Businesses continue to face rising labor and input costs. While passing those increases along to customers can preserve your profits, businesses that set prices too high or that implement too many small incremental increases could lose customers to competitors. Here’s an overview of the cost, customer and market factors that need to be considered when setting prices.
Recent trends
The CFO Survey, a collaboration of Duke University’s Fuqua School of Business and the Federal Reserve Banks of Richmond and Atlanta, tracks CFO optimism and top concerns. The most recent survey, published in December 2023, found that CFOs expect unit costs to increase by 4.7% in 2024, compared to 5.7% in 2023. In response to higher unit costs, 47.9% of respondents expect to charge higher prices in 2024 compared to pre-pandemic norms — and 10.5% of respondents expect to charge significantly higher prices this year.
However, businesses that raise prices could see pushback from customers that are resistant to further increases. For example, after a series of price hikes by some food manufacturers, consumers have begun shifting their buying behaviors for certain products. To avoid paying higher prices, some shoppers are switching to smaller package sizes and cheaper private-label brands. In fact, store-brand cereal sales reportedly spiked nearly 20% in 2023. These trends have caused the top three cereal manufacturers (General Mills, Kellogg and Post Consumer Brands) to consider lowering their prices to entice shoppers to resume spending in 2024.
3 critical factors
Timing is the key to implementing a price hike with minimal loss of customers. It’s hard to be the first one in your industry to raise your prices. If others don’t follow suit, your business could be in the position of having to rescind price increases and determine other ways to make ends meet. Here are three important considerations when weighing the pros and cons of increasing your prices.
- Costs of production. This is a logical starting point. After all, if your prices don’t exceed costs over the long run, your business will fail. More than just direct materials and labor should be factored into the equation. You should consider all the costs of producing, marketing and distributing your products, including overhead expenses. Some indirect costs, such as sales commissions and shipping, vary based on the number of units you sell. But most are fixed in the current accounting period. Examples of fixed costs are rent, research and development, depreciation, insurance, and selling and administrative salaries. Product costing refers to the process of spreading these variable and fixed costs over the units you expect to sell. The trick to getting this allocation right is to accurately predict demand.
- Customer loyalty. Some companies have built a base of loyal customers who are willing to pay a premium for their brands. Others have a customer base that’s made up of bargain hunters who would be willing to switch brands to save a few dollars. To gauge customer loyalty, you’ll need to evaluate customers’ purchasing patterns over the years and their responses to promotional events that you and your competitors have offered. If there’s significant customer turnover and you increase prices, your business could be in a vulnerable position.
- Commoditization. Another consideration is the nature of what you sell. If it’s a basic necessity and you dominate your market, your customers might have little choice but to accept a price increase. And even if you sell “luxury” products and services, you might also be in a good position to raise prices to the extent that your customers have an abundance of disposable income and aren’t price sensitive. Of course, that wouldn’t hold true for cost-conscious buyers of nonessential products.
Questions
Once you’ve laid the groundwork for assessing the likely impact of a price increase, you should answer the following questions:
- Which products or services should I raise prices on?
- How much should prices increase?
- When should the price increases take effect?
- Should I notify customers about increases and, if so, how do I explain the increases?
These questions must be considered based on the extent to which you’re being squeezed in the current business environment. The more urgent the situation, of course, the less flexibility you have.
When deciding which items to raise prices on, consider the potential cash flow impact. The most immediate effects will come from increasing prices on high-volume products. However, if you’re selling some high-volume, low-priced “loss leader” items to draw in customers who will also buy more profitable items and that strategy is working, you might want to go easy on raising prices on those bargain items.
Generally, gradual, selective price increases are less noticeable to customers than an across-the-board price increase. But in some cases, a one-time “tear-off-the-Band-Aid-quickly” price hike, not to be repeated in the short term, can make sense if accompanied by an explanation that customers can accept. Alternatively, you can refresh your product or service offerings and then charge a premium for “new-and-improved” versions that cost you about the same as the old ones.
Market research
Prices should reflect customer demand and current market conditions. They should never be a static number; rather, they should evolve with your business. Pricing strategies should consider what customers want and value — and how much money they’re willing to spend. Examples of economical ways to research customers and competitors include:
- Conducting informal focus groups with top customers,
- Sending online surveys to prospective, existing and defecting customers,
- Monitoring social media reviews, and
- Sending free trials in exchange for customer feedback.
It’s also smart to investigate your competitors’ pricing strategies using ethical means. For example, the owner of a restaurant might eat a meal at each of her local competitors to evaluate the menu, decor and service. Or a manufacturer might visit competitors’ websites and purchase comparable products to evaluate quality, timeliness and customer service.
The current attention on inflation and other unfavorable external market conditions may provide a good cover for your business to increase its prices, especially if others in your industry are raising prices, too. By tying your increases to, say, an increase in the consumer price index, or average gas prices, you can help justify a price increase to your customers — and they’ll likely appreciate your transparency.
What’s right for your business?
Your financial advisors can help evaluate where price increases would be most impactful. They can also recommend alternative or supplemental business moves you can make to keep your business secure in these uncertain times.
Sidebar: Pricing strategies: Think beyond low-cost pricing
Rather than raising the price of a product or service, you may decide to set a low price, at least temporarily, to drive competitors out of the market and build market share — or to survive adverse market conditions. Being a low-cost leader enables your business to capture market share and possibly lower costs through economies of scale, but you’ll earn a lower margin on each unit sold.
Similarly, you may discount some loss leader products to draw in buyers and establish brand loyalty in the hope that customers will subsequently buy complementary products and services at higher margins. You also may decide to offer discounts when seasonal demand is low or when you want to get rid of less popular models to lower inventory carrying costs.
However, offering the lowest price isn’t the only way to compete — and it can be disastrous for small players in an industry dominated by large conglomerates. Your business can charge higher prices than competitors if customers think your products and services offer enhanced value.
For example, if your target market is more image conscious than budget conscious, you can set a premium price to differentiate your offerings. You’ll probably sell fewer units than your low-cost competitors but earn a higher margin on each unit sold. Premium prices also work for novel or exclusive products that are currently available from few competitors.
If your company engages in one-to-one selling, such as in a car dealership, management should compare pricing trends among salespeople, as well as changes in gross margins over time. In these types of sales environments, it’s critical for salespeople to understand how to price products to different categories within your target market without losing money or tripping any legal minefields.
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