Jan 29, 2024 | Financial Acceleration

How do I decide what discount to give to a prospective client?

Q. Dear Zenagos,
I usually provide services to individual professionals, but I have an opportunity to write a proposal for an association, where I can sell to lots of professionals at the same time. I know they are expecting me to offer a discount, but how big a discount should I give? Do you just pick a percent, like 15% off?
–Virgil

Most entrepreneurs obsess about pricing: They worry that if they set their price too high, they will drive off customers, and if they set their price too low, they will leave value on the table. It would be great if pricing were an exact science, and you could just follow the rules and set the right price. However, there is no magic formula for pricing. You need to take into account your customer, your industry, your costs, and your operating margin – and there may be other factors, as well.

Think of Discounting as a Type of Marketing
Think of discounting as a marketing cost. The expense is worth it if the total new revenue you bring in is greater than the total marketing cost. With a discount, the cost is an “opportunity cost” – you miss the opportunity of collecting the full price. So, the key to choosing a discount percentage is estimating how many more customers you’ll win in comparison to the discount that you are giving up.

Do the Math
For example, let’s say that you sell something for $100 at full price, and you usually get 10 customers a month. So, you usually make $1,000 a month. Any discount you give will affect the customers who would already have come, so if you give a 15% discount, you are giving up $150 that you would usually have made that month ($1,000 x 15% = $150). If you give a 20% discount, you are giving up $200 a month ($1,000 x 20% = $200). So, to make the discount worth it, the additional customers who would come as a result of the discount need to contribute more than you are giving up. So, for a 15% discount to be worth it, I need to get at least 2 extra customers ($100 x 2 = $200, which is greater than the $150 I would give up). So, in your estimation, will you get at least two additional customers if you offer a 15% discount? If you think you will, then the discount is worth a try.

Approaches to Pricing
We provide four valid approaches to pricing below. You should choose the approach that most resonates with you, select a draft price to use in your financial projections, and move on. Obsessing about price is unlikely to get you meaningfully closer to the optimal answer. The truth is that you won’t really be able to refine your price until you begin selling. As you sell, it will become clear very quickly if your price is too high, and you can always raise your price if you find that you have unexpectedly high demand.

Setting Price Based on Costs
Once you know what it costs to make and deliver your offering, it makes sense to set your price comfortably above that cost level. After all, you won’t be in business long if you charge less than it costs you to deliver! To use this pricing strategy (called “cost-plus” or “markup” pricing), you just add a fixed percentage to your costs. For example, let’s say:

  • You sell marketing data reports,
  • It costs you $100 to produce each report, and
  • You decide to price at “cost plus 25%”

To set your price, you would follow this formula: Price = Cost x (1+ markup percentage)
Using our example:

  • $100 x (1 + 0.25) =
  • $100 x (1.25) = $125, so
  • Your price would be $125 for each report.

The advantages of Cost-Plus pricing are that it’s easy to figure out and easy to explain to customers. Customers expect that you to need to make a living, so they don’t generally object to the “plus” part of cost-plus pricing. However, Cost-Plus pricing may make you less competitive if someone who makes a comparable product has a lower cost level. Also, it may invite negotiation, since revealing your costs will tempt a haggler to try to reduce each element of your costs and percentage.

Setting Price Based on Competition
Before you set your price, it is always wise to pretend you are a potential customer and see what competing options you would consider. If they don’t publish their prices, you may need to pose as a customer or send someone else to pose as a customer, so you can get a quote or other pricing information. It is smart to always keep an eye on the competition. If you do not have any direct competitors, consider the alternatives your customers consider when making a purchase. Look at how they are priced. And, don’t forget, your customers always have the option of making no purchase at all. Think about why they should buy your offering, instead of just waiting. Really try to get into your customer’s point of view to make sure you see all of their options.

As you look at each option, write down its price. Also, consider its competitive features. Where you set the price depends on what you learn. If your offering is unique – it’s the only way to solve the customer’s problem, and the customer urgently wants to solve that problem – then you may be able to set a high price. If your offering is more convenient for the customer or faster for the customer, then set your price above the less convenient or slower options.

The primary advantage of Competitive pricing is that it keeps you in touch with your competition and serves as automatic research for addressing customer objections. The disadvantages are that it takes work and the research needs to be updated at least once a year, if not twice. Also, you may fail to discover a key option, and new options may arise at any time, which can create the need to adjust your price.

Setting Price Based on Quality
If you feel that you provide higher quality than your competitors, then you can set a higher price than theirs, based on quality. Setting a higher price may, by itself, signal quality to potential customers. Research has shown that consumers place more value on purchases with a higher price, a phenomenon that psychologists call the “Marketing Placebo Effect” (Business Insider, 2018). For example, researchers purchased two $14 bottles of wine and then asked study participants to taste them. They were told that bottle A was a $12 bottle of wine and bottle B was a $29 bottle of wine. Participants preferred the “more expensive” wine (bottle B). When the prices were switched, participants still preferred the “more expensive” wine (in this case, bottle A). If you believe that you offer higher quality (or that it is difficult for customers to truly evaluate which offering is of higher quality), then try setting your price above competing options.

The primary advantage of Quality pricing is that it can create a positive cascade (a “virtuous cycle”) for your business. You will feel better selling a high-quality product, and it may make it easier to attract great employees and build customer loyalty. However, this is only true if customers recognize the superior value of your offering. This pricing may not work if customers do not recognize the value or if they believe the claims of a competitor who has an inferior offering, but a convincing-sounding pitch.

Setting Price Based on Shared Values
Customers consider a lot of factors when making a purchasing decision, and their values can be an important consideration. Some customers will pay more to purchase a product with which they have some philosophical or political affinity. If your product is better for the environment, then customers who prioritize the environment may be willing to choose your offering over the competition and/or pay a higher price for it. If you believe that it is your best strategy to use affinity pricing, then set your price at least 10% higher than your competitors.

Affinity-Based pricing is a “polarity” strategy: You take a strong position, and this attracts customers who share that strong position. The advantage of this strategy is that it can lead to very strong loyalty, both in customers and in employees. Your company will enjoy a strong sense of mission – a feeling of being “the good guys.” However, the disadvantage is that for every customer who chooses your offering based on an affinity driven by shared values, there could potentially be a customer who rejects your offering for the very same reason. So, when you make this commitment, you need to be confident that the slice of the market that you are attracting is large enough to sustain your business. You also take the risk that your position could become politically unpopular in the future, requiring a pivot. With Affinity-Based pricing, you do need to stake out a strong philosophical position, or you could end up in a limbo that reduces your potential market from all directions.

The Reason This Is Hard Is that it’s Hard!
If after reading all of this, you still aren’t sure how to price, give yourself a break: Nobody knows how to price! Fancy economists write complicated papers about pricing every year, but no single genius has emerged as the Einstein of pricing. Airlines employ a veritable army of technical PhD wizards to try to figure out how to squeeze the highest possible price out of every airline seat, and yet they are still constantly changing their approach to pricing. The reason that this is hard is that it is very difficult to pin down the information you need in order to set the optimal price. The variables are constantly changing, and it is difficult to collect enough data to take an evidence-based approach. So, don’t spend too much time on it. Choose a method, pick a price, and give it a try. You can (and almost certainly will) change your mind in the future as you learn more.

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References

Business Insider. (2018, December 11). Here’s the psychology behind why we like expensive things. Retrieved on January 28, 2018 from https://www.businessinsider.com/sc/why-we-like-expensive-things-2018-12

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