Tag Archives | Pricing

Capital Asset Pricing Model (CAPM)

See Also:
Cost of Capital
Cost of Capital Funding
Arbitrage Pricing Theory
APV Valuation
Capital Budgeting Methods
Discount Rates NPV
Required Rate of Return

Capital Asset Pricing Model (CAPM)

The most popular method to calculate cost of equity is Capital Asset Pricing Model (CAPM). Why? Because it displays the relationship between risk and expected return for a company’s assets. This model is used throughout financing for calculating expected returns for assets while including risk and cost of capital.

Cost of Equity

Also known as the required rate of return on common stock, define the cost of equity as the cost of raising funds from equity investors. It is by far the most challenging element in discount rate determination.


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Calculating Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) states that the expected return on an asset is related to its risk as measured by beta:

E(Ri) = Rf + ßi * (E(Rm) – Rf)

Or = Rf + ßi * (risk premium)

Where

E(Ri) = the expected return on asset given its beta

Rf = the risk-free rate of return

E(Rm) = the expected return on the market portfolio

ßi = the asset’s sensitivity to returns on the market portfolio

E(Rm) – Rf = market risk premium, the expected return on the market minus the risk free rate.

Expected Return of an Asset

Therefore, the expected return on an asset given its beta is the risk-free rate plus a risk premium equal to beta times the market risk premium. Beta is always estimated based on an equity market index. Additionally, determine the beta of a company by the three following variables:

  1. The type business the company is in
  2. The degree of operating leverage of the company
  3. The company’s financial leverage

Risk-Free Rate of Return

Short-term government debt rate (such as a 30-day T-bill rate, or a long-term government bond yield to maturity) determines the risk-free rate of return. When cash flows come due, it is also determined. Define risk-free rate as the expected returns with certainty.

Risk Premium

Additionally, risk premium indicates the “extra return” demanded by investors for shifting their money from riskless investment to an average risk investment. It is also a function of how risk-averse investors are and how risky they perceive investment opportunities compared with a riskless investment.

Cost of Equity Calculation

For example, a company has a beta of 0.5, a historical risk premium of 6%, and a risk-free rate of 5.25%. Therefore, the required rate of return of this company according to the CAPM is: 5.25% + (0.5 * 6%) = 8.25%

Download the free Pricing for Profit Inspection Guide to learn how to price profitably.

capital asset pricing model

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capital asset pricing model

Originally published by Jim Wilkinson on July 23, 2013. 

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Benefits of Using Margin

What Are the Benefits of Using Margin in Pricing?

Do you know your gross margin? What about your profit margin? Your company’s margin indicates whether it is profitable or not. A company can have an extraordinary volume of sales, but without the proper gross margin built into the economics of the company, it results in an unprofitable business.

Start pricing your products or services to result in profit every time. Click here to download our Pricing for Profit Inspection Guide to begin.

The profit margin is the amount that sales (revenue) exceeds costs. So if your profit margin is low, then it may mean that you are making little to no money at all. Setting the correct price on a product or service is the key to profitability. You want it high enough for you to make money, but low enough for products and services to still sell.

Use margin to help you calculate exactly how much you are trying to make per unit, how much you need in order to break even, and most importantly, how efficient the company is.

Margin vs Markup

It is easy to interchange and confuse both terms of “Margin and Markup.” After all, they are remarkably similar. But when it comes to the bottom line, they are recorded and calculated different. Terminology speaking, markup percentage is the percentage difference between the actual cost and the selling price, while gross margin percentage is the percentage difference between the selling price and the profit.

For example, suppose the price of a product is $100, and it costs $80 to make. Both the markup and the margin would be $20. We calculate the profit margin percentage by dividing $20 by the $100 selling price and that equals to 20%. However, we calculate the markup percentage by dividing $20 by the $80 cost and the markup percentage would be equal to 25%.

Price for profit with our Pricing for Profit Inspection Guide.

