We’ve spoken with dozens upon dozens of people who manage ecommerce sites. One of the questions we ask is, how do you set your prices? It’s probably not a surprise that most people say something to the effect of, I take my cost and add a markup of “x”.
If all products and customers were the same, if there wasn’t competition, if customers valued our products in the same relation to cost, and if we could somehow know what that magical “x” should be, then that approach would work just fine. We all know that none of those ‘ifs’ are reality and yet, companies continue to set prices that way.
Though, on the one hand, it seems to make perfect sense: we know our costs and we know how much margin we need to cover them and also provide some amount of profit. It’s comfortable and easy to base prices on what we know. On the other hand, despite its ease, many of us know that the cost-plus approach isn’t right, because it leaves out the customer. Expressly excluding the customer from the equation means we have no idea what the price means to the customer. Is it too high? Too low? The obvious result is that we are overcharging in some cases (and losing sales) and undercharging in other cases (and losing margin).
A silver bullet solution to capture forfeited profit would simply be to know the price customers would be willing to pay.
How can we find that out? Despite the crazy things that people do from time to time, people are rational actors. Nobody (in their right mind) will buy a $10 bill from you for $15. Though not as overt, similarly, nobody will buy a product from you that creates $10 worth of value for a $15 price. That simple example leads us to a simple question to ask, how much value do customers derive from our products? If we knew the answer to that question, we’d know the maximum price we could charge. And now, we have a simple framework for setting prices: Prices should be set above costs and below the value the customer derives.
A Framework for Setting Prices
Prices should be set above a product’s cost and below the value the customer derives from it.
But that’s easier said than done. It’s not like we can hold a ‘demand-o-meter’ above each site visitor’s head to discover that value. Until the demand-o-meter is invented, we can get a sense of the derived value by varying prices (in a methodical, controlled way) and observing the resulting purchases. It’s an elegant and inherently reliable way of indirectly gauging the value a product creates for a customer. The greater the value, the higher that price that is supported. Once a price is raised above that value ceiling, customers no longer purchase. Sure, for most all products, few if any customers would go through any sort of value calculation, but nonetheless, the result is the same: the retailer discovers the value customers derive and the price it can charge.
This is one of the critically valuable ways Optivity(X) can help. One of the core modules of our solution, the Price Testing Engine helps to identify the value customers derive and enables setting prices within the cost floor and value ceiling framework. For more on this topic, visit the white paper section of our website.