NEW PRODUCT—PRICED AT $395
BUT WHAT PRICE GIVES MOST PROFIT?
Enterprise Value Accelerator
(Blending Marketing and Finance)
(Story #5)
5-minute read
It is a beautiful Minnesota autumn morning as I drive to our little factory on the banks of the quickly flowing and pleasant Mississippi River. It was the third year of our e-commerce startup creating handmade women’s handbags with a rustic classic appeal. We were finding our niche. The business was growing nicely, attracting loyal customers across the country and around the world.
As a self-funded startup, we watch every penny. This year the business had to make money or at least break even, as another year of negative cash flow would threaten ownership and maybe even the life of the company.
In an old manufacturing district of St. Paul, I park my SUV, and my big black lab, Sydney, jumps out, and we head up the street to the dog-friendly office. Today is the day to finalize the marketing plans for our new all-leather handbags. The key players are here: Jen, head of marketing and partner, Luba from production, Bev from product development, and we have Beth, our consumer researcher, on the phone from Georgia.
The team had done a great job. The first production sample run is complete, and the material cost and labor costs are right on the original creative design criteria. I met the team weekly for a year, including meeting with our leather suppliers, to ensure the minimum target margins were met. Today, I share my appreciation with a big smile to all that made it happen.
Having the production costs on target is great, but today’s goal is to make the product work, which means pricing right to make a profit. As the chief financial executive, I know the margins must support growth of inventory and provide capital for new products and factory equipment.
Everyone gives ideas about pricing with enthusiasm and heart. I listen to everyone, but, as the financial leader, I need to find a path for more profits. I could not risk the work my people are doing nor the future image of the company.
My questions go beyond “which decision is best?” My questions return to the basics: “Do we know our customers”? and “How much risk can we take”? The decisions I make today impact the survival of the company and its future enterprise value.
The Unknown Causes Pain – The Pain is in My Head
The team has a great product! But I am scared. Can I make it successful? Price too low and we will struggle to grow and finance the future of the company. Price too high and sales will not materialize hurting morale and putting in question my leadership as the company struggles.
As I weigh the best decision, I consider our product successes last year. Our most successful product is an over-the-shoulder medium-sized canvas woman’s handbag. It is made of rugged, pleasing, special-order canvas, with leather trim, appealing to many customers. With its success, we are now introducing four all-leather versions. Same size and features of the canvas handbag, but all leather. We have four colors:
Deep Natural Black Leather.
Bright Evergreen Leather.
Rich Buffed Heritage Leather.
Creamy Dove Leather.
The meeting, to finalize marketing, is in our factory lunch room. It is the only room big enough to display all the new product, and, from the lunch room, we can see the whole factory with the whirring pocketa-pocketa-pocketa of 30 sewing machines, to the whoosh-click of the rivet machine. The romantic aroma of the freshly tanned leather drifts into our meeting room as we finalize minor changes to improve production and prepare samples for catalog and web site photographs.
Each leather bag is of identical design with the same manufacturing costs. If each leather handbag had a retail price of $395, the total leather line would have a 65% gross margin.
65% Gross Margin Is Good! But Is it Good Enough?
With the product development work done, and the first samples made, the next step begins. We start photography for the catalog, the web pages, and social media. I see, in the team’s smiles, their enthusiasm and appreciation for the product. I sense their pride, and the importance of the pricing decision sits with me bolstered by the pride I feel for the team and their work.
In parallel with the photograph and catalog design, we must finalize pricing today or the marketing schedule will be delayed. The price I set locks us into the long-term market strategy as it impacts pricing for related products we introduce later.
This is not the world of a Fortune 100 company with years of experience with its customers and competing product. The exact opposite. This is a new product in a niche market we have barely explored. How can an entrepreneur’s creative energy make something special happen?
The Crisis and Challenge Are Clear
Price Too Low: Risk Company Failure as We Run Out of Cash
Price Too High: Risk New Product Failure as Sales Fall Short
This is the world of an entrepreneur, making operational decisions that impact the life of the company. In this case, the creativity of an entrepreneur is using their experience and their expertise to address the challenge of pricing. With the future of the company in balance, how does an entrepreneur establish the best price for a new product line?
I get Beth, our consumer research consultant, who understands our customers intimately, and Wayne, our direct mail consultant, on a phone call, and I push hard to squeeze every ounce of knowledge and energy from each of them. In the end, I make the pricing decision.