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It is very important to remember that there are more factors that affect the selling price than merely cost. What the market will bear, or what the customer is willing to pay, will ultimately impact the selling price. The key is to find the price that optimizes profits while maintaining a competitive advantage.

Focus on the Profit Margin

A company’s main focus when it comes to pricing should be based around their profit margin. The margin measures the efficiency of a company when using their labor and raw materials in the production process. The profitability of a company relies on the established profit margin. For this purpose, a company should spend the proper time and effort to calculate the perfect profit margin for their industry and needs.

Pricing for Profit

Discover your company’s perfect price for maximum profitability. As you analyze the benefits of using margin, it’s an opportune time to also take a look at your pricing. Download the free Pricing for Profit Inspection Guide to learn how to price profitably.

Benefits of Using Margin

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Benefits of Using Margin

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Realizing Profit Potential

Over the years, we have asked our clients what business issues keep them up at night. Consistently, realizing profit potential was one of the top issues that kept business owners up at night. Is there money left on the table that hasn’t been realized? Is there potential that hasn’t been capitalized on yet? As a financial leader, it’s your job to maximize the profitability of your company.

Realizing Profit PotentialWhat is Profit Potential?

Profit potential indicates the capacity for a company to make more money in future business and trading transactions. I like referring to it as the monetization of your total capacity to drive earnings. Furthermore, profit potential measures the profit a company can achieve if all their operations are at peak efficiency. This includes pricing, efficiencies, operations, turnover, etc. Also, look at profit potential as the maximum revenue with the lowest possible costs. It’s important to keep in mind that “potential” hints at what a company can accomplish with ideal conditions. But most companies do not meet these conditions in reality. Also, be realistic about peak performance. For example, a manufacturing plant simply can not run at 100% capacity. There is down time for things like maintenance.

A great way to start realizing profit potential is to look at your pricing. Click here to learn how price effectively with our Pricing for Profit Inspection Guide.

Steps to Realizing Profit Potential

What are the steps to realizing profit potential? While I could probably write hundreds of different ways to realize a company’s profit potential, I have compiled a few steps that every small to medium size company can focus on first.

Focus on Throughput

Throughput is “is the number of units of output a company produces and sells over a period of time.” Remember, only units both produced and sold during the time period count. Profit potential lies between producing X number of products while simultaneously reducing operating and inventory expenses.

Do not forget to take into consideration your Total Units produced must consider down time for routine maintenance.

To calculate throughput, use the following formulas:

Throughput = Productive Capacity x Productive Processing Time x Process Yield 

Throughput =   Total Units    x  Processing Time  x  Good Units 
             Processing Time       Total Time        Total Units 

Analyze SG&A

Another step to realizing profit potential includes analyzing your company’s SG&A expenses. SG&A stands for Selling, General, and Administrative expenses. It is also known as overhead. When a company analyzes SG&A, they will realize this is the easiest place to looking for unrealized profit potential. Does your company have a large number of non-sales personnel? Are those employees needed to operate? If not, then merge responsibilities for those employees into the roles of essential personnel. Do you carry a lot of expenses that if cut would not disrupt either the manufacturing or sales processes? If so, then analyze whether those expenses are necessary or required.  Do you have sales people that are compensated with a base salary when it should be commission based?  How did you build your budget for SG&A this year? Did you just take last years budget and add 5%, or did you really analyze SG&A?

If you have cut all the SG&A possible and are still not profitable, then take a look at your pricing with our Pricing for Profit Inspection Guide.

Realizing Profit Potential

Know What Is Valued

Companies are giving away more value per dollar of revenue than ever before. That’s what marketing teams are being taught to do. However, many companies are giving value away without being able to actually afford it. Look at your minimum viable product. Is all the extra bells and whistles you are adding to your product and service actually adding value to your bottom line? Ask yourself whether customers would leave if you cut those extra “value-adders”. If you determine that they would not leave, then streamline your product and/or service.

