Adapted from Nagle, Hogan, and Zale’s The Strategy and Tactics of Pricing, 5th Ed., Chapter 1
Introduction
Many factors determine profitability:
- technology
- regulation
- market information
- consumer preferences
- relative costs
Pricing strategy must take these factors into account to match products with prices that will deliver value to customers and profits to suppliers.
Cost-Plus Pricing
Cost-plus pricing ensures that a fair return is made on every product after all costs are fully allocated. The problem is that in most industries it is impossible to determine a product’s unit cost before determining its price. Unit costs often change with volume because a significant portion of costs are fixed.
The Cost-Driven Death Spiral
To deal with this loop of price forces, cost-based pricers often assume a certain level of sales and work back to a price. However, if sales are lower than assumed, costs will be higher which would suggest an increase in price. If sales are higher than expected, unit costs will be lower and prices should be lower. Cost-plus pricing leads to overpricing in weak markets and underpricing in strong ones.
Managers should not use pricing to cover costs. Instead, they should ask whether a change in price will cause a change in revenue that is more than sufficient to offset a change in total fixed variable costs. When (change in revenue) – (change in variable costs) > 0, the firm is earning more revenue to cover its fixed costs, and vice versa.
Customer-Driven Pricing
This procedure follows the customer’s willingness-to-pay. However, this ignores the true value of the product and can undermine long-term profitability.
This strategy poses two major threats to long term profits. First, sophisticated buyers are rarely honest about how much they are actually willing to pay for a product. Once buyers learn that sellers’ prices are flexible, the buyers have a financial incentive to conceal information from and even mislead sellers. This undermines the salesperson’s ability to establish close relationships with customers and to understand their needs.
Second, the job of sales and marketing is not to sell at whatever price customers are currently willing to pay, but rather to raise customers’ willingness-to-pay to a level that reflects the product’s true value. Many companies underprice innovative products because potential customers are ignorant of the product’s value.
Instead, understand the value of the product to satisfied customers and communicate that value to others. Low pricing is never a substitute for an adequate marketing and sales effort.
Share-Driven Pricing
This policy allows pricing to be dictated by competitive conditions. Managers often believe that greater market share produces greater profit, but this may not be the case. Although price-cutting is usually the fastest way to achieve sales objectives, it is usually a poor financial decision. Because a price cut can be easily matched by competitors, it offers only a short-term advantage at the expense of permanently slimmer margins. Therefore, unless a company believes that its competitors cannot match a price cut, the long-term cost usually exceeds any short-term benefit.
The goal of pricing should be to find the combination of margin and market share that maximizes profitability over the long term. Strategic pricing requires making informed trade-offs between price and volume to maximize profits. Lowering prices may provide an opportunity to drive volume. If the change in incremental volume is large enough, a lower contribution margin can actually drive a higher total profit. Conversely, the economics of a price increase can also be compelling. For example, a product with a 30% contribution margin could lose up to 25% of its volume following a 10% price increase before resulting in lower profitability. Effective pricers must regularly evaluate the balance between profitability and market share.
What is Strategic Pricing?
For strategic pricing, the objective is profitability. This requires
- ensuring that products and services include just those features that customers are willing to pay for, without those that unnecessarily drive up cost by more than they add to value;
- translating the differentiated benefits of the product into customer perceptions of a fair price premium for those benefits;
- creativity in how you collect revenues so that customers who get more value from your differentiation pay more for it;
- varying price to use fixed costs optimally and discourage behavior that drives excessive service;
- building capabilities to mitigate the behavior of aggressive competitors.
Overall, effective pricing strategies are value-based, proactive, and profit-driven.
A good pricing strategy involves five distinct but very different sets of choice that build upon one another. The choices are represented in the pyramid below, with those in lower levels providing the necessary support for those above. Although the principles that underlie choices at each level are the same, implementing those principles in any given market requires creative application to the specifics of each product and market.
The Strategic Pricing Pyramid
Value Creation
It’s often said that the value of something is whatever someone will pay for it. However, people sometimes pay for things that soon disappoint them. They do not repeat the purchase and discourage others from making the same mistake. Of greater importance to innovators, most people are unwilling to pay more for things that are new to them.
The strategic approach is to show marketers how to create value cost-effectively and convince people to pay for that value.
Some companies fail to create value for customers. They sometimes make the mistake of believing that more technology is better for the customer. The following chart illustrates the flawed logic that leads many companies to produce good quality but poor value.
