Do's And Don'ts In Pricing

Profitable companies use pricing lever to realize profits, while unprofitable companies rely on increasing sales volume.

There is a crisis in pricing. Every executive knows that a company's profits depend on only three variables: Price, Cost and Sales Volume. Yet, a recent study of 21,000 American CEO's conducted by Atenga, a price optimization firm in Calif., showed that while profitable companies use the pricing lever to plan and realize profits, unprofitable companies rely on increasing their sales volume. They pay almost no attention to their pricing.

For instance, a manufacturer of high-tech consumer goods once tried to focus their entire resources on increasing their sales volume. The sales force had pressured the management to drop the price of one of their main products from $3,200 to $2,800. They convinced the CEO that this would increase sales volume substantially and make up for the lost margin. But, this strategy completely failed and resulted in a 40% drop in sales volume for the product (and, of course, a greater drop in margin) because their customers associated the lower price with poorer quality. Plus, once the lower price had been established, the company could not just change it to the previous price. They had to develop an enhanced product to justify increasing the price again. It took the company more than a year and a half to recover.

As this company learned, there is no one solution to profitability. Had this company known the price elasticity of their main product and used more "reliable" data sources for their pricing decisions, they could have avoided this problem altogether.

Here are some of the basic do's and don'ts in pricing:

Do: Base pricing decisions on hard data. Companies need to understand at a detailed level the factors that drive their customers' purchase decisions. Many companies know reasonably well why customers buy their products, but rarely do they know why customers choose not to buy their product, what drives a customer to buy a competitor's product, or -- all too often -- not buy at all. Companies relying on anecdotes from the marketplace rarely have access to the true answers. When companies ask, "lost customers" why they chose a competitor, most customers will give them the easiest answer -- "You are too expensive so I bought the other instead."

Do: Develop a data model for making rational price decisions. Rigorously collect and analyze that data and use it to set price levels and to build price realization strategies.

Companies need to use hard data from objective 3rd party market research for their price decisions. They need to understand from this data what price drivers are important for their customers, what is their customer's willingness to pay, and what bundling and different pricing schemes will enable them to capture the maximum of that willingness to pay. They need to understand from the data why they are losing business and what they can do to un-commoditize their product, add more value and realize higher prices.

Don't rely on whimsy, "gut feelings" and anecdotes from the salespeople for pricing decisions. Companies should not trust that their sales and marketing people would feed them accurate, un-tainted data. They should find data sources that are more reliable.

Do: Leverage the Iron Law of Pricing: Different customers will value your products and services differently. Savvy companies look at their marketplace and identify their most profitable customer segments. They do cost-to-sell and cost-to-serve analysis, and they have processes and a single customer database with data tags that identify their marketplace's purchase and price drivers.

A company in the distribution chain recently needed to figure out what value both their customers and suppliers attributed to their distribution services. They approached a price consultancy firm for help and their research conclusively showed that the company would actually be able to double its prices. However, the CEO with more than 30 years in the business was skeptical about these findings. He said that he "knew" the market and knew what his customers would be willing to pay, so he decided to increase the price by only 25%. Nevertheless, the results were overwhelming. The company's sales volume went up 30% and the average sales cycle time went down 30% -- a result of a non-linear price elasticity curve. When the prices were increased, the customers attributed a higher value to the company's product, which made it easier for them to make purchase decisions. With the old price, customers thought it was "too cheap and cannot be any good."

Do: Find a segmentation scheme that works and apply it rigorously. Companies should tag every customer and every prospect with Market Segment tags, so all of their analyses can look at the costs, revenues, and rates of change and profits by market segment. They should be wary of shortcuts like SIC code, which are generally available, but rarely sufficient.

Once a company has a segmentation system in place, they should perform cost-to-sell and cost-to-serve analysis so they can identify which segments to grow. They should also build bundles of products and services that tailor their products to the precise needs of their targeted market segment. The bundles allow them to raise or lower prices in a given marketplace without changing their overall price list. They also allow companies to deliver targeted products and services.

Don't aggregate your data at too high a level. The important differences between groups of customers are the basis for substantially improving a company's profits. Companies should be sure their marketplace segmentation scheme is sufficiently detailed to allow them to uncover, understand and leverage the important differences in buying motivations, patterns and policies.

For example, a manufacturer of business-to-business products utilized five unconnected customer databases for their marketing, sales, customer support, shipping and finance departments. The company had anecdotal information on why they were successful, but their databases had no basis for building profitable market segments so they could only do general marketing and they had to set their prices to an "average." However, competitors with better targeting capabilities began to pick-off the most profitable segments. The competitor had substantially lower costs because they served only a few segments, but they had higher profits. This competitor constituted a serious threat to the company's customer market leadership.

Another classic example of this mistake is when an automobile manufacturer decided to sell their 4-wheel drive vehicles only in ZIP codes where snow was expected. Later market research revealed that the "coolness" of 4-wheel drive also made Florida and Southern California, locations with hardly any snowstorms, prime markets for these vehicles. But, had this company maintained sufficient data in their customer database and done research to define their market's buying preferences, they would have known this ahead of time.

All too many companies use simplistic pricing schemes and processes. They cannot identify their most profitable customers or customer segments. They do not know why customers buy or don't buy, and what they are willing to pay. Instead, they rely on stories and guesses.

This lack of hard information, or the guesswork that is the alternative, means that all too many management teams have their sales staff "shooting in the dark." Their marketing and sales efforts are inefficient and costly. Some companies even embrace policies and pricing strategies that drive away their best customers, and then their CEO wonders why their profits are not growing! The truth is, there is no one solution to profitability, but by following some of these basic do's and don'ts in pricing, companies can easily improve their business results.

Per Sjofors is founder and managing partner of Calif.-based Atenga, Inc. More information is available by calling (818) 887- 4970 or visiting www.atenga.com.

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