The importance of pricing
User acquisition. That’s what most people think of when they think about growing profit. But the biggest lever you can pull, as a brand, is on pricing strategy.
How often do you evaluate your pricing? Are your prices aligned to your business objectives? Pricing analysis, especially on mature products, is easy to overlook as “business-as-usual” while focusing on the problem of the week. However, as the most powerful tool in your profitability arsenal, your prices need to be regularly evaluated to make sure they are delivering on their objectives.
Companies have many different pricing strategies, but they all boil down to a single objective: your pricing strategy is to maximize your profit. Maintaining the long-term health of your business requires a thorough understanding of how well your pricing strategy is accomplishing that goal. To that end, below we’ll take a look at:
- Why maintaining the right price point is so critical
- How pricing discipline can help you prioritize profitability
- How to analyze and determine the optimal price
With this understanding, your company will be further along on your path to profit growth and long-term success.
How pricing drives profitability
How would you increase your profit in the near-term? Taking a broad level view of profit, we can divide it into purely revenue and cost. Fundamentally, profit increases come from either raising revenue, or lowering costs. Cost can be broken down further into several components. COGS, SG&A, Shipping are some of the major buckets, we can get even more granular if we want to, but for the purposes of this exercise, let’s look at those. On the revenue side, the two drivers are price and volume.
Of these levers, which has the greatest impact on your profit? You have probably guessed from the title of this blog that the answer is price, but let’s take a look at why.
Consider a retail apparel product with the following economics:
- $100 price
- $45 cost of goods
- $10 shipping
- $35 SG&A cost
- $10 contribution margin (after accounting for all of the cost factors above)
At the current price point, that is a 10% profit margin. An increase in price in this example of 1%, bringing the price to $101, would increase profit margin to $11, resulting in a 10% gain in total profit. In order to achieve a 10% gain in total profit with your cost levers, you would need to decrease your combined cost of goods and shipping cost by 2%, or SG&A cost by 3%. In addition to the relatively larger change needed for cost levers, they are also less directly in your control. It would take a major negotiation effort to reduce either COGS or shipping, and a long lead time to reduce SG&A.
However, you might also (correctly) note that a price increase will potentially lead to a sales volume loss. In the above example with a 10% margin, holding your fixed costs constant, you could afford to lose -2% of volume and break even on total profit. We have looked at increases so far in our example, but this is why it is so critical to get pricing right. Would you lose 2% in volume with a 1% increase in price? Would you gain 2% volume with a 1% decrease? You could be leaving huge amounts of money on the table by not making small adjustments in price to optimize your price and volume trade-off.
Optimizing price to prioritize profitability alongside growth
As a retail brand, it can be tempting to focus primarily on sales growth. Many brands will argue that once they capture sufficient market share, they can then turn their attention to profitability. However, this approach can make improved profitability constantly elusive. As your brand grows, your variable costs will grow in tandem. Even your fixed costs will increase over time as you incur more overhead to maintain your sales, marketing, and technology teams and platforms. This can rapidly turn into an adverse feedback loop, where the perceived path to profitability is growth, which leads to higher expenses, which in turn leads to needing more growth.
Instead, brands should make profit maximization a key part of their growth strategy from the start. By using pricing to optimize your profit margins today, your volume growth will yield improved returns to total profit. Additionally, improved profit today can help your brand better invest resources into future growth. As we saw above, pricing is the profit lever that you have direct control over today to change your feedback loop from one that requires growth to be profitable, to one that uses profit to enable growth.
How to determine your optimal price points
Now that we have looked at the importance of getting pricing right, let’s look at how we can determine the optimal price. The best method for doing this is to use an A/B test to make sure you have a clean test and control group. Start with one product:
- Select the price points that you want to test. You can test several different price points at once, but for simplicity you may want to start with just one or two. If you test two, test a price higher and lower than your current price.
- Determine your KPIs and breakeven metrics. We looked at an example above using a 10% margin. Based on your actual product economics, what is the breakeven point in your sales volume for the price point you are testing? Profitability is the most important metric to track here, but what other KPIs are important for your business? You should use this test opportunity to see how they respond to different price points.
- Select a random subset of page visitors that will see the test price points, while the majority of visitors see the current price.
- Collect your data. Critical here is to collect any data points that might be relevant to your pricing strategy. You will definitely want to collect:some text
- Sales volume on the tested product
- Sales volume on all other products
- Customer identifiers
- Page views
- Add to cart
- Analyze your data. some text
- How much did your sales volume change? Did you reach your breakeven metric?
- Incorporating both the change in price and the change in volume, what was the impact on total profit?
With the direct impact on the tested product established, take a look at how your other products performed during the test (the “halo effect”). You will want to incorporate any volume increases or decreases that you saw in those products as well into your total impact calculation.
You can now expand the A/B test to other products in your portfolio, repeating the same steps. Once you have a handle on the process, you can start also testing combinations of price changes across different products. How do price changes work in tandem across multiple products? How does it impact your entire business? As you can probably see, this can become very complicated very quickly, so it is best to start simply and expand your analysis after you are comfortable with the process. In your future state, you will want to consistently be testing the prices across your portfolio, in order to make sure you are capturing as much of your opportunity as possible.
Note that if you are not able to run an A/B test, you can still perform a pricing analysis. You can change your pricing manually for a period of time and compare that to your baseline. However, make sure to pick a time period that you can easily compare to a baseline (for example, not a seasonal period). You can also analyze historical price changes if you have a record of them.
We have also so far looked at this through the lens of trying to maximize profit on each individual product. In reality, you may have some strategic considerations for specific products, even with the overall goal of driving total profit. For example, some products that are loss leaders for your portfolio. In this case, you should still be testing price points to make sure that you are maximizing your profit, but with more emphasis on the halo impact described above. If you expect that loss-leader products should drive long-term customer conversions, make sure you track the customers in your test groups over time to see if you are converting them. For more information on this, take a look at our post on “Understanding your customers,” where we explore customer cohort tracking.
Conclusion
If you take away nothing else from this article, remember that pricing is your profit lever. Your business works tirelessly to drive sales, growth, and profit. Make sure that you are working smarter and not harder to achieve these goals. Pricing is immediately within your control, and can be tested as soon as you decide to. Getting the prices right on your products will generate stronger returns on your growth, and better set up the long-term health of your business.
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