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How to set the wrong price, based on costs 2/3

How to set the wrong price, based on costs 2/3

Last time we introduced the topic, identifying the major factors that affect the company’s wealth, and the role of pricing among them. Now we will focus on the major factors that affect the market’s willingness to buy from our company.

Clients couldn’t care less about our costs!

Did we ever decide a purchase after having assessed the costs (in particular, the fixed costs) incurred by the supplier?

… and, therefore, why should our client adopt that approach in relation to our offer?

Other things equal, given a certain product/market combination, a specific competitive context (i.e. a certain competitive profile of our company in terms of perceived value), and within a well-defined price range, the market’s willingness to buy from our company (i.e. to award us a “slice” of the overall market “pie”) is directly related to our price level.

This type of relationship is normally summarized by the famous “demand curve” (in this case, our firm’s demand curve) described below.

As you can see in the following figure, I avoided the economists’ approach (prices on the Y axis, and quantities on the X axis), for several good reasons:

• we are not talking about commodities, but about our company’s sales in a given competitive context
• it is obvious that, given that context and other things equal, the size of our “slice” depends on price (dotted arrow in the figure), and not vice versa!
• the quantities sold depend, in turn, on our ability to gain a “slice” of the overall “pie”, given its size: these dimensions (the pie and the slice) are the true variables that, in a real life context, directly affect quantities, while price has just an indirect impact (precisely, via the “slice”).

how to set prices using the demand curve

You can also notice the little “wall” that I tried to draw above the curve: it just means that the demand curve is an objective and very real thing, against which we incur the risk of hitting our head, if we are not able to see it, or at least to feel (estimate) it. There’s no help for it:

• the market “sees” our price (at a given level of perceived value, and unless we are talking about status-symbol products or the price is by itself a major indicator of value): if we increase it, our “slice” shrinks, if we reduce it, our “slice” grows
• in any case, the market doesn’t give a damn about our costs!

Next time we will finally show, with a little spreadsheet model, why the cost-plus pricing could not work by definition.

Selected bibliography:
• These three posts on pricing are translated and adapted from G. Gandellini, “Come sbagliare i prezzi basandosi sui costi”, in G. Gandellini, D. Possati, M. Manzoni & A. Pace, Perfectum, Franco Angeli, Milano, 2005.
• Thomas T. Nagle, The Strategy & Tactics of Pricing: a Guide to Profitable Decision Making, Prentice Hall, 1987 (or later editions by the same author or co-author).

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