Of course, I am not saying to decrease the quality or tear away value that is actually valued. However, companies should know what the company values. Then, they should focus on that. For example, Tesla offers an incredible experience with its technology. It’s no doubt that they have found value in their vehicle. But what if Tesla started including a fuzzy steering wheel cover? Their customers would probably think that the fuzzy cover is tacky and does not add much value. They want to feel the leather under their finger tips. Therefore, Tesla should stop spending money purchasing the unwanted fuzzy steering wheel covers for their customers.

Address Your Culture

Another thing that may be impacting your profitability is your company’s culture. When you address your culture, look at productivity, efficiency, accuracy, moral and the people.

For example, a sales driven firm knows they could be more profitable. They have reduced their costs and priced their products for profitability. However, there is still something missing. The financial leader walks through the sales department, factory floor, and ends up in the customer service department. There are no smiles, yelling, and phones slamming. Unfortunately, no matter how hard sales and operations worked, customer service representatives were loosing more customers than normal. The financial leader discovered that their culture was all about making the sale and delivering it. They did not value servicing customers or continuing to build a relationship with those customers.

In another example, a company noticed they were only focusing on the unprofitable or lower margin clients. The profitable customers did not have the same level of attention. Instead of loosing the unprofitable clients, they chose to pull back support and created a paid support program. If those needy customers wanted more support, then they were going to have to pay for it.

Analyze Pricing

Are you pricing for profitability? By now, you should have looked at your COGS and SG&A (or operating expenses). If you have already reduced those costs as much as possible, then determine if you are profitable or not. If you are still not profitable or as profitable as your shareholders want, then you need to make changes at the top – pricing. Access our Pricing for Profit Inspection Guide to learn how to price profitably.

Realizing Profit Potential

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Realizing Profit Potential

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Why Valuation Matters

why valuation matters The other day, a client asked why valuation matters. It seems like a lengthy process that is complex and differs in each case. You see, I didn’t respond in an elaborate explanation of the different methods of valuation. Instead, I start off by saying that life is very unpredictable.

Have you ever experienced a life-altering moment (good or bad)? One moment, you are driving; then the next, you are upside down. In another moment, you walk into the office proud of the company you built. Then the next, you are being served with a suit that will put your company out of business. In a less severe example, you may have everything together for the day, only to spill your hot coffee everywhere. Life happens. And unfortunately, there’s nothing that we can do to take the uncertainty out of it.

But there are things you can do to prepare for those unexpected moments. For example, you learned how to punch out a car window in the case of an accident. In another example, you never start a project or venture without completing a full SWOT analysis so that you can minimize any legal risks. Or you simply learned not to carry too many things – especially with hot liquids.

But have you ever thought about the value of your company? You might be thinking why valuation matters. My health is good. My life is good. And the economy is good. We all know that some things in life just happen, beyond our control.

In fact, when our founder, Jim Wilkinson, unexpectedly passed away last June, we found our answer on why valuation matters. You can’t wait for life to just happen to react to it. Preparation will make everyone’s lives less stressful and more productive.

Why Valuation Matters

Before we go into why valuation matters, we need to know what valuation is and why a company needs to be valued. Valuation determines the economic value of a business, asset or company. Although the goal is to determine the fair market value, there is no one way to be certain of the ultimate price paid. Typically, it depends on many factors including industry, sector, valuation method and the economic conditions.  You can also count on a fact, you can have your business valued by two professionals and you will come up with two different answers.

A company needs to be valued if it is being bought, sold, or liquidated. Sometimes a company must provide a value of its assets or company as a whole to raise debt also. A valuation professional typically employs the financial statements, cash flow models, and market analysis. In other words, they are going to look at the discounted cash flow (DCF), market valuation multiples, and comparable transactions. A strategic buyer will also value your company. They may use some of the methods already mentioned, but they will also look at your management team.

