When is it Time to Raise Prices? Posted by Paul Finkle on Thu, May 31, 2012 @ 2:32 PM Raising prices is always a difficult decision – particularly in times of low inflation. In a competitive market there is always the concern that a price increase can drive customers to the competition. So how do you justify a price increase and when is the best time to impose it? A recent article in Inc. Magazine used the example of Pandora, the Internet music company. Following its initial public offering, revenue grew 58% as of the May 2012 announcement and the stock price is performing relatively well. Financial losses however, have more than doubled at Pandora over the prior year. Most entrepreneurs are not public and do not concern themselves with stock price, what they are more concerned with are operational losses. One way to stem those losses, particularly in a market where it is difficult to get financing, is to ask customers to pay more. According to the Inc. article, Pandora’s issue is operating margin. While active listening audiences increased by 53% over the prior year, so did the music royalties Pandora pays to the artists, leaving quarterly earnings in a perpetual flow of red ink. An examination of the financials for Pandora reveals that G&A, marketing and R&D cost 48% of revenue. These percentages of “overhead” are not out of line for many businesses. The real challenge for Pandora is the cost of the royalties it must pay. Content acquisition expenses and royalties cost over 77% of gross revenue. This is an extremely large ratio of cost to revenue for one line-item. Pandora’s hope hinges on increased revenue. Implementing a Price Hike When considering a price increase, there are many factors that go into the decision including customer loyalty, competition, and general market conditions. In the music business, price sensitivity is a critical factor since there are many online options for music and most carry little or no cost. The question when you raise prices is how many customers will you lose, and if
you drive away customers, will you end up with higher profits overall based on the increased revenue from your existing customers? If you are as large as Wal Mart or Starbucks you can conduct a consumer survey and competitive studies to get an idea of the price sensitivity of your customers. For entrepreneurs on the other hand, the best advice is to look before you leap. Most of our clients tell us that if you can justify (in the customersâ€™ mind) a basis for the increase (for example: raw material cost increases, which are widely known) then you are less likely to scare away customers. There may be logical carve outs for a set of customers who are in contract or whose expectations are set at a particular level, and who will be miffed if you disrupt those expectations. Once you have decided to impose a price increase, it is usually wise to provide reasonable notice of the increase. In the current economy, with the present low rate of inflation, most customers are not expecting price increases. Our client experience indicates that the most successful scenario for a price increase exists where there is strong business justification, solid customer loyalty, as well as a high degree of perceived value. On the other side of the coin, if you do not raise prices a little as you go, by the time inflation makes the need obvious, you will be faced with the imperative for a large price increase which will almost certainly be unwelcome. Some entrepreneurs use a pricing strategy of increasing prices only for new customers. If you are a new customer and pay a little bit more, most customers will not find this offensive and your long-term customers will feel rewarded for tenure. Think of how you feel when pricing works the other way. Cell phone companies and cable providers are notorious for offering deals only to customers lured from the competition while at the same time offending long- term customers.
Significance Many of our clients comment that they feel as though they spend as much time thinking about pricing as they do product development. This is really more of a comment on the frustrating nature of determining pricing. We recommend careful analysis prior to taking price increases in the current environment.