By Ernesto Lanata
I was talking to my clients about pricing yesterday. They are small business owners and some are start-ups that are taking our training to get a better understanding of the issues related to managing their company and the structure that a business plan can provide for the planning stages and the implementation of new growth strategies.
Pricing is a very confusing topic to the small business owner who wants to compete against the larger organizations and needs to generate revenues as fast as possible. They argue that the most logical starting point is to be cheaper than the competition, with relatively similar products, so that the buyers will have an obvious reason to purchase from them.
Before I go into my argument against entering the market as the cheapest alternative, I will present some of the most common pricing strategies used by most businesses:
Cost Absorption Pricing
In this strategy, the price is set by calculating all of the cost components of the good or service to be sold, plus an additional value for administrative costs, plus an additional value for the expected profit desired for this particular product or service.
As a numerical illustration, let’s say that I will sell an object XYZ. So the selling price of this XYZ object is made out of the following components:
Raw Materials: $50 per unit
Labor Costs: $20 per Unit
Allocation for Administrative costs: $20 per Unit
Allocation for Profit: $10 per Unit
Total Price: $100 per Unit
Market Driven Pricing
In this strategy, the business owner relies on the general market to establish to appropriate price for the good or service they provide. When the product or service being transacted is considered to be a commodity, the law of supply and demand will be very influential in determining the price.
In general, the price of gasoline will closely follow the general market trend, giving the owners of the gas stations little choice in the final price of the gas they sell (a few cents up or down from the general consensus).
Value Driven Pricing
This pricing strategy can be used with most non-commodity products, because it is based on the perceived value the customer derives from the use or consumption of the goods or services being provided. In this strategy, the seller creates a gap between the cost to produce the product or service and the value that it generates to the client.
The traditional example is the computer repair person that charges the client $5,000 for a repair that took 10 minutes, but saved the client $1,000,000 per day in productivity loss. The value of the services is clearly not placed in the time spent to repair the computer, but in the revenue that this working computer generates to the owner every day.
There are many other pricing strategies that the big businesses use to get us to buy from them rather than their competition. But in general these three strategies cover most of the common practices that small and medium sized companies use.
Given the lack of sophistication and measuring tools that the small business owner has at their disposal, the most used pricing strategy in this segment is the Absorption Pricing Strategy. The problem is that many forget the part about allocation for profit, and a few forget about the allocation for administrative costs.
So when they go into the market and see that some of the big companies charge $85 for the same product that they should charge $100 for, they want to go at $80 thinking that they don’t have overhead and that they are making $10 of profit.
The problem is that the big companies have economies of scale that the small business owner does not have. They have a large number of clients and their inventories rotate pretty fast. Furthermore, the small business owners do not anticipate the fact that once they set a price for this product or service, creating a client following and sales start to pick up, two things will happen; the more they sell the more money they will lose, and their clients will be very disappointed when the price is increased, which will drive them right back to the competition.
My contention is that low price competition is a good strategy, but only for the big guys. No small or new company should start with price as their most significant competitive advantage, because very quickly it will become a hard-to-shake disadvantage.
My recommendation is to adopt a Value Driven Pricing Strategy. Although it is a more complex approach, the small business owner has the advantage of being nimble, accommodating clients’ needs in such a way that larger organizations will never be able to compete. Examples of these are, time spent with the client to make sure they are happy with the product or service, discovering what the client perceives as value and enhancing that value from the basic price of the product or service, becoming a solution source for the client, so that any time they need something related to the service or product provided, the small business owner is the first source they can think about.
There are many ways to create value. The point is to make a real effort in discovering this value for the client and sell on these points. Once that value can be quantified, the cost of the product or service becomes much less questionable and the potential for creating more profits is maximized.
There are many techniques for value identification and value enhancement. LaSo has developed a set of seminars that address these issues. Join us in our next training session on August 29th for a Saturday full of very useful techniques to connect, collaborate and close sales. Click here for more details.