Believe it or not the status of your accounting records will also influence the value of your company. Especially when you are looking to sell the business. I have been told twice by Investment Bankers (I.B.) that having clean accounting records based on U.S. GAAP vs. Not having good accounting records based on GAAP can have a difference of a multiple of 1 x turn of EBITDA by one I.B., and the other I.B. stated a difference of 20%-30% of value. That is because if you do not have good clean accounting records based on U.S. GAAP, how are they ever supposed to have confidence in your reported EBITDA or Net Income? The buyer will need to build a cushion for his acquisition, even if they love your company and are a strategic buyer.

why valuation mattersHow To Deal with Valuation

When dealing with the valuation process, it is important to get as many facts as possible with 1-2 clear goals. Why are you valuing? What are you trying to accomplish with this valuation? You need to assess what the purpose of this valuation is.  It could be shareholder disputes, estate planning or gifting of interests, divorce, mergers, acquisitions, sales, buy-sell agreements, financing, and purchase price allocation.

To identify areas of improvement for your company’s value, it would be wise to identify any weaknesses or threats that are destroying your value. Click here to download our Top 10 Destroyers of Value whitepaper. Don’t let the destroyers take money from you!

Valuation for Mergers, Acquisitions & Sales

Interested parties during a merger, acquisition, or sale need to obtain the best fair market price of the business entity.  They need to look at their return on their investment.  (your company is their capital being deployed).  This will ultimately be negotiated between the buyer and the seller.

In buy-sell agreements, you transfer equity or assets between partners and/or shareholders.

Valuation for Estate & Gifting

Death is a fact that everyone is going to face. But the timing of that event varies for different people. If your business is part of your estate, you need to conduct a valuation of your business. This can be done either prior to estate planning, gifting of interests, or after the death of the owner.

The IRS also requires this type of valuation for charitable donations.

Valuation for Disputes (Shareholder or Divorce)

When a couple divorces, they need to divide the assets and business interests from one another.

Occasionally, a breakup of the company is in the shareholder’s best interests. This could also occur when shareholders are withdrawing and need to transfer their shares.

Valuation for Financing

Banks hate risk. As a result, they need to validate their investment in your company before they provide capital. At this point, they request for a business appraisal of your assets.

Valuations are important, but there are “destroyers” that are lurking to limit the value of your company. If you are valuing your company, click here to download our Top 10 Destroyers of Value guide.

why valuation mattersPricing Your Deal Right

There is no one way to value a business and there are multiple valuation approaches, including Income, Assets, and Market. Valuation can be a very complex process. It can also bring up issues that weren’t previously addressed – such as an owner’s differing interest from the other shareholders. In order to price the deal right, you need to figure out which approach will best work for your company and which one really applies.

There are three primary business valuation theories that fall into the following groups:

Income Approach

The income approach determines a company’s value based on the income. This may include:

Asset Approach

In comparison, the asset approach determines business value based on the assets of the company. This is where you might engage an appraiser to discuss value of assets based on market value and possible liquidation.

Market Approach

The market approach decides the value by comparing it to similar companies. A valuation professional will focus on the comparative transaction method. Then, they will appraise competitive sales of comparable businesses to estimate the economic performance of revenue or profits.  This works well with publicly traded companies where earnings information is readily available or when looking at real estate it is easy to find recent comparable transactions.

Valuation Destroyers to Watch Out For

There are a couple valuation destroyers to watch out for. Hopefully, you aren’t in a moment where you have to value immediately and are just preparing for a potential event. Some of the destroyers of value include having:

  • No recurring or consistent revenue
  • No good accounting records
  • A lack of clear direction or a weak management

To discover other potential destroyers of value and to learn about the above three destroyers, click here to access our free Top 10 Destroyers of Value whitepaper.

why valuation matters

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Increasing Pricing on Products

increasing pricing on productsRecently, Netflix – streaming service giant – increased their pricing on two of their products by more than 10%. At first, media and customers displayed anger and backlash. But after the pricing increase, many customers remained at the increase was approximately a $1 difference. Plus, you have to factor in that many people are “cutting the cord” from traditional cable companies and converting to streaming services, like Netflix, Hulu, and Amazon Prime, for their entertainment. Netflix isn’t the first company, nor the last, to increase their pricing on products or services. But how to you manage to increase pricing without losing customers?

