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Price Optimization

Price Optimization: The Science-Like Art of Finding the Sweet Spot

July 13, 2023

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Figuring out how to price your goods or services is a bit like fumbling in the dark. You may eventually find what you’re looking for, but no one likes blindly fumbling around as they stumble and flail in the dark. And price optimization, without data, can be a similarly frustrating process.

Many companies will set their prices based on what their competitors are charging--which could be right on the money. But for most businesses, this approach isn't ideal. An effective price optimization strategy should take into account your company's costs, operating revenue, and business goals.

There isn't any magical solution to help you find the optimal price point. Pricing strategy takes time and research. Tools like SPARXiQ can make the process easier. This pricing optimization software can effortlessly analyze all of your sales and customer information--customer segments, historical data, price points, and market data--to offer astute price recommendations based on product or service and customer segment.

Let's take a look at some best practices for price optimization, including what you should be optimizing for with your pricing strategies and some common mistakes to steer clear of.

We'll cover some basic terms and concepts related to price optimization, too.

After reading this article, you should have a good understanding of how pricing optimization works, various pricing strategies to consider, and how smart pricing--which sometimes means higher pricing--can improve customer satisfaction.

What is Price Optimization?

Simply put, price optimization means the process of finding the right price for a product or service. The process takes into account costs, competition, customer willingness to pay, and ultimate perceived value to customers.

What is Price Elasticity of Demand and Why Does it Matter?

Price elasticity of demand is a measure of whether customers are willing to buy a given good or service when the price changes.

  • Elastic demand: When customers buy a lot less of something because the price has increased.
  • Inelastic demand: When customers will continue to buy something regardless of price, even when it goes up.

Typically, we may think of price demand as elastic. When something goes up in price, customers' willingness to pay goes down.

But that’s not always the case. Some goods are inelastic, like prescription drugs, baby formula, gasoline, a jug of milk, and other necessity goods.

Price elasticity is an important concept for any business to grasp. If your business has a product with inelastic demand, you can adjust (raise) pricing and maintain the majority of your customer base. But with elastic goods and services, however, you may want to keep your prices low to maximize sales.

3 Things to Optimize Pricing for

There are three things to optimize your pricing for.

  1. Profitability: The price must be set high enough to cover costs and turn a profit.
  2. Competitiveness: Your price should be competitive, or on parity, with similar products or services.
  3. Value: The price must be considered fair or reasonable by customers.

If you're priced too high, the customer may not buy the product because they can't afford to or they're seeking more inexpensive options.

If you're priced too low, your company may not be maximizing its profit--or turning any profit at all. And, you may lose potential customers who perceive your goods or services to be of lower quality based on your pricing.

When you optimize your pricing, it's not just one set price you're considering. You're looking at your starting price, and then any discounts or promotions you want to offer to attract customers and be competitive.

  • Starting Price: This is your initial price point, based on costs (production, distribution, and marketing) and industry research, including consumer insights.
  • Discounted Price: Discounted pricing is a powerful lever to attract new customers, drive sales during slower periods, or clear out inventory at risk of obsolescence. Discounted prices are typically offered for an indefinite period of time. Offering too many discounts may diminish how your brand is perceived and/or erode any profits.
  • Promotional Price: Promotional pricing is a reduction in price but for a limited period of time. Typically it is tied to a specific sales event like Black Friday or Cyber Monday. While discounts are generally designed to drum up (sorely needed) additional business or attract new customers, promotional pricing is meant to create a sense of urgency or scarcity or to test new goods or services.

Even the most high-end of prestige brands will occasionally lower prices or run promotions. While they may shy away from BOGOs or price tags ending in $0.99--techniques that could dilute their brand--there are other tactics they may employ, like free gifts with purchase, reduced cost gifts with purchase, free concierge services, and free shipping.

Bargain-hungry customers want deals. Offer too many discounts, you train customers to expect (demand) them all of the time. Additionally, freebie-seeking customers are not brand-loyal and will turn on your brand in an instant. But by not offering any discounts, you're leaving money on the table--and customers at the door.

Getting the mix right--for starting, discount, and promotional pricing--is a delicate balancing act. Dynamic pricing solutions--blending customer data, consumer behavior, and competitors' prices--can help you strike the right balance.

Pricing optimization software can take these myriad inputs and offer you data-based recommendations to guide pricing, like pricing tiers or pricing rules by customer segmentation.

Common Reasons Why Price Optimization Fails

Here are some common reasons why your price optimization strategy may fall short.

Your Data is Outdated or Inaccurate

With data that is outdated or inaccurate, you will set your prices too high or too low or not understand current market trends and consumer preferences. The current, accurate data you need should come from your sales figures, market research reports, competitor intelligence, and industry publications. Market research firms, price optimization software, and statistical software can analyze the data for trends and patterns, including enhanced data visualization.