With Pricing in Place, Max Enterprise Value Will Be Achieved
My decision is made, and we are on our way. I call Bob, my catalog designer, and explain I need a new product description copy for each product. I send an email, with the highly unusual pricing scheme, for the introduction of our new leather handbags:
- Creamy Dove Leather at $395 and a 65% gross margin
- Bright Evergreen Leather at $445 and a 69% gross margin
- Deep Natural Black Leather at $495 and a 72% gross margin
- Rich Buffed Heritage Leather at $545 and a 75% gross margin
It is a clever entrepreneurial solution that works in this special case, because it sets the stage for an important analysis of price elasticity within the framework of maximizing profit. It is great for the company, as it will achieve, through testing, a bright successful future for all our new products by avoiding a pricing guessing game.
Bob and his wordsmiths create the language and taglines we use to clearly differentiate each handbag product in the eyes of the consumer. Beth’s work established that the customer interest was shared equally across all colors. With consistent customer interest, I knew the next year would reveal price elasticity for these products and allow us to stage prices across the product line and move to max profitability, max margins, and max Enterprise Value.
My pricing scheme did, as we move forward, explore the prices of our products in the eyes of the consumer and deliver crucial data to analyze for profit success.
Details and Results:
After the testing, we knew the most successful product was the Rich Buffed Heritage Handbag at $545. We continued testing for the balance of the year. The following season, we moved the Rich Buffed Heritage Leather handbag from $545 to $595 and all the others to $545. This moved the average gross margin to well above 75%. The financial and marketing analysis and testing worked perfectly. We gained profits and Enterprise Value from these handbags. Of additional benefit, the testing of this product impacted the pricing of related product lines.Now, how can you study price elasticity for your new product?
For the college professors, price elasticity is easy to explain — “the sales unit volume changes as the price goes up and down”. The professor talks of “Inelastic Prices” meaning there is no change in demand as prices change. “Elastic Prices” demand changes dramatically as prices change.
For the entrepreneur, it is a difficult but necessary task to determine the best price of product based on a practical understanding of how to apply these concepts. With our new products, in new product categories, we literally had no idea of price elasticity. Let me repeat, we had no idea which price would give us the most profit and the most Enterprise Value. When in a similar situation, for anyone to think otherwise, or to have someone tell you the price is known, is a sign of naiveté and lack of entrepreneurial spirit. You must test!
From Rex, a wise associate, I learned the mantra:
“There are never great marketers; there are only great customer researchers and testers”
Price elasticity must be tested and measured. If you fail to do this, you will not achieve the profitability and the Enterprise Value available to your company.
I have found, while working on price elasticity of products, that companies can sometimes double prices and generate 3 or 4 times more profit. Recently, I worked as a consultant with two different companies. By adjusting prices and measuring the subsequent change in demand, both companies increased profits by over 200%.
Studying the price elasticity of your product is not easy. It will take deep thinking and often the “Guerrilla Marketing” passion of an entrepreneur. If it were easy, everyone would do it. Let me share a few ideas:
- Test Large Price Changes
Understanding the best price for your product takes testing large price changes. We are addressing large price changes, so you can measure the volume and profit change associated with price elasticity. Later, after the testing, you can think operationally about smaller price changes, but to make the testing work, and to provide information, you should test price changes of 50%, 75%, and 100%.
- Use a Customer Researcher
Your market research professional is a key player. If you do not have one—find one. Focus group interviews and controlled shopping experiences can shed light on the sensitivity of price to volume. They cannot create the detail you will get from actual testing, but you will learn a lot, and it will start you on the right path to success.
- Real Testing in the Marketplace
Analytically measuring volume changes, as function of price, requires a tightly controlled sales environment. You must test a similar product, remember it does not have to be identical to learn about elasticity. The test must have different SKUs in the same customer universe. Beyond product differentiation, you can control advertising channel segmentation, distribution channel segmentation, or geographic segmentation, but always to the same universe. You, as an operational entrepreneur, can figure out methods to test price elasticity.
- The Testing Must Not Be Static
Go beyond just one round of price testing. You must be dynamic with price testing adjustments over time. This gives you multiple looks at the range of elasticity.
With these important tips, you can create Enterprise Value using your own experience and creativity. Good luck!
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