Increasing Pricing on Products

Increasing pricing on products is a result of various things – such as increased costs, additional services, improved quality, etc. When a company decides to hike their prices, we found that it stemmed from either two things: costs increased or they had their economics wrong in the first place. The other big one is taxes.  Taxes actually increase prices.  Companies that have their act together and run a streamlined operations will capture even taxes in their costs, even it is “below the line”.   Be assured when taxes go up, so do prices to the end user.  One of our goals when we work with clients to be more profitable is to look at their prices. Will increasing the price retain more customers or drive them away? Will there be more value added to compensate for the increased prices? When do you increase prices and how?

When to Increase Prices

Timing is everything when you want to increase prices! If you time it wrong, then customers will be annoyed that they didn’t get the special or backlash because their monthly payment just increased a certain percentage. Netflix timed their pricing really well. Because they were releasing a new season of House of Cards, Stranger Things, and The Crown (all of which have been award winning and original content) within the next month or two, Netflix was able to communicate added value. For that extra $1, you will get more seasons of your favorite shows.

But what if you aren’t a streaming service? For example, you may be a Tax CPA firm. If you needed to increase prices for your services, then the wrong time would be in the middle of the tax season. Find those gaps between the rush of customers and communicate the value – even if you aren’t necessarily adding anything new. Be sensitive to price increases and avoid the “shock” factor.

How to Increase Prices Effectively

When you have figured out the timing of when to increase prices, you have to answer the question, “how to do it?”. As a financial leader, this is where you cross lanes from the accounting department into the operations, sales, and marketing departments. You know the economics of your company, but if the salespersons cannot sell the product/service at that price, then it will fail.  I actually had a CFO tell me that they had a “pricing problem”.  Come to find out, they did not have a pricing problem.  They knew exactly what the price needed to be, they had a management problem because the sales guy did not want to put pressure on his buddy who is the buyer.  I guess the sales guy was afraid of losing the invitation to the annual fishing trip.

Pricing is a sensitive subject. We get it. But are you pricing your products to result in profit? Click here to download our free Pricing for Profit Inspection Guide.

Add Extra Offerings

One of the things that we have found with our clients is to add something “extra.” For example, Company ABC wants to increase their price on widget A from $80 to $150. They don’t have any other products, but they need to increase the prices so that they will be profitable. Instead of losing customers that may not be able to afford the $150, Company ABC splintered their products into three separate items – priced at $47, $56, and $89. Once a customer saw value in those smaller products, they opted-in to purchase the $150 product.

This is also a numbers game. When you provide extra offerings, you are able to capture more market. Hopefully, you will be able to promote those purchasing the cheaper products into a higher price range.

Adjust the Product

While this option isn’t necessarily increasing pricing on products, it is changing the cost structure and improving profitability. This tactic is used frequently in restaurants. Have you ever frequently visited a restaurant and your favorite meal started getting smaller… Yet, you were still paying the same price? Many companies chip away parts of the product to reduce costs, and therefore, increasing the price per plate, ounce, etc.

increasing pricing on products

Occasionally Run Specials

Think of that customer that is very price conscious and sensitive. Every once in a while, offer your products with a discount – essentially bringing it back down to its original price. This is a great way to retain previous customers that were conditioned with their prior expectations. Retailers do this all the time.

Change Your Customer

Increasing pricing on product often brings to light the fact that you have the wrong target audience. For example, one audience is highly sensitive to price due to the currency exchange. While another is less sensitive. Explore what it would look like to focus on that preferred audience. Maybe your specialized expensive item belongs in a specific industry that values your product, and not in a more general industry that maybe does not need or appreciate it.

Do Your Homework

Increasing pricing requires a lot of work on behalf of your marketing, sales, and operations team. If you are increasing pricing on products, are you absolutely sure that you will not have to do it again in the next few months? Because this process is an undertaking, do your homework and research the costs of your product. Will there be anything that could influence your costs?

