The Importance of Pricing Analysis

At a very basic level, pricing strategies are used by people to assign market prices to their products and services. Your run-of-the-mill standard academic style business education will expose you to pricing strategies like market penetration, premium pricing, skimming, bundle pricing, etc. These topics aren’t mind-blowing, but the conceptual importance of them is profound in business.

Two things small businesses may commonly overlook when setting pricing is their products’ price elasticity and competitive position of their products in the market. Small oversights in pricing can lead to significant unnecessarily lost profitability.

Here’s An Example:

Consider a fictional mom-and-pop business, Edith’s Bakery (EB), that sells an average of 600 pastry products to public/corporate buyers per day averaging at $10/dozen or $0.83/unit. EB is only open 6-7 hours/day until they sell out all of their products, and they are only closed on 10 federal holidays. That’s $177,500/year in revenue.

Now let’s say they priced a single unit at $0.94 with their volume sales discounts also proportionally priced with their competition. This is below the price/unit at both Dunkin’ Donuts chain stores and a better known Minnesota bakery located in Cold Spring, both priced at $0.99/unit (rough estimation based on said company websites). If these two companies are EB’s major competitors and EB’s pricing plan is to undercut their competition to be competitive, they are probably throwing away money.

Why?

EB is $0.05/unit below nearby competitors, more than 5% lower than the competition.
Food products tend to have an inelastic demand, so they shouldn’t expect the volume purchased to drop much if they slightly raised prices.
Their loyal customers are highly unlikely to leave if they stay below competitor’s prices. Price sensitive consumers are also unlikely to leave as long as they don’t raise pricing by more than $0.03-$0.04.

So How Does This All Work Out?

If EB raised their price/unit by $0.03 as well as proportionally increasing all of their volume discounted business, they now make an additional $6,390/year. That’s a 3.6% increase of revenue/year! Yet they’d still be under their competition by more than 2% in price.

Unless there is a very slight increase in hours worked (if their demand lessens), they have no additional significant expenses. A significant portion, if not all of the $6,390 will drop straight down their P/L sheet as gross profit.

If EB has a gross margin of 50%, they would have had $88,750 in gross profit. When $5,000 of the aforementioned $6,390 is added directly as gross profit they just increased their gross margin by roughly 5.6%. That’s the approximate difference in gross margin reported between Walmart and Target each year.

Pricing analysis is one of the more important tools that is overlooked or lacking in many businesses, but especially in small businesses who don’t have the resources to pursue it. Don’t let your organization fall victim to this.