Manufacturing Today

Proper Pricing

Once upon a time there were two aerospace parts manufacturers. One had revenues of $20 million a year and its bottom-line profitability was break-even. The other manufacturer’s revenue was only $3 million a year, yet it had a profit of $700,000. Does that sound like just a fairy tale? Actually, it’s a real example of the difference the right pricing strategy can make.

By Robert Baraker

Avoid the four big mistakes

More than 90 percent of manufacturers make four mistakes in pricing:

• They don’t consider the uniqueness of their product. The closer a product resembles a competitor’s product, the smaller the price difference the buyer will accept.
• They don’t determine the price elasticity of the product. If demand for a product changes significantly with only slight changes in price, the product category is considered elastic with respect to price. If no significant volume changes occur even with significant price changes, the category is inelastic. The greater the price elasticity, the closer a product’s price may be to competitive products. The lower the elasticity, the greater the difference in price between competing products may be.
• They don’t analyze the size and composition of their market. When setting prices for a product, one of the first imperatives is to estimate the size of the market and potential market share. In a large market, where one is not competing for market share, pricing can be more flexible.
• The cardinal sin is to base the selling price on internal costs rather than on what the market will accept. Ninety-five percent of manufacturers use a formula based on internal costs because it’s convenient to do so. Rather, pricing should be based on what the market will bear; i.e., on the value the product has to the customer.

Would it be justifiable to set prices based on internal costs if a manufacturer uses the most up-to-date equipment and best manufacturing techniques, purchases raw materials at the best price and takes advantage of a low-cost labor pool? Clearly not. Doing so only passes the efficiencies to the customer – for the benefit of the customer, but not the manufacturer.

The art and science of pricing

Pricing the right way involves market research, which is more challenging than pricing based on costs. Where does the product fit in the marketplace? What is the market willing to pay? Does the company want to grab market share with a low price, or does it want to enter with a high price as the premium brand? Pricing based on market research has the additional benefit of telling the manufacturer when it’s necessary to lower costs or operate more efficiently in order to compete and make a profit. Just look at how foreign competition has actually helped the U.S. economy by increasing efficiency. The marketplace determined the need for competitive pricing, and manufacturers had to become more efficient to compete. Internal costs, on the other hand, only shed light on operating efficiency and whether or not one can even compete in one’s market.

"Our pricing used to be a guessing game," says Miriam Fust, president of E.L. Burns, a manufacturer of extruded aluminum walkway covers, canopies, bus shelters, pedestrian bridges and similar products. "We would test the waters. If we were not getting enough jobs through the bidding process, we would have the estimator lower the price a bit. Then, if we still didn’t get anything, we might lower prices again. When business picked up, we’d increase prices a bit. We were pricing in a vacuum."

"Today, we investigate what the market will bear. Even though sometimes it’s necessary to lower prices in response to market pressures, we understand that we still need to make a profit. Breaking even may be better than going under, but it’s not a viable scenario."

Faust says the pricing formula at E.L. Burns is not cast in stone. "It helps us test the waters rather than guess," she says. "Our new pricing methodology, based on market research, has made all the difference in the world. If you’re not pricing your product correctly, it doesn’t matter what else you’re doing right; you’re either going to out-price yourself or start doing jobs just to cover the payroll."

Listen to the marketplace

Responsibility for gathering market data is shared by everyone from sales to marketing, from purchasing to production. However, the final determination rests with the owner of a small company or with the CEO of a large enterprise. It’s too important to the success of the company to let anyone else make that final decision. Never rely on salespeople to make pricing decisions! It’s a recipe for disaster. Sales reps are only interested in making sales, so they will always want to set the lowest possible price, not the price that is most profitable to the company.

So how exactly can manufacturers listen to the marketplace? Simply by surveying existing customers by mail or phone. What do customers really want? What products are they looking for and what benefits and features do they expect? Do customers that buy components want greater reliability? The specific questions depend on each company’s unique niche. The idea is to find out what is important to customers, develop products to meet those needs and then market them.

Finally, research the competition. What are they selling and for how much? Is it possible to take market share away from competitors, or would it be preferable to develop one’s own market? Either way, determine what marketing and pricing strategies are likely to be successful.

A tale of two manufacturers

Remember the two aerospace parts manufacturers? The one that broke even at $20 million a year based its pricing on internal costs. The one that made a profit of $700,000 at $3 million a year determined its selling price by the needs of the marketplace. When the owner of this company was asked to provide a vital part that would get a helicopter off the ground, he charged $10,000 for the part even though it only cost him $500. He knew that to the customer, getting the helicopter back in the air was worth a great deal more than $500. So he charged the price the market would accept.

Ask the GEs, IBMs and other successful manufacturers of the world if they would ever determine the selling price of their products without market research. The answer would be "no." Successful companies listen to the voice of the marketplace. Although it may be more difficult to assess the size and demand of the market, and the uniqueness and degree of elasticity of one’s product than using a formula to determine price, the effort pays off handsomely in the bottom line.

Robert Baraker is a senior business consultant with International Profit Associates (IPA). He holds a bachelor’s degree in engineering and masters degrees in both management science and finance. IPA and its companies provide comprehensive business consulting services and business valuation services to companies in the United States and Canada. For further information, call 847-495-6786 or visit www.ipa-iba.com.