Persistent inflation is forcing every local business to raise prices. Learn the best techniques for finding and setting the ideal price point for each product.

There’s a “perfect storm” of issues causing an increase in costs: rising wholesale prices, disrupted supply chains, increasing wages, rising rents, etc. Small businesses must raise prices, but the big question is how to do it most effectively.

The good news is that consumers expect price increases right now, so it’s a good time to reassess the pricing of your products. The bad news is that most business owners just increase prices to match their increased costs — not realizing consumers are more price-sensitive for some products than others. If your costs rise by 10%, you might be able to raise some prices by 20%, some by 10%, and some not at all. For this last group of products, you might need to discontinue or rework them to reduce your costs.

Measuring Price Sensitivity

The best way to understand price sensitivity is to watch and learn from the results of each price increase (or decrease). Customers’ responses provide great insight into how price-sensitive they are and their tolerance for future increases. There can be a wide range of outcomes:

Graph showing a price increase and the resulting impact on sales
  • They completely stop buying the product and switch to a competitor (very high price sensitivity, low loyalty).
  • They switch to a lower-cost alternative that you offer (high price sensitivity, high loyalty).
  • They keep buying the product but reduce the quantity purchased (high price sensitivity, high loyalty).
  • They buy the product at the same rate (no price sensitivity).
  • They buy even more of the product (increased perceived value).

The metrics to watch (after adjusting for seasonality) include:

  • Sales of the product. Ideally, sales will increase by the same percentage as the price increase (indicating zero price sensitivity), but this is uncommon. Any increase in sales should be considered a win because the product is more profitable after the price increase.
  • Sales of alternative products. Customers may switch to lower-priced alternatives, such as switching from a latte to a brewed coffee. This is typically a bad outcome, as the alternative products often have lower margins. This is why you should always raise prices across a category of products at the same time (see below).
  • Order size. A declining order size indicates customers are switching to lower-priced alternatives or reducing the quantity purchased. The overall increase or decrease in order size is a good indicator of price sensitivity.
  • Items per order. Similarly, this metric indicates whether customers are responding to a price increase by buying fewer items.
  • Profits. This is the ultimate measure of success, as the primary reason to raise prices is to improve profitability.

After doing this analysis across hundreds of local businesses, here are the primary lessons learned:

Lesson #1: Adjust Prices by Location

Using the Price Change Analysis feature of the Sprk™ app, it’s easy to see how the same price increase for the same product across two different locations can have significantly different results.

Price change analysis showing significantly different results between locations

In one location, there was no price sensitivity, as the units sold actually increased after the price increase. In the other location, however, units sold dropped significantly. The differences are typically not this extreme, but they can be at times.

This occurs because the demographics are often different for each location. Or, there may be more competition for the business or specific products in one location than another.

The bottom line is that prices need to be set by location rather than assuming customers in all locations will respond the same to a price increase.

Lesson #2: Both Amount and Frequency Matters

Analysis of price increases relative to inflation

If you’ve been slow to raise prices (as in the example shown), you may feel compelled to raise them quickly and significantly. However, to reduce the risk of a negative impact on your business, carefully consider the amount and frequency of each increase.

Customers need a chance to acclimate to each price increase. Even if your prices are well below those of competitors, loyal customers will still compare your new prices to your old ones — not just your new prices to your competitor’s current prices. In these situations, it’s better to increase prices multiple times but in smaller increments each time to allow your customers to mentally adjust to your new prices.

The frequency of updates is also important to consider. Some businesses choose to make many small price increases rather than fewer larger ones. The logic behind this approach is to increase prices so incrementally that no one notices, but the risk is creating the perception that you raise prices every time they visit.

Lesson #3: Increase Prices by Category

To avoid the risk of customers switching to lower-priced options, raise prices for all products in a category. This way, the price difference between each option (such as small, medium and large sizes) stays relatively equal. If you just raise the price of the large size, for example, you’re just encouraging customers to buy the small or medium size — not just because they’re cheaper, but because now they’re much cheaper relative to the large size.

Similarly, if a bakery sells both cupcakes and cookies, it’s best to raise both prices simultaneously to avoid encouraging customers to switch to the products without a price increase.

Lesson #4: Price Based on Perceived Value

Local businesses tend to raise prices in line with increases in their costs. Customers, however, don’t know or care about your costs. They only care about the value they perceive your product provides them.

You obviously need to price your products to provide a good profit margin, but you will be able to raise your prices beyond that point for some products. A “cost-plus” pricing strategy can identify the minimum price acceptable to your business, but don’t assume that it is always aligned with your customers’ perceived value.

Measuring price sensitivity is the best way to identify perceived value. If you raise a product price and it has no impact on units sold, there may be an opportunity to increase the price further — even if your cost remains stable for that product.

Lesson #5: Differentiate or Discontinue

To follow up on the previous lesson, it’s important to find ways to differentiate products to allow further price increases. If this isn’t possible, you may need to discontinue products that fall below the necessary profit margin.

For example, let’s say customers indicate they’re not willing to pay more for a bakery’s cupcakes. The bakery should consider ways to differentiate its cupcakes, such as adding a Hershey Kiss to the top of the chocolate cupcakes or adding seasonal decorations to them. A $0.05 increase in per-unit cost might allow a $0.50 increase in price because of the change in perceived value.

You may need to discontinue products that don’t have an acceptable profit margin and cannot be differentiated. There is room for some lower-margin products (loss leaders) if they can attract customers who also buy higher-margin products, but having too many of them is not sustainable. Cut your losses if the perceived value of a product falls below your cost-plus price minimum.

Next Steps

It’s not easy to predict a price increase’s impact on product sales. Every situation is different and presents an interesting opportunity to learn more about your customers.

By using analytics to measure the impact of each price change, you can start to see which products/categories have the most price sensitivity. You’ll get a better feel for how often you can increase prices and by how much. You’ll also have the opportunity to reverse a change if you see an immediate catastrophic drop in sales as a result of a poorly received price increase.

Next Up: Optimizing Store Hours: 7 Tips for Finding the Ideal Hours

All screenshots are taken from Sprk™ using either fictitious data for illustrative purposes or real data used with permission.