Is the price right?

As much art as science, determining how much to sell your goods and services for is a make-or-break topic for any business. It repays close study, finds Andrew Saunders.

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Last Updated: 09 Oct 2013

How much?' 'Quanto costa?' 'C'est combien?' It's the crux of commercial transaction the world over. If you're selling, a lot rides on your answer to that question. Price too high and you may lose not only this deal but many others like it. Too low, and you'll be swamped with customers but on your way to the bankruptcy court.

But what is the right price? Do products and services still have intrinsic value that customers recognise, or is all that old hat in today's friction-free high-tech world? Should pricing just be a matter of how much you can persuade someone to pay? And how do you decide?

It's something of a hangover from our glorious industrial past, but the starting-point for many pricing decisions remains the time-honoured 'cost-plus' model. You know how much it costs you to make, buy or provide your goods or services, and you know the gross margin you want. Apply one to the other and voila! - your sticker price (but don't forget your GCSE maths; adding 20% to your costs gives you a gross margin on the resulting price of only 16.6%).

Add a bit more to give some wriggle room if you think you can get away with it, or shave some off if you're pricing aggressively to win market share from rivals. Repeat the process to get a sticker price for everything you sell, tattoo the results onto the studded collars of the attack dogs in sales, sit back and watch the money roll in. Easy.

Chris Dawson, a market trader turned retail entrepreneur, uses a modified cost-plus approach in his The Range home superstores, selling 70,000 lines, from garden gnomes to three-piece suites. 'I have a margin that I want to make across the board,' he says. 'But I will vary it from line to line to get the sale. I am after volume and everything is priced to go. I purchase to sell and I price to sell - I may sell something for only a quid, but if I bought it for 10p that's still a pretty good margin.'

It may sound simple but it has helped amass a £150m fortune and earned Dawson 10th place in MT's 2008 Top 100 Entrepreneurs list.

'Cost-plus is still used extensively,' not least by professional-services firms, agrees pricing expert Alastair Dryburgh of Akenhurst Consulting. It is not without its attractions - after all, the model favoured by most accountants can't be all bad. 'The hourly-rate system (typically calculated at four times the hourly salary of the professional involved) is cost-plus. Its advantages are that it's simple and objective,' says Dryburgh.

In other words, customers understand it and it gives the appearance at least of being fair and treating all buyers in the same way.

It has its pitfalls too: for a start, disaster beckons if you don't get your costing right. When the British Motor Corporation launched the original Mini in 1959, it was an instant hit. Revolutionary product, bargain price. But the accountants had got their sums wrong - arch-rival Ford estimated that it was costing BMC £40 every time it sold one. That kind of success can be very bad for business - these days the Mini brand is, of course, German-owned.

But even if your costing is forensic, cost-plus is constraining, advises Dryburgh. 'I am very much against it. If you use cost-plus, every time you cut your costs, you cut your prices. You pass on all the benefits of your efficiency gains to your customers, and it doesn't allow you to consider the extra value you may be adding.'

Another popular approach is competitive pricing. As the name suggests, this is a market-based model that involves checking out your rival's offering and setting your prices accordingly.

In reality, most cost-plus systems also incorporate an element of competitive pricing - as Dawson says. 'I always keep one eye on the competition - that's what determines how much you can do on the price.' But rely too slavishly on this method and the marketing director will be after you - price is an important differentiator, and if your price is the same as everyone else's, prospects will assume that your offering is too.

But all of these models make fundamentally flawed assumptions, says Irene Ng, associate professor of marketing at Exeter University and author of The Pricing and Revenue Management of Services (Routledge 2007) - especially when it comes to offering services rather than products alone. 'The art of pricing has not been well understood. Firms over-value the importance of cost, because it's what they understand best. But money is not the only currency involved in pricing; the customer's time and effort matter too. People will pay more to trade-off effort.'

In other words, customers are a lot more interested in themselves, and in what it costs them to obtain something at a given price, than they are in what it costs you to offer it. Make their lives easier and they will be prepared to pay handsomely.

'Increasingly, the things that we buy are outward expressions of the knowledge that has gone into providing them,' says Dryburgh. 'You can no longer assume that the price charged bears any direct relationship to the costs of producing it.' From Ferrari to Bulgari, this is a lesson that the luxury-brand business has learned very well.

It's also one of the reasons that in many industries the sticker price is an increasingly endangered creature. IT companies no longer want to sell you a new piece of software every year or two; they would much rather sign you up to a nice, regular monthly service contract. Their original 'product' - computer code - is now almost an afterthought. No-one baulks at the fact that a flight to Rome might cost you anything from a quid to 150 times that amount, depending on when you want to go.

Our personal economics are becoming a lot more sophisticated, and only some companies are managing to keep up. 'Too many firms make the mistake of thinking that there is a static price. There is no static price,' says Ng. 'People's willingness to pay varies, depending on the time and what else the customer is trying to do.'

Low-cost airline easyJet pioneered the concept of yield-management pricing. Instead of trying to arrive at a fixed price per seat per flight regardless of how many are selling, it aims to fill 85% of seats on all its flights, and varies the price in order to do so. 'Our brand offer is "Book early, pay less",' says communications director Toby Nichol (unlike most firms, easyJet does have a head of pricing, but it doesn't let him out in public). 'A last-minute booker is prepared to pay more because the chances of them wanting to change their plans are that much less.'

It says much for the intrinsic validity of this concept - economists call it 'price elasticity of demand' - that yield management is now the de facto standard not only for airline tickets but for much of the rest of the travel industry, too, from car rental to hotel rooms. The irony is that despite the huge variation in the price of the 'same' thing, you really do get what you pay for. Top dollar for ultimate timing convenience, or a rock-bottom bargain if you are prepared to get up at 4am on Wednesday morning and stay in a motel on the wrong side of town.

