The price of a product or service is fundamentally a function of supply and demand.
- If supply is constant and demand increases, the price goes up.
- If supply is constant and demand falls, the price goes down.
- If demand is constant and supply increases, the price goes down.
- If demand is constant and supply falls, the price goes up.
However, it’s not always quite that simple. Economists measure what they call “Price Elasticity of Demand” (PED) and “Price Elasticity of Supply” (PES).
PED quantifies the extent to which demand fluctuates in response to a change in price. The demand for a good is considered elastic, when changes in price have a relatively large effect on the quantity of a good demanded. It is considered inelastic, when changes in price have only a small effect on the quantity of a good demanded.
PES quantifies the extent to which supply fluctuates in response to a change in price. The supply of a good is considered elastic, when changes in price have a relatively large effect on the supply of the good into the market. It is considered inelastic, when changes in price have only a small effect on the supply of a good into the market. Bear in mind that supply and production are not necessarily the same, as suppliers hold stocks that fluctuate and account for the difference between the volume supplied and the volume produced.
So what does all this mean in practice?
Let’s consider a market that’s growing. Demand for the products is increasing, which will tend to push prices up. However, the critical factor is what is happening to the supply side. If production capacity and output is keeping up with demand for the products, but only just, prices will still be pushed up. If production fails to keep up, prices will increase even more but, if production capacity and output increase, at a faster rate than demand, prices will fall. So a rising market doesn’t necessarily mean that prices go up, they can also go down, depending on the combined capacity and output of the suppliers.
In a falling market, the relationships are similar. The falling market will tend to depress prices but, if capacity is being taken out and supply falls, at a faster rate than that of the market decline, prices will increase and, once again, this happens quite often.
In addition to supply and demand factors, price elasticity is also influential. If PED is relatively elastic, suppliers have little opportunity of raising their prices without reducing their sales volume. In some circumstances, for example where a product is being phased out, increasing prices to reduce volume may be an appropriate strategy. However, in most circumstances suppliers must consider whether lowering prices to stimulate more volume, or even to maintain existing volume, is in their best interests. This is particularly true if the choice is maintaining volume or downsizing the business.
On the other hand, if PED is relatively inelastic, there is very little opportunity of increasing volume through the price mechanism; although there is an opportunity to increase margins without reducing sales. Under these circumstances, there must be a strong argument for increasing prices.
Let’s now consider the product cycle and how market dynamics can also affect price.
Innovators want to buy the product at all costs. For them it’s a “must have” and, at this stage, there is often limited competition, so the price can be very high, reflecting R&D costs, low volume production etc. As the product cycle moves on through early adopters and early majority, the market grows, competition develops, the product becomes increasingly commoditised and prices fall. However, as the cycle moves into the late majority and laggards, some players withdraw, downsize or diversify and supply falls, allowing prices to firm up again. Where your product or service sits within this cycle tends, therefore, to have a significant effect on the price it can command and the direction of travel, in which prices are going.
These market forces are at work all the time and, to a greater or lesser extent, they affect all markets for all products and all services. Furthermore, most businesses and particularly small and medium sized ones, have little or no control over any of them. The best you can do is to understand the factors that are in play and respond in the way that is most appropriate for your business. Large companies, with substantial strategic marketing resources, often have a fairly good fix on how these market dynamics are affecting their products and services; they can, therefore plan accordingly. However for many SMEs, it can be a real problem because they don’t have that level of market intelligence; and this lack of awareness can sometimes lead to either entirely inappropriate pricing strategies or no pricing strategies at all. As a result, some SMEs fail to exploit the market opportunities that exist.
If I was to finish this blog at this point, I would leave the reader with the impression that businesses have no control over their prices at all, and that their only strategy is to respond, as best they can, to the market forces, in play at the time. This clearly isn’t the case; and, whilst most businesses have little or no control over the market forces at play, they can, in the right circumstances, have significant influence over the actual prices they command.
So let’s now start to think about individual markets. Consider a 230 gram bar of chocolate. The average price may be £2.50 (I haven’t researched these prices accurately; it’s guesswork merely to establish a principle). However, the product may be available from perhaps £1.50 at the lowest to £3.50 at the highest. It’s very unlikely to be generally available for £0.50, which would be well below cost; and, normally, no one is going to pay £50. So the actual price you pay can vary within a relatively defined range and will depend, very largely, on where you buy it and the brand you buy. Local convenience shops will probably charge more than supermarkets and branded products will be dearer than own brand.
If there is a sudden surge in demand for these chocolate bars, creating a shortage of supply, the price will go up; but they will still be available within a price range. It’s just that the range may now be between £2.00 and £4.00 rather than £1.50 and £3.50. Similarly, if there is a sudden drop in demand or excess of supply, the price range will fall.
In this simple example we’ve seen two factors that can affect the price, namely the precise route to market and the brand. So let’s examine these further.
A convenience store commands a higher price, for the same product, than a supermarket. The supermarket is looking for volume throughput to provide critical mass, whereas the convenience store is satisfied with a much lower volume of sales and possibly a higher margin. The route to market for the convenience store is likely to be via a wholesaler; whereas the supermarket will probably buy direct from the manufacturer. Nevertheless, the manufacturer’s margins for sales, via wholesalers, are probably higher than those for sales to supermarkets. One provides the manufacturer with critical mass; the other enhanced margins; so it works. The final customer, in this case the consumer, will probably want to buy the bulk of his/her chocolate bars, as part of his/her weekly shop, at the supermarket. This way he/she will benefit from the cheaper price. However, if he/she runs out of chocolate between weekly shops, he/she may well be prepared to pay more at the nearby convenience store, because of the time and cost involved in going to the supermarket, just for a bar of chocolate.
