Manufacturers tend to base product prices on direct production costs. Then they occasionally adjust prices for inflation or when the costs of raw materials or labor rates spike. Here’s why this simplified pricing model may compromise market share over the long run — and how market leaders factor market-based considerations into their pricing strategies.
Direct production costs are a logical starting point for pricing new and existing products. For example, suppose Company A spends $2 in raw materials and $3 in labor to manufacture a widget. The owner adds up these costs ($5) and applies a 10% markup to arrive at the selling price ($5.50) for each widget. The problem is that markups are often based on historic performance or gut instinct.
What happens when competitors sell their widgets for $5.15? This often happens to smaller manufacturers that compete with larger companies that can negotiate lower supply costs or companies located in areas with lower labor rates. Unless Company A can provide a compelling reason for customers to pay a premium, such as superior quality or more responsive customer service, its market share will likely diminish — and overhead costs will eventually consume profits.
Conversely, what if the $5.50 price point is significantly below competitors’ prices? Below-market pricing may cause demand to skyrocket — and the factory may not be able to produce enough widgets to keep up with demand. As a result, quality may suffer, or customers may become frustrated by production delays.
When demand outpaces production capacity, cash flow shortages also may occur due to lags in the cash conversion cycle. That is, Company A will need to front production costs (cash outflows), but it will take a while to bill and collect payments from its customers (cash inflows). A slight price increase can help reduce demand and the pressure that’s putting on plant workers.
Market leaders factor more than direct costs into their pricing strategies. They also conduct market research, which improves the accuracy of their sales forecasts. For example, salespeople can informally survey customers about which features they value most, how the company can improve the customer experience and how much customers would be willing to pay for new products or improvements to existing products. To entice customers to participate in these surveys, consider offering free trials of new products or discounts on future orders.
It’s also important to research competitors. Pay attention to the products they offer, the prices they charge and how they position their products in the marketplace. (See “Low cost vs. differentiation strategies” in the sidebar.)
Any research aimed at competitors should be ethical, however. For example, you shouldn’t hire a competitor’s R&D director and solicit proprietary information. But you can legitimately visit a competitor’s website and review copies of print marketing materials that are available to the general public.
Market research helps management decide how to position the company’s offerings relative to those of competitors — and whether future sales volume will be similar to past performance. Forecasts are often based on historical sales volume. But changes in market conditions, such as the introduction of a new competitor, changes in technology and evolving customer needs, may require adjustments to historical results.
Overhead Cost Allocations
Overhead costs also need to be forecasted and allocated to products to help make better informed pricing decisions. As with sales, future overhead costs may not mirror what’s been paid in the past.
Materials and labor costs are just a few of the expenses manufacturers incur. Overhead items may be variable (such as sales commissions, packaging and shipping costs) or fixed (such as depreciation on equipment, managerial salaries and rent). As a company grows, it may need a larger factory or additional salespeople, leading to incremental fixed costs.
Accurate forecasts of sales and overhead costs can be used to calculate a markup that’s based on more than guesswork, leading to more methodical and responsive pricing decisions. Your Elliott Davis advisor can help implement pricing models based on market research and comprehensive costs. We can also teach you how to monitor prices going forward.
Sidebar: Low Cost vs. Differentiation Strategies
Market positioning affects pricing decisions. Companies that compete on price typically earn a modest gross margin on each unit sold, but they make up for it with high sales volume. Low-cost producers tend to be large and efficient and offer no-frills service.
Not every manufacturer should be a low-cost producer, however. Some customers make purchasing decisions on more than just price. Smaller “boutique” manufacturers may differentiate themselves from the pack by offering superior features and service or offering product customization. Differentiation strategies generally allow companies to charge high margins, but they compromise market share.
To complicate matters, some manufacturers select one base product to serve as the “hook.” This base product is priced below similar products in the marketplace. Once the customer has invested in the base unit, the manufacturer charges premium prices for its complementary products, parts and accessories, and postsale service.