Get It Right: Pricing Strategies That Work
Many entrepreneurs hope for success by offering low prices. World-class entrepreneurs succeed by setting higher prices.
For my book Bootstrap to Billions, I interviewed 23 hundred-million-dollar and five billion-dollar entrepreneurs, and found that 50 percent of these world-class entrepreneurs succeeded with higher prices by offering more value and knowing how to sell that value. An additional 25 percent excelled in merchandising—they used the high-low pricing strategy (or high-free in industries such as the Internet) where they priced low on a few items to attract consumers and priced high on others to earn an attractive profit. So if your strategy is to succeed by pricing low, please think again.
Pricing is the heart of a business. It affects everything you do and is affected by everything you do. Economists talk of supply and demand as key factors behind pricing—successful entrepreneurs manipulate demand by making their products more desirable.
The right price should fall between your cost and the value you offer to customers. Within this range, your prices should be closer to the value of what you're selling. So to price high, add value, then learn to sell value.
The following six steps will help you determine the right price for your product or service:
1. Understand Your Customers' Unmet Needs and the Value You Offer
Your pricing potential is related to the value added for your customers, and their willingness and ability to pay. Products with more features and benefits can be priced higher. For example, a luxury brand vehicle is priced higher than an economy compact car, and a burrito at a gourmet fast-casual restaurant costs more than one at a fast-food chain.
To understand your target segment and their willingness to pay, first analyze the type of customer you're targeting. Corporate customers don't generally buy from small, unproven businesses even when those companies offer lower prices because they want vendor stability and strength. But corporations do buy from ventures that have value-adding technologies, and they'll pay accordingly.
Similarly, high-end customers need high-level benefits and will pay more for those benefits. So focus on the value and benefits you offer, and price your products and services accordingly. Customers need to perceive the benefits of what you're selling—the higher the perceived benefit (all other things being equal), the more you can charge.
2. Evaluate Your Competitive Strengths and Weaknesses
Understand the relative value you add compared with that of your competitors by comparing your product to theirs. Understand that even if you've added more value, you may not be able to charge more for very long, because your competitors may copy your product. For instance, Chobani benefited from giant yogurt companies not reacting sooner to its success in the Greek yogurt market.
The stage of your industry also affects your pricing. In an emerging industry, where customers are forming new relationships, you need to be flexible to determine the right price and the best product-market combination. In mature industries, relationships between your competitors and your potential customers are already set. As the new entrant, you'll need to find the segment that will switch vendors and pay more for the added satisfaction you offer.
Also consider your competitors’ resources and potential response. If you're competing against giants, a frontal assault with lower prices may only cause failure. So consider entering via the side door and, say, focusing on high-income customers with higher prices. Chipotle did this by focusing on organic ingredients, which made it difficult for the giant fast-food companies to compete because doing so would have required a major change in their business model. Differentiate yourself to gain an edge—and you may be able to charge more.
3. Choose Your Strategy, Then Link Your Advantage With Customer Needs
To determine your strategy, focus on your key differentiating factor—your strategy should reinforce this unique value to keep your customers loyal and willing to pay more due to the unique benefits you offer.
When determining your strategy, seek a long-term advantage where you can defend your differentiation. If you can't, others may enter the market and erode your edge, prices and profitability. For example, Sam Walton built Walmart’s base in rural America, a base which had been impregnable. He then used this strong base to expand to other areas. Other big-box retailers tried to enter the same rural markets, but they haven't been as successful.
Here are a few strategies you can choose from when determining your prices:
- Price based on value. Many entrepreneurs start with costs to determine pricing, but if customers value your product more than that of your competitors, they may pay more. Companies that add high value can have high gross margins in excess of 55 percent. In order to charge higher prices, however, you have to know how to sell the value you're offering. Every business plan I've read over the past 40 years claims to offer great service to justify higher prices. Unfortunately, this is easier said than done because many entrepreneurs don’t know how to sell value, and investors don’t know whether you can truly sell value. If you're able to sell value, however, your gross margins can be higher. Investors will evaluate your pricing and value by checking your gross margin (gross profit divided by sales). High-value companies most often have high gross margins. Although Microsoft’s image has been through highs and lows, its gross margin is still 77 percent.
- Price based on perception. Lower prices won't always mean higher volume. Sometimes a low price can create doubt about your value. Customers may believe “you get what you pay for.”
- Price with the trend. Trends affect pricing in many ways. For instance, new technologies may offer more benefits than existing ones and provide high margins. As the trend ages and competition increases, gross margins decline. This will require newer products to generate profits. This is one reason why car and soap companies keep introducing "new and improved" cars and soaps on a regular basis.
- Know how to raise or lower prices. Raise prices when you offer, and can sell, more value; when your own costs have increased; or when you see higher demand and have the flexibility to do so. In some businesses, this can be daily or weekly. Abrupt changes without any notice are often met with resistance. So if your business doesn't change its prices frequently, make sure your customers know ahead of time when a price hike is coming and explain the factors to show that you're reasonable. This is especially true when you're selling to larger companies. Be sure to also check whether competitors are raising or dropping their prices.
