Well, so why is pricing so important?
Let's have a look at this chart.
This, our questions ranked on a 1, less important, to 5, most important in
top executive minds as to what is their most important or a high pressure problem.
Look at price, the price of consumer goods and the price of industrial goods and
of services rank at the top.
So one of the reasons as to why we should spend some time in pricing is because it's
one of the marketing variables or
marketing challenges that is at the top of executive minds.
Now, you may ask,
why do they consider pricing to be such a high pressure problem?
Well, the answer is here.
This is a study based on an average of something around 2,500
companies from the Compustat aggregate index whereby
we can see on an average what will happen to a 1% increase or
improvement in price in comparison to some other variables, and a couple of income
statement, and what their relevant impact is of that improvement on the bottom line?
Let's look at the variable cost.
A reduction in variable cost of 1% will improve your net income in
approximately 7.8%.
An increase in volume, approximately, will improve about half as much 3.3 and
reducing fix costs will improve your bottom line 2.3%.
What do you think the impact of price is on the net income of a company.
You've guessed right.
Price is the most important variable affecting the income statement.
A 1% improve in price will affect on the aggregate for
these 2,500 companies, approximately 11% your bottom line results.
So since it is such a high pressure problem, because it has a tremendous
impact on your bottom line results, let's look how much executives know.
How do they rate that they know, or what do they know about pricing?
And as you can see, once we take into account costs, variable costs,
fixed costs, and competitive prices, and then product value to customers and
price response, only somewhere between 30% and 60% of top managers
seem to claim that they are well-informed about these two fundamental variables.
So given that price is so important and
that top executives seems to be relatively uninformed or
not as well-informed about these fundamental variable, let's go and try to
review how you should think about setting up prices for your products or services.
So before we can speak about prices, we have to understand a thing or
two about cost.
There are three important cost that we need to take into account.
First of all is the variable cost.
Let's take the case, as an example, for a hotel, for example.
The variable cost is the one that truly depends on the level of activity, right?
So if you're going to rent an extra room, what you really want to determine is what
is the extra cost of renting that room to try to be able to determine at what's
the minimum price at which I can actually be able to sell the room for the night?
So the variable cost or
the variable activity might be the time of the person cleaning the room,
or it might be the supplies that are needed to clean the room, or
the cost of switching the linens or the bathroom toiletries, etc., right?
So those are costs that actually depend on the level of activity and
that are specific to that one additional room.
On the other hand, there are semi-fixed costs.
These costs only scale in steps.
For example, employees might be a semi-fixed cost, because for example,
you might operate a hotel with a certain set of people during the low season,
say in the winter, versus a different set of people, in the summer,
where the activity of the hotel climbs up to a different level of activity.
And in the other hand, there are fixed costs, and
those are costs that do not vary by the level of activity.
So for example, if you're not the owner of the hotel property,
the rent might be an example of a fixed cost, cost that stay the same
regardless of whether you rent, or you don't rent the additional room.
Two important other concepts are those of contribution or contribution margin.
First of all, there is a unit contribution margin,
which we'll denominate CM over here, which is fundamentally the difference
between the unit price minus the variable cost of the good sold.
And the other one is a total contribution margin,
which is the number of units that you have sold times the unit contribution margin.
These two concepts are very important to what's going to come next.
Now that we have understood the three kinds of cost and contribution margins,
let's try to understand what the break-even point is.
Oftentimes, a measure of the level of profitability of a company can be
expressed as the difference between the total contribution margin and
the fixed costs.
In order to illustrate that, lets see how this applies and
how to estimate the break-even point.
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Mario CapizzaniLecturer
