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The True Cost of Bad Pricing

Posted On - 14/02/2014 09:33:45

Bad Pricing: Charging Anything Less than You Could
This blog workshop rounds up the series ‘TOD'13: Price Competition and How to Do It'.

In it we focus especially on bad pricing. Because, while it's unlikely anyone would disagree that bad pricing is bad for business, what is bad and how bad makes bad?

You can look at pricing in all sorts of ways. We're going to start by looking at it from how it impacts sales - using the Law of Demand. This Law states as price goes up, volume goes down and vice versa. Pretty much everyone gets this and it's probably what's behind the belief, held widely by many Indies we meet, that low pricing is good pricing and anything else is, well, bad.

Using the Law of Demand is fair enough except this price/volume relationship – dubbed price elasticity by economists – is different for different thingsNow being aware of the Law of Demand is fair enough. But problems arise if it's just assumed and applied blindly. Because while the Law is true it also varies.

In other words the relationship between price and sales can be different for different things. Just compare how price impacts sales of salt or Prada handbags. Or commuter travel versus cans of Coke.

For some things price matters very much, while for others sales remain constant over a wide range of prices. Economists dub this Price Elasticity and the more sensitive something is to price the more elastic it's said to be.

So why the Economics lecture? Because you need to think about price elasticity for IT products and services. Because you need to be informed and rational when you think about pricing. You need to have a better sence of what adding or taking off 10% from a price will actually do rather than what you think it might, what your worst fears are or what customers dictate. Because those are truly bad ways to price.

What can we say about the price elasticity of IT? Well quite a bit - and quite a bit based on facts and data. How? The Retail Price Comparison gives us a ton of numbers we can use to plot price elasticity curves. And we've done that – see below. What do they show? That IT products and services are price inelastic. That volume barely changes with price. That pricing ±15% around the average only changes volume ±1-2%.

Don't believe it? Well it might not be what you were expecting but you shouldn't be surprised. Because price is not the key factor in sales of what you sell. There are many other considerations at play in purchasers' minds. Selling IT is not like selling something simple like fruit and veg. And you've only got to look at Tesco's experiences to see how absolutely real that is and why they're pulling out of selling IT and consumer electronics.

Price elasticity curves shows is IT products are price inelasticBut the real hum-dinger from what we know about the price elasticity of IT is how this counters prevailing beliefs. Of how what many of you expect to happen to your business if you change prices will actually pan out. Because yes, while good (lower) prices may attract business and high (bad) prices scare it off, in both cases it's marginal.

And that's the crux of it: the impact of price on sales is negligible. So thinking commercially you have to ask yourself do good (lower) prices attract enough business to ‘pay' for themselves, or do they just net give money away? And do bad (higher) prices lose so much business they wipe out your extra profit, or will you net still come out better off regardless? Could it be what's believed to be good pricing is actually bad for business and bad pricing is good?

Discombobulated? Don't be. Trust us, this is all facts and data. And if that's not enough, here's some maths too!

Maintaining profits while varying price can have unexpected consequences for volumesOpposite is a graph showing ‘Change in Sales to Break Even'. What it shows is the theoretical relationship between sales and price for given mark-ups. Key is that the lines represent the relationship so that profit levels are maintained steady. It was introduced during an earlier blog workshop from the 2013 Open Day ‘Why Every Retailer Should Take Part in The RPC (Retail Price Comparison)'. And it was used there to bring to life this good/bad question.

In that session we discussed how sales volumes would need to change to keep profits steady while we flexed the price up and down on something. To be precise it was a ±£1 flex on a £13 product with a mark-up of 30%. The results? Discounting -7% (-£1 on £13) demands a 44% uplift in volume to maintain profit.  Going the other way, raising prices the same amount only loses money if volumes drop more than -23%. And even a mere -3% discount (that's just -40p on £13) demands a 15% uplift in volume. And a 40p raise can afford -12% volume drop.

By the way the value of the product and discounts/raises in these examples doesn't matter, the percentages hold whatever the case.

Don't be fooled: low pricing doesn't win business it just gives money awaySo how does all this matter? Well, this is about how what the theory tells us about price changes isn't born out in practice.

Remembering we're talking about reasonable price changes and not seeking to profiteer - just price fairly - there's some really important consequences.

The price elasticity data shows we haven't a hope of creating the volume increases needed to make low pricing commercially sensible.

But what's really interesting is the implications for price increases. The elasticity data shows raising prices just doesn't kill business anywhere near the extent it'd need to make it commercial suicide.

So pricing low and discounting won't make you money, in practice you'll lose.

And raising prices won't lose you money, in practice it'll make you more.

It turns out IT being price inelastic is a very good thing. You now know that pricing low is plainly unwise. While bringing it in line with peers won't make business fall of a cliff. And, frankly, neither would edging them just a few %'s higher.

But be that as it may, this blog was meant to be about the true cost of bad pricing. So has it told us what bad pricing is? Yes, categorically it has. Bad pricing is quite simply selling things for anything less - even just 3% matters - than you could. Bad pricing is pricing at anything less than your peers would.

But the true cost of bad pricing isn't measured in terms of £'s, it's measured by what it means you can't doWhat about the cost of bad pricing? Well if you price low, even marginally, you are forgoing profit. You are giving money away. Worse, you've giving the most valuable money away you could. Because your business is surviving as is, so any extra you could make would be all profit, all cream, all money you could use at your discretion.

But the true cost of bad pricing isn't measured in terms of £'s, it's measured by what it means you can't do. Of how it makes you're life more difficult, stunts your business and thwarts your ambitions.

Be under no illusions, if you underprice through choice - because you're being noble, think it's shrewd or or any other reason - you are forgoing being able to invest in your business and people. Perhaps worse, you are forgoing income for you and your family, for a better life. And why? Because it's entirely unnecessary.

For more on the true cost of bad pricing, what ‘bad' is and how bad does have to be to be bad, see the video.

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