the 15% on the 50-50 scenario.

To reflect the real weaknesses and strengths of this pricing strategy, let’s use a realistic scenario with a product cost of 70-90€ (current total expenses are 100€). Our gross profit, calculated as the ratio between gross margin and total cost, varies in the range 5%-21%, with a final price of 85€-95€, which leads the customer to a maximum saving of a 15%.

Strengths

  • The 50-50 sharing in the potential profit is an effective way to persuade a customer to purchase our product and also a simple and rapid way to establish a flexible pricing strategy “on-the-go”.
  • Our relative gross margin and profit is always higher than the customer saving percentage, so even though the absolute benefit is shared 50-50, our results are better and it is not expected for the customer to claim for a higher stock.

Weaknesses

  • Since the price is calculated by adding a half-profit to our costs, two threatens may appear. First, our operational costs become “public”, so any competitor could use our business as a benchmark. Second, we must communicate them clearly to the customer so it in no chance for him to feel tricked.
  • A 10-20% gross profit doesn’t allow large further expenses if our target is running a “blue ocean niche”. The customer withstands a portion of the cost considered in the final price, since the shared profit decreases as it rises, so the more flexible and attributably our costs become the better.

Summary

The proposed method allows to set a dynamic pricing strategy in order to effectively communicate our value proposition to the customer, while picking some of the benefit generated in order to avoid a zero-sum competition, reaching profitability even with a price drop by means of any cost optimization.

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Categories: business, pricing, value