Lewis Surtees Assistant Accountant

How do you determine the optimum price for a product?  

With inflation rising, price increases will be essential to maintain or increase margins, but it can be difficult to know how far to go. For instance, a recent study by Harvard Business School researchers has shown that increasing pricing by just 1% could lead to an increase of up to 11% in profits.

So how do you ensure that your pricing is set at a level that benefits your business?

Price sensitivity analysis helps you to identify the optimal price point to maximise sales. To be able to price intelligently, you need to understand your customer’s “Price Sensitivity”.  This measures the impact on revenue of price increases. Almost inevitably, as the price of a product increases (relative to a comparable item, or earlier price), the volume of products sold decreases.  But, depending on the price sensitivity of the market, the increase in revenue could more than offset the decrease in volume.  

Here are 2 ways you can gauge the price sensitivity of your market:

Van Westendorp’s Price Sensitivity MeterA relatively simple but effective way of assessing the price perception of your customer, by asking 4 questions to a sample of customers:

  1. At what price do you being to perceive the product as so expensive that you would not consider buying it?  
  2. At what price do you begin to regard the product as so inexpensive that you would feel the quality is not very good?
  3. At what price would you consider the product starting to get expensive, although not out of the question, but you would have to give some thought before buying it?
  4. At what price would you regard the product as a bargain.

As you can see, this quickly identifies the point at which a product is:

  • Too cheap
  • Too expensive
  • Expensive 
  • Cheap 

By plotting results on a graph as below, you can identify the ‘Optimal Price Point’ (OPP) and the ‘Indifference (or Normal) Price Point’ (IDP).  The OPP is the point where there is the lowest probability of a customer rejecting the price.  The IPP is the point at which revenue will be maximised.

Price Elasticity of Demand (PED)PED take a slightly more scientific approach, but can be useful in understanding the interaction between price and market demand.  PED looks at the effect that price changes have on the quantity of a good supplied, as highlighted below:-

This is calculated after a change in price has been implemented, and is measured as an absolute value – always a positive number. The results can be regarded as follows:

>1    Demand is Elastic – a change in price will lead to a proportionately larger change in quantity demanded.  Customers are price-sensitive, and a significant increase in price is likely to lead to a decrease in revenue.

1    Demand is ‘Unit Elastic’ – a change in price has an equal effect proportionally on the quantity demanded (theoretically possible, but very unlikely to occur in real life!).

<1    Demand is Inelastic – a change in price has a proportionally smaller effect on the quantity demanded.  Customers are less price-sensitive, so an increase in prices is likely to lead to an increase in revenue.

These results aren’t set in stone for any particular product.  In fact, the customer’s perceived value is a significant influence on the PED of a product, so increasing brand awareness and brand loyalty can make demand more inelastic.

Obviously, products and circumstances vary enormously from business to business, and neither of the approaches above takes into account a number of significant factors, such as competitors’ pricing, government policy, availability of supply, and other considerations, but using one, or both of these models will help to build an idea of your target market’s value perception of your product.

As always, we’d recommend looking in detail at all factors influencing the price and demand in your market, and develop a robust pricing strategy to ensure sustainable profits.