Price management is definitely one of the most important areas of the entire business activity; Is in fact defined as "strategic."

For "price management" I mean "setting appropriate price levels for a given product in a given market context." It is also talked about very clearly here on INC.COM (in English), where price management is addressed very clearly and concisely.

This is not the place to summarize the various theories on pricing (price is determined by the meeting of supply and demand, elasticity of demand must be evaluated, etc.): in this article the focus is on methodology also because traditional economic theory proves to be quite inadequate in explaining, in the field of pricing, the real behaviors of supply and demand.

Let me explain further: the demand for a good/service is not sensitive only to the price lever as it is, because price is always linked to the perception of value and the maneuvering of other marketing levers that need to be managed according to the type of product/need and the stage of the life cycle the product is in.

For example in the case of a new product, it is useless to operate only the price lever: the lever of promotion and communication must be moved first to create interest and the very "need" for the product.

By virtue of the foregoing, it must be inferred that a change in price instantly alters the relationship between "perceived value" and price and affects, precisely, the market's propensity to buy from a particular supplier.

Pricing in Price Management

In "pricing," one of the most common misguided practices is to use only accounting data to make strategic decisions: doing so overlooks the opportunity costs associated with choosing certain strategies.

Costs that can be very significant. I want to make it clear that cost accounting is important in a company but, compared to strategy, has other objectives. The optimum would be good management control, supplemented by diagnostic tools to assess the relationship between benefits and costs and between results and investments, and only partly based on accounting data.

The logic that should inspire a company in setting its price must take into account multiple factors. Simplifying, we can identify the main ones:

  • The goals (market share? Image? Turnover? Profitability? Traction of other products?)
  • The Constraints (the level of Variable costs and definitely NOT Fixed costs).
  • The time option
  • Market behavior

A brief discussion, which then introduces the concept of contribution margin, I devote to constraints: I have pointed out that a major error in pricing is the consideration of fixed costs.

In addition to getting our prices wrong, and potentially preventing us from achieving a larger and more profitable market share, this has an original sin: our customer could care less about our fixed costs. Full unit cost can be a useful indicator of efficiency and competitiveness, but it is simplistic and potentially risky to use it for pricing.

It is not the price that must cover fixed costs and allow a profit margin because this function must be fulfilled by the product's total contribution, that is, the difference between the product's revenues and variable costs.

Not fixed costs. Fixed costs come in for another little game: the total product contribution is calculated through the contribution margin, which is the difference between the unit selling price and the unit variable cost.

By relating the contribution margin to total fixed costs, we obtain an important piece of information about the turnover of break-even that is, how much, at that percentage level of contribution margin, I have to charge to cover my fixed costs.

Let's give an example that shows us how to get prices wrong based on fixed costs:

A company sells a product with a variable unit cost of euro 6.00 The company's fixed costs are euro 600,000 The company assumes to sell 200,000 units of product and wants to earn a gross margin of 25%. The unit cost calculated by the WRONG method will be euro 9.00 (6+600,000/200,000) and the unit price will be euro 12 (9/1-0.25).

Why is this method (which yet so many people use) wrong? First, because the entrepreneur does not have the "glass ball" and therefore cannot know exactly how many pieces he or she will be able to sell over the course of the year, but then also because choosing this method can lead to large opportunity costs.

Price management: two scenarios

A) The company realizes that at 12 euros it can sell 400,000 units of product instead of 200,000. Applying the same criterion (maintaining the 25% margin on the price with the same allocation of fixed costs) would result in reducing the price to 9.33 euros by making the company lose 2.66 euros (potential) for each piece sold. Let's see: (6+600,000/400,000)=7.5 7.5/1-0.25 = 9.33

B) The company realizes that it cannot sell at euro 12 more than 100,000 units. Application of the same logic would like to see an upward price revision to euro 16 (6+600,000/100,000)=12 12/1-0.25= 16 This makes even less sense given the obvious greater price elasticity of demand than expected: in short, at euro 16 the product is not sold.

The problem, then, is that it is assumed that a given volume is sold regardless of the price charged (calculated, moreover, on the basis of the allocation of fixed costs) while in reality exactly the opposite happens: it is the price that influences volumes at least to a large extent and not vice versa.

With the contribution margin methodology, we can modulate our strategies of pricing and also make decisions with reference to the behavior of our competitors.

Assuming that every company wants to set a price that will enable it to cover the costs of producing, distributing and selling the product, and guarantee it a profit margin that also rewards the work done and the risks, it has been seen, with the above examples, that estimating a given sales volume a priori is extremely risky.

But what if, as we saw in examples A and B, the sales levels were different? Since no one can predict the future, we must resort to the break-even point tool (break even point). Through a simple calculation the entrepreneur can visualize in a table how much turnover he or she needs to "take home" to cover all fixed costs and from when onward he or she can start earning money. The table shows us that fixed costs remain the same regardless of sales volume, while variable costs, grow in proportion to volume

The B.E.P. formula is this:

Fixed costs/(price-variable cost) or fixed costs/contribution margin

How do we modulate our pricing strategy?

Simple: by assuming different prices and their possible impact on sales volume and profits. It is then sufficient to clearly identify the fixed costs and the unit contribution margin to immediately get an idea of the sales volumes needed to achieve the break even. In addition, the enterprise should always try to reduce costs, fixed or variable because lower costs lower the volume of break even.

Written by Daniele Nalli

Note from Valerio

Price management is of paramount importance, as you could tell from this post, for any business, even one you can start online, such as an e-commerce or product info sale.

The information you find here can be applied (indeed, should be applied) in any area where there is a sale on the line. I won't deny you that among my clients, that of price positioning is one of the most heartfelt worries that causes many to have sleepless nights, because as you well know, by going online and publicly displaying your price list, you m not so much to competitors as to the comparisons your potential customers will make.

Getting the price management wrong from the start is probably the biggest mistake you can make.