The Art of Smarter Pricing

Some of your prices are too low. Some customers would pay more, and there are times and places where you could charge more. Of course none of your customers will tell you this, though they are all too ready and eager to tell you when your prices are too high.

In the meantime, your competitors harangue your customers with promises of lower prices, and besiege you with price wars. On a daily basis, the media challenge profitable businesses and train their audiences to be price-sensitive bargain hunters. All this price pressure is one way: downwards.

There is another way. This article is aimed in the other direction, helping to move your customers and your business upwards. It's all about commanding the right price, and the right price is, more than you would imagine possible, a higher one. This is smarter pricing.

THE IMPACT OF PRICING

Finding the smarter price has greater impact on market success than any other element. The case is long proven – in 1992 a McKinsey survey covered 2,483 companies and calculated that a successful 1% increase in prices improves operating profit by 11.1% – greatly exceeding the impact of a 1% improvement in fixed costs (+2.3%), volume (+3.3%) or even variable costs (+7.8%).

And a 2003 report by McKinsey suggested that 80–90% of poor pricing decisions featured under-pricing.

Finally, Mark Ritson, London Business School's assistant professor of marketing, pithily summarised the situation: 'Pricing is the worst managed of all marketing areas. How prices are decided is often a mixture of voodoo and bingo.'

Smarter pricing takes into account three perspectives: those of the company, the competitors and the customer. Steve Watson, writing in the Ashridge Journal (summer 2003) expressed it lucidly: 'Pricing decisions are made where the key pricing forces meet. This is the interface between the three main players: the buyer, the seller and the competitor.'

Too often, price setting is unbalanced, over-emphasising costs and competitors rather than considering all three forces. Smarter pricing takes into account all three forces and is an iterative process, informed by pricing research, pricing experience and good judgement for the future.

FIVE BEST PRACTICES FOR SMARTER PRICING

Five best practices can be identified that result in smarter pricing. Not always, but often, these smarter prices can be higher than the current figure.

Pricing Research

Customers seem unable to answer honestly the question: 'How much would you pay for this?' David W. Lyon's award-winning article, 'The Price is Right (or is it?)', published in Marketing Research (Winter 2002), states the obvious problem with this question. He writes, 'Hearing such a question, many respondents immediately shift into bargaining mode and produce opening offers that aren't even remotely reflective of what their real world behaviour would be.' Customers may hope to encourage price cuts or may simply be unable to admit to intangible reasons for paying more than a minimum. It is unwise to develop a strategy based on reactions to customers leveraging one supplier over another to get the best possible price. (see Figure 1)

Develop Pricing Strategies to Shape Profitable Customer Behaviour

In consumer markets, price promotions can damage long-term returns. Customers find it hard to pay regular prices after noting the promotional price. So they await the next promotion. Many B2B companies operate a flexible and responsive policy, lacking strict criteria for discounts. The big danger: customers learn that price resistance is rewarded with higher discounts. Good customers are incentivised to become bad customers! The answer: use smarter pricing to encourage customers to behave profitably.

• Develop price stairways. Determine clear price structures with volume and time conditions. If you must offer highly competitive base prices, then link these to tougher conditions. For example, industrial users of electricity can get very low prices if they sign up to interruptible supply contracts. How much better to go up the price stairway and receive secure supply.

• Be one step ahead. Falling prices of successive generations of electronic equipment give a perverse incentive to prospective customers to hold back until the price comes down. The Carphone Warehouse – one of the UK's leading retailers of mobile phones – overcomes this with the ultimate price promise. Ninety days after buying a mobile phone, the company's computer compares the price paid and the current price. If the price has fallen, a voucher for the difference will automatically be mailed to the buyer to be redeemed for a phone accessory or put towards a larger transaction. It is a pricing tool to encourage profitable behaviour. There is every reason to go ahead and buy today.

• Shape patterns of consumption. A 2002 Harvard Business School study found that the member paying $50 per month to join a health club is more likely to attend regularly (and renew their membership) than the person making a single annual payment of $600. The single payment member feels a need to get value for money and uses the club heavily initially until his drive to get value lessens. By contrast the member paying monthly has a regular reminder on their bank statement to continue working out. And regular users renew (Gourville, J. & Soman, D., 'Pricing and the Psychology of Consumption', Harvard Business Review, September 2002).

• Charge more to segments who gain greater value. A Lake District village needed a car park extension for visitors stopping by to photograph the view over its nearby lake. Rather than penalising locals and tourists alike, it devised an inverse pricing scale. With payment on exit, the longer you stayed the less you paid. Hence the visitors paid more, reflecting the full value of a photostop.

• Think creatively. At the Oriental City Food Court in north London, the cost of a self-service Chinese buffet meal is £15 per head. Uneaten food on your plate is charged at £5 per 200g. So diners take small portions and refill with dishes they enjoy. Good behaviour is supported by the pricing structure.

Differentiate From Value Players

Brand leaders expect challenger brands to compete at a price somewhere below their own – it is a conventional strategy. But today, deep discounters and disruptive innovators are opening up price chasms. The value players are on the march.Verdict research published in the Financial Times (16 July, 2005) shows that value retailers took 19.7% share of the UK clothing market in 2004 – up 60% from 1999. In Germany, hard discounters count their share of the grocery market at 40%.

However, competitors can fight back. JetBlue – launched in February 2000 in New York – does not offer the lowest air fares on the US market, yet succeeds through a benefit-led advertising message to consumers. It trades on such features as its in-flight comforts, 24 channels of DirecTV and industry-leading punctuality. In July 2005 JetBlue delivered its 18th consecutive quarter of profit and a 9.1% operating margin.

