The link between pricing strategy and profit

I came across this study by John Hogan, of Monitor Group Perspectives. It shows that the most successful companies that implement a value-based pricing strategy earned operating profits 24% higher than their industry peers.

However, the key to success was both having a value-based strategy AND strong execution capabilities.

Building a better pricing infrastructure

McKinsey, the consultancy, stated in a study of global corporations that a price increase of 1% typically delivers a profit incease of 8.7%.

Well you do not need McKinsey to work it out for your own business. We now have a price positioning tool where you can work out the price sweet spot for your self – the price you need to rise to, for maximum profit.

Find the price sweet spot

I have been working for a while on the simplest, most practical way to present business readers with the mathematics of price and profit maximization.

Last week I took pen and paper while travelling and by the end of the return flight I put together a simple four-variable formula to summarise the thinking and statistical theory behind demand-based pricing.

Go to the references and resources / tools section of the site to see the calculation in action, in graph form. Read the pricing strategies page to follow the logic.

Gross margins in telecomms

Cable and Wireless Worldwide sent me their gross margins for 2009/10. You may be interested. These were sent to all shareholders in their annual review, so the information is public domain and may be re-quoted.

Sector	Revenue (GBP millions)	Gross margin %
UK enterprise	837	53%
UK public sector	285	59%
UK carrier	349	32%

This illustrates standard gross margin differentials:

• for public sector business, you can achieve a higher gross margin. Why? Buyers are not buying with their own money, so their demands will be as much on quality of service, your ability to meet tender or supplier requirements, and other issues
• For business with intermediaries, you can expect a lower gross margin. Why? More people in the supply chain, so more people to share the overall end-to-end profit

Price as a driver for business productivity

It is rare that a low price will bring you more business. This could only happen if customers are buying only on price, not service, and if they could as easily obtain exactly the same product elsewhere, and if switching to another supplier causes them no trouble at all.

So when you select your pricing strategy, lowering the price to stimulate demand is the one to try last.

I was reminded of this when Tony Rice, chief executive of Cable and Wireless Communications, sent me the answer to a question about the future drivers of his business without once mentioning price.

Question: What are the future drivers for your business and how are you positioned to take advantage of them?

Tony Rice:  There will be four drivers:

• product innovation
• mobile data
• the triple play ( pay TV, fixed comms, broadband comms )
• the economy

Strategic issues all completely outweighing price as a factor in doing business with his customers.

Price and margin visualiser

For August 2010 we have uploaded a great, visual, but really simple visualiser for price strategy.

using sliders you can play with ideas for the price or margin, to see the impact on your future financial position. It will show you the results and the total sales and margin you can expect.

You can even try different predictions for demand. useful for example if you expect a price decrease to come with a demand increase.

Or if you are expecting a cost change, put that in too, to see the impact on margin percentage and ultimately profitability.

What is the difference between gross margin and mark-up?

Mark-up is different from margin. ( People also use the term gross margin ).

Margin is the difference between the price at which you sell and the cost that you pay. It is the part of the selling price that is your profit. When you take about margin as a percentage, you always express it as a percentage of the selling price.

Mark-up is the extra percentage that you add on to the cost you pay, to arrive at the price at which you sell. So the mark-up percentage is the margin expressed as a percentage of the cost price.

The two figures are always different. This example shows how.

You sell an item for 100 and it costs you 80. The margin is therefore 20.

• The margin percentage is 20 as a percentage of the selling price, 100. So the margin is 20%
• The mark-up is 20 as a percentage of the cost price, 80. So the mark-up is 25%.

I would always advise you to think in terms of margin, because it is the profit on what you actually sell that is what matters. This table shows the match between some standard margins and mark-ups.

Margin	Mark up
20%	25%
25%	33%
33%	50%
50%	100%