How to Set a Price

How to Set a Price

One of the most important aspects of businesses is pricing a product or service. Many managers or business owners do not realize that pricing can be a major driver of growth and profitability, which is ultimately what matters in a business. In this article, we will do a deep dive into how to price your product or service, maximizing revenue and growth while satisfying your customers.

Most businesses, especially small retailers or manufacturers, resort to cost-plus pricing as their primary pricing methodology. Cost-plus pricing is setting your markup on top of your cost. For example, a bottle manufacturer’s cost per unit is $10. They set a markup of 25%, which is considered adequate for many businesses, leading to a selling price of $12.5 per unit.

Cost Price = Raw Materials + Direct Labor + Manufacturing Overhead

Cost-Plus Selling Price = Cost Price * Markup

While cost-plus pricing methodology in theory ensures that your company has a consistent profit margin across products, that is often not the outcome in most cases. If another manufacturer sells the same bottle at $12 per unit, customers will not buy your product unless that manufacturer is supply-constrained. Therefore, you need to study the market to assess the kind of markup you can charge for your products before producing or marketing the products to be profitable.

There are ways to set a price that reflects the perceived value of the product from the customers rather than deriving from the cost of making a product or service available. With intricate market research and pricing strategies, businesses can leverage their insights into the marketplace to achieve optimal pricing, leaving no money left on the table.

According to the Harvard Business Review, the definition of value-based pricing is “the method of setting a price by which a company calculates and tries to earn the differentiated worth of its product for a particular customer segment when compared to its competitor.”

Let’s say your product, a water bottle, is made out of recycled plastic. Customers who have pledged to environment-friendly or sustainable corporate practices might value your product more than your competitor’s offering since it helps fulfill their sustainability goals and make their product more appealing to their customers. With this differentiation, you can charge extra for the additional value that your product provides compared to the nearest competitor’s product.

But by how much?

You will have to measure the willingness-to-pay (WTP) of your customers. Willingness-to-pay is the maximum dollar amount your customers are willing to pay for your product, and calculating the WTP is not only essential to maximizing your revenue and profit but it also provides insights into where your product development should be heading.

Ways to Measure WTP

1. Van Westendorp’s Price Sensitivity Meter (PSM)

A graph of price sensitivity meter.

Although it’s an archaic method born in the 1970s and not many companies currently use it due to the recent advancements in surveying methods and data analytics techniques, many people like it due to its simplicity.

It shows the product to the respondents and asks the following question – at what price scale would you consider this product to be:

  • Too expensive
  • Too cheap
  • Expensive
  • Cheap

The optimum price point reflects the price where the number of respondents considering the product to be too expensive is equal to the number of respondents who considered it to be too cheap. Van Westendorp suggests that this number should be the price of the product in question.

The indifference price point reflects the price where the number of respondents considering the product to be expensive is equal to the number of respondents who considered it to be cheap. He suggests that this should be the median price or the price of whatever competitor is charging.

While it is useful to have some sort of standardized method in place, Van Westendorp’s PSM method has a well-documented issue called hypothetical bias. Because respondents are evaluating the price of a product in a hypothetical setting, aka having no “skin in the game,” they value the products higher than what they are actually willing to pay for.

In short, the PSM method should mostly be disregarded due to concerns around its accuracy.

2. The Becker-DeGroot-Marschak (BDM)

The Becker-DeGroot-Marschak (BDM) method tries to mitigate the impact of hypothetical bias by introducing “incentive-compatible” pricing methods. By structuring an incentive for respondents to report what they would actually pay for the product, the BDM method tries to ensure that the respondents have “skin in the game” when it comes to guessing a product’s price.

Under the BDM structure, an individual reports a bid for a product, and then a random number is drawn for the price of said product. If the bid is above the price, the individual receives the product and pays the drawn price. If the bid is below the price, the individual does not receive the product and pays nothing.

Because participants have to purchase the product if they bid higher than the random number, they cannot go higher than what they’re actually willing to pay for – and understating the bid can lead to a lost opportunity to buy the said product.

In theory, the BDM method should solve the hypothetical bias problem, but many individuals fail to understand the connection of the acts from the outcomes when participating in a BDM study. In an environment where many of the subjects fail to recognize the consequences of their choices, the corresponding results of the study are likely to be misleading.

3. Multiple Price List (MPL)

The Multiple Price List (MPL) method tries to address the problem of the two aforementioned methods: asking the participants to come up with a number that reflects the value of the product. 

In real life, customers are presented with the price of a product rather than asking for the maximum amount of dollars that they are willing to pay, so the MPL method replicates that by giving multiple price points to individuals and asking whether they are willing to buy a certain product at those prices.

Multiple Price List.

Researchers have historically recommended MPL over the BDM method due to its simplicity and transparent nature.

However, a recent study suggests that the use of the MPL method leads to systematically lower willingness-to-pay compared to the other methods, possibly because allowing participants to focus on each value (yes/no) elicits the opportunity cost of money rather than expending it.

4. Discrete Choice Modeling (DCM)

Discrete choice modeling is employed to elucidate or forecast a selection among a group of two or more discrete (that is, distinct and separate; mutually exclusive) options. All of the previously mentioned methods conduct a pricing study about one product, which undermines the reality of many purchasing environments.

Instead, the DCM method prompts individuals to choose an option from a set of similar products with varying degrees of features and prices, just like on a product page on Amazon.

Discrete choice of products.

Companies can focus on the value of the product alone (with the exception of branding) with the DCM method because it enables real-life like shopper experience while excluding external factors such as marketing and promotions.

Which Method to Use?

According to the Lenny’s Newsletter, it is important to include some incentive-compatible element in your study regardless of the method you are choosing to use, so the participants have some skin in the game.

As you can see from the graph above, incentive-compatible studies were less likely to deviate from the actual results. So, it is essential to insert incentive-compatible elements in your study design.

Depending on the product you’re selling, different WTP study methods are recommended.

  1. Frequently bought, familiar products:
  • Use an open-ended method like BDM. Since the participants will be familiar with the product and its price range, it’s easier for them to come up with a price that they will consider buying the product for.
  1. Unusual or high-ticket items:
  • Use a choice-based method like DCM. Because participants are neither familiar with the product nor its pricing, it’s easier for them to decide on a number when they’re given alternatives.
  1. A new product:
  • Use a choice-based method like DCM. Like unusual or high-ticket items, participants may need references to take hints from when it comes to pricing or making purchase decisions.

If possible, a better approach is to use a multitude of these methods to enhance the accuracy of your pricing study.

Selling the Product

After conducting a WTP study on your new product, it becomes easier to decide whether or not to sell the product. While the marginal cost of one additional sale is relatively small for software or other intangible goods, physical goods or services can have a cost structure that is unsustainable if not priced accordingly. 

If your business cannot factor in more than 25% gross margin based on the price derived from the WTP study, it might be wise to not sell your product or modify it so that customers feel that it has a higher value.

Once the pricing has been set, make sure that you sell the product to your customers and scale the pricing based on real-time demand. Pricing your product dynamically allows you to assess whether the result of the WTP study has been accurate and helps you make better decisions for your future products and their pricing schemes.

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