Pricing Strategies During an Economic Slowdown

Business managers are trying to make informed decisions to address the 2022 economic slowdown. Higher inflation, supply chain disruptions, and other factors are making it tougher to generate sales and profits. While many businesses consider cost reductions in a slowing economy, managers should also analyze pricing strategies. 

In this podcast episode, Rachita Sundar, SVP of Finance at HubSpot, explains how detailed planning is the key to maintaining profitability. This discussion explains a number of factors that you can use to make better pricing decisions.

Understanding Costs for a Product or Service

The starting point for pricing is to identify all the costs required to create a product or deliver a service. As an example, assume that Reliable Plumbing provides residential plumbing services. 

Generally speaking, costs are either direct or indirect:

• Direct cost: Costs that can be directly traced to the product. Material and labor costs are common direct costs.

• Overhead (Indirect) costs: Costs that cannot be directly traced to the product. Instead, these costs are allocated, based on a level of activity. Companies often use labor hours worked or machine hours incurred to allocate overhead costs.

Plumbing supplies, such as pipes and brackets, can be directly traced to a specific plumbing job, along with the hours worked by a plumber. Depreciation on the company truck, however, is an overhead cost that must be allocated to customers. The business might allocate depreciation expense based on the total mileage driven to complete each plumbing job.

Costs can also be either fixed or variable. A rent or lease payment is a common fixed cost, while utility costs are variable (based on weather and other factors). In addition to these categories, there are other factors that impact costs.

Considering relevant costs and relevant revenue

Relevant costs and relevant revenue refer to future revenue and expenses. In other words, these are amounts that may change in the future, based on the decisions you make. Past costs (or sunk costs) that don’t change are not a factor. 

Let’s assume that Reliable Plumbing is deciding whether or not to shift some of its business away from residential plumbing jobs and into commercial plumbing work. One relevant cost is an increase in errors and omissions insurance premiums to cover the risk of working on larger projects. A mistake made on a $3 million building creates more potential liability than work performed on a $300,000 home. 

Reliable will compare the changes in relevant costs with the potential increase in revenue, and decide if the move toward commercial work makes financial sense (if relevant revenue is greater than relevant costs).

Mulling over special orders

Profitability on special orders is calculated differently than other customer orders. A special order is a one-time order that is priced below the normal selling price, and special orders often occur in the last few days of the month. These are the factors that impact a special order:

• Fixed costs: Most or all of the fixed costs incurred for the month have already been paid using other sources of revenue.

• Excess capacity: A special order can only be filled if the seller has excess capacity to create the product or deliver the service.

• Lower sale price: Fixed costs are not included in the special order profit calculation, because other revenue has already paid the fixed costs. The sale price (and profit) is calculated based only on variable costs. Variable costs are relevant, fixed costs are not.

Here’s an example: A building owner asks Reliable Plumbing for a price quote to perform work on 10 apartment units on the 29th of the month, and the building owner is getting price quotes from two other plumbing companies. Based on current scheduling, Reliable has plumbers and trucks available to complete the work. The building lease payment, insurance premiums, and other fixed costs have already been paid for the month.

Reliable normally prices its services at $170 per hour, but the company can quote a lower sale price and compute a profit margin based only on variable costs. Salary and benefits for the job’s plumber, mileage, and parts (pipe, brackets, etc.) are all variable costs. Reliable quotes a price of $125 per hour, and gets the business.

Evaluating make vs. buy decisions

A company may be able to lower costs by outsourcing work that was previously completed in-house. If the total cost to outsource the task is less than the expenses incurred to perform the work in-house, outsourcing can make sense.

However, there are other factors that impact your decision. Will the quality of the outsourced product meet your specifications? Can the third party deliver items when you need them? If the total cost is lower and you can find a reputable supplier, consider outsourcing.

Currently, the plumbing staff performs all welding work required on customer jobs. However, some welding tasks are complex, and a professional welder could complete the work in less time. If Reliable can save money by bringing in a dependable third party welder to perform complicated welding jobs, total hours worked and labor costs will be lower.

Deciding on opportunity costs

Opportunity cost is the revenue and profit given up by deciding to go in one direction instead of another. Every business operates within limitations, including limited staff, marketing budgets, and available cash, and these limits impact opportunity costs. To determine opportunity costs, consider the revenue lost and the costs saved by not choosing a particular customer or product line.

For this concept, assume that Reliable’s owner has an opportunity to allocate five plumbers to work on an office building renovation for three weeks. The owner needs to evaluate these variables:

• Relevant revenue: How much revenue is gained on the office building project, compared to revenue lost by not having the five plumbers available for residential plumbing jobs?

