‘Pricing is the third business skill. (The first being the ability to create value and produce goods or services. The second being the ability to sell products or services.)’
Ernst-Jan Bouter, pricing professional and author
In a nutshell
Price has a direct impact on profit. £1 additional revenue results in £1 additional profit. Similarly, a £1 discount results in £1 less profit.
Given the competitive environment facing the majority of businesses, pricing decisions are too important to leave to operational departments using traditional cost-based approaches. Pricing has strategic importance.
Competition and customer pressure often result in the temptation to offer discounts; however, this can have a detrimental effect on profit. By focusing on customer ‘value’ instead, businesses may be able to increase prices and profitability.
Need to know 
Why is this important? 
There are a number of strategies a business can use to increase profit. These include:
- ■Efficiency – through productivity of the workforce and reducing overheads
- ■Attracting new customers
- ■Retaining existing customers and encouraging repeat business
- ■Increasing the frequency of customer transactions
- ■Increasing the average value of each transaction by selling more to each customer
- ■Increasing the average value of each transaction through higher prices.
Although all the above actions are beneficial, higher prices generally have the biggest impact, by far, on profit. In addition, compared to the other actions, pricing takes the least time, effort and cost to change. For many businesses, the increase in profit as a result of higher prices can more than compensate for any lost business.
Many businesses, however, have an unfounded fear of raising prices. Increasing competition in most industries keeps businesses from putting up prices.
It is important that businesses understand the impact of price on the ‘bottom line’ and how to price profitably while giving customers the value they desire.
In practice 
Except for low-value generic goods, customers are not as price sensitive as believed. ‘Value for money’ is usually more important than price. A higher price is usually acceptable in return for higher benefits and conversely a lower price for lower benefits. It’s a trade-off.
Additionally, a purchase is often much more than a ‘value for money’ decision. Customers consider many factors when making an important purchase. Rarely do they simply go for the cheapest option.
Many businesses ignore this when setting their own prices and don’t emphasise the value differentiators between themselves and their competitors. For example:
- ■Quality of service including after sales service and support
- ■Other products and services offered (perhaps through ‘bundles’)
- ■Guarantees offered
- ■Efficiency of account management
- ■The degree of personalisation offered
- ■The reliability of their product or service
- ■Their reputation and brand.
How to set prices
| Cover costs | A business should calculate its minimum acceptable price by identifying all the direct costs associated with a product or service and adding their minimum acceptable ‘premium’ to cover indirect costs and profit (see the Nice to know section below). Covering costs will ensure that the business does not make a loss. This is, however, only the starting point as it does not consider the customer’s perception of value (see below). |
| Price according to value | A customer-centric approach to pricing focuses on what customers are willing to pay, based on the value they receive from a product or service. A business should try to understand its customers’ perception of value. Undertaking research, such as focus groups, can be helpful. For bespoke products or services this is best done through dialogue to understand what is important and what is non-value adding for each customer (see price customisation in the Optional detail section below). These conversations should be used to raise the customer’s appreciation of all the features and benefits they will receive and to balance their value scales. |
| Watch competitors | It is important to benchmark competitors’ prices of similar products and services, not to undercut their prices, instead to consider positioning. Undercutting competitors’ prices is a risky game which can only be played by those with scale and volume. Price sends a message of what a company stands for in the eyes of its customers (and potential customers), relative to its competitors. Customers will consider relative benefits against relative prices. |
| Regularly review prices | Over time, costs may change, new competitors may enter the market and old ones leave. Just as importantly, a customer’s perception of value can change over time. Prices should be reviewed as often as possible and the topic of ‘value’ should be a regular conversation with customers. |
| Note: Every industry and market is different. Each business may be in a different position. One size does not fit all with pricing. Not every approach will be appropriate nor can be used. | |
Nice to know 
Offering discounts
The presence of high street and online discounters in the retail world has influenced the rest of the business world and many purchasers are now conditioned into automatically requesting discounts. Many people, especially in sales, have an inbuilt desire to please others and avoid conflict. Consequently, it is common for businesses to offer discounts. Unfortunately, the potential increase in sales may not always be compensated by an increase in profit, in fact, for many businesses the opposite is true.
