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“Optimal” Pricing

We’re frequently asked to “optimize the price” of a product or set of related products, though it surprises many to know that there are actually two optimal prices for every product: that which maximizes profit or gross margin, and that which maximizes sales.

But we don’t recommend setting price to maximize either of them.

First, let’s discuss the two ideal price points.  Economics 101 taught us about elasticity, or the change in units over the change in price:

… and that when price goes up, units sold go down:

Since we have prices, and unit volume at each price, we simply multiply to get a sales curve.  Subtracting out COGS we can get the margin curve.   And we see that the tops of those curves occur at different prices- these are the two optima, one for sales and one for gross margin.

So which one should we pick?  Neither.  The right answer is a point somewhere between sales and gross margin goals, effectively trading off a certain amount of profit for a certain amount of revenue.   The real world of pricing is fraught with complications like meeting volume targets, leveraging fixed assets, meeting shareholder expectations, “investing” in an account, factoring in loss leaders, and more.  So what usually starts as a bit of analytics to find a single elasticity metric quickly becomes a broad strategic discussion- which makes pricing engagements some of the most important work we do.

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