Warren Buffett often says that the most important element of a company, when he analyses it, is the pricing power of the company’s products.
Pricing power is the most important competitive advantage. This entails many things underneath; strong market positioning, product leadership, innovation or access to resources that the competition cannot.
Let’s take a look at a very simple but effective pricing framework, based on the experience of venture capitalist Tomasz Tunguz, who knows a lot about this subject.
There are four components of pricing: strategy, philosophy, structure and positioning.
#1 Strategy: goal of the price
There are three possible goals: gain market share (number of customers, volume), maximise our revenues or maximise our profits.
/ Gaining market share -> penetration
The product/service is sold at a low price, below market prices or if we are based on costs to breakeven or for some new products even without covering the costs. Once we have acquired a certain share and customer loyalty for that particular product, we then move on to the other two strategies, either by raising prices or expanding the range of associated services.
/ Maximising revenue -> maximization
This is about charging the maximum possible price to each customer. It usually works in market segments where our product is not differentiable from the rest.
/ Maximising profits -> skimming
This is a totally different strategy to the first one, although not totally opposite. We already have market share, customers know our product with a certain loyalty, what is done is to sell the product at a very high price and then continue to win with the customer with added products at low cost.This is what Apple, for example, tends to do.
#2 Philosophy: price relative to cost
There are two philosophies in pricing: cost-based pricing and value-based pricing.
In theory, the latter is best, but it is very difficult to apply and not all products or services can.In markets for non-differentiated products (commodities), cost-based pricing is the way to go. In the consulting market the best is value-based pricing, but you need a great brand, a great product and alternatives that are difficult to find.
Value-based pricing -> charging customer what they are willing to pay. Another way of looking at it is the value you add, e.g. money they save with your solution or money they earn with decisions based on your guidance.
An example of the latter that I have encountered with an external CFO client is a currency hedging company for B2B (specialising mainly in e-commerce); instead of charging hedging commissions, they charge based on what we gain or lose from hedging + the time their automation saves us.
In the latter case, we did not hire them because there are much cheaper alternatives and in our case they did not provide us with as much value.
#3 Structure: pricing rubric
The classification Tomas gives us here is for software companies, but we can apply it to any company.
/ Linear pricing: each product, service or unit of use costs the same.
/ 2 part tariff: a fee of X euros and from there a lower tariff.
/ 3 part tariff: a fee of x euros, a lump sum for x amount of products/services and a linear tariff once the initially contracted amount has been covered.
The most commonly used is the second one. And it makes a lot of sense because the company is assured of a minimum income. However research suggests that the third is the best.
#4 Positioning: communication of the price
In my experience, the most important determinant of pricing is positioning. This is determined by many strategic factors of the company and the product. A company that is poorly positioned or not very well positioned will never be able to have high or premium pricing because it will not be maintained over time.
There are 3 ways to position the price: per unit of consumption or service, per job or licensing agreement.
In order to know the right pricing strategy it is essential to know what are the needs and concerns of our customer, cost or value, what is their unit of measurement, a person, a gigabyte, an investment decision?
It is important for us to understand the implications of price changes (discounts, promotions etc) on cash generation and product margins.
It is important to work on this with product and especially marketing managers.
Finally, prices are not static, they change as the market changes and we need to be well positioned and understand customer needs to continue to have control over pricing.