Using Pricing as a Strategic Tool
Eric G. Mitchell
THE PRICING PROCESS
The following five factors should be considered when establishing a pricing strategy:
COMPETITION: Who is your competition? How many competitors do you have? The number of competitors you face can often be more important than who they are, especially when involved in a bidding process.
CUSTOMERS: Should you differentiate pricing according to customer class instead of service or product? This practice is more and more common as most businesses have several classes of customers, some of which are price-sensitive, while others are not.
FINANCIALS: What are your gross margins on products and services?
PERCEIVED VALUE: Do your customers perceive a difference between your services and those of your competition? If so, are they willing to pay for the difference you offer?
MARKETING OBJECTIVES: What are your primary and secondary objectives? Obviously, some of your objectives will conflict. It is your role as CEO to resolve these conflicts by determining and communicating primary and secondary objectives. You instinctively know which objectives are most important, but your people require constant direction to maintain their focus. In addition, quantify your objectives whenever possible.
CORNERSTONES OF PRICING PHILOSOPHY
WHEN SHOULD YOU RAISE PRICES? Deciding when to take prices up or down is one of the most fundamental pricing issues. Consider the following pricing scenario:
Case Study:
- Price: $100 per unit
- Profit: $5 per unit
- Gross margin: $50 (assuming total sales of 10 units per year)
If you raise the unit price, what effect will it have on sales? If you raise the price to $105, your profit becomes $10 per sale instead of $5. With this price increase your “A priority” break even point – sales you can afford to lose is 50%.
In this scenario, the price increase is a profitable action as long as you sell more than five units. Strategically, it may not be a wise choice if you lose customers, but from a profit standpoint, it is a positive step. If sales stay at 10 units, you will double profits. If sales sink down to seven units, profits will increase.
Disregarding other strategic considerations, a 5 % price increase on a low margin product creates a high affordability index (the room for error on sales impact). For example, with a gross margin of only 3%, you can afford to lose almost two-thirds of your sales and still break even.
If you have a very high margin product, the affordability index narrows considerably. Before you increase price on a high margin product, be certain it will not have a significant negative impact on sales.
Low margin products and services are the best candidates for price increase. Challenge your people to raise prices on your low margin products. The only acceptable grounds for a low price on a low margin product are strong negative reaction from your customer base or other key strategic considerations.
WHEN SHOULD YOU CUT PRICES? Cost cutting is also related to gross margins. Higher margins allow more flexibility in price reduction. For example, at a 10% price reduction, your 20% gross margin is reduced by half A salesperson would have to double sales to maintain current profit levels. However, a 10% reduction would take less of a cut out of a higher gross margin.
UNBUNDLING LOW MARGIN ACTIVITIES: If another business can make a higher margin on your low margin services, contract those services out. This will free assets from unprofitable activities and limit your management of the service to the vendor instead of several in-house employees.
REDUCING REVENUE LEAKS
Increasing profits is not just about raising prices. Plugging revenue leaks can serve as a source
of money and profits that won’t drive prices up. Common revenue leaks are:
INCENTIVES OR PRICING STRUCTURES THAT REWARD VOLUME OR QUANTITY BUYING: Change the volume requirement so the buying point is higher. This technique does not change the visible perception of the price, but it will raise revenues.
If you are getting hurt on small jobs, consider a minimum order or job size. Whether a customer buys one item or a large quantity, quantify the processing costs involved in the transaction. In businesses that involve bidding or contracts which require processing costs even if you lose the order, quantifying these costs is very important. Processing costs must be taken into account in your pricing structure.
Small and medium-size firms often don’t have a minimum order requirement. They think they are making big profits on items because they have decent profit margins. However, if they don’t take into account the processing costs, the profits are far less than they think.
FREE SPECIAL SERVICES, REPAIRS, DELIVERIES, ETC.: Unbundle these services to someone who can make decent margins. If you choose to keep these services in-house, establish a price for them even if you don’t charge. Identify and list all special services and set a target price for each of them. If you don’t charge the customer, appraise them as is the value of the service you are providing. Customers won’t put a value on your services; you need to do it for them.
