Relative Perceived Value
More generally, a price ceiling is a function of the relative perceived value that a product delivers in the marketplace.
Relative perceived value is centered on three fundamental premises:
(1) Customers buy products not for their features (e.g. Pentium chip) or their specific functionalities (e.g. pc processor speed), but rather for the perceived benefits that the products deliver. Features and functions - which are often the focus of product design specifications - are simply the 'envelop' for delivering the benefits that are desired by customers.
Customer perceptions are critically important! A product may meet objective performance criteria (i.e. validated by internal laboratory tests), but a company only 'gets credit' if the customers recognize (i.e. "perceive") that the product delivers the benefits.
(2) Similarly, potential customers make purchase decisions considering a product's perceived price. That is, how much a customer thinks that a product will cost them. These perceptions may or may not accurately reflect reality.
And, though rational buyers should consider a product's fully loaded lifetime cost, some may be swayed by simpler measures like shelf price, which may not be appropriately inclusive.
(3) Perceived value is a consolidated measure: either the difference between the perceived benefits that a product delivers and its perceived price, or the ratio of the perceived benefits and the perceived price.
As a ratio, value translates to "benefits per dollar", a standardized relative metric that enables comparison:
(a) Against a specific customer's requirements (e.g. not to pay more than a certain price)
(b) Across a set of reference products used explicitly or implicitly for perceptual benchmarking (e.g. this type of product should cost roughly this amount)
(c) Among substitutable products that may be directly or indirectly competitive. For example, Coke and Pepsi are directly competitive. Coke and bottled water are indirectly competitive (since both are beverages).
In the classic 3Cs framework, relative perceived value can be defined as:
A standardized measure of benefits to price (value), as perceived by customers, relative to comparable competitive products and a customer's specific buying criteria.
Relative perceived value sets the theoretical price ceiling for pricing decisions, and costs (plus minimum acceptable profits) set the price floor.
The actual price selected, while confined to the range between the floor and the ceiling, is specific to a company's strategic objectives (e.g. skim or penetrate) and the competitive landscape, which may limit the viability and sustainability of prices substantially above the floor since competitors may undercut prices and still earn acceptable profits.
Finding the "sweet spot" between the floor and the ceiling is critically important because of the impact of price leverage on profitability. Given a typical company's cost structure, a price increase of 1% can often generate a 10 to 15% increase in net income.