Sunday, February 8, 2009

What's the Right Price?

How much is the right price to charge for something? Not only have volumes been written on the subject, but doctorates have been earned just by studying one type of metric around price, pricing, price elasticity, and the economic impacts of prices on consumer behaviors. Well, I am not going to try and cover all those issues in today’s Metric Monday, but I thought it would serve us well to cover two basic price metrics – Reservation Price and Percent Good Value.

Reservation Price is the value a customer places on a product or service and subsequently the maximum price that individual is willing to pay. Percent Good Value represents the proportion of customers who believe a product or service is a “good value” at a specific price. When combined these two metrics provide a marketer an evaluation of pricing and customer value.

To calculate your Reservation Price you need to know the maximum price a customer will not go over. This is going to require some research of your target market (i.e. customers, prospects, etc) and is no easy matter to do. Most market researchers will suggest doing a conjoint analysis (a fancy way of relating variables to one another) but I suggest some basic surveying on your part. It won’t be perfect, but you should get some basic information to use – such as a range of maximum prices your target is willing to pay for something. In doing this, you are essentially combining Reservation Price with Percent Good Value.

In your survey you can ask a two-two part question to get to this data.
  1. Considering the [product/service], would you attend if the price was set X? (your control question).

  2. Considering the [product/service], please indicate the point at which the price goes over what you would be willing to spend.
The first question can be considered your control question and I suggest testing three or four prices using common industry prices, or aggregates of what the competition is charging. By way of testing, you only want to ask their answer to one price, so in essence you’ll have a couple of different survey editions. The second question asks the respondent to provide their maximum price (reservation price). DO NOT ask these questions back-to-back in your survey or you’ll likely get a lowball number or one equal to the control question. Separate them by at least three or four questions.

Now you have two data sets. Take the range of respondents from the second question and associate the number of respondents to each value. For simplicity, you may want to make some minor adjustments in the scale to make the data set more manageable. You also need to know what your variable cost is for the product or service so that you can understand the price as it relates to your organization’s contribution margin (see earlier post for more on this).

When you map out the range of respondents to the second question you’re getting something called a demand schedule. In another column subtract the variable cost from the price you’re charging. This basically shows you how much you lose or make at each price level, and at what point the price becomes high enough that your demand starts to go down.

In the example below I’ve created a sample chart to explain how this looks. Let’s assume that you want to price your conference, workshop, or charitable gala. You want to know what the right price per ticket should be. After doing your survey you get a range of Reservation Prices between $25 and $325. You’ve listed the number of people who said that is the maximum they’d pay, and you’ve also listed your variable costs for that event (I have mine set at $40).

The math from here on is pretty simple. You subtract your variable cost from the price you sold a registration for, and multiply it by the number of people buying it at that price. In the example you will see the contribution margin go up, peak, and begin to decline. Thus, from the data you gathered, it appears that $185 is the optimal price.

Now, back to the survey questions and that control price. This is basically our “good value” price. Most of the time it is hard to get data sets for the Reservation Price study. By asking the control question we’re essentially asking our target if our product or service is a “good value” at a particular price. We can map out the most common answers and check our demand curve price against it. This process is also useful to help you know at what price to set your product/service and what discount levels you can offer.

Bottom Line: If your pricing strategy is akin to throwing a dart against a wall or going with what the competition is charging you are creating a lose situation for your organization. You may be leaving critical monies on the table by not charging enough, or you may be diminishing your market impact by overcharging. Using a method like Reservation Pricing and Percentage Good Value allows your organization to understand not only what your customers value, but also what prices contribute and take away from your top line revenue.

For more on pricing strategies, listen to my radio show with Reed Holden, author of Pricing with Confidence: 10 Ways to Stop Leaving Money on the Table.

-- David Kinard, PCM

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