UNCONTROLLABLE COSTS OR QuOTE PROCESS: Always try to include an escalation clause in the contract to cover these costs. Some customers will allow it and some will not, but if you don’t ask, you won’t get it.
PRICE INCREASE GUIDELINES
- When raising prices, give your customers a reasonable explanation that imparts a sense of fairness and remorse. Give them a detailed picture of the current situation: how much your costs have risen, how long it has been since you have raised prices, how much of the cost penalties you have already absorbed while trying to protect them from the increase, etc. If you blame your price increase on cost, you have a responsibility to your customer to identify those costs.
- Give your salespeople four to six weeks advance warning of a price increase. This allows them to bring business forward at the same price and help diffuse price increases.
- A major price increase is better than several incremental price hikes. Price increases are always distasteful; consolidate them as much as possible.
COMPETITION
Ask your sales people what is going on in the market; they are your best source of information about -your competitors. Role play with them to determine pricing trends.
Competitive intelligence, or gathering information–including pricing information–about competitors, is being widely practiced as industries enter rapid growth phases. Track the ways in which your competitors buy business, when they turn business down, and what their pricing strategy appears to be. Meet with your sales reps face-to-face or hold round table group meetings. This is the only effective way to gather information about your competitors.
Do not directly ask competitors what they charge. Instead, try to use suggestive statements or challenge them with incorrect statements. Their answer will usually tell you all you need to know.
SERVICE PRICING
Price your services based on the value of the service and what it is worth to different customers. Do not price according to the cost of raw materials. Although your employees would prefer a blanket price for all customers, you need to be as flexible as possible when pricing services for customer classes.
To gain market share in a service industry, concentrate on raising the perceived value and the quality of service. It is better to spend money to achieve this goal than to cut prices. Customers in the service sector do not respond to pricing weapons as well as they do to an increase in perceived value.
Set your prices high enough to allow your people to provide a very high quality of service. Consider the following techniques for identifying extra value:
- Bundling: Bundling adds easily identified value to the customer, but only adds incremental costs to your business. Remember, identify the extra value for the customer at all times.
Case Study:
A regional banking firm introduced a very successful marketing program that included three possible entry points and a bundle set. The three points of entry were:
- A $5,000 savings account
- A $15,000 certificate of deposit
- A $25,000 home equity line of credit
Meeting any one of these criteria allowed the customer to open a “crown” account. With that account, the customer received the following bundled services:
- Interest checking
- No charge for checks
- Free safety deposit box
- Free traveler’s checks
- One-half point off on loans
There is nothing overwhelmingly special about any one of these individual services, but as a bundle they are a very good deal. With the exception of the interest checking and the one-half point off on the loans, the bundle did not cost the bank anything.
With relationship customers, the key to bundling is to offer services that do not cost much. Make the entry points as non-discriminatory as possible in order to avoid limiting the definition of who can take advantage of the bundling. If you are an industrial manufacturer, create multiple entry points for your distributors. Include your long-term, very large, or rapidly growing distributors, if possible.
Create multiple definitions of a valued customer, then consider providing added incentives that won’t be too expensive. Incentives can include:
- Small product rebates at the end of a quarter
- Percentage points of slow movers
- Price cuts on certain items
- Extra percentage co-op allowances
- Customer seminars or distributor advisory councils
- Unbundling: mitigates the need to raise prices. If you feel uncomfortable with an increase, unbundling is a good place to start raising profits. Identify services you currently provide free of charge, create a price list for those services, and begin charging for them.
CUSTOMER GUIDELINES
Follow these guidelines for all customers:
- Know how your customers keep score: How do they budget? Do they budget for materials? Consumables? Capital budget? Does the purchasing manager get promoted based on a percent-off list discount? How does the purchasing manager score points with their boss?
- Danger signs: Raise the alarm when customers ask for your financials. This could be a precursor to discussions of your cost efficiency, productivity, etc. Also, beware when customers start calling you “partner.”
- When price is a problem: When the customer says price is a problem, try to pinpoint the problem. Find out how much is too much. Discuss each item to determine their limit on each one. Make the customer do the work. Make them tell you what is important to them, what specs they need, etc. They should tell you what their most important concerns are and whether you are overcoming those objections.