But compared to cost-plus, it's fiendishly complicated to execute. 'In the early days, it was all done by Stelios looking at the sales figures and tweaking the prices manually,' says Nichol. Now easyJet has its own bespoke computer system - the code for which was originally written by former easyJet CEO Ray Webster. 'Last year, we did 287,0000 flights, and there were probably 10 price-points for each flight - three million price points in total - that's a system that needs to be automated.'

Yield management can't always be made to work, either, as even Stelios discovered. He tried to set up easyCinema, where price would have been based on demand - 20p to watch a movie on a Tuesday morning, rather more on a Friday night. But the film distributors wouldn't budge from their £1-a-head fee, so, unlike the airline, this was one easyIdea that never got off the runway.

However you do it, price is one of the key determinants of profitability - it's a crucial component of the top line. Studies suggest that the impact on profitability of raising your price by 1% is considerably greater than that of reducing your costs by the same amount. And yet cost-reduction gets a lot more boardroom airtime than pricing. 'But what do you do when you have cut costs to the bone and still want to improve profitability?' asks Dryburgh. 'The answer may be to look at your pricing.'

Of course, it's never a good time to put the price up, but there are ways and means of sugaring the pill to keep both you and your customers happy. This is the holy grail and it's called value-based pricing. The trick is not to start with what your costs are, but to concentrate instead on the value you offer to your customers. What exactly do they buy from you, and why? 'Firms tend to jump to conclusions about their customers without having the data to back them up. Explain the value and benefits,' says Ng. 'Don't focus on the price.'

Wally Olins, founder of top branding agency Wolff Olins and now chairman of Saffron Brand Consultants, has sold perhaps the ultimate intangible - corporate identity - to companies, including BT, Orange and First Direct. He's now working on branding Poland. 'We never compete on price,' he says. 'Although we are by no means always the most expensive. Sometimes it turns out that we were cheaper than our rivals. But I don't like it when that happens.'

Despite a reputation for fearlessly charging top whack, Olins remains frustrated that branding is not as highly regarded as some other forms of consultancy. 'There is a pecking order,' he says. 'Architects get paid less than branding consultants, and firms like McKinsey and the investment banks are paid hugely more. It's not because they are cleverer or because what they do is intrinsically more valuable, but because of the client's perceptions. I have spent my life trying to raise those perceptions and put up our fees accordingly.'

Making the effort to understand your customer's needs in detail may also reveal areas where you can generate revenue for next to no extra cost. The phenomenon of priority boarding as used by easyJet and Ryanair is a good example of this - not every customer will buy it, but it's pretty much all profit when they do. 'With oil at over $100 a barrel, why wouldn't we do something that raises revenue without adding to our operating costs?' asks Nichol.

Perhaps the purest example of value-based pricing is the idea that customers should be allowed to pay only what they think something is worth. Brit rockers Radiohead famously tried this approach when the band launched its album In Rainbows as a web download last year. What people thought the album was worth turned out to be not very much - somewhere between £1 and £3, depending on whom you believe.

Despite denials from Radiohead front-man Thom Yorke that it was 'a model for anything', this strategy has been heralded by excited boosters as just that: a new business model, part of the frictionless 'free-conomy' where things will be so cheap as to be, effectively, free. Wired magazine's editor-in-chief Chris Anderson, author of The Long Tail (Random House, 2006), is even writing his next book on the subject.

Downloads are certainly a lot cheaper to provide than CDs, and since Radiohead left EMI the band doesn't have a record company to keep in the style to which it has become accustomed. Profit can thus be made off a much lower selling price. But the fact that the subsequent CD release has become a bestseller on both sides of the Atlantic, despite retailing for a rather more substantial £13, proves that the old economy is far from dead. What's really going on here is a new variation on an old pricing theme called 'market segmentation'.

'If your customers number in the thousands or millions, you can't deal with each of them individually,' says Dryburgh. But you can segment the market into distinct customer groups. 'Typically, markets are composed of three segments. At the top are a small number of customers who are prepared to pay a very substantial premium for your services. In the middle are a larger number who are prepared to pay a reasonable price for the convenience factor. And at the bottom is the 'long tail', a potentially large number of people who might consider a stripped-down version of your service or product - if it were cheap enough.'

Radiohead's download album was aimed at one segment - the web-savvy early adopter - while the CD was aimed at another: the fan happy to pay more and wait longer, in return for the feel of a piece of shiny polycarbonate in their hands. That way, all your customers get what they want, and you get to make more money - the proverbial win-win.

But if the prospect of a web-enabled utopia of ubercheap products and services may have been over-hyped, that's not to say that the internet has had no effect on pricing. Far from it. At the very least, consumers are now vastly better informed about how much things cost and whether they can be got more cheaply from other firms - or even other countries. With such powerful information only a mouse-click or two away, it has become much harder for companies to maintain local pricing differentials based largely on their own costs.

Inspired by his favourite band, Mick Callaghan is trying the same thing at his Poole restaurant, Penn Central. Now midweek visitors to the a-la-carte eatery are free to pay as much as they wish. 'We call it the Anti-Price Menu. We've been full every Wednesday and Thursday since we started,' he says, 'and the majority of people are fair-minded. They want a nice meal and a good night out and are happy to pay for it.'

But, he warns, it's not universally applicable. Like so many aspects of business life, choosing the right pricing model turns out to be a question of sound judgment as much as good economics. 'I also own a pub and the customers are on at me to try it there. But if I did, the regulars would tuck me up and laugh while they were at it,' he says.

It may no longer be the only model out there, but it looks as though the sticker price will be around for a while yet.

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