Six mistakes you should avoid when making pricing decisions

​Only 12% of large companies in Latin America—those with revenues over US$50 million per year—have formal pricing management processes. If your company is among the 88% of companies without analytical pricing tools, at least make sure not to commit any of the following mistakes:

Setting the price based on cost plus a reasonable profit
The difference in manufacturing cost between a 128GB iPhone and a 32GB iPhone is less than US$10. However, the first one is priced US$100 higher than the second. If Apple were to set its prices based on cost plus a reasonable profit, the price difference between the two models would be less than US$20.

Costs should not determine the price of a product or service. Prices should be defined based on the value perceived by the customers for whom the solution is intended. Perceived value is also influenced by the other alternatives available to customers to meet their needs. Once the market-based price is defined, it should be validated to ensure it covers costs and provides a profit margin. If, for any reason, this resulting margin is not attractive enough, one of two decisions should be made: (1) find a way to reduce costs, or (2) not offer that solution in the portfolio.

Offering only one option
The reason customers tend to haggle when presented with a commercial proposal containing only one option is because, literally, they "have no alternative." Every buyer always looks for ways to reduce the “pain of paying” associated with the price they are charged.

To minimize this pain, customers focus all their attention on lowering the price of the single option presented, which automatically leads to haggling. However, if buyers are offered multiple options with different levels of price and value, their attention will focus on understanding the pros and cons of each, automatically reducing the tendency to haggle over a single price.

Responding to the threat of a cheap brand by lowering the price of a premium brand
A leading company in the paint category had the brand with the highest brand equity in the market. However, over the years, numerous budget brands had taken half of its market share. To defend itself, the company lowered the price of its products, attempting to close the price gap with competitors. As a result, in addition to continuing to lose sales, their margins became increasingly narrow.

There will always be a group of highly price-sensitive customers willing to forgo certain attributes—such as the emotional value of a brand—in exchange for a better price. Therefore, especially in consumer markets, companies should use lower-value brands to serve highly price-sensitive customers, rather than lowering the price of the premium brand. This way, customers who cannot afford the high-value brand will find a budget-friendly option within the company’s portfolio instead of buying a competitor’s low-end brand. As Steve Jobs said: “Cannibalize yourself before the competition does.”

Setting prices based on elasticity data
A large retail chain decided to measure the price elasticity of each of its products to optimize pricing decisions. They calculated how much the sales volume of each item had changed due to price changes over the past three years. To their surprise, the information was of little use; 98% of products showed no correlation between volume changes and price changes. Only a small part of the portfolio demonstrated some correlation, but this information was insufficient for making decisions across the entire portfolio.

Price elasticity of demand should not be used to set prices. As mentioned earlier, prices should be defined by comparing the price/value ratios of products available in the market. Once prices are set, the impact on units from the suggested changes can be estimated using known elasticity data. Price elasticity is a supporting factor, not the main driver, in the pricing optimization process.

Overengineering your products or services
In the early 1960s, the broad North American middle class, wanting a sports car, could not afford the high prices of a Corvette or Alfa Romeo. These customers were not seeking power but a sporty-looking car for under US$2,500. Lee Iacocca, Ford’s CEO, began a design process emphasizing appearance over performance. By building an attractive body with the engine of an economical sedan, Ford launched in 1964 a sports car that fully satisfied this attractive segment’s needs at a price under US$2,500: the Ford Mustang, the best-selling sports car in U.S. history.

When designing a solution, only include attributes relevant to target customers, excluding those not valued by price-sensitive customers. The idea is to identify attributes not perceived as added value and remove them to avoid creating additional costs.

Making across-the-board price hikes
The board of directors of a large consumer goods company made it clear that their expected average price increase was 5% for the following year. The management proceeded to apply a general price increase as instructed—multiplying the current price list by 1.05 in a spreadsheet. In December, they communicated the new prices to customers, effective January 1. By the end of the first quarter, more than half of the increases were reversed as sales of these products had plummeted.

When a company makes a general price adjustment, it increases the prices of all products in the portfolio proportionally. This can make fairly priced products too expensive, expensive products even more expensive, and cheap products may still not reach their fair price. To avoid this problem, pricing decisions should be made for each product individually, not across the board.