In business, selecting the right pricing strategy can feel a lot like a game of poker. If you’ve taken the time to learn the rules, practice the game, and fine-tune your approach, you have a pretty good chance of striking it big. If you go in blind, however, with little understanding of the game, the rules, or your opponents, it could feel like the chance of winning comes solely down to luck.
It should come as no surprise that to build a pricing strategy that maximizes profits, a company needs more than just luck. A data-driven pricing model leverages quantitative and qualitative information to determine the price of a product based on not only cost, but the perceived value as well. With the right price optimization strategy, organizations can take the guesswork out of balancing profit, value, and desire.
What Is Price Optimization?
Price optimization strategies have been used across countless industries—retail, consumer services, manufacturing—to maximize profit margins by looking at your company from a customer perspective and predicting the behavior of those potential buyers. What is price optimization, though, and how does it work?
Price optimization is one method of price determination that utilizes big data such as historic sales records, customer reviews, churn rate, market data, and operating costs to identify a price point that maximizes profits without compromising demand.
In addition to price optimization, other price determination methods include:
- Cost-Plus Pricing: One of the most straightforward price determination models, cost-plus pricing is exactly as it sounds: you price your product or service by adding a product’s unit cost to a fixed markup.
This model, though simple and easy to implement, often leaves money on the table. Cost-plus pricing does not take perceived value or consumer demand into consideration, which means even though you are guaranteed to make a profit with each sale, you are not guaranteed to make the maximum profit possible.
- Competitive Parity: Unlike cost-plus pricing, competitive parity does not use unit cost to determine a product’s price. Instead, someone using a competitive parity model will look to their competitors to list their product at or around the same price point.
Competitive parity can be seen most frequently in established markets where newcomers are hesitant to rock the boat. By pricing their products similar to their competitors, they cause little market disruption and have minimal if any effect on demand.
- “Make the Sale” Pricing: Regardless of what pricing method you aim to use, your sales team may still be pricing based on what they believe is the best price for their customers. Likely a blend of cost-plus and competitive parity, this approach leaves authority with the sales team to determine the price needed to complete a sale. This happens frequently in companies where volume is very important and commercial teams are decentralized.
While this type of pricing leverages sales experts, it may not use data to drive optimal pricing decisions, leaving money on the table.
Even though setting prices based on cost or what a competitor is charging may have some benefits, overall, it isn’t going to see the same success as a value-based model like price optimization. Why? These pricing strategies ignore the market value. If you aren’t considering what the market is willing to pay for your product, how can you be sure you aren’t selling yourself short?
Data Needed to Optimize a Product’s Price
Though the initial concept of price optimization is fairly straightforward—analyze consumer behavior to understand the perceived market value—the actual work involved in determining a value-based pricing strategy is more complex. Luckily, once an organization has done the research and analyzed the data, this method of value-based pricing can be used to help determine everything from a product’s initial starting price, discounted price, and even possible promotional offers.
To understand how price optimization helps determine market value, it is important to first understand what kind of data needs to be collected. Information used for price optimization include:
- Customer Survey Data
- Demographic and Psychographic Data
- Sales Data
- Churn Data
- Product Lifecycle
Once collected, information like this can help identify patterns in the features, benefits, price points, and sales tactics that drive or diminish a product’s market value. That data can then be used to determine a product’s specific value metric or the way a company measures the per-unit price of a product.
How to Optimize Your Pricing
To optimize a product’s price, a company needs to create a demand estimation model. This formula will help predict how different price points will influence demand by visually representing the inverse relationship between the two factors. By using a demand estimation model, you can identify the right balance between price and demand to maximize profits.
Demand Estimation Model:
(y = slope(b) * price(x) + intercept)
Y = demand
B = impact of price on demand
X = any price point to sell the offering
Intercept = starting point of sales
When optimizing prices, it is also important to remember the price elasticity of demand. Price elasticity is the ratio between the percentage change in the quantity demanded or supplied and the corresponding percent change in price. Price elasticity of demand is the percentage change in the quantity demanded of a product or service divided by the percentage change in the price.
Simply put, price elasticity helps predict how consumers may respond to a product’s price increasing or decreasing.
To Determine Price Elasticity:
(%Δ in Quantity demanded) ÷ (% Δ in P) = Price Elasticity of Demand (PED)
Once the research phase of price optimization is completed, companies can begin evaluating how features, functionality, and positioning positively or negatively impact their product’s perceived value. From there, pricing changes can be implemented to reflect the true market value of that product or service.
Since value-based pricing and price optimization rely heavily on consumer behavior data, it allows companies to gain a deeper understanding of their customers’ unique wants and needs. This valuable consumer insight opens the door for more efficient product development and improvement.
Any change to a product, brand, or positioning within the market may require value adjustments to guarantee prices are always optimized. In essence, as a product improves, and as a customer’s willingness to pay increases as a result of those advancements, prices need to increase as well.
Though time-consuming, ongoing value analysis is an easy way to ensure you are adjusting prices accordingly to maximize your profit.
Why More Companies Don’t Optimize Their Prices
Price optimization takes time, resources, and patience – but without the expertise and experience, most companies don’t know where to start. We’d suggest beginning with a value-based price setting process. This method is backed by internal and external research and analysis, which means unlike wasting time and energy relying on luck or guessing games, real data is used to determine the most profit-generating price. But price optimization isn’t a one-time event. Once you’ve established your price setting methodology, it’s time to build an ongoing price optimization system through a dynamic learning model with supporting processes and tools.
Price optimization enables more thorough and intricate pricing decisions that lead to greater price improvements. And remember, unlike volume or cost adjustments, just a 1% improvement in price falls directly to your bottom line. Therefore, managing and optimizing price results in a substantial boost in profits—anywhere from 8-11%. Other benefits of price optimization include:
- Faster ROI
- Maximize sales and profits
- React faster to market changes
- Gather valuable customer insights
When executed properly, value-based pricing identifies money left on the table to optimize profits as well as the perceived value of your business. With years of experience in pricing and profit strategies and management, INSIGHT2PROFIT can help optimize your business’s profitability efficiently and effectively.