You're Using Guess Work or Hunches

Many business leaders pride themselves on having that "gut feeling" they can rely on for making major business decisions. And it may be that some people do have those magic, crystal-ball instincts.

But in general, operating off crystal-ball instincts or gut feelings is unreliable. Hunches require luck and are influenced by personal bias, which can lead to some truly epically bad outcomes.

Another problem with hunches is that the loudest voice or most senior title in the boardroom wins, and may make decisions not grounded in reality (data).

Using data to make informed decisions removes both politics and hunches from the agenda, and provides a neutral framework from which to work.

You're Using Too Many Discounts

Using too many discounts can be a big reason why your price optimization solutions aren't working.

When you overdo it with markdowns, you devalue your business' products and services. You train your consumers to expect a discount, or switch to a competitor offering price reductions. This can also lead to people viewing your goods and services as less valuable or premium.

Excessive discounts can also cannibalize your regular sales, leading customers to pay a reduced price for your goods when they would have been otherwise willing to pay full price.

Finally, too many discounts will make it extremely difficult for you to raise prices in the future. Even if customers value your brand, you've trained them not to pay full price. You're that company that always has a promo code.

Offering discounts can be an important component of your overall price optimization, but make sure to deploy them strategically.

You're Not Pricing for Value

Your pricing strategy may fail or be less-than-effective if you're not pricing your services or goods for the value you're delivering to customers.

Ask yourself these questions:

  • What problem is your product or service solving for your customer?
  • What impact is it having in their life?

As we've stated before, you can't set prices too high or too low. Price high enough so you're making a profit and/or positioning yourself as high-quality, but not so high you're scaring away customers.

This is why understanding the value you deliver--and customer perception of that value--is so key. It's not simply a matter of taking landed costs x 2.5 to reach your selling price.

Take prescription eyeglasses, for example. Glasses--with first-quality lenses and designer frames--cost anywhere from $6.50 to $18 to make but sell at a 1,000% markup--or more.

Customers are willing to pay more because of the impact prescription glasses have on their life, and they're accustomed to a higher price tag. Customers are so well-trained, in fact, they would likely distrust a $15 price tag at the optical store

Even Warby Parker, known for disrupting the market with its ultra-cheap eyeware, sells Rx glasses from $95--which is still around an 800% markup.

You're Not Pricing for Geographic Area

Even if you sell primarily to the U.S. market, the geographical expanse of the country is huge. The cost of living varies significantly by region throughout the U.S. Even within the same metro areas, many retailers will price goods differently based on micro-market conditions. Some suburbs or portions of suburbs may have different residential and economic characteristics.

Additionally, customer expectations and business competition can vary by location.

Using geography-based pricing--or micro-pricing--will help you optimize pricing and maximize profits. And you'll also maintain customer satisfaction by meeting their specific expectations of their well-defined market segments.

Your Process is Too Complex

While regular data and analysis are crucial to any business pricing strategy, it can fail if your process is too complex. Just because your pricing strategy could have 50 different tiers–based on myriad ways to slice and dice the data–doesn't mean that it should.

Too much complexity is:

  • Confusing for customers. Make it simple and easy to understand. Have just enough options for them to feel empowered, but not overwhelmed.
  • Difficult for sales reps and other company stakeholders to understand. This can lead to errors, slowdowns, and other inefficiencies.
  • Expensive to implement--potentially prohibitively expensive for some businesses.
  • Hard to update. It's challenging enough to update prices for any business, but with a complex pricing strategy, you're turning a hard task into a herculean one.
  • Increased risk for your business. The more complexity in your pricing, the greater the risk of errors, lost sales, and business fallout.

Pricing can be complex, but it doesn't have to be painful.

  • Keep it simple so it's easy to understand, implement, and update.
  • Be flexible and make sure your pricing strategy is responsive to emerging competition, changes in demand, or other external forces.
  • Continually test, iterate, monitor, and adjust.

Optimize Pricing the Right Way: What Does it Involve?

Price optimization is the process of setting prices for products or services in a way that maximizes profits. It is a complex process that involves a number of factors, including:

  • Costs of production, distribution, and retail overhead.
  • Demand for the product or service.
  • Competitors - how many direct competitors do you have and how does their pricing compare?
  • Target market - who is your customer base, what are their needs, and what are they willing and able to pay?
  • Company goals -pricing needs to be aligned with business targets.
  • The target market: The target market is the group of people that businesses are trying to sell their products or services. Businesses need to make sure that they are setting prices attractive to this group.
  • The company's goals: The company's goals are also important to consider when setting prices. Is the priority to increase revenue over new customer acquisition? What are the current financial targets?

