Costs don’t drive pricing. Willingness to pay drives pricing. Fixed costs never matter to pricing. Variable costs barely matter to pricing. These are truths. However, costs are going up in these inflationary times. Should pricing ignore inflation? What should you do?
A cost increase is NOT a reason to raise prices, rather it is a SIGNAL that it’s time to revisit pricing.
Willingness to pay drives pricing, but a buyer’s WTP in the presence of competition is the price of the competitive product plus the value of your differentiation. Cost increases probably don’t change the value of your differentiation, but they very likely drive price increases from your competitors.
If your competition raised prices already, then it’s an easy decision for you to make. Follow their lead, get your margins back to where finance wants them, and continue to compete on value, not price.
However, if your competitors haven’t raised their prices, then ask yourself if you’re normally a price leader or price follower? If you normally lead price changes in your market, then raise prices now. Competitors will likely follow.
The hard decision is if you’re normally a price follower. In this situation, you may hold your prices and continue hoping your competitors raise their prices. Or, you may try a price increase and see if your competitors follow, but be prepared to bring your prices back.
In a world where your competitors never change prices, then you simply set your price relative to their price based on your differentiation. The prices won’t change much. However, as costs increase, margins get squeezed, and everybody is trying to find a way to get margins back to normal. Knowing that WTP is a function of your competitors price gives you the opening to increase prices if your competitor does.
One industry where we see this happen often is gasoline. When the price of a barrel of oil goes up, the price of gas at your corner gas station goes up the same day. Yet it takes approximately 9 weeks for a new more expensive drop of oil that comes out of the ground to make it to your gas station. Gas stations don’t use the price of oil to set their prices, but as a signal that other stations will raise prices too.
We haven’t seen much inflation for years, so we aren’t as experienced at these price changes as gas stations. But the idea is the same. It’s always about your buyers’ willingness to pay, which in part is based on your competitors’ prices. It’s wise to watch your competitors’ prices closely. You can even signal them with trial price increases. But DON’T talk to them about prices. It’s illegal.