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The Importance of Pricing Analysis

At a very basic level, pricing strategies are used by people to assign market prices to their products and services. Your standard academic-style business training will expose you to pricing strategies such as market penetration, premium pricing, skimming, bundle pricing, and more. These topics are not mind-blowing, but their conceptual importance is profound in business.

Two things that small businesses may typically overlook when setting prices are the price elasticity of their products and the competitive position of their products in the market. Small omissions in pricing can lead to an unnecessarily large loss of profitability.

Here is an example :

Consider a fictional family business, Edith’s Bakery (EB), which sells an average of 600 baked goods to public/corporate buyers per day for an average of $10/dozen or $0.83/unit. EB is only open 6-7 hours a day until they sell out all of their products, and they’re only closed 10 federal holidays. That’s $177,500/year in revenue.

Now let’s say they priced a single unit at $0.94 with their volume sales discounts also proportional to the price of their competitors. That’s below the price/unit at both Dunkin’ Donuts chain stores and a more well-known Minnesota bakery in Cold Spring, both priced at $0.99/unit (rough estimate based on company websites). If these two companies are EB’s main competitors and EB’s pricing plan is to undercut their competitors to be competitive, they are probably wasting money.

Why?

EB is $0.05/unit below close competitors, more than 5% lower than the competition.

Food products tend to have inelastic demand, so they shouldn’t expect the volume purchased to drop much if they raise prices slightly.

Their loyal customers are highly unlikely to leave if they stay below competitor prices. Price-sensitive consumers are also unlikely to leave until they raise prices more than $0.03 to $0.04.

So how does it all work?

If EB increased his price/unit by $0.03 and scaled up his entire business at a discount, he now earns an additional $6,390/year. That’s a 3.6% increase in revenue per year! Yet they would still undercut their competitors by more than 2% in price.

Except for a very slight increase in hours worked (if their demand decreases), they do not have significant additional expenses. A significant portion, if not all, of the $6,390 will fall directly on their balance sheet as gross profit.

If EB has a gross margin of 50%, it would have made a gross profit of $88,750. When $5,000 of the aforementioned $6,390 is added directly as gross profit, they have just increased their gross margin by approximately 5.6%. This is the approximate difference in reported gross margin between Walmart and Target each year.

Pricing analysis is one of the most important tools that is overlooked or lacking in many businesses, but especially in smaller businesses that don’t have the resources to pursue it. Don’t let your organization fall victim to this.

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