- Use the high-low strategy to attract customers. Many businesses sell some products at a lower price and promote these lower prices to attract customers—this practice is relatively common in retail and fast food. But if you do this, make sure you know how to sell your high-margin products. In fast food, for instance, the high-margin products are the drinks, fries and desserts. Train your employees to sell these.
- Price lower to dominate your market only if you have a long-term cost advantage. Amancio Ortega built a great clothing empire (Zara) by taking inspiration from the newest fashions and using his efficient network of manufacturing and retail stores to sell these trendy clothes quickly. With vertical integration, he was able to control all facets and offer new fashion at lower prices.
- Know that it's easier to lower prices than to raise them. Some of the most successful computer makers and other high-tech manufacturers have introduced their fantastic new product at a high price, then lowered prices as competitors copied them. Then they introduce a new product at a high price.
- Add services to get a higher margin. American consumers are used to cheap products but not cheap services, so think about offering services and warranties. Selling warranties can be great for profits, especially if your product or service is high quality.
4. Evaluate Your Costs, and Keep Your Break-Even Low
After value, cost is the second most important factor behind pricing. Ideally, your price and your costs should make your cash flow positive. A negative cash flow is very difficult to finance—only about 0.05 percent of U.S. entrepreneurs get venture capital to offset this negative cash flow, and most of them are in Silicon Valley.
At the start, it's very unlikely that your costs will be lower than those of your established competitors. So charging lower prices based on lower costs is usually a large-company strategy, unless you have a new, better technology. But, again, charging less for better new technologies may give the wrong message about your value and quality. Know your costs so you know your floor. If your price is below this floor, you'll lose money.
Your costs depend on a number of factors, including your quality and volume. It's easier to have lower costs and greater efficiency when you deal in larger quantities. Costs can include:
- Direct costs of materials, labor and production overhead; and the indirect costs of sales, marketing, operations, administration and financing
- Variable costs that vary with volume, and fixed costs that don't vary with short-term sales.
At the start, keep most of your costs variable, and adjust them to the actual level of sales.
5. Adjust Your Prices Based on Margins, Volume and Cash Flow
Should you price higher, lower or the same as your competitors? If you price higher, you'll need to be able to sell value. If you price lower, you'll need to be more cost-efficient, which can be difficult for new companies. If you price the same, you'll need to differentiate yourself elsewhere to attract customers.
You'll need to understand the link between the prices you charge and the volume you get as well as the impact on your gross margins. Gross margins vary from industry to industry. They're usually highest in emerging, high-tech industries due to the high-value products they sell, and they're usually lowest in the older, mature industries because the products have become commodities.
When a product becomes a commodity, many businesses have limited pricing power because they have no differentiation. As Scott McNealy, the former CEO of Sun Microsystems, once pointed out, without being able to differentiate themselves in the market, they can't differentially price, and consequently, lack market power and the ability to profit.
You should monitor all facets of your business to know whether you're staying on track and whether your price policies are being following by your staff. So focus on the big picture, but monitor the details, especially cash flow. Check costs regularly. Check competitors’ prices. Check value. Understand the impact on your margins. Most importantly, connect your strategy to your goals, resources, ability and endurance:
- Your goals. Your pricing should be a part of your overall strategy and goals. This means that if your business is a high-end business, your prices should be at the high end and so should the rest of your operation. If, on the other hand, you want volume, then you need to know how to compete in the large segments of your industry. If you want to succeed in a niche market, know the market’s needs, and price your products accordingly. The key is to be consistent throughout your business. For instance, don’t price low and have high overhead, or price high and have poor quality.
- Your resources. If you're growing with your own resources, price for cash flow. If you're expecting to grow with venture capital, focus on growth and dominance in your emerging industry and price accordingly. Unless you're a hot Silicon Valley company, you'll probably need to become cash-flow positive quickly if you want to survive and succeed. Understand the connection between prices, sales and cash flow. Also, how much capital do you have relative to your direct competitors? Is it enough to win a price war? If not, don’t get into one. Learn how to sell value.
- You. The two strongest skills of the world-class entrepreneurs I interviewed for Bootstrap to Billions were sales and marketing, and accounting. During the research for that book, I found that these successful entrepreneurs were either accountants who knew how to sell or salespeople who knew accounting. Where does your expertise lie? If you're like Steve Jobs and can develop insanely great products and know how to promote them, you may want to consider pricing high. Then hire someone who knows numbers. But if you're like the majority of us, you should learn numbers to control your costs, then learn how to sell for added value or margins, or get a partner who can.
6. Repeat Until You Get It Right
The fact is, not many entrepreneurs get it right on the first try. Sam Walton tested various models of discount stores for 12 years until he got the right mix of price and strategy—the result was Walmart. Dick Schulze, the founder and former chair of Best Buy, changed his company's model from small, labor-intensive stores to warehouse stores, lowered prices and became market dominant. So you shouldn't make too many long-term commitments, especially for space or other inputs, before you've found the mix of price and strategy that works for you.
The worst thing you can do is try to sell high-cost products but not understand how to sell value at those higher prices. Learn accounting to know your costs, and learn sales to sell value. Knowing the basics will help your pricing strategy succeed.
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