What Are Some Different Price Optimization Models?

There are many price optimization models that businesses can use to set prices. Some of the more common models of price management and optimization include the following:

  • Break-even analysis: As the term implies, break-even analysis is a model that determines at what price point your business can break even. It identifies the exact price needed to cover all costs of production, distribution, marketing, and retail overhead.
  • Target return pricing: This is a more complex model and helps your company set prices at figures that will enable you to achieve a target return on your investment. This model considers all the costs in a break-even analysis and also takes into account your desired profits.
  • Marginal cost pricing: This pricing model sets prices so that production and overhead cost are less than the total revenue generated from the sale price. Whereas target return pricing is about achieving specific business goals, with marginal cost pricing your company sets the price so it's equal to the marginal cost of production--which is the cost of producing one additional unit of the product.
  • Psychological pricing: This strategy takes into account the consumer mindset (perceptions) when making a purchasing decision. Price optimization techniques here may involve creating a sense of scarcity, sense of urgency, or sense of value (i.e., bundle pricing, BOGO).
  • Dynamic pricing: In this model, prices change dynamically over time in response to market demand, competition, or other factors. This model is commonly used for online products and services.

These are just a handful of price optimization examples. There are other ways to set or adjust pricing, and many pricing strategies can be a hybrid approach.

The best pricing process for your business depends on many factors, including your industry, product or services sold, your target market, and pricing data from your competitors.

What Are Tools and Inputs You Can Use to Optimize Pricing?

There are a number of tools and inputs that can be used to optimize pricing. Some of the most common ones include:

  • Demand forecasting: This means predicting how much demand there will be for your goods or services. Ideally, you use this information to set prices just high enough to meet demand without overstocking or understocking inventory.
  • Cost analysis: This is the process of determining all of the costs that go into producing and selling a product or service. This information can be used for break-even pricing or marginal cost pricing.
  • Competitive analysis: This is the process of studying your competitor landscape to understand their prices and pricing strategies.
  • Pricing software: Software can be used to automate the process, using any of the tools or techniques we've discussed. Pricing software takes in data from a variety of your business inputs--like historical sales figures, production costs, and customer feedback--and considers other factors--competition, CRM, market insights, economic conditions, customer behavior, and consumer research--to recommend optimal prices.

What About Price Optimization Software?

As touched on in our previous section about price optimization tools, price optimization software can greatly automate the process for you.

While you'll still need to gather customer, sales, and competitor data--and know your business targets--price optimization software can use these inputs to recommend the best price or prices for your goods and services.

The process is still arduous and painstaking because it’s crucial to get it right, but software can help you automate large chunks of the process with expert analysis and actionable data visualization.

What to Look for When Choosing the Right Price Optimization Software

When evaluating the right software solution for your business, there are a few things to keep in mind.

  • Your type of business. Different industries will have different needs. Epicor, for example, specializes in software solutions for manufacturers, distributors, and retailers, whereas Procore and Kahua specialize in the construction industry.
  • The size of your business: Larger or enterprise-size businesses may have more sophisticated software needs and require a deeper level of support, expertise, and deeper software analytic capabilities.
  • The features you need: make a list of the different features important to your business. Common features can include demand forecasting, break-even analysis, competitive analysis, automated reporting, automated dynamic pricing, market alerts, shared leads, and prescriptive sales recommendations.
  • The cost: price optimization software can cost a couple of hundred dollars to tens of thousands of dollars or more. Make sure to find the package that fits your needs and your budget.

As you evaluate different options, other factors should be considered too.

  • Accuracy: Does the software have a proven record of accurately predicting demand and price elasticity?
  • Ease of use: The software should be user-friendly and intuitive.
  • Ease of implementation: Is implementation seamless with minimal time to value (TTV)? Is there ample and adequate training and customer support for all users?
  • Flexibility: Can the software flex to meet your unique business needs? Are there any customizable options?
  • Support: There should be ample and robust customer support long after implementation, TTV, and whenever you need business guidance.
  • Real-world human expertise: The best software solutions offer expert algorithms and expert human beings you can talk to--individuals with years of success in your industry who are able to share their insights.

Bottom Line

Setting prices for your business products or services can be a complex process, but gathering and analyzing the right data can help you avoid missteps. Pricing too high or too low could mean lost customers and lost sales, but a good price optimization process takes into account production and distribution costs, changing customer demand, competitor pricing, business goals, and the "going" market price that customers are willing (or trained) to pay.

Continually gathering and analyzing data and keeping a flexible approach can help you optimize pricing to meet the expectations of new and existing customers and business stakeholders.