• Relevant costs: Reliable will incur new costs (labor and materials) for the office building work, but residential plumbing costs will be lower, since five plumbers aren’t available for three weeks.

If relevant revenue is higher than the relevant costs, the owner is gaining more than the company is giving up. The opportunity costs are less than what is gained by working on the office building project.

There are other factors that managers should consider. Company decisions may have an impact on staff morale and productivity. If a retailer sees an opportunity to carry a new product line, the company will tie up cash by carrying the new product in inventory. These factors should also be considered when analyzing costs.

Once you determine total costs for your product or service, you can determine a sale price that is appropriate for the product.

Factors That Impact Prices

On a basic level, a sale price is determined by total costs and the desired profit margin. If the total cost of a product is $54 and the company wants a 10% profit margin, the sale price should be $60 ($6 profit divided by $60 sale price is 10%). The desired profit margin is only one of several factors that impact the sale price.

Also keep in mind that technology allows every consumer to have the same basic information about a product’s features and price. The higher the sale price, the more research consumers perform before making a purchase.

Dealing with limited capacity

Every business faces limitations, including limits on available cash, staff size, production capacity, and time constraints. In 2022, for example, supply chain problems are creating limitations for thousands of businesses. 

A tech company may earn a huge profit margin on a product that is in high demand, but can’t get enough computer chips and other component parts to fill all orders. Assume that the tech company can only produce 10,000 units instead of the 50,000 needed to meet customer demand. The sale price generates a big profit margin, but total revenue is limited by supply chain bottlenecks.

Managing competitive pressures

The sale price customers will accept depends heavily on the number of competitors in the market. Think about the dozens of cereal brands you see at the grocery store. Consumers have multiple choices for every category of cereal, and buyers may not see much difference between brands. In a slowing economy, many shoppers may switch to cheaper brands to save money.

Businesses may respond to competitive pressures by cutting prices, or by improving the product and keeping the price unchanged. If the seller can convince buyers that the new innovation justifies the price, sales may not decline.

Understanding demand inelasticity

Demand inelasticity means that demand for a product does not change in direct correlation with a price change. Buyers are less sensitive to an increase in price, and some will continue to purchase the product after a price increase.

A good example here is attending a popular sporting event. Businesses buy tickets to big events to reward employees and to solidify relationships with customers and suppliers. If the price for Super Bowl tickets increases by 25%, corporate demand for tickets may not decline. The fact that the event is becoming more popular may motivate the buyer to accept the higher price for a “must-attend” event.

Addressing price elasticity

Price elasticity of demand exists when consumers are sensitive to price changes, including both increases and decreases. In this example, assume that your favorite music group is in town, but tickets are priced at $300. Days before the concert, remaining tickets are discounted to $125. You weren’t willing to pay $300, but you’ll buy tickets at $125. You (and likely other fans) are sensitive to the lower price.

The seller benefits, because filling a seat at $125 generates more revenue than no sale at all. The average of all ticket sales is less than $300, but may still be enough to generate a profit.

Offering a purchase discount

Purchase discounts may be based on the total dollar amount spent over time, or related to the number of individual purchases. The business makes less money on the discounted sale, but the transaction may still be profitable. Offering discounts can also build customer loyalty over time.

Each of these factors may influence your ultimate decision about a sale price, and there are several methods you can use to calculate prices.

Going Over Pricing Methods

Businesses can approach pricing by computing total costs, and adding a desired profit margin. However, in a competitive market, buyers may not accept a sale price that generates the seller’s desired profit margin. Here are a number of strategies to determine a sale price.

Using target costing 

With target costing, you estimate a price that the customer is willing to pay, based on a number of factors explained throughout this discussion. Once the target price is determined, you set a target cost for the product or service, and the difference between the price and cost is the profit margin.

To illustrate, assume that Treeline Bikes has designed a new bike tire tube that reduces potential flats for mountain bikes. Serious riders who put in long mileage on bikes need a tire tube that is more durable and reliable. Changing a flat tire in the mountains is frustrating.

Estimating a target price

The biggest factor for determining a sale price may be the customer’s perception of your product, and how your product is viewed in the marketplace. If you’re able to differentiate your product from the competition, buyers may be willing to pay a higher price.

Get feedback from your salespeople who interact with your customers. Businesses also survey customers and talk with focus groups, in order to gather market research.

Treeline Bikes gets feedback by attending mountain bike races in the spring and summer, and determines that riders are willing to pay $15 for a better tire tube. The price is higher than other tubes, but riders are motivated to pay a higher price for more reliability.