- Minimize the numbers: Teach your people the creative art of minimizing price differences. Emphasize the benefits customers receive from your services and downplay the costs.
NEW PRODUCT PRICING
- Skimming: Introduce a product at a relatively high price with low sales expectations. Skimming is a low risk, financially oriented process. However, skimming invites competition. Competitors can quickly and easily push into the market with imitations of your product.
Skimming can be successful for companies that make products on an isolated basis, without loyalty between their products. For example, a specialized software research house can enter the market, skim the price, transfer the risk to another engineering company, then get out of the business and move to a new product. Toy companies also skim because there is no loyalty between their products.
- Penetration Pricing: Penetration pricing is a strategy designed to capture market share. Introduce the product at a very low price. Base your price on what the unit price should be if everyone in the market bought the product at some point in the future.
Penetration pricing is sometimes considered dumping. The purpose is to get quick market penetration by taking price out of the equation. Price will not kill the new product. Although profits will be low, this strategy aggressively seeks market share. Some technologies need to get into the market first to have a fighting chance.
- Slide down pricing: Introduce the product at a high price and slide down the pricing scale incrementally as you sell more product. 4Ramping, a variation of slide down pricing, starts out very aggressively but cuts the price immediately. Slide down pricing is very popular because it involves less risk.
The electronics industry uses slide down pricing with emerging products to pick up market share at each introduction of new product technology. The strategy works well when the value or applications of the product improve each time you change the price. The key to success is not to lower your prices too quickly.
A QUICK LOOK AT THE BASICS OF ESTABLISHING
A PRICING POLICY
SET PRICES ACCORDING TO YOUR MARKET, CUSTOMER AND COMPETITIVE NEEDS: Do not set prices according to your costs or profit goals. Reasonable prices flourish when your product or service satisfies the market’s needs. Costs do not determine what your customers will pay; they simply establish a floor below which you cannot make a profit. When announcing price increases, avoid rationale based solely on cost increase. This rationale is no longer acceptable.
SHORT-TERM PRICING DECISIONS WITH A LONG-TERM PRICING PERSPECTIVE: Each pricing decision you make should be based on your company’s need for stability, controlled competition in key markets, and the loyalty of key and established customers.
FIND CREATIVE WAYS TO REWARD RETENTION: Make price structure a consideration for your key customers. In many businesses, 80% of sales come from 20% of the customers. Rewarding retention will insure that key accounts do not exert uncontrolled downward pressure on your margins.
WHEN IN DOUBT, START HIGH: Established and familiar products are more price sensitive than new products aimed at new markets. In general, customers will be willing to buy new products on the basis of their new technology, performance, capabilities and reliability. Price is often a secondary consideration.
COLLECT IMPORTANT PUBLIC INFORJWATLON ABOUT MAJOR COMPETITORS: Review trade publications; collect price lists of major competitors; spot check sales information from the sales staff; and interview personnel newly hired from competitors. Compile the information in a database and comparatively analyze it against your own price/product offerings.
WHEN POSSIBLE, SET INTERNAL TARGET PRICES: A review of costs, pricing history, competition and market trends will help you select target prices.
CONVEY TARGET PRICES TO YOUR SALESPEOPLE: If an account is important to your company, establish special pricing controls when you set a target price. For example, you may normally give sales managers discretion to drop up to 5% below your target price. On an important account, however, you may decide to approve all price concessions yourself.
DESIGN AND BUDGET FOR PROMOTIONAL PRLCJNG: Planned promotions should be designed to help improve market share without risking a competitive price retaliation; both the net economic effect and time span of a promotion should be reviewed with this objective in mind. Promotions should be dollar budgeted along with targeted sales (increase) objectives. Promotions can be rotated among products/product lines and tested geographically prior to a national roll-out. This strategy reduces the risk of giving away too much price in a promotion and allows for market feedback. Promotions will not cure inferior products. Therefore, a promotion program should be managed as a tactical device, not as a strategic tool for turnaround.