SMEs should learn how to price for profits

SMEs' pricing decisions can have a greater impact on customer loyalty and satisfaction. (Illustration for representation)

Pricing for profits is critical for all businesses, and more so for small and medium enterprises (SMEs), because it directly affects their financial health and ability to compete in the market. Unlike large corporations, SMEs often have limited resources and face greater challenges in terms of pricing strategy.

Here are some reasons why pricing for profits is critical:

SMEs often have limited resources in terms of financial capital, human resources, and tech tools. As a result, they cannot afford to make pricing mistakes that could adversely impact profitability. By pricing their products or services effectively, SMEs can maximise revenue and profits with limited resources.

All businesses today operate in highly competitive markets where price is a key factor in customer decision-making. If the pricing is not competitive, business may lose out to competitors who offer better pricing or perceived value. Effective pricing can help to gain a competitive advantage in the market and attract customers based on the value.

Cash flow management is critical for SMEs more than ever now since they have to ensure their survival and growth. The right pricing will ensure that they have enough revenue to cover their expenses. This, in turn, can help SMEs avoid cash flow problems and maintain their financial stability.

SMEs often have a closer relationship with their customers than larger companies. This means that pricing decisions can have a greater impact on customer loyalty and satisfaction. With the right pricing, SMEs can build strong customer relationships based on trust and perceived value. Effective pricing can help SMEs achieve long-term growth and sustainability. By maximising profits, they can reinvest in the business, expand the operations, and hire more staff.

Pricing for profits: How to set the right price

Pricing is the one activity in the firm that affects the topline and bottomline immediately. A well-planned pricing strategy can make a significant difference in the profitability of a business. Studies suggest that a 1 percent increase in realised price can lead to an 11 percent increase in profit. Despite this, pricing remains little understood, and it is often practised on an ad-hoc basis. Many SMEs tend to use a cost-plus approach as the default option, without taking into consideration the customers' propensity to pay and the profit impact of a price correction.

One of the challenges with pricing is the lack of understanding of how customers are likely to respond to changes in prices. Often, businesses are unaware of what the profit impact of a price change is likely to be. This lack of knowledge leads to businesses setting arbitrary prices that have no relationship to the expected volumes. In today's globalised and competitive environment, implementing a pricing strategy that goes beyond a cost-plus or a competition-centred approach is fundamental to profitability. No wonder we see a proliferation of short management programmes from IIMs on this subject.

The first step in pricing for profits is to understand the customer's perspective. Customers are not just buying a product or service; they are buying the value that the offering provides. The value that a customer perceives is not always directly related to the price. Therefore, SMEs should look beyond the cost of production and focus on the value proposition that their offerings provide to the customer.

Another critical aspect is the willingness of customers to pay. It is not always a straightforward concept. It depends on factors such as the customer's income, lifestyle, needs, and preferences. Therefore, it is crucial to conduct market research to determine the customers’ willingness to pay. This information can be used to set prices that are in line with the perceived value.

The next step is to analyse the competition. Pricing should not be based solely on the cost of production but on the price at which competitors are selling similar products. A competitor-centred approach to pricing can help SMEs attract customers. However, this approach may not always be sustainable in the long run. To set the right price, businesses need to take into consideration the value that the product or service provides compared to that of their competitors.

Businesses can also use a demand-based pricing approach to determine the right price. This approach involves setting prices based on the customer's demand for the product or service, like airlines and hotels do. That’s why you pay a higher price during peak demands such as Diwali or summer vacations. This approach can help businesses maximise their profits by selling at the right price.

Pricing also depends on the stage of the product life cycle. At the launch stage, the price may be set lower than the cost of production to attract customers. As it gains popularity, the price can be increased to reflect its value proposition. At the maturity stage, the price may need to be reduced to maintain sales, while in the decline stage, the price may need to be further reduced to clear out inventory.

SMEs must follow the right strategy to creatively price the offerings and keep in mind the above points to ensure sufficient profitability.