University of Illinois Extension

Product Pricing: A Touchy Issue for Businesses and Customers Alike

Differences in the price of identical or at least similar products from one region to another can be puzzling to all of us. The price of petroleum products during the past year is a good example. Most of us can probably recall several instances when we observed noticeable price differences not only on a regional basis but many times on opposite sides of the street. Why does the price of a pizza, hamburger, gallon of gasoline or any other product for that matter vary so much from location to location. While the experts will explain these price differences result from a number of variables including transportation, land or labor costs, some successful business owners will tell you, “all that really matters is what the customers are willing to pay.” It is a fact that customers don’t like higher prices. It is also a fact that even though customers may not like it, they will continue to buy at a higher price if they value what the business has to offer.

Just as customers struggle to accept higher prices for the goods they want or need, business owners are also confronted with issues driven by ever increasing production costs. The challenges of determining the optimum product mix and pricing these products high enough to make a profit but low enough to maintain a sufficient sales volume is not an easy task. Also, given the dynamics of today’s business environment, pricing decisions must constantly be analyzed and adjusted to compete.

For the majority of products, periodic price increases are just a fact of life. Increasing costs for various supplies, ingredients and overhead have to be passed on to the consumer. Developing successful pricing strategies is the key to long-term profitability. Deciding when to increase prices and by how much can be a challenge for even the most successful business manager and resistance to change has led to the demise of many businesses through the years. While profit margins for some businesses may be sufficient to withstand small increases in production or overhead costs in the short-term, most managers would agree that it is generally better to work prices up in smaller increments, over time in an effort to avoid so-called “sticker shock.” For example, a five percent price increase today followed by another next year will not generally cause as much backlash as a one time 20 percent increase. A bakery owner once noted that some customers will always complain, but you can’t let them dictate your business practices. The quickest road to pricing profitability is paying close attention to what customers want and what they are willing to spend.

Although price increases are inevitable, discounting can also play an important role in an overall business strategy. Discounts can be utilized effectively to introduce new products as well as to rekindle interest in older products or speed the liquidation of excess inventory. While discounting can be a useful tool, the profit related benefits of these programs depend on both the type of product being discounted as well as the type of business. It is fair to assume that a price reduction would spur sales of any given product and to a point that is true. However, a 20 percent discount on the price of a pound of green beans would probably not generate the same sales volume response as would a 20 percent discount on new car prices. Why is that? Well the economic theory of elasticity can explain it all but let’s leave that alone for now. Just realize that the sales of some products are more responsive to price changes than others and good managers understand the characteristics of their products.

The following example will illustrate some of the issues that should be considered in a discounting program. Assume our current situation involves a product line that is generating $10,000 of profit from a 2000 unit sales volume. This results in gross sales of $20,000. This product also sells for $10 and costs $5 to stock on our shelves. If the product is discounted 20 percent, sales volume would have to increase by 66 percent (3,333 total units) just to maintain the $10,000 profit margin. Although sales volume would have to increase dramatically to maintain the same level of profit, gross sales would only increase by about 33 percent. In order to realize a 20 percent increase in the profit from this product line at the discounted price, sales would have to increase 100 percent (4,000 units).

Now consider the effects of a 20 percent increase in the price of our example product. This would result in a selling price of $12. In order to maintain the $10,000 profit margin now, only 1,428 units would have to be sold. So as long as the sales volume did not drop by more than about 28 percent the business would profit from the price increase. Taking this a step further, a 20 percent increase in profits could be realized at a sales volume of 1,715 units, which is about 14 percent less than the 2,000 units sold in the original scenario.

In conclusion, it all comes down to value and the perception of value will vary from person to person. As customers, none of us like to see prices of anything go up, but we realize they will and we will continue to buy the majority of the things we need and want. For the business owner, the challenges of pricing profitably and competitively will continue as they look for ways to add value to the products and services they provide.