This article appeared originally in Gulf News: link to original article
Recently, and via consulting, I had the chance to observe how different companies go about their pricing tactics. Surprisingly, there is no one-size-fits-all kind of approach.
In fact, there are a few basic guidelines that businesses should follow regardless of the nature of the businesses, with alterations made based on different factors. Some of the factors are: the nature of the operations, market share, industry position, and quality of products or services.
Before getting into details, let’s first clarify that whatever demand or supply is, there is a specific threshold that a business cannot go below when it comes to pricing. That is determined by the business operations and overheads.
In Adam Smith’s classic, “Wealth of Nations”, he relates price to the combination of land, wages, and profit. Things have surely changed since the 1700s, but not that much.
Land is rent, wages are overheads, and profit is how much return the business owner wants to get from the investment. Now the trick is in how to combine all three in a way that would produce the minimum threshold, and then set a reasonable price to people and profitable one for business owners.
For that, the starting point and the most straightforward one are the overhead costs. The first cost that should be computed is that of materials used. Then, knowing how many labour hours go into the process, another cost is added to the overhead.
In contrast, the first cost that should be calculated as part of the price is the cost incurred from production, i.e., the variable cost.
The reason why rent cannot be just simply divided and added is because of the different levels of production that can take place, which brings us to the second stage of pricing products and services — the supply and demand for them which decide the levels of production.
An attempt to divide rent by all products will result in higher costs per product in a few months, and lower costs in others. Besides that, another issue will be how much rent amount should be computed into the price of a product or service instead of carrying out a simple division of total rent across all products or services?
Therefore, many business owners prefer to treat rent and utilities separately, deducting them from revenues to arrive at the profits. However, if you still want to include rent, you can add the rent component as a ratio of the sales of that product to total sales.
The second stage of pricing products and services is the one that deals with demand and supply. Adam Smith mentions the concept of “effectual demand”, which relates to demand that results in people walking into a business and ordering products or services, and not the demand of wanting to have that products or services.
A higher demand will push prices up until excess supply balance it out, and excess supply will drop the price down to the point where demand is met. So, how to price the product or service within such ambiguity?
The price, or the service provided, should be first benchmarked with others in the business. Taking into consideration the threshold that the business cannot go below, a benchmark will establish a next possible threshold subject to the factors mentioned earlier.
For a new business, it is recommended to set the price below the benchmark for two reasons: one, to test the market, and, two, going for market share. Testing the market will show how elastic the market is, at least theoretically.
Once all of that is done, the last component that is yet to be added to the calculation is how much return the business owner seeks on the investment. A gradual increase in price can generate additional profits by raising revenues but not expenses.
Businesses with the right data and set of tools can master this to the tenth and hundredth of decimals. A better quality can facilitate price increase, while effective marketing will make sure that people are aware of it and understand the higher price charged.
Now the question that I want to leave you with is: Why do options that come with any product or service matter so much in pricing?