When is the last time you had a price increase?  You would be surprised how many times we speak to a business and they had gone years without a price increase.  These companies are not evening covering the cost increase attributed to inflation.

Increase Pricing on Intervals

Service companies frequently use this pricing tactic. They increase their pricing after a 6-month or 12-month membership. It’s expected. Sure, you may have customers that work around the system – finding new services, signing under a different name, etc.

Examples of Recent Price Hikes

While we have discussed extensively about Netflix, there are other industries, companies, and areas of the market that are having to adjust to a) the loss of customers, b) the increase of costs, and c) growth.

Movie Theaters or Cinemas

Before the era of streaming networks and DVRs, movie theaters or cinemas were all the rage. That was the only place you were able to watch new releases before you could purchase their respective DVDs. But as we have seen, more potential customers choose to stay home and watch on their home television instead of going out. Maybe this is caused by generational preferences. Regardless, movie theaters are having to increaseproduct to compensate for decreased customers AND add value. Theaters are now offering fully stocked bars and restaurants, reclining chairs (or pods), and creating a high scale environment. iPic Theaters is a great example of how the environment of movie watching is changing.

Price for Profit

Whether you are increasing the prices of your products in the next couple of months or years, it’s important to price them right the first time. Oftentimes, when we work with our clients, we find that their pricing was not resulting in profits. After seeing this so often, we developed a Pricing for Profit Inspection Guide that you can access here for free. Download the free Pricing for Profit Inspection Guide to learn how to price profitably.

increasing pricing on products

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increasing pricing on products

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Black Friday

In America, Black Friday is an event that is not only the most shopped on day during a typical year, but it also generates huge sales.

“Only in America do people trample others for sales exactly one day after being thankful for what they already have.”

~Author Unknown

Black Friday Definition

The Black Friday definition is a retail store sale that occurs the Friday after Thanksgiving – an American holiday in November. Many consider this event to be the kick-off to the Christmas shopping season. Many retailers, such as Walmart, Kohls, Kmart, Macy’s, Express, and other major retailers, open their stores in the early hours of the morning to receive the first rush of customers. Door busters, sales, huge discounts, and giveaways are all part of this event.

The History Of Black Friday

Black Friday originated in 1952 as the start of the Christmas shopping season. Because many states in the United States considered the day after Thanksgiving to be a holiday as well, retail shops realized that there were enormous amounts of potential shoppers available during this four-day weekend. But since 2005, this event has launched into record numbers for sales, shoppers, etc. For example, sales dropped for the first time since the 2008 recession in 2014. Yet, sales boasted $50.9 billion over that weekend.

Although not all states in the United States permit workers to work on national holidays or even the day after Thanksgiving, companies have broken many boundaries to take advantage of this rush of customers. Over time, retail stores and e-commerce platforms have expanded on Black Friday to include Cyber Monday. It’s become a tradition to many.

Cyber Monday

Because Black Friday became such a hit, online companies created another shopping event – Cyber Monday. It occurs the Monday after Thanksgiving and encourages shoppers to purchase more gifts and things on Monday. Originally, it was launched in 2005.

The Cost of Black Friday

While it may be tempting to join in on Black Friday specials and sales, you have to consider the cost. Remember, a sale isn’t necessarily a good sale. It has to be a profitable sale.

Some of the costs associated with Black Friday include.

How to Win on Black Friday

In order to win on Black Friday, you have to price your products for profit. Especially since you project to sell large quantities of product, you need to make sure you don’t start with a pricing problem. If you cut prices off a product that is already not profitable, then you will loose more potential profit. Before you start planning for Black Friday, make sure your pricing is in check. Click here to download our Pricing for Profit Inspection Guide.

Price for Profit During These Sales

Each sale you make has to return a profit. Therefore, you need to allocate as many costs to each good to make it easier. How much inventory do you need to push in order to turn a profit? But also, what prices are customers willing to spend? The trick with Black Friday is that since everyone is competing for the best deal, you must know what others are pricing the same product at.

