Why don’t conventional pricing techniques work?
Many companies still define their prices using traditional methods, but these approaches have important limitations that prevent true profitability. To understand why, it is first necessary to clarify what it means to be profitable.
PRICE SETTING
What is profitability?
Profitability is often thought of simply as making more money. Others, with a more technical perspective, associate it with selling at a better margin. However, profitability combines two fundamental factors: margin and turnover.
An example illustrates this clearly. Two brothers, Juan and Pedro, each receive an inheritance of 500 thousand dollars. Juan invests in a business that generates one million dollars in sales and obtains a net profit of 100 thousand dollars a year. Pedro, meanwhile, invests in a business with annual sales of 250 thousand dollars, but also with a net profit of 100 thousand dollars.
From a margin standpoint, Pedro’s business is more attractive, with 40%, compared to Juan’s 10%. In contrast, in terms of turnover, Juan’s business is superior, with a turnover four times higher than Pedro’s. By combining both factors—margin and turnover—you obtain profitability, which in both cases is 20%.
This demonstrates that there are different ways to achieve healthy profitability. Juan reaches his profitability through high turnover, while Pedro does so through a high margin. Both approaches are valid, and within the same portfolio, products with high margins and others with high turnover can coexist, fulfilling different but complementary roles.
What goes wrong in traditional pricing?
Despite understanding profitability, many companies continue using conventional techniques that do not take this duality into account. One group of companies pursues high margins and defines its prices based on cost plus a desired markup. This approach has two main issues.
First, if the company’s costs are higher than those of the competition, prices may fall outside the market. Second, if costs are low and the desired margin is modest, prices may end up too low, leaving money on the table. In addition, this method creates a mathematical paradox: by using total unit cost to define the price, the price affects sales, sales affect cost, and cost in turn alters the price again, generating a vicious cycle.
Another group of businesses seeks high turnover, like Juan, and chooses to please the customer at all costs. In consumer markets, this translates into excessive promotions that train customers to buy only with discounts. In industrial markets, companies give in to haggling, which fosters opportunistic buying behavior that quickly spreads among customers.
A third group of companies also focuses on turnover but defines its prices exclusively based on the competition. This practice can lead to serious mistakes if the relationship between price and value is not considered. Comparing prices without understanding whether the solutions are equivalent can result in leaving money on the table if the product is superior, or being uncompetitive if it is not.
So then, how should prices be defined?
If pricing based on costs, customer appeasement, or competitive matching doesn’t work, it’s time to rethink the approach. The answer lies in a strategy centered on the value perceived by the customer. But that is a topic that requires deeper analysis.