One topic that seems to trip up both new and experienced product managers is the process of pricing. As a recent post highlights, the most important lever we have in our bag of tricks to influence the profitability of our products and business, is the price. Yet, establishing a good price, and holding variance to a minimum is a top concern of the product management function.
Judging by the amount of shelf space taken up by books on Pricing, and how much I have personally invested in the process, I suspect that many of my peers and much of the Product Management community also shares this struggle.
While much of the literature I have read is focused around either the brass tacks of the process, and how large organizations often have a team who is 100% focused on pricing effectively, I have found that often, even when there is a Pricing organization, it falls on the shoulders of the Product Manager to define and implement the pricing strategy.
This is one area where an MBA degree can be beneficial to the product manager. You do learn about how to calculate the profitability, the effect of variances, and how to calculate break even thresholds for changes in price (i.e. if you cut the price X % you need to sell Y more to achieve the same profitability, hence “break even”). But if you don’t have an MBA, fret not, as the calculations are not difficult, and truth be told, even some MBA’s that I have worked with forget the primacy of price in the importance of profitability.
In this first part, let’s begin on the path to pricing for profitability.
Calculating the Profitability
Before you can even do the most basic “what if” analysis, you need to have a firm grasp on the profit per unit of sale. While we can go around and around on what a unit is, and there is great variability especially in the realm of services, I shall define it simply as what is exchanged for value to the customer.
For a bicycle shop, it is a bicycle. For a shoe shop, it is a pair of shoes. For Jiffy Lube, it is an oil change. We can always define a unit of something that is on offer, and that is what is being sold.
Each unit sold, is paid for by a financial transaction. This is the “Price” or P. Note that it might be the list price of the offer, or there might be a variance, a “discount” in the parlance negotiated. Still, it is the exchange of value in the transaction.
The concept of “Variable Cost” or V, is what it costs you to produce one unit of the product. If you are building a bicycle, it is the material costs, and the labor to assemble. If you are selling a service, it is the cost of one “service”. This is an important concept, and in the future, we will go into a great deal of detail on how to arrive at this, suffice it for now that it is a cost per unit.
It is useful to calculate the “Contribution Margin” of a sale. This is quite simple to calculate, as it is the price minus the variable cost per unit sold. If you interact with finance teams, they often will refer to the marginal contribution, and this is what they are implying.
CM = P - V
The contribution margin is a quick and dirty way to capture the value of each sale, and how to capture the potential profit for a pricing change (increase or decrease) and the likely volume differential.
Finally, there is the “Fixed Cost” or F. This is often referred to as overhead, or plant and fixtures. It often includes sales and marketing expense, management salaries, machinery, etc. In a SaaS context, it would include the hosting, or the costs of the AWS/Azure/Rackspace spend.
With these simple definitions, we can assemble the profit equation thus:
π = Q * (P - V) - F Where: π = profit Q = quantity sold per period P = Price per unit sold V = Variable cost per unit F = fixed costs per unit
Asking ourselves what is the best use of our effort, reducing variable or fixed costs, increasing volume, or increasing price all by the same percentage, it is easy to show that regardless of the fixed, and variable costs, the best improvement is experienced with in increase in price (or, in the real world, reducing the discount required to close the order).
Thus, for product management, the best use of our time is to work to hold the sale price as high as possible. There are of course many strategies to explore with this, including:
- Identifying key selling points and tying them to value in a way that resonates with customers
- Understanding the price elasticity, and your segments/strengths, targeting a strike price that delivers enough value to customers to buy in acceptable quantities, yet delivers an optimal profit
- Segment your market, and pricing strategy to capture pockets of value where possible by a fencing strategy
- Understanding the psychological factors at play in your customers, and pricing to capture their allegiance.
While much of the literature focuses on consumer products, the concepts and analyses apply equally to B2B transactions, and sales that aren’t high volume. In future posts, I will build upon this core concept, and help to explain what it takes to price with confidence.