Example
The direct costs of product X are £75. ABC Ltd sells 1,000 units of X per month for £100 per unit.
The table below calculates the following:
- 1The impact of a 10% discount assuming no change in sales volume.
- 2The sales volume required to maintain the same level of profit with a 10% discount.
| Before discount | 1. After discount (no change in volume) | 2. After discount (volume to maintain profit) | |
| Price/unit | £100 | £90 | £90 |
| Cost/unit | (£75) | (£75) | (£75) |
| Profit/unit | £25 | £15 | £15 |
| Sales volume | 1,000 | 1,000 | 1,667 |
| Gross profit | £25,000 | £15,000 | £25,000* |
| 40% reduction in profit | 67%* increase in sales volume | ||
| Note: * rounded | |||
Therefore, for product X’s existing 25% gross margin:
- ■a 10% discount would lead to a 40% reduction in gross profit (assuming no change in sales volume)
- ■sales volume would need to increase by 67% to maintain the same level of profit.
The cost of discounts is magnified with lower margins. For example, if product X had a lower 20% gross profit margin, a 10% discount would cause a 50% reduction in profit (assuming no change in sales volume); or would require a 100% increase in sales volume (to maintain gross profit).
Margins and mark-ups
Despite the benefits of value-based pricing, many businesses still set prices by adding a ‘premium’ to costs to cover overheads and profit. There are two ways to calculate the premium:
| Margin | Mark-up |
|---|---|
| Margin is profit as a percentage of the ‘sales price’ (see also ‘gross profit margin’ in Chapter 23 Profitability performance measures). It is useful to measure the margin from each sale. It is calculated as follows: | Mark-up is profit as a percentage of ‘direct costs’. It is often used when setting prices as it is easier to use in practice than the margin. The mark-up is simply added to direct costs, rather than working backwards as required by the margin. Using a mark-up is often referred to as ‘cost plus’ pricing. |
Example
ABC Ltd sells product Y. The direct costs of each Y are £1,000. If ABC uses a 30% mark-up it will price each Y for £1,300. This also represents a 23% margin as illustrated below:
| Margin | Mark-up |
|---|---|
The margin will always be less than the mark-up.
It is important to understand the difference between these methods. In practice, confusion between these terms may lead to underpricing, for example, if decision makers communicate using margins and operational staff incorrectly understand them as mark-ups.
Optional detail 
Dynamic pricing
Technology has enabled the prevalence of dynamic (or ‘demand yield’) pricing. That is offering different prices based on demand and supply.
For example, airline prices change according to the availability of seats, seasonal demand, the actual time of the flight, the number of days before departure and competitor pricing. It is possible for prices to change several times in one day.
Uber uses ‘surge pricing’ in times of high demand. This ensures that those who need a ride can, and are prepared to, pay a premium can get one. If the premium is too high, customers have a choice either to wait or choose an alternative form of transport. It is a classic interaction of demand and supply.
Dynamic pricing can result in a consumer backlash when it is seen to be unethical and untransparent. During the Covid-19 pandemic some retailers were accused of unjustifiably significantly increasing prices of hygiene products.
Price discrimination
Price discrimination (or price customisation or personalised pricing) is offering different prices to different customers, based on their relative perceptions of value.
Some forms of price discrimination are widely accepted, for example student or senior citizen discounts. However, other, less transparent, forms of price discrimination are more contentious.
