The Mystery of Pricing
It's a question every small business owner hates to ask, "am I charging enough?" Or worse, "am I charging too much?"
Although the internet has made price comparison easier for commodity products, it is
still difficult to get good information on pricing services. Because of that, there is a huge variety of prices available for the same service.
The variety in prices makes it difficult for business owners to set their prices in a fair way - fair to both the consumer and the business owner. That mystery has helped encourage the
practice of price testing.
What is Price Testing?
Price testing is the concept of trying out different prices to see how the market reacts. Not to get all Microeconomics 101 on you, but the idea is simple: the higher the price, the lower the demand - generally speaking. By trying a number of different prices with your audience, you can begin to
measure their price sensitivity - or the change in the demand for your product or service based on the change in your price.
Measuring price sensitivity is a complex statistical process that even the largest corporations don't "get right." But you don't have to be a statistical whiz to leverage the information.
By choosing a time period that usually generates a certain number of sales, say a week, month, or quarter, you can measure the change in sales over the same period due to your price change.
Yes, there are challenges with this method, including adjusting for seasonal demand, your marketing and advertising efforts, and other variables, but generally speaking,
you can get a decent idea of the effect of your price changes by watching demand over an appropriate time period.
The One Big Mistake in Price Testing
The error many companies make in price testing is
having the wrong goal. Your goal is not to maximize how many new sales you have, it's to maximize your profit. If the unit cost of each item is the same, then it is enough to maximize your revenue.
Why does this matter? It matters because
you might actually make more money by selling fewer things.
Think about it this way: if you charge a lot of money for a product, you will make money on each unit, but you won't sell any. If you charge too little, you may sell a lot, but lose money on each one. Both of these strategies lose.
But somewhere in the middle is the
perfect spot where you make the most money: maximizing price x units.
You don't want to set the price to sell more product; you want to set the price to
maximize your total revenue.
Making the Science Simple
This pricing technique is used by airlines, hotels, retail stores, and even some banks to set their prices. It involves heavy statistical analysis and a mathematical technique called optimization.
But small businesses do not have to do all of that to make it work. They can simply test prices and make adjustments with a simple rule I call
The Rule of 5's.
The Rule of 5's
Whatever your price is today, choose a period of time to use as a baseline: a week, a month, whatever period where you might sell more than, say 20 units. Then raise the price 5%. You might think that will kill your business, but a 5% movement is price can be barely noticeable in all but the most commoditized markets.
Wait the same period of time and observe the (perhaps) decrease in your sales.
Here's the rule: if your unit sales went down by less than 5%, then raise your price to the new price point. If your unit sales went down by more than 5%, return your price to the old price point.
If you kept your price point where it was, repeat the experiment in the other direction. Lower your price by 5% and measure unit sales. If your unit sales went up by more than 5%, keep your price at the new, lower price point. If your unit sales went up by less than 5%, keep your price where it was.
Using
The Rule of 5's gives you an easy way to find the price point that maximizes your revenue by taking advantage of your specific market dynamics. This takes your brand proposition and service level into consideration.
In this episode of the Scale to Success podcast, I talk more about pricing as well as some strategies to create more stable, recurring revenue.
Not selling more than 20 units? Then we definitely should talk.
