THE BLOG
02/14/2016 06:31 pm ET Updated Feb 14, 2017

Profit Problems From Misunderstanding Pricing

As a result of profit declines three quarters in a row, Bloomberg claims that the US is slipping into a profit recession. Some believe this is a result of a slump in crude oil prices and a sharp rise of the dollar. Of course, it is easy to point to those or even a slowdown of the Chinese economy. Instead of looking at the glass is half empty, some argue that these might be good things. There are definitely trade-offs. To increase profits, too many businesses focus on cutting expenses. That's the "easier" thing to do, and is one way to greater profits if there is not a corresponding decline in quality. Unfortunately, too many expense cuts come with quality declines -- especially when inferior materials are substituted or labor cuts cause drops in customer service.

Lower expenses financed by those that work for a living

Since the financial meltdown, salaried employees have financed the cutting of expenses. Too many jobs and profits have gone bye bye. According to Bloomberg, US companies are keeping $2.1 trillion overseas to avoid taxes. Some pay less income tax than you and I. When consumers have less money to spend, this creates a vicious cycle, which hurts these companies too. To help avoid these problems, many believe it is preferably to focus on revenue to increase profits because that can produce more win-win situations where all boats rise. Where does revenue come from? It's the result of price times quantity (Revenue = Price x Quantity).

Pricing

Pricing is one of the fundamental building blocks of marketing. Many believe price is easy to understand when, in fact, it is one of the most difficult. McKinsey points out in an article entitled Shedding the commodity mind-set, too many companies leave large amounts of money on the table. Pricing experts know that setting the right price is difficult because, in addition to the physical factors of cost and profit, price is subject to psychological factors. The best companies can do to have control over these psychological factors is to do a great job of branding. And to get the branding right, companies have to know how to develop the right underlying corporate image and positioning strategies. In short, creating a brand image of the product that is impossible, or extremely difficult, to copy is the key to having control over your pricing strategies. If you are able to do that, you will be able to employ the most powerful and effective of all pricing strategies -- What The Market Will Bear (WTMWB).

What the Market Will Bear

In markets where there is little or no competition, companies can employ a pricing strategy that optimizes profits. It is often called a What The Market Will Bear (WTMWB) price. This strategy sets the price based on the maximum price the market will pay for the product. On the one hand, the company wants to realize the highest profits possible in the shortest amount of time to help recoup high start-up costs, such R&D (research and development), production, and marketing costs. On the other, it may not want its profits to be so attractive as to entice cutthroat competition to enter the market within the time window it needs to build market share and establish a leadership position. This strategy typically works because those likely to buy a new product -- the Innovators and Early Adopters -- are not particularly price sensitive. If there is considerable uniqueness and desirability built into the product brand, your company can employ a WTMWB strategy. If not, you might consider other effective pricing strategies.

Gross Profit Margin Target

In almost all cases, pricing strategies should begin with a Gross Profit Margin Target (GPMT) strategy. Companies typically know the gross profit margin they need to pay back their expenses and generate positive net income and cash flow. Once your company knows the cost of sales (cost of goods and services sold) of a particular product and the Gross Profit Margin Target it wants, it can easily employ a GPMT strategy. Gross Profit Margin is defined by the formula (P-C)/P, where P=Price and C=Cost of Sales. Anybody can put this formula into a spreadsheet program, and as costs change, recalculate the price that will produce the targeted Gross Profit Margin. Most companies know the GPMT they want. If you don't, there are some common guidelines you can follow.

  • Manufacturers typically aim for a GPMT of 50%
  • Distributors (Wholesalers) usually need a GPM of 10 to 15%
  • Dealers (Retailers) require a GPM of 30 to 50% (the higher percentage is for retailers that have to train people (customers and employees) to use the product and the lower margin is for retailers that are selling a product that does not require after-sale support.

The price, or marked-up cost, to achieve these target GPMs is as follows:

  • Manufacturers P=2C so the formula is (2C-C)/2C = 0.5, yielding a GPM of 50%
  • Distributors P=1.18C so the formula is (1.18C-C)/1.18, which will give them a 15% GPM
  • Dealers P=1.5C so the formula is (1.5C-C)/1.5C, for a 33% GPM.

When I develop pricing strategies for a client that is a manufacturer, I always start with a GPMT pricing strategy that is twice their cost, or 2C, since that is an easy calculation that will give them their GPMT of 50%.

Most Significant Digit Pricing

For products that will be sold to consumers, most companies employ a Most Significant Digit (MSD) pricing strategy. Why? Studies and experience show that sales will be significantly higher if a product is priced at say $29.95 or $29.99 instead of $30. Most humans focus on the most significant digit - the "2" in this case. To them $29.95 or $29.99 seems a lot less than $30 even though it is only 1 to 5¢ less. Even expensive homes in Beverly Hills might sell for $7,995,000 rather than $8 million. There are exceptions. In upscale restaurants, it is usually a mistake to price an entrée at $31.95. Instead it will be priced at $32-. For some reason, people do not think the food is as good if MSD pricing is used in a high-end restaurant.

Combining all three

If a product is positioned as unique, smart marketing companies will typically use all three of these strategies in combination. For example, Apple has priced its new iPad Air and iPad Pro starting at $499 and $799 respectively. Apple is using a MSD strategy in addition to a WTMWB strategy because the iPhone has uniqueness built-in since Apple controls the platform. It also aims for a GPMT, which is not officially published, but which is in the 30 to 50% GPM range of well-positioned products in competitive markets. When Johnson & Johnson launched a margarine developed in Finland that lowers cholesterol, it priced a tub of this margarine at between $5.79 and $5.99. At the same time, a tub of regular margarine sold for 99¢. Based on this pricing, which used MSD and WTMWB strategies, many speculated that J&J priced the product at 8C, which gave it a GPMT of roughly 87.5%.

Pricing your products

When you are pricing your products, what gives you control over the price is the uniqueness built into your positioning, or branding, strategy. If you have created a product image that is impossible, or very difficult, to copy, you can employ a WTMWB price that will give you a good GPM that enables you to achieve your desired GPMT. And, if you sell your product in a consumer market, it would be a good idea to also employ an MSD pricing strategy. For example, if you are a manufacturer that is targeting a GPM of 50% and your cost of sales is $15, you might consider selling the product for $29.99 - a penny less than the price of 2C. Best of luck.