Why is setting prices such a complex task?
How to price a product is one of the most important decisions a company can make. Businesses want to be competitive in the marketplace, while also maximizing their profits. That requires a complex understanding of their customers’ behaviors, needs, and willingness to pay. Pricing research measures and decodes these factors into an optimal price point.
So, why is setting prices such a complex task? The factors that influence pricing can shift at any time, driving a rise or fall in customer demand. A competitor launches a new product line, a brand faces a reputational risk, there is an economic downturn; all of these can affect how much a customer is willing to pay. Businesses may need to rapidly adjust their prices to account for these changes. For that reason, pricing strategy is rarely a one-time event.
This article explores what makes pricing decisions difficult for businesses, the steps in the price setting process, and common pricing research methods.
What makes pricing decisions challenging
There are several reasons why setting prices is such a complex task. At a basic level, a company can set its prices using a cost-based pricing approach. To do this, the company calculates the total cost of producing a product, plus a profit markup. In some competitive markets, such as FMCG or retail, this is sufficient as the lowest price always wins. However, companies might be leaving money on the table if customers are ready to pay more for a better service or product.
A more sophisticated approach to setting prices takes into consideration a wider set of factors, including:
Value proposition: Why do customers value a product or service?
Competitor pricing: How do the business’ prices compare to competitors?
Willingness to Pay: How much are customers willing to pay for a product or service?
Price elasticity: How sensitive is customer demand to price changes?
Pricing strategy: How do bundle pricing, subscriptions, and other pricing strategies affect a customer’s willingness to pay?
By integrating multiple factors into their pricing decisions, companies balance costs, value, and customer expectations. This approach also enables businesses to adapt to market changes and customer needs, ensuring sustained growth and profitability over the long term.
Image: Why is setting prices such a complex task?
How do you set prices?
To pinpoint the optimal price point for a product or service, businesses need to understand their costs and value proposition. Knowing the cost of production, distribution, and marketing establishes a minimum price point at which a product is commercially viable. Identifying the value proposition then establishes customers’ willingness to pay above that minimum price point.
A B2B market research company can answer a question like “How do you set prices?” by conducting a pricing study. This often involves a multi-method research approach that combines common pricing research methods:
Qualitative research: To establish the value proposition of a product, B2B market research companies usually start with B2B qualitative research. This can include a focus group or in-depth interviews with key decision-makers. A free-flowing discussion establishes what factors influence customers’ buying decisions for a product.
Quantitative research: A quantitative survey is used to establish the performance of a product against desirable attributes, and the premium that customers are willing to pay for those attributes. It often benchmarks the product’s performance on these metrics against other well-known brands. This identifies where a product can command a higher price, or if it needs to be competitive with the market.
Data analysis: Market researchers use common price analysis methods, such as Gabor-Granger analysis and the Van Westendorp Price Sensitivity Meter to determine the optimal price point on a demand curve.
Pricing research is often used in conjunction with other research, including customer journey mapping, product research and development, and brand health research. This can help to build a fuller picture of a brand’s perception with customers, beyond whether its product or service is priced well.
Establishing what factors influence buying decisions
Qualitative research establishes the full range of factors that customers consider in their purchasing decisions. It helps to narrow down the value proposition for a particular product or service. A customer’s perception of a product and brand can have a significant impact on their Willingness to Pay.
In a focus group setting, customers are asked what factors make a product or service unique, and why they would choose that product over the competition. This may include an in-depth consideration of the features and advantages of a product, including price, as well as brand awareness and reputation.
Customer decision making is often influenced by complex feelings and emotions, which can make it challenging to parse out what is important. Decision making can also vary between customer segments. A market researcher needs to take this into account when recruiting participants and designing the discussion guide for a focus group.
Common pricing research methods
Quantitative research is used to accurately pinpoint the price that brands can charge. There are two common pricing research methods:
Gabor-Granger Analysis
Gabor-Granger analysis is a common pricing research method that determines the optimal price point for a product. It was developed by economists André Gabor and Clive Granger in the 1960s. Customers are asked about their likelihood of purchasing a product at different price points. The results are then plotted on a revenue and demand curve.
However, there are downsides to this pricing method; namely, customers are often unable to provide accurate assessments of their own behavior. When asked directly, they often underestimate how much they would be willing to pay – particularly for a brand or product they prefer. This can bias the results and lead to a brand underpricing a product.
Van Westendorp Price Sensitivity Meter
The Van Westendorp Price Sensitivity Meter establishes the acceptable range of prices by understanding demand and sensitivity at a range of price points. The framework is also adaptable, based on whether profitability or volume is a company’s priority.
A survey with Van Westendorp analysis includes the following questions:
At what price would you consider the product to be too expensive?
At what price would you consider the product to be too cheap?
At what price would you consider the product to be expensive but still a viable option?
At what price would you consider the product to be good value?
Using the best tools for a Van Westendorp Price Sensitivity Meter, market researchers analyze the data gathered to generate a graph that clearly illustrates the boundaries of price sensitivity.
A Van Westendorp Price Sensitivity Meter is more complex than Gabor-Granger analysis, however, it has the advantage of reducing bias leading to more accurate results.
The role of price elasticity
A price elasticity model measures how sensitive customer demand is to price changes. If a small change in price leads to a significant change in demand, the product is considered price elastic. However, if demand remains stable despite price changes, the product is price inelastic. This concept is critical for understanding how pricing can affect overall sales and profitability.
A price elasticity model enables businesses to predict the impact of price changes on sales volume and revenue. It guides strategic decisions, such as when to raise prices or offer discounts, to maximize profitability. Elasticity can vary across different market segments and over periods of time. Businesses need to regularly measure price elasticity to respond effectively to market dynamics.
How macroeconomic factors affect prices
The factors that affect customers’ Willingness to Pay can vary over time. In particular, macroeconomic factors can have a significant effect on price elasticity:
Economic conditions: During a recession, customers become more price sensitive. And in boom times, they are willing and able to spend more.
Supply shortages: Supply shortages can send the price of certain goods soaring. For instance, eggs became more expensive after bird flu outbreaks in the US.
Consumer trends: Demand for certain products can rise and fall depending on consumer trends. For instance, the price of airline tickets skyrocketed after the Covid-19 pandemic as consumers booked delayed vacations.
Production costs: Falling production costs can make some products cheaper over time. This is particularly the case with newer technology. In recent years, the price of solar panels has fallen as production became more efficient.
Market competition: New entrants in a market can increase competitiveness on prices. Newer companies are often more willing to undercut existing brands on price to win market share.
Understanding these dynamics can help businesses to price their products accordingly and anticipate how customer behavior will change.
Conclusion: Why setting prices is complex, but essential
There are many reasons why setting prices is a complex task. However, it is essential for businesses looking to maximize their profitability and strengthen their market position. While there are straightforward methods to price products, such as cost-based pricing, a more sophisticated approach yields greater price optimization.
Pricing analysis is rarely a one-time event. Businesses continually revisit their pricing strategy to make sure they are still competitive in the marketplace. Staying tuned in to macroeconomic trends also helps businesses anticipate changes in customers’ price sensitivity. In many cases, this is achieved with the help of a market research agency conducting a pricing study.