- 1 Book Summary - The 1% Windfall by Rafi Mohammed
- 1.1 Key Insights
- 1.2 Key Points
- 1.2.1 If you just need to think about one customer, price relative to their alternatives.
- 1.2.2 If you have a broader customer base, maximize profits by finding the ideal balance between demand and margin.
- 1.2.3 Prices are not always a “one-size-fits-all” situation.
- 1.2.4 Understand the reason for a customer’s resistance in order to offer the right solution at the right price.
- 1.2.5 Don’t give in to the temptation to sacrifice your profitability during a recession.
- 1.3 The Main Take-away
- 1.4 About the Author
Book Summary - The 1% Windfall by Rafi Mohammed
If you’re not thinking about how to price strategically, your company is probably missing out on profit.
The standard advice for pricing is based on adding a profit margin to what it cost you. This cost-based pricing strategy is problematic because what you’re selling is about more than what it cost you.
Your price should be based on the value it brings to your customers. What they’re willing to pay is not based on what it cost you. Value-based pricing strategies can help you plan for different situations, and keep the profits rolling.
The 1% Windfall refers to a study from McKinsey & Company that found that imposing a 1% increase in prices can create an 11% increase in operating profits. Thinking about your prices creatively for all situations can lead to a big payout.
If you just need to think about one customer, price relative to their alternatives.
A value-based pricing strategy for one customer or one product prices according to the target customer. Specifically, you need to price relative to the next-best alternative for your customer.
This is a one-on-one pricing calculation. You identify who you want to sell to. Then, you identify what the alternative is priced at. Use your best judgment to adjust your price above or below that price.
For example, if you have a home to rent, you can compare it to the nearest neighbor also renting out their home. If your home is a little better, bigger, or has an extra feature, you can adjust upward. If the neighbor’s home has the upper hand, you can adjust downward.
Of course, you should try to get a sense of the market. Make sure you’re not tethering yourself to an outlier. Think through the comparison to the next-best alternative.
By looking at what is selling and what it’s selling for, you can introduce your product with a pricing strategy that fits the market.
If you have a broader customer base, maximize profits by finding the ideal balance between demand and margin.
A one-on-one pricing strategy may be ideal for introducing a product to a single customer or a small number of customers. But a multi-customer value-based pricing strategy is a little different.
Let’s say you produce large quantities of your goods and there’s more variability in your target customer base. Start with a general idea of the right price using the one-on-one pricing strategy you would have used for a single customer.
Then, you need to estimate how many units you can sell at that price. Your profit margin per unit multiplied by the quantity sold will be your total profit.
But that estimated price based on a single customer may not maximize your profits. When you take a small dip in profit per unit, you could sell a lot more units. The total profit may end up being higher even if the profit per unit is lower.
On the flip side, you could have a higher price with a greater profit for every unit you sell. This means that you’ll likely have fewer units sold. Your total profit could go down even with a higher profit margin.
The quantity sold depends on demand by your customers. The more your customers value your product, the fewer sales you’ll use when setting higher prices. Value-based pricing has to take into account the demand curve to optimize total profit.
You can also position your products to have a higher perceived value compared to alternative goods. A luxury brand can charge more and the customer value remains intact. Your profit margin is much higher and the quantity that must be sold to maximize profits is lower. But it depends on whether your customers value your products as elite goods.
Prices are not always a “one-size-fits-all” situation.
Just because you set a price doesn’t mean all your potential customers are going to be willing to pay it. You don’t want to haggle, but you also don’t want to lose customers. What do you do?
A variable pricing strategy is a key to meeting more customers where they are without compromising your profit potential. You adjust what you’re offering (and the price that goes with it) to stop a customer from walking away.
Versioning is a pricing strategy that aims to capture the maximum profit without compromising on the base unit price. You start with the core price for your core product or service. Then, you start adding or taking away features to get a premium package or a budget package.
For example, think about theme park tickets. There may be a standard price for a day’s admission. Value-conscious customers can be reached by offering a discounted ticket for evening hours or off-peak days. Customers that see value in a splurge may spend more for a VIP package with shorter lines or early admission.
When you create versions, think about your customer’s unique needs. Maybe there’s a demand for a certain combination of products. You could bundle them and take a small hit on the price per unit of each component because you’re selling multiple products.
Understand the reason for a customer’s resistance in order to offer the right solution at the right price.
People have different reasons for being unwilling to make a purchase. But a creative, variable pricing strategy can adjust to each of these reasons.
What if your customer likes the idea of the product, but doesn’t want to commit to ownership? Plenty of products offer rentals, leases, and fractional ownership. Figure out a way for the customer to enjoy the product without full commitment and you get to enjoy the profits.
Sometimes, the amount of money is just too high to spend at any given time. It’s not that the customer doesn’t believe the product is worth the price. They just don’t have the money. That’s where financing comes in. You can offer 0% interest for any purchases above a certain amount. Without having to worry about up-front spending, your customer may even buy more than what they originally came for. It may take a little longer, but you get all the profits in the end.
Maybe your customer just doesn’t know if the product is the right fit for them or if it’s worth the money it costs. Give them a guarantee. Like a lawyer working on a contingency, you only get paid when the customer gets what they want. Alternatively, you can license the product to them. They pay less, but you collect ongoing royalties.
If the value is uncertain for you and the customer, use an auction. With open bidding, the value of a product becomes clear fairly quickly.
What if your customer is resistant to spending that doesn’t have a fixed price? Think about a phone plan where you have to pay by the minute. Instead of charging based on their usage, you can offer an unlimited monthly price that offers predictability. Alternatively, you can charge a lower variable price with a higher membership fee at the outset.
Don’t give in to the temptation to sacrifice your profitability during a recession.
If you’re going through an economic downturn, demand for your product may drop. You may think to lower your prices, but that’s a trap. Lowering your prices only makes your customers less willing to pay the full price again for them in the future.
Ideally, you should plan for tougher times with a robust pricing strategy. Knowing that there will be times when people are inevitably going to have to cut back on their spending, you can design a product line for them. This can be available at a lower price point for anyone who needs it.
Creating a budget line is a preemptive pricing strategy that keeps you afloat as your regular products’ sales slow down. It is a well-established strategy utilized by companies like the guitar maker C.F. Martin & Co. They created a basic guitar model for a recession and, after, they stopped offering that line and customers could upgrade as the economy picked up.
If you’re also facing inflation that increases the price of your raw materials, raising prices may deter customers. Instead, you can adjust your product so that you use fewer raw materials. For example, Breyers made its ice cream containers slightly smaller for the same price. You maintain your profit and customers see the same price.
The Main Take-away
A robust, value-based pricing strategy should an integral part of your corporate culture if you want to maximize profit.
Cost-plus pricing is an outdated method that can leave profits on the table. Think about the value to your customer by comparing your product to alternatives to set a price. Adjust your price up or down to maximize total profits by targeting a price that balances quantity sold with profit margins. Plan for challenging situations like a recession and offer alternatives to that accommodate resistant customers. Creative pricing strategies can lead to greater profitability.
About the Author
Rafi Mohammed is a pricing expert with more than 25 years of experience in pricing issues.
Originally from Milwaukee, Mohammed was raised in Cincinnati. He received degrees from Boston University and the London School of Economics and Political Science before receiving his Ph.D. from Cornell University. He is the Batten Fellow at the Darden Graduate School of Business and the University of Virginia.
Mohammed’s commentary has been featured on several media outlets, including the Harvard Business Review, National Public Radio, the Wall Street Journal, and The New York Times.
He founded a consulting company called Culture of Profit. Through that organization, Mohammed works with businesses on their pricing strategies.