How do you figure out what to charge? How much is too much and how much is too little?

Setting prices for your products is one of the most important business decisions you'll make. Here's what you need to keep in mind when deciding what to charge. It seems so easy, right? What you charge determines the future of your business. You can charge too much or too little, and each leads to the same result: failure of the product and/or failure of your business.

Once you build your product/service, is the moment to answer this fateful question:

Hou much should I charge for my product?

There are different methods to define the price:

• Competitor-based method;
• Willingness To Pay (WTP) method;
• Cost-based method.

With a competitor-based method, the price is simply defined considering the competitor's price for the same product. Is your decision to align your price to the competitors or not? A clear example of competitor-based pricing is the Coca Cola and Pepsi strategy:

1. Coca Cola in some country is more expensive than Pepsi and in some country not,
2. From both of them, there is always the objective to avoid a price war, creating an almost perfect "Duopoly".

Let us now analyse the Willingness To Pay method. When you decide to charge a specific price for our product/service, based on how much value you are able to create, you are implicitly defining:

• How much value you are giving to suppliers;
• How much value you are giving to customers;
• And, most important, how much value you are capturing!

A good business must have the ability to capture value, and your goal is to capture as much value as possible!

How this goal is achievable?

The goal is achievable by:

Increasing bargaining power with suppliers, in order to reduce all the cost to a minimum possible. How? Here are some examples:

• Re-negotiate the agreements, providing new targets in terms of price and quantity for the short and long term;
• Create strategic events, in order to capture in different ways (brand reputation, brand awareness);

Increasing customer's WTP. How? Here are some examples:

• Providing new features that allow you to increase the price more than the cost;
• Providing services that solve customers' specific needs;
• Design a powerful marketing strategy;
• Creating a customer-centric communication and business strategy.

A clear example of this strategy is Apple. Apple, with its very strong brand reputation, built on years and years of powerful marketing strategy, is able to sell very good features to a very high price. Why? Because customers perceive that the product has more value than its real value, allowing Apple to charge a higher price than its competitors (e.g. Samsung).

Let's analyse now the third method, that is the cost-based method.

Every successful business owner knows their financials. If you designed and manufactured the product, you know every piece and part, including all associated costs like shipping and labour. You carefully considered the best way to manufacture a quality component in the most cost-effective way. In other words, you have the cost of the item detailed to shocking proportions. There are different methods to allocate cost (and a couple of articles to explain them properly), but generally speaking direct cost plus the indirect costs are what you consider “cost.”

Among all the different costs, once the product is ready to go to the market, you have to reach as many customers as possible. In order to understand how much is the right amount to spend to acquire a customer (Customer Acquisition Cost), it is truly important to answer this question:

How can I quantify the customer's economic value for my business?

For this, it is vitally important to identify the most valuable customer, from which one do you capture the most value. To do so, there is a very powerful instrument: Customer Lifetime Value (CLV) which represents a customer’s value to a company over a period of time.

There are several methods of calculating CLV that go into more detail and can focus on the individual customer, but you can calculate a simple Customer Lifetime Value model for your company with this formula:

Knowing your CLV you can determine, among other things:

• How much you can spend to acquire a similar customer and still have a profitable relationship;
• What kinds of products customers with the highest CLV want;
• Who your most profitable types of clients are.

Together, these types of decisions can significantly boost your business’ profitability.

A clear example of this method is Netflix.

Based on their lifetime value metric, an average Netflix subscriber pays $11.65 a month, which means that over a span of 12 months, the customer would have spent $139.80.

If you were Netflix, would you be willing to spend $150 to acquire a new customer? The answer is: YES!

Let's see why. During the first year, the customer would only be paying $139.80, and assuming Netflix paid $150 to acquire the customer, Netflix would lose money ($20.2 to be exact). However, according to the lifetime value metric, an average Netflix subscriber maintains its subscription for 25 months. What does that mean? It means that the Customer Lifetime Value is almost $150 (($11,65 x 25) - $150 = $147,25). What can we conclude? We can conclude that looking at customer profitability from a CLV perspective allows a business to focus more on a mid-long-term rather than the short term (in this example, one year). In conclusion, Netflix can generate a profit, but to see how much gains, it’s necessary to have an overview of the whole period of 25 months.

If Netflix didn’t know the lifetime value of their customer they simply wouldn’t be as large as they are today.

I'd like to conclude this article with a very interesting and insightful quote from the Oracle of Omaha:

The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price 10 percent, then you’ve got a terrible business. [Warren Buffett]

Thanks for reading my article!

Pietro Gagliano

https://www.linkedin.com/in/pietro-gagliano-3508578a/

__________________________________________________________________________Sources & Readings

https://www.linkedin.com/pulse/create-before-you-capture-thoughts-value-tom-lewis-fca/

https://medium.com/evergreen-business-weekly/why-value-capture-is-the-most-important-business-idea-you-haven-t-read-enough-about-c035c657d091

https://www.shopify.com/encyclopedia/customer-lifetime-value-clv

https://exponea.com/blog/customer-lifetime-value-guide/

https://directiveconsulting.com/resources/glossary/lifetime-value/

https://www.businessknowhow.com/money/chargeproduct.htm

https://neilpatel.com/blog/how-netflix-measures-you/

https://crealytics.com/blog/lifetime-value-important-metric-ecommerce/

https://processcreative.com.au/uploads/general/Meetup-Pres-Slides-191106.pdf