Alternative Approaches to Value Creation
Engineering and manufacturing teams design and make what they consider a “better” product, and in the process incur costs to add features. Finance then totals these costs to determine “target” prices. Only at this stage does marketing enter the process to begin the task of demonstrating enough value to justify the premium price. When these prices prove too high, managers may try to offer flexibility in the markups, which cuts into margins.
Solving this problem requires a complete reversal of the process. The price is based on the estimates of the value of features and services chosen to best serve the targeted market segment. The job of financial management is to insist that costs are incurred only to make products that can be priced profitably given their value to customers.
Price Structure
The most simple price structure is price per unit and is adequate for most commodity products and services. More complicated structures can be used to capture the best possible price from each segment, to make the sale at the lowest possible cost, or both.
Airlines are famous for their tiered price structures. A business traveler who needs to meet a client at a particular place and time gives more value to a seat than a pleasure traveler for whom different destinations and days of travel may be flexible. To attract price-sensitive pleasure travelers without discounting business travelers, they created a segmented price structure that allows passengers to pay a price according to the value they place on having a seat. For example, seats are charged differently by cabin class, boarding privileges, charges for rebooking or changes, and fees for checked bags. The airlines maximize the revenue from each flight by limiting the number of seats available at the discounted, non-cancellable prices to a number that they project could not be sold at higher prices.
More recently, airline price structures are being used to discourage behaviors that make some customers more costly to serve than others. For example, Ryanair offers highly discounted ticket prices, but charges customers for most service components. This includes charges for not printing out the boarding pass before the airport, checking bags, flying with babies, bringing a car seat or stroller, etc. In less than a decade, Ryanair has risen to first place among European airlines in passengers carried, in revenue growth, and in market capitalization.
Price and Value Communication
A successful pricing strategy must justify the prices charged in terms of the value of the benefits provided. The content of value messages will vary based on the type of product and the context of the purchase. The approach for frequently purchased search goods such as laundry detergent or personal care items will tend to focus on very specific points of differentiation to help customers make comparisons between alternatives. In contrast, messaging for more complex experience goods such as services or vacations will focus on assuring the customer that the offering will deliver on its value proposition if purchased. Similarly, value messages must account for whether the benefits are psychological or monetary in nature.
Price and value messages must be adapted for the customer’s purchase context. This requires understanding the customer’s values as well as where the customer is in their buying process. If customers are at the information search stage, the message should emphasize the most differentiated and value creating features so that he or she weighs these features heavily in the purchase decision. As the customer moves into the fulfillment stage, the message shifts from value to price as marketers try to frame their prices in the most favorable way possible. For example, a cellular provider may describe its price in terms of pennies a day rather than one flat fee. Reframing prices this way can have a significant positive effect on customer price sensitivity.
Ultimately, the marketer’s goal is to get the right message, to the right person, at the right point in the buying process.
Pricing Policy
Pricing policy refers to rules or habits that determine how a company varies its prices when faced with factors other than value and cost to serve that threaten its ability to achieve its objectives. Good policies enable a company to achieve its short-term objectives without causing customers, sales reps, and competitors to adapt their behavior in ways that undermine the volume or profitability of future sales. In other words, good policies enable prices to change along the demand curve without changing expectations in ways that cause the curve to shift negatively for future purchases.
Price Level
Price setting should be an iterative process. The first action is to set appropriate pricing objectives, whether that means to use price to drive volume or to maximize margins. The second action is to calculate price-volume trade-offs. A 10% price cut for a product with a 20% contribution margin would have to result in a 100% increase in sales to be profitable. The next activity is to estimate the likely customer response by assessing the drivers of price sensitivity that are unrelated to value. The marketer’s job is to understand how price sensitivity varies across segments to better estimate the profit impact of a potential pricing move.
Implementing the Pricing Strategy
Implementation is often difficult because it requires input and coordination across so many different functional areas: marketing, sales, inventory management, and finance. Success comes from three competencies: an effective organization, timely and accurate communication, and appropriately motivated management.
Additional KDC Articles
Pricing Strategies – a set of guiding questions for developing a pricing strategy
Everlasting Light Bulb – a case study of a pricing exercise for a new product
How to Raise Prices the Right Way – self-explanatory!
Coca-Cola – a mathematical exercise demonstrating the effect of price changes
K Does Cases 