Financial Analysis for Profit-Driven Pricing

Internal financial considerations and external market considerations are, at most companies, antagonistic forces in pricing decisions. Financial people allocate costs to determine how high prices must be to cover costs and achieve their profit objectives. Marketing and salespeople analyze buyers to determine how low prices must be to achieve their sales objectives. The pricing decisions that result are politically charged compromises, not thoughtful implementations of a coherent strategy. Although common, this situation is neither necessary nor desirable. An effective pricing decision should involve an optimal blending of, not a compromise between, internal financial constraints and external market conditions.

Unfortunately, few managers have any idea how to facilitate such a cross-functional blending of these legitimate concerns. From traditional cost accounting, they learn to take sales objectives as “given” before allocating costs, thus precluding the ability to incorporate market forces into pricing decisions. From marketing, they are told that effective pricing should be entirely “customer driven,” ignoring costs except as a minimum constraint below which the sale would become unprofitable. Perhaps, along the way, these managers study economics and learn that, in theory, optimal pricing is a blending of cost and demand considerations. In practice, however, they find the economists’ assumption of a known demand curve hopelessly unrealistic.

Consequently, pricing at most companies remains stuck between cost-driven and customer-driven procedures that are inherently incompatible. The result is tactical pricing focused on short-term objectives. For example, when planning for the forthcoming fiscal year, companies often set unrealistically high “list” prices to cover costs, only to discount them near the end of the year to make sales. No company can have a real pricing strategy, a plan to maximize long-term profitability, until management has learned how to balance these opposing forces strategically. Thus one purpose of this article is to suggest how managers can break the tactical pricing deadlock and make the pricing decision process more strategic. A second purpose is to develop contribution-based pricing procedures that allow managers to determine “optimal” pricing without using highly technical formulas and without having to precisely define a demand function.

An Integrated Approach to Pricing

As representatives of their respective stakeholders, the finance-accounting and marketing-sales functions have legitimate concerns with regard to pricing policy. The problem is that these concerns are often addressed in functional isolation, and they are decided by whichever functional group wields the most political control.