The strategy of pricing is among the most crucial tasks businesses must perform. Prices are the primary component of the company’s revenue. If they are properly managed, they will yield high profits and, consequently, cash. However, setting prices correctly is difficult, and if errors are made, businesses fall victim to the consequences.
The article Toptal Finance Expert Dalibor Pajic takes his 15+ years of experience in finance for corporate companies to present seven concrete examples of situations where pricing strategies play a significant part, with the intention of showing the way pricing decisions can be handled in different scenarios. Pending
Pricing Strategy Basics: A Powerful Tool to Generate Profit and Cash
In the first case, we determine the costs, then allocate the costs to a single product and then select the markup. The amount of cost assigned to a particular product will depend on the present situation of the business (current profit, capacity utilization cap, capacity utilization, etc.). Markups are defined according to different goals, such as, a target gross margin, benchmark gross margins for the industry, and so on.
To aid in analysis, the costs will be divided into various levels. The levels are illustrated below.
In the end, the aim is always to be able to cover the costs and have the goal of achieving a positive EBIT margin; in actual practice, some instances require one to pay only for certain expenses (I’ll provide a few cases later on in this article).
The second option is that we begin from the market price for the identical (or comparable) product and then work backward to the cost. This way, we try to determine if, using the current market price, we will be able to meet all of our expenses and still achieve our markup target. This strategy is usually employed when competition in the market is high, and an individual player cannot affect the market price (such as FMCG and travel services, for example).
N.B. In rare circumstances, the price of goods and services can be controlled by the government to safeguard the people from the excessive cost of essential goods (such as electricity and public transportation) or services for the community ).
Seven Examples of Pricing Strategies in Action
To show the power and significance of pricing choices, In this section, I’ll present seven examples of real-world situations where pricing is a crucial instrument and should be treated with caution. As I said, the examples are all drawn heavily on real-world problems I’ve encountered throughout my career. Although they’ve been edited for illustration and the privacy of the data, these examples reflect the reality as closely as they can.
Maintaining Business Performance at a Targeted Level
In my professional life, I’ve encountered instances where a particular goal was set by headquarters (e.g., EBITDA, targeted EBITDA), and every employee within the company works towards this specific goal. The most common scenario is that sales personnel will press to reduce prices in order to boost sales. Still, in these cases, you must be cautious to ensure that the additional sales resulting from lower prices are sufficient to offset the loss in margins. Otherwise, EBITDA targets are missed (and HQ is unhappy).
To address this problem, I designed an algorithm that was able to, for each product, determine the price sensitivity in relation to the desired EBITDA. The model identified the amount of volumes that needed to be increased by each price reduction level to keep EBITDA margins. It was later used as a benchmark for sales personnel when they were negotiating with customers.
The image below provides an example of this calculation. Let’s suppose that in our annual budget, we assumed that the price was $50.00/kg for the specific product being discussed. After discussions with the client, our sales representative is suggesting to lower the sales amount to $48.00/kg. The initial budgeted quantity was 1000 tonnes; we must estimate the additional quantities that will be sold to maintain EBITDA at the level budgeted.
Initiation into the New Market
On the other hand, on the production side, we face direct costs, extra costs resulting from selling in the market of tomorrow (new markets research costs of local distributors, sales force personnel for the fresh market transportation, and so on. ) Production fixed costs, administrative expenses, and depreciation (which typically stays at the same amount). There are also investments to adjust your product for theProductionnts of the market or to increase thethe productioncity. The usual method to establish prices is to use the cost-plus markup method, so we’ll go through an instance and then contrast it to the cost of the market. It is then time to determine the payback time of the investment required for the market.
In our illustration for our illustration, we’ll keep using the fictional company that we discussed in the previous example in the preceding section. Let’s assume that the company has decided to expand its business to a new market. We’ll think there’s an excess of productive capacity, and there is no need to invest in more production capacity is necessary. The formula of the product that is suitable for this market is the same as that used for the market in the US, and so the direct costs of production remain the same. A $500,000 investment is needed to alter packaging to the new market.
Additionally, the business will need to recruit a sales representative for this market. His annual salary is $50,000, and he pays for warehouse rental costs of $60,000 annually. The anticipated amount of this particular market will be 200 tons annually. The target price is five percent less than the competitor who has the lowest price on the market (this competitor is priced at $48 per Kilo). We are already making money in the US market. Transport costs for the new market are $6.00 per kilo from the warehouse that is rented and an average of $2.00 peKilolo to the warehouse that is leased to U.S. retail stores. Customers who purchase from this market Kilopaid in 60 days, while the stock in the warehouse will be kept at Kilo0 tons.