Reduce DSO by Turning Over Inventory

The risk for big sales like Black Friday is that there will be some that cancel their credit card transaction for $1,800 worth of product. Because you are putting a lot of cash up front to increase inventory, you need to collect cash as quickly as possible. For example, you can offer discounts for cash only. For other pricing tips, download the free Pricing for Profit Inspection Guide to learn how to price profitably.

Black Friday

Strategic CFO Lab Member Extra

Access your Strategic Pricing Model Execution Plan in SCFO Lab. The step-by-step plan to set your prices to maximize profits.

Click here to access your Execution Plan. Not a Lab Member?

Click here to learn more about SCFO Labs

Black Friday

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Why You Need a New Pricing Strategy

Larry is operating a lemonade stand, and he thinks that his lemonade is the most valuable drink available. Because he interprets his lemonade as highly valuable, he decides to charge $85 for a glass of lemonade. Larry wonders why no one buys his lemonade. Although he may seem highly profitable when you work out his unit economics, he has not sold a single glass of lemonade. Like Larry, you may need a new pricing strategy.

What is your current pricing strategy? For example, you may be setting the prices on your perceived value of your product/service like Larry. But have you thought about how you could price your products/services better to improve your company’s profitability?

need a new pricing strategy

What is a Pricing Strategy?

To determine if you need a new pricing strategy, you need to identify what pricing strategy you are currently using.

Often, pricing is seen as the marketing and sales department’s role. But as the financial leader’s role morphs into a value adding position, you must work with every department (including marketing/sales) to be able to squeeze profits from every corner of the business.

The Variety of Pricing Strategies

When you are looking for a new pricing strategy, you should assess the different types of pricing strategies and the reasons for picking a one over another. Some of the more common pricing strategies include neutral, penetration, forward, skimming, and value-based. Although there are other strategies that we could dig into, these are among the most popular.

Neutral Pricing Strategy

The first pricing strategy that companies can use is the neutral pricing strategy. As the most common strategy, businesses price their products or services so that their customers are indifferent between a competitor’s product and yours. After taking into account all the features and benefits of the product, the price is set – essentially making you neutral in the pricing game.

While this may seem intelligent, it makes it difficult to expand your customer base as they have no real reason to choose your product over another of the same price. There is no value expressed in the neutral pricing strategy – thus, limiting the profit capabilities.

If you want to gain more profit margin, neutral pricing strategy is a safe (and ). To price your product or service correctly, download our Pricing for Profit Inspection Guide whitepaper!

Penetration Pricing Strategy

If you want to be more aggressive than the neutral pricing strategy, you may want to choose the penetration pricing strategy. This strategy is used to gain market share, but it has several drawbacks. For example, price wars can start between competitors. Because you don’t want to lose your market share, you may be tempted to lower your prices. But your competitors will likely lower their prices as well to compete for their customers. If you continue to lower your prices, your margin will be squeezed until you are unprofitable.

Grocery stores most commonly use the penetration pricing strategy. Most recently, Amazon acquired Whole Foods (a traditionally expensive grocery store chain) to compete with other grocery stores such as Walmart, Target, Kroger, and other local stores. As Whole Foods slashes their prices, stock prices in major grocery stores have declined in anticipation of them having to reduce their prices to compete. It’s too soon to see the result of implementing a penetration pricing strategy; but unless these stores gain more customers or offer other profitable products, they will become less profitable.

Forward Pricing Strategy

Like the penetration pricing strategy, a forward pricing strategy focuses on the future costs associated with that product or service. Companies are willing to price below cost of goods sold at first if they know that in the future, they will have higher margins. If a company cannot predict that if they sell X units by Y date, then having a forward pricing strategy may not be the best strategy for your business.

If you need a new pricing strategy, you need to think about pricing for profit. Download our Pricing for Profit Inspection Guide to learn if you have a pricing problem and how to fix it.