Routes to market can be extremely varied both within individual markets and between different markets. So I’m not going to try and outline them all here. Suffice it to say that the route to market can have a significant effect on both the price of the product to the final customer and the margins, within the various parts of the supply chain. The choice of which route or routes are adopted can, therefore, have a significant effect on pricing strategy.
Now we come to brand; and, of course, every business is a brand. For example, Cadbury is a manufacturer of chocolate and confectionary; but the name “Cadbury” is a huge brand in its own right. However, Cadbury manufactures and sells a vast range of branded products such as “Dairy Milk” and “Bourneville”.
Brands, whether they are a company, a product or both, can be local within a small community; they can be regional within a specific country; they can be national throughout a country; and they can be international. Furthermore, brands can be consumer brands or they can be commercial or trade brands; they can be associated with one specific market or they can be leveraged across several different markets. But two factors apply to all brands.
Firstly, every brand is associated with a range of brand values that embody it. An obvious example is the car manufacturer, Rolls Royce, which is epitomised by, amongst other things, superb engineering, top quality, ultimate luxury and very expensive to buy. However, a tradesman, such as a plumber, could also build a reputation, in his local community, for quality and reliability and these then become his brand values. Many large companies spend huge sums of money to establish, support and maintain their brand values and, even then, they don’t always achieve everything they want. Smaller companies, with less financial muscle, are less able to promote their brand values, which tend to be more influenced by market perception; and this may be different from the company’s own ideas of itself, its products and services.
Secondly, every brand is positioned within its market to appeal to a specific profile of customer or potential customer, within that market; and, whilst there will always be some customers from outside that profile, they are unlikely to become core business unless the brand position changes. Think about the car market. Bentley and Skoda have very different brand positions and they attract entirely different types of customers. Each brand is positioned to meet a particular range of expectations, from a defined profile of potential customers. Both brands are owned by Volkswagen; so, in theory, Skoda could have the capability of manufacturing/marketing a car to match the specification of a Bentley. However, it is unlikely that it could command the price that Bentley is able to charge, because the brand wouldn’t support it. And this brings us back to pricing.
Brand position can have a substantial influence on the price that a product or service can command. A high end, high quality product will normally not only attract a significant premium over an equivalent budget product but also provide an enhanced margin. But a brand can only achieve the position that its brand values support.
The UK home improvement market has some good examples of how brand and price are related. Everest has been a massive brand in double glazing for years. It charges top dollar prices, offers a good product and great service. But it’s one of only a few double glazing companies that have really developed high profile brands. Most suppliers are much smaller businesses, operating at a local or regional level and charging prices that are substantially lower than Everest’s. Yet, in many cases, they are providing a product that is very similar to Everest’s and a standard of installation and service that compares very favourably. But their brand values don’t support a brand position that can attract an Everest type of customer. Hence they sell to a more budget orientated profile of customer. And this leads me on to the dilemma facing SMEs in many different markets.
There are really only two ways of building brand values. The first is through advertising and PR and the second through actual performance in the market place. SMEs don’t normally have huge advertising and PR budgets; so, realistically, they only have one option. They have to be really good at whatever it is they do; and they have to understand and meet all the expectations, including price, of their target profile of customer. The better they are at this, the more likely they are to develop brand values that position them where they want to be, and the more control they are likely to have over the price they charge for their product or service. When SMEs aren’t good enough at what they do, the market takes control and positions them where it sees fit; and, more often than not, this is at the budget and most price-driven end, thereby limiting their options and ability to optimise their profitability.
The title of this blog is “How much control do you really have over your selling prices”? What I hope I’ve shown here is that selling prices are a complex issue. Large businesses tend to have sophisticated strategic marketing and market research resources that analyse their markets in great depth and seek to provide answers to the type of questions that I’ve raised. For many SMEs, marketing means little more than advertising and PR; and they have limited knowledge of many of the factors that affect the price, at which they can sell their products and services. This undoubtedly leaves many smaller businesses vulnerable to more sophisticated competition.
SMEs can sometimes unwittingly price themselves out of markets by maintaining higher prices than the market is prepared to accept or that their brand can support. They may see some limited success at these high price levels and assume that this can become the norm through more effective advertising and developing stronger selling skills. And whilst it would be churlish to suggest that better advertising and selling won’t help, it’s equally unrealistic to believe that they can counter market forces over a sustained period. Ultimately, for a business to be sustainable it must sell at a rate that the market will accept and the brand will support.
By contrast some SMEs under price and don’t maximise their margin opportunity. In these circumstances, the market is almost certainly prepared to accept higher prices and their brands are capable of supporting those higher prices. These companies are just unaware of the opportunity they are missing and possibly frightened of taking, what they see as, a risk, by increasing their prices. The consequence, however, is that their margins often remain low, their profits poor, their balance sheets weak and they are unable to fund the growth and future development that they need to remain sustainable in the longer term.
For SMEs, optimising their selling prices without sophisticated marketing support can be difficult. However, in many markets, there is an abundance of market data freely available or available at a very modest cost. Unfortunately, SMEs don’t always make use of it because the day to day pressures mean there just isn’t time. And this is where bringing in external help can often be beneficial. A business review or a strategic marketing review and perhaps some limited on-going support can often give greater clarity to an SMEs market dynamics, brand values and brand position, thereby enabling it to optimise its pricing strategy, its price/volume relationship, its margins and, ultimately, to secure the long term sustainability of the business.