The Visible Hand of Pricing

Pricing is the most effective lever to increase profitability when compared to sales, fixed costs, and variable costs. Managers should take ownership of pricing decisions rather than relying on the “invisible hand of the market”.

Smart Pricing by Jagmohan Raju and Z. John Zhang

Studies across various industries have shown that a 1% increase in price can result in a 10% increase in profitability. This premise is also the basis of The 1% Windfall, another book on pricing strategy. Knowing this, managers responsible for pricing should understand the options available and choose the right one based on their customers and market. In Smart Pricing, Jagmohan Raju and Z. John Zhang present a deliberate and informed approach to pricing decisions based on an understanding of the market and customer.

The authors identify nine alternatives to common pricing strategies. Raju and Zhang illustrate that there are many ways to creatively approach pricing that go beyond cost-plus, competition-based, and consumer-based strategies.

The flaws of cost-plus pricing

The book points out that the most popular pricing approach, cost-plus pricing contains many flaws. First, costs are not always known precisely, leading to errors in calculating the final price. Second, cost-plus pricing is based on sales estimates which are then translated to production numbers spread across the estimated volume. A product which is estimated to sell 1 million units with a $100/unit cost and 70% markup based on an internally set IRR will sell for $170 per unit. If the sales estimates are incorrect, then the price will not reflect its assumptions. Third, cost-plus pricing does not take into account the possibility of premium pricing based on customer preference. Many items which are inexpensive to produce are often sold for far higher amounts because of intangible factors such as emotional value. The authors also point to studies which have shown that customers do not necessarily expect companies to pass along cost savings obtained through efficiencies in the form of lower prices. Rather, they only expect companies to lower prices if costs of inputs have decreased. This finding puts into question the rationale behind cost-plus pricing.

This video expands on the inherent weakness in cost-plus pricing–Rutledge says you’re “leaving money on the table” because you are giving your engineering team control of the price. It is the engineering, or manufacturing team, that controls sourcing and materials, and thereby the cost which is the basis of cost-plus pricing.

Shortcomings of competition-based pricing

Likewise, Raju and Zhang point out that competition-based pricing has shortcoming such as the risk that all market participants will unwittingly being a price war or stay locked in to high prices. Consumer-based strategies, on the other hand, can lead to discriminatory pricing.

Alternative Pricing Models

By highlighting methods such as “pay as you wish”, price wars, and “micro pricing”, Smart Pricing provides a quick journey through several interesting ways companies have approached pricing.