B2B Pricing Strategies: A Guide to Maximizing Profit in the 21st Century
This guide provides manufacturers with insights into modern B2B pricing strategies, aiming to optimize profitability in the 21st century.
This guide aims to give manufacturers an overview of the advantages and disadvantages of different pricing strategies. By understanding these strategies, B2B management can make more informed pricing decisions and optimize their universal goal of increasing their company’s bottom line.
Historically, management’s profit-increasing strategies concentrated on increasing sales, marketing programs, and labor and material reductions, with minimal-to-zero consideration of product pricing.
The fastest, costless, and most effective way for a company to realize its maximum profit is to get its prices right. —Harvard Business Review: “Managing Price, Gaining Profit” by M. M. Marn & R. Rossello.
To begin our discussion, let’s agree on the following B2B Product Pricing Truisms:
Non-optimal product pricing can nullify the company’s engineering, marketing, and operations excellence by leaving money on the table or demotivating customers with price sticker shock.
The company's bottom line is the sum of its products' net profits, so each product's net profit directly affects its net profit.
A product should be priced at what the market will bear but always above its net profit break-even price.
Per GAAP (Generally Accepted Accounting Principles):
Product Net Profit = (Unit Price – Direct manufacturing costs – Allocated Companywide Costs*
“Pricing is the most powerful management lever for driving or destroying a company's operating margins.” —According to McKinsey & Co.,
Historically, allocating companywide costs (Marketing, engineering, finance, CEO compensation, health insurance, etc.) to an individual product has been difficult, so the industry adopted Cost-plus, Gross Margin, Competitive pricing solutions, etc. The following describes the pros and cons of these commonly used solutions and the newly introduced OptumPricer pricing tool.
OptumPricer Pricing
OptumPricer uniquely calculates product net profit and break-even prices by solving the GAAP equation, including allocating companywide costs to each product. OptumPricer (An inexpensive SaaS product) instantaneously calculates net profit product and breakeven prices.
Advantages:
Manufacturers using OptumPricer:
Only sell net profit priced products and make net profitable new business bids
Can recover profits diluted by ever-creeping companywide costs
It supports manufacturing management’s goal of maximizing company profit.
The ability to view all products for net profit encourages onscreen what-if scenarios that improve the product’s and the company's total net profit.
Knowing every product’s net profit breakeven price avoids profit-killing discounting.
Encourages both direct and SG&A cost containment.
Disadvantages:
Requires a subscription fee.
Cost-Plus and Gross Margin Pricing
The most straightforward type of pricing strategy is cost-plus, aka Gross Margin pricing. This method involves calculating the product’s production costs (including materials, labor, and direct manufacturing costs) and adding a fixed percentage as a gross profit margin. The “fixed percentage” is management’s best estimate of the dollars needed to make the product net profitable.
For example, if a product costs $10 to produce, and the manufacturer wants a 20% gross profit margin, they will price the product at $12 (i.e., $10 + 20% of $10).
Advantages:
An arbitrarily set Gross Margin doesn’t guarantee a product’s net profit or 100+% absorption of allocated companywide costs.
This solution cannot calculate a product’s net profit breakeven price and can create a vulnerability to profit-killing discounting.
May underprice by ignoring the value perceived by consumers or competitor pricing pressures.
This can lead to inefficient production (i.e., the manufacturer has no incentive to lower costs).
Disadvantages:
An arbitrarily set Gross Margin doesn’t guarantee a product’s net profit or 100+% absorption of allocated companywide costs.
This solution cannot calculate a product’s net profit breakeven price and can create a vulnerability to profit-killing discounting.
May underprice by ignoring the value perceived by consumers or competitor pricing pressures.
This can lead to inefficient production (i.e., the manufacturer has no incentive to lower costs).
Value-Based Pricing
In contrast to cost-plus pricing, value-based pricing focuses on the amount the target customers are willing to pay, taking into account the benefits they perceive from the product. It is commonly used in high annual volume consumer product pricing analysis. Uncommon in B2B pricing analysis.
To implement this strategy, manufacturers must analyze their target customer segments, understand their needs and preferences, and assess how their products deliver value compared to competing products. This process often requires expensive, time-consuming market research and customer surveys.
Advantages:
Aligns product prices with the value perceived by customers.
Rewards quality improvements and innovation.
This can lead to higher profit margins.
Disadvantages:
This solution is more applicable to consumer pricing as the size of the B2B customer groups limits accurate statistical analysis.
Difficult and expensive to implement, as it requires extensive market research with possibly a high degree of inaccuracy.
It can be difficult to justify prices to customers with limited knowledge of the product's benefits.
This solution cannot calculate a product’s net profit breakeven price, so a net profit loss solution may be required as supplementary decision support.
Competitive Pricing
Competitive pricing involves setting a product's price based on the prices charged by competitors. Manufacturers may price their products slightly higher or lower than the competition, depending on factors such as product quality, brand recognition, and features.
This strategy requires constantly monitoring market trends, competing product prices, and customer preferences. Additionally, B2B pricing to larger customers is rarely published.
Advantages:
Easy for customers to compare products
Increases the odds of attracting price-conscious consumers
Can help manufacturers maintain or gain market share in competitive industries
Disadvantages:
This solution can lead to loss pricing as it ignores the following:
Competitors' actual direct cost advantages and scale if the competitor enjoys a greater market share. Blindly competitive pricing can lead to profit stumbling.
Allocated companywide costs of the product.
This may lead to downward price spirals and reduced profit margins if all competitors follow suit.
It can dilute brand image if the product price is too low
Requires continuous monitoring of market conditions
Summary:
Optimizing the company's bottom line requires management to select product pricing tools that can illuminate both the maximum product prices the market will bear and the product’s net profit breakeven price.
Knowing each product’s net profit breakeven price prevents profit-killing discounting and encourages management's ongoing constraint labor, material, and companywide costs.
Due to the ongoing creep of companywide costs, labor, and material, it is prudent for management to update the underlying data that drives the net profit breakeven prices quarterly.