Computing a target cost

Treeline’s next step is to identify all of the costs incurred to produce tire tubes, including direct materials, direct labor, and overhead costs. Management concludes that the total cost per tire tube is $12.75. The sale price of $15 generates a $2.25 profit per tube, or a 15% profit margin ($2.25 divided by $15 sale price).

Evaluating the profit margin

The final step is to assess the profitability, and decide if the level of profit justifies producing the product or delivering the service. Is a 15% profit margin attractive enough to produce the product? Many companies have a minimum profit margin that they must meet, and items below that minimum are not added as product offerings.

Managers may also identify costs that can be reduced, in order to increase the profit margin. Maybe Treeline adds a new supplier who sells raw materials at a lower price, for example. 

There are some other strategies that impact the sale price decision.

Other pricing strategies

Dig deeper and consider whether or not these strategies will work for pricing your product.

Skimming the market

When you skim the market, you charge a higher price for a new product to customers who want to be the first buyers. This is a frequently used strategy for technology companies. We all know people who want to be the first in line to buy the newest iPhone or MacBook. Once the product is out, many tech buyers will wait for prices to come down before making a purchase. 

If you have a target group of customers who are passionate about your new product, you can skim the market and charge a higher price.

Using peak-load pricing

Peak-load pricing is a strategy of charging higher prices when demand is peaking, and this pricing strategy is similar to skimming the market. You may have seen this strategy when planning a vacation, because hotels and airlines use peak-load pricing when travel demand increases. Flights in mid to late December are priced higher, due to holiday travel, and many customers are willing to pay higher prices.

Determining a price for a specific customer

A business may charge a particular customer a higher price, if the customer makes demands that require more time, effort, and spending. For this strategy, think about a catering business.

Big Event catering has a roster of 20 corporate customers, and the Big Event caters for dozens of events each month. The caterer provides a price list of food and beverage items, based on food costs, labor costs, setup time, and travel costs.

Acme Manufacturing, a corporate client, frequently changes their requirements at the last minute, and Big Event must invest time to change the services to be provided. In some instances, staffing the catering event must be changed, and cooks work overtime to supply new food requests.

Big Event’s manager explains to Acme’s owner that he will begin charging a fee for late changes to the catering plan, in order to recover the additional costs incurred. Acme can avoid the additional fees by sticking to its original catering request.

This strategy can change a difficult customer’s behavior. It’s reasonable for Acme to expect additional charges for additional work, and the customer may change their behavior to avoid the extra fees.

Changing the sales mix

An individual product’s sale price and profit margin is only part of the picture. When you price a product, you need to consider the impact on company-wide sales, and that includes your firm’s sales mix.

Sales mix refers to the percentage of total revenue (sales) that one product generates. If you can’t increase the profit margin of product A, you may be able to shift your marketing efforts to another product with a higher profit margin.

To explain, consider the Treeline Bikes discussion above. The new tire tube sells for $15 and generates a 15% ($2.25) profit margin. Treeline also sells a $30 bike pump that fits under the bike seat, and the pump profit margin is 20% ($6). To increase total profits, Treeline could shift its sales and marketing efforts to sell more bike pumps and fewer tires, shifting sales to a product that generates a higher profit margin.

When you expand this example to companies that sell hundreds of products, you can imagine how the sales mix can dramatically change business profits.

Next Steps for Managers

Review each of the pricing strategies discussed above, and to consider whether or not to automate more processes. These two steps address both the revenue and the cost components of your business.

Successful companies are using automation to save time, increase productivity, and to position the business to scale. Consider these points:

• An 2021 survey by System Soft found that “42% of organizations agree automation speeds up repetitive tasks and business workflow.”

• McKinsey & Company’s 2020 survey notes that “prioritizing automation has become even more important to enable success.”

• This Spiceworks article explains that: “Companies must implement technologies to make employees more productive and take the time to reskill and upskill their employees for the digital roles of the future. Automation helps companies optimize their workforces and build digital capacities where there are gaps in the workforce.”

Review every routine task that you perform. The more time your team spends on a particular task, the more benefit the company will gain from automation. Accounts payable (AP) is a time-consuming process for many businesses, and Stampli’s AP Automation saves time and sharply reduces the risk of errors.

Stampli’s end-to-end AP platform gives you full control and visibility over all your corporate spending, from cards to invoices to payments — all in one place. Stampli brings together accounts payable communications, documentation, corporate credit cards, ACH, and check payments, all within a communications hub that can be accessed by all stakeholders.
Take control over invoice processing with smart, intuitive, and actionable AP Automation from Stampli. Use this entire discussion to make informed pricing decisions, and to maintain profits during an economic slowdown.