In 2018, the UK’s FCA (Financial Conduct Authority) published the research paper, ‘Price discrimination in financial services: how should we deal with questions of fairness?’ and has since released a series of discussion and consultation papers into different financial services, such as insurance and cash savings. Also in 2018, the UK government and the Competition and Markets Authority (CMA) announced that they are researching retailers targeting online shoppers with personalised pricing in areas such as holidays, cars and household goods. In 2021, the CMA published a related consultation paper ‘Algorithms: How they can reduce competition and harm consumers.’ This is clearly an issue which is becoming more relevant.
Price skimming
‘Price skimming’ is a strategy used for new products or services which are highly desirable, differentiated from the competition and generally high quality, for example the latest smart phone or accessory.
This is evidenced by a high initial price, which is gradually lowered over time. Early adopters who are keen to buy the product or experience the service are willing to pay a relatively high price and are the first layer to be ‘skimmed’ (like a layer of cream). As the price is lowered more people are attracted and the next layer of customers is ‘skimmed’ at that price point and so on.
This pricing strategy enables the supplier to maximise revenue and more quickly recoup high initial costs, such as research and marketing.
Penetration pricing
For new products, services or markets, a strategy of price penetration, that is low prices, is often used to gain market share, brand recognition and economies of scale. For example, Lidl and Aldi managed to gain market share in the highly competitive UK Supermarket via low prices. This has resulted in further competitive discounting by the established players. In 2018, Tesco, founded a new chain branded Jack’s to directly compete against Lidl and Aldi.
Penetration pricing is challenging as a long-term sustainable strategy, without a lower cost business model to support low prices. Uber, for example, has managed to gain market share from traditional taxis via low prices supported by a lower cost technology-based model.
Reflect and embed your understanding 
- 1Reflect on your own purchasing behaviour. Is price the main driver for your purchasing decisions? To what extent are you influenced by value differentiators? Which differentiators are most important to you?
- 2Discounts can be very costly to a business yet remain a popular way of attracting customers. What are the benefits of offering discounts?
- 3Consider examples of real-life organisations who operate dynamic pricing. Is this a fair approach to product/service pricing? What benefits does it have?
- 4Price discrimination is usually legal, although is it always ethical? Reflect on any real-life situations where unethical price discrimination is evident.
- 5Who should be responsible for pricing within an organisation?
For the authors’ reflections on these questions please go to financebook.co.uk
Where to spot in company accounts 
An annual report may refer to competitive or even ethical pricing in its annual report; however, as pricing strategy is competitive in nature, it is unlikely to be covered in detail.
Company accounts include ‘revenue’ within the P&L account (see Chapter 3 Profit and loss). Some annual reports and press releases (see Chapter 21 Information in the public domain) may include information about units sold. Using this information, it is possible to determine an average price; however, in a multi-product/service company this may not provide much insight.
Some annual reports provide information on a company’s business model. A business model may refer to pricing strategy or approach.
Extract from Greggs plc 2020 annual report and accounts
A description of Greggs plc’s business model is provided within the 2020 annual report.
Value is part of Greggs plc’s business model. To quote ‘We offer great value in an extremely competitive market place.’
(Annual Report and Accounts 2020, p. 8)
Consolidate and apply
To see how the concepts covered in this chapter have been applied within Greggs plc, review Chapter 36, p. 428.
Watch out for in practice 
- →How does the business set its prices? For example, does it use ‘cost plus’; competitive based; and/or customer-centric prices?
- →Does the business compete on price alone or does it attempt to demonstrate value for money and other value differentiators?
- →Does the business consistently offer discounts? Does it have a discount policy?
- →How often are prices changed?
- →Who has responsibility for setting prices within the organisation?
- →Are price matching guarantees offered, for example John Lewis historically used the slogan ‘Never knowingly undersold’ (in 2020 the firm announced it was reviewing the pledge).
- →Is there evidence of anti-competitive or anti-consumer behaviour? Note this is prohibited under competition law. For example, in 2019 Casio Electronics Co. Ltd was fined £3.7m for breaking competition law by preventing online discounting for its digital pianos and keyboards.