There are some situations where it makes sense to raise your prices. Freelancers, agencies and other service providers are often encouraged to raise their rates periodically, which I agree with in many situations.
I’m going to give you a high-level overview of pricing concepts, share how pricing is abused in eCommerce strategy and talk about a few situations where it makes sense to raise prices.
As a reminder, the purpose of this article is to arm you with the knowledge to build a healthy customer file. And a healthy customer file enables a business to succeed today, but it also sets a business up for success in the future.
If you’ve ever been within five feet of an economics textbook, you have probably seen one of these diagrams:
They illustrate the number of consumers willing to buy a given item for a given price, and the number of suppliers willing to produce it at the same price. The point where the two lines intersect tells you the quantity of the item that will be produced and the price the market will charge.
These charts simplify a really complex ecosystem in order to illustrate different economic concepts. Economic theory is based on the principles that humans act rationally (lol!) and prices and demand are guided by the “invisible hand” of the market (sounds pretty pervy to me, tbh).
The reason I bring this up is because the demand side of the equation is true: fewer people will buy something as it becomes more expensive. And that’s all you really need to know about raising prices. Newsletter over.
The price that an individual is willing to pay for a given product or service is influenced by a number of factors:
How bad do they need it? If you need a certain medication to stay alive, you’ll be willing to pay a lot for it. You will probably tolerate price increases until the medication consumes your entire incoming cash flow and ability to take on debt.
I’m not going to editorialize on that example because this isn’t a political newsletter. But most of you reading this aren’t selling insulin. So you need to be thoughtful about price increases.
How much do they care about it? Very few consumers have the time or money required to pursue “the best of everything”. Instead, they pursue the best products they can afford in a handful of categories they care about and their purchases in other categories are guided by price and convenience.
You can think of your potential market as containing enthusiasts and everyone else. Enthusiasts will go for “value-based pricing” (more on that below) and pay more. Everyone else will buy from you if (1)the product is priced acceptably relative to their disposable income and (2) it is convenient to purchase.
How much disposable income is available? There was a study that said money does buy happiness…up until your salary exceeds $70k per year. After that point, salary increases produce diminishing returns where happiness is concerned. The reason? Once you hit $70k, you have enough disposable income to stop counting every penny. Or at least that was true when the research was performed in 2010. The new, inflation-adjusted happiness number is closer to $100k.
As your disposable income increases, you feel less willing to invest time and energy in comparison shopping and your standards for a “minimum viable product” increase. So people with more money are willing to pay higher prices…up to a point.
What will the neighbors think? We live in a society, and that’s why brands like Louis Vuitton, Mercedes Benz, and Yeti can get away with charging a lot more than many of their competitors. Ostensibly these brands are offering a superior product, but that doesn’t explain their pricing strategy fully–their margins are also much higher than the competition.
These brands charge more because they signal something to your community–usually that you have a lot of money. As “the neighbors” have shifted from our IRL neighbors to people we’re connected with on social media, the dynamics of this pricing principle have evolved. But you can still charge more if you’re selling a status symbol.
Pricing Are Prices Set?
So, are prices set by the invisible hand of the market? If you’ve worked in eCommerce, you know that isn’t true. You don’t price your products with a Ouijia board.
There are two approaches to pricing strategy: cost-based and value based.
In cost-based pricing, you set your price based on the cost of producing your product, plus a margin that will cover the operating costs of the business and leave you with some profit. This is pretty straightforward: the cost structure of your product should mirror the cost structure of your idealized P&L.
In value-based pricing, you set your price based on the economic value of your product, regardless of the cost of producing it.
This is what big-name consulting firms do when they charge multiple millions of dollars for a few hundred man-hours of work and a powerpoint deck. Hypothetically, the work enables the client to unlock tens of millions of dollars in business value.
For consumer products, the Baby Shusher is a great example. It’s a plastic speaker with a two-setting timer. There is no way it costs anywhere near $35 to produce. But I am so terrified that it will break that I’m considering buying a backup (it helps your baby fall asleep).
If you sell your goods in the wholesale channel, the wholesaler also has the ability to demand a certain margin structure based on their own business needs.
Brands essentially do all of this strategy work and hope it aligns with how the market will value their product. Or they just wing it or use “the markup we’ve always used”. There is a reason that “price” is one of the Four P’s of marketing: marketers play a large part in influencing consumers’ willingness to pay for something.
When Should You Raise Prices?
So when should you raise prices? There are a few scenarios when it makes sense to do this, but the outcome will almost always be the same: you will wind up with fewer customers for your brand.
Luxury brands, aka “Velben Goods”, are the exception to this rule. For these brands, raising prices actually increases demand. Chanel’s pricing strategy for its handbag line is the perfect example of this in action.
But proceed with caution: raising your prices doesn’t turn you into a luxury brand. You need to build the desirability and reputation before you raise prices, or the move will make your sales decline.
Raising prices is a tradeoff between fewer total customers and increased spend per customer. In an ideal scenario, you walk away with more profit. Before you make a pricing decision, you want to analyze a few things about your business and your existing customers:
- Based on customer spend in the last 12 months, how does the AUR distribution of your transactions fall into deciles? For example, your AUR distribution may span from $15 to $299 and the lowest decile is $15-29.
- What is the preferred decile band of your customers who purchased in the last 12 months? You should calculate this on a unit basis. If a customer purchased two units between $15-29 and one unit between $30-49, their preferred band is $15-29.
- What percent of your last 12 month sales was driven by customers from each decile band?
- What percentage of your current full price product assortment sits within each decile band?
- When you raise your prices, how will the distribution of your assortment shift?
Customers generally do 60-80% of their spending within their preferred band, and the remainder of their spending at a lower band. If you take away all the products that sit in a certain price band, customers who prefer it will also go away.
You can use this method to estimate the impact of a price change on your existing customers’ spending. You can then weigh the loss of those customers against the gains you think you’ll realize in overall spend per customer. The more dramatic the price change, the more customers will churn, and the more important customer acquisition will be to your success.
There are certain scenarios where you may actually want fewer customers. Maybe there is a hard upper limit on your ability to produce your good or service, so you want to refine your customer base so only the best customers remain.
Brands who are trying to pull back on promotionality and refine their perception are essentially raising prices (eliminating discounts is a form of raising prices). The thought is that sales growth will slow down initially, then pick up again when the brand becomes more exclusive and desirability increases.
But in some cases, brands try to solve customer acquisition problems by either raising or lowering prices. Obviously, this doesn’t solve the underlying issue. Consumer brands are high churn businesses by nature; you need a steady stream of new customers to “fill the bucket” enough to grow.
In other cases, external factors like the rising cost of raw materials may force you to raise your prices. If you do so, you need to anticipate that some customers will churn. Big CPG companies–the masters of pricing science–have developed some tactics to get around this, like “shrink-flation”.
How much should you call attention to a price increase? It depends. If you have a broad assortment that changes frequently, consumers are less likely to notice a small price adjustment. The greater the percentage increase in price, the more customers will “feel” it, and the more they may feel entitled to an explanation.
Pricing and promotional strategy could be its own newsletter. But as it relates to tanking your eCom business, here are your takeaways:
- Higher prices = fewer customers.
- You are probably not a luxury brand. Raising prices doesn’t suddenly make consumers perceive you as one.
- Pricing doesn’t fix underlying issues with customer acquisition or retention. Identify and fix those issues!