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An art and a science is behind price-setting

A couple of weeks ago I read an article on the Harvard Business Review blog about the logic behind pricing practices of Internet retailers. Succinctly stated, the prices change often and they change widely.

I’ve experienced this when checking airline and hotel prices, only to find that the price had changed when I was ready to book. Have you had the same experience? How did you feel? I know I was unhappy, actually angry. Of course, I was happy the one time the price had dropped.

Regardless of how you feel about the practice, as a business owner, it is important to understand what is going on and how to learn from it. There is far too much to consider about pricing to cover in this column. Instead, let’s discuss some pricing practices and guidelines.

Every business owner wants to set the “right price,” defined as the price that yields the highest total profit. Because the highest total profit is a function of price and the quantity that can be sold at that price, the search is never-ending. Internet sellers use the Web as a tool to determine the right, or optimal, price by constantly varying the price to test buyer resistance, customer segmentation, importance of timing, and opportunistic actions.

Brick-and-mortar retailers and service providers can do the same, at least to some extent. They can vary prices and learn from the results. For example, can or should a tax-preparer charge more to clients who bring their information at the last minute compared with clients who are organized and more punctual? Should a retailer raise the price on a hot-selling item when stock is running low?

Price sensitivity is the effect of price on a buyer’s actions. Many businesses never learn the effect of price elasticity or sensitivity because they follow a rigid method of price-setting. Most often, price is set either by adding a specific markup to cost or by matching the competition. Neither method provides any information on what the buyer may be willing to pay. Most businesses operate on rather thin net-profit margins. Failing to test pricing sensitivity can result in lost profit that may mean the difference between success and failure or between thriving and merely surviving.

An easy-to-use tool to help in pricing decisions is the break-even analysis. The calculation quickly shows how many units of a product or service must be sold at a given price to break even. Management judgment then determines the price-unit sale combination that will yield the highest total profit. The tool can be refined by including a minimum desired profit as part of the fixed cost in the break-even formula. If you are not familiar with the use of break-even analysis, ask your business adviser. This valuable tool is far too often unused.

For some products and services, the price-sensitive customer may want only a bare-bones product while the less price-sensitive customer may be willing to pay more if there are added benefits with a more-expensive purchase. Perhaps both customer types can be attracted if the optional benefits are unbundled from the basic product or service.

A little time and thought can significantly increase your profit.

Bowser@BusinessValueInsights.com Dan Bowser is president of Value Insights Inc. of Durango, Chandler, Ariz., and Summerville, Pa.

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