Skimming Pricing Strategy

Converse to the penetration pricing strategy, skimming pricing strategy allows companies to segment the market to gain access to those customers who are willing to spend more per unit. Most commonly, a company utilizes skimming at two different periods in the product life cycle, the beginning and the end of the product’s life.

Apple’s Skimming Pricing Strategy

For example, businesses that are in a semi-monopolistic positions use the skimming pricing strategy when launching the product. Think of the iPhone. Apple set their prices for the iPhone high as they were only wanting to sell to those customers with the willingness and ability to pay. As that small market depletes or slows down, Apple reduces their prices to sell to the next tier and then the next. Recently, Apple released the next generation of iPhones – iPhone 8 and iPhone X. If you’re looking to access the iPhone 8 with 256GB, expect to pay $849. You can get the iPhone X for $1,149 with the same storage as the iPhone 8.

If you look at the prices of each of their products, expect to pay 2-3 times as much for a similar product compared to other competitors. So how are they so successful? Apple has created a culture in which people are willing to spend a large amount to remain in the Apple community. Unfortunately, not every company will be able to replicate Apple’s pricing strategy. But it’s important for you as a financial leader to study what other brands are doing in regard to pricing.

Value-Based Pricing

Ask yourself this question: How much is your customer willing to pay for your product or service? There is a price that your customer is willing to pay for something without having any knowledge to how much it costs to produce or anything else. Value-based pricing is the next pricing strategy. While implementing this strategy is not simple, you can potentially gain more profit than using any other pricing strategy available.

In business school, students are taught to use the cost-plus method. Instead of adding value with their product, business leaders simple decide on the margin that they would like to have. There’s no real thought process in cost-plus pricing, but it is an easy way to bypass your customer and be in sync with your competitors.

For example, Apple has created a value for its products. They didn’t decide on a margin, but instead established such a perceived value that people cannot wait to get their hands on the next product. Some have converted all their technology over to Apple because of that added value. It’s not going to be the cheapest technology on the market and may not even be the best. But the customer is willing to pay for it at the price Apple has set. According to CNN, Apple is worth $750 Billion so they are doing something right!

need a new pricing strategyWhy You Need a New Pricing Strategy

Unfortunately, your company may be pricing your products or services too low (or too high). And your customers are not buying. You may need a new pricing strategy. Ask yourself some of the following questions:

  • When did you last interview your customers about your pricing?
  • When did you review your pricing strategy last?
  • Have you ever tested your pricing on different groups?
  • Which markets have you not be able to get into yet?

Pricing is the basis of your business and is the most important factor in profitability. If your company is solely relying on something other than pricing to improve profitability, you may need to assess why.

Buttress The Business

As you decide if you need a new pricing strategy, assess whether your pricing is a buttress of the business. We can agree on the fact that businesses exist to provide real value. Your business should be structured to support and validate the reason for the price per unit (and the value provided). McKinsey & Company highlights that most businesses do not pay enough attention to their pricing!

Most businesses fail to test customer value perceptions and price sensitivity after products launch and have no idea how the critical trade-off between price and volume shifts over time. Second, companies must make pricing decisions in the context of their broader product portfolios because when they have multiple generations of a product in a market, a price move for one can have important implications for others.

Increase Profitability

Price Intelligently references to a “landmark study [that] was published in a 1992 Harvard Business Review by Michael Marn and Robert Rosiello, both senior pricing folks at McKinsey and Company. The dynamic pricing duo studied the unit economics of 2,463 companies and found that a 1% price improvement results in an 11.1% increase in operating profit, which compares to 1% improvements in variable cost, volume, and fixed cost only resulting in profit increases of 7.8%, 3.3%, and 2.3% (respectively)” Having a value-based pricing strategy will improve your profitability. If you are looking to drive more profits this next quarter, you need a new pricing strategy. To learn how to price for profit, download our Pricing for Profit Inspection Guide.

need a new pricing strategy

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