The answer is neither to cede nor attack on price. Rather it is to identify critical benefits that customers forego with the value player and to build a proposition based on these. Every value player takes away some benefits to fund its price platform. Identify what the customer will miss. Strengthen these benefits and stress their relevance to customers. Fight back on a benefit battlefield.

For some brands, innovation is the differentiating benefit. The special expertise of Vacuumschmelze, a leading global manufacturer of advance magnetic materials, lies in melting and forming tiny components from nickel, cobalt, silicon and boron. Its defence against lower-priced products rests in around 1,000 patents.

Emphasis on trust, reassurance and certainty is another differentiator. In the automotive market, a potential customer could sift through 50 marques, some of which are very competitively priced, but are not household names. There is a short cut: select a known and safe brand. Since 1974, the Volkswagen Golf has been such a brand. On average, 2,100 customers a day bought a Golf between 1974 and 2003, making it the top-selling model across Europe for most years.

Base Prices on 'Purchase Laboratory' Data

Purchase laboratory data are derived from actual customer behaviours to indicate what the market will bear. For a business-to-business example let us look at DHL, the global air express transportation company. Writing in Fast Company (March 2003), Charles Fishman describes the research conducted for DHL by the Texasbased pricing consultancy Zilliant.

Rather than trying to get the price right mathematically, Zilliant will look for the right price. It doesn't raise prices across the board by 5% and watch for customer defection, nor cut prices by 15% and hope for a 20% sales increase. Instead, the software runs numerous experiments, testing slightly changed prices on real customers. Zilliant tests a new price in a controlled way, measuring the response of cells of customers. Tests cover prices for all weights of package across 43 different markets. There are thousands of data points.

Specifically, the software measures customers who called, asked for a price and then did not ship – failed prices. These failed prices indicate the price ceiling. Lower prices calibrate the potential for volume increase. The results showed that DHL – with its strong international reputation – did not need to match lower-priced rivals UPS and Fedex. Hundreds of prices were changed. Some prices were lowered slightly, still maintaining a premium over competitors while gaining volume, revenue and profit.

Faced with no-frills rivals, leading brands can defend and grow sales without matching bottom-dollar prices. The smart strategy is to pick the right package of benefits, meeting customer needs like punctuality, innovation, responsiveness and reassurance. Best practice says you beat value players by matching better benefits with smarter prices.

Manage Price Increases Effectively, With Confidence

Companies are reluctant to announce price increases for three reasons: customers may protest or even reduce purchases; staff may be apprehensive in communicating and negotiating; and the news is likely to receive unfavourable media coverage. Many companies hope that quietly slipping in an increase with an anonymous press release will minimise resistance.

Although counter-intuitive, clear communication fronted by a senior person can achieve positive results. There is a benefit from confidently asserting that prices must rise, giving ample notice and a valid rationale. It is important to be able to demonstrate that you have taken costs out of internal systems before seeking increases. Bringing in new benefits to customers at the time of the price rise can reduce resistance. Transparent behaviour can also encourage competitors to respect the upward price movement and respond with their own increases.

Be scientific and specific. Where value is being delivered to customers with a strong customer surplus, increase prices boldly. Where the surplus is smaller, increase at a lower rate. Where customer resistance is well-founded, hold prices. Where value to customers has diminished, consider price reductions. Review segmentation for opportunities to increase margins through higher prices to less price-sensitive groups and to increase volumes from price-sensitive segments by lowering prices, where achievable without encouraging sales leakage between the segments. An across-the-board increase may be the wrong approach. Smart pricing is about capturing value.

It may even be possible to increase what customers pay without a formal price increase, through revisions to discount structure, introducing charges for minimum orders or urgent deliveries, and other techniques.

Measuring Pricing Effectiveness

If customers never tell you when they would have paid more, how might you spot opportunities for increasing prices? Conventional measures of pricing effectiveness cannot help. Using measures like volume sales growth and market share gains may result in prices that are too low. Measuring improvement in margin or contribution may risk sales volumes through over-pricing.

Best practice suggests there are five measures to consider.

1. Failed order rate or the 'look to book' ratio.

What proportion of potential customers who ask for a quotation go on to place the order? How many enquirers follow on to make the purchase? If the strike rate is close to 100% or rising rapidly, the price may be too low.

2. Sound of silence.

Customers will complain vociferously if prices are too high. Listen for the sound of silence. Few grumbles about price may suggest that prices are too low.

3. Switching rate.

The third key indicator is the switching rate. What percentage of last year's customers are not buying this year? How many existing customers have switched to other suppliers? If the churn rate of customers is declining, the price may be too low. If sales information by customer is not available, for example at a retailer, it can be possible to research sample groups of customers to establish this information at a macro level.

4. Market share movement.

If share is being gained from comparable competitors, then prices may be too low. An exception is where pricing is being deployed as part of a corporate aim to grow market share. In this instance the consistency of share growth is the indicator.

5. Fixed costs per unit sold.

Eugster, Kakkar and Roegner, writing in McKinsey Quarterly (Eugster, C., Kakkar, J. & Roegner, E.

'Bringing discipline to pricing', McKinsey Quarterly, 2000, 1), recommend this as a further way of assessing a market. They suggest that a decreasing fixed cost per unit sold is an indicator that prices may be too low. Conversely, an increasing fixed cost per unit sold could warn that prices are too high. In their view, lack of quick pricing or volume swings show that prices are at an optimal rate.

These are best practices, but it is important to say that success in pricing comes from considering a wide range of factors, and managing them carefully and consistently. It does not come from getting one big thing right.

You must combine customer insight, competitive context, a clear view of strategic aims and a solid knowledge of tools and techniques.

You need informed judgement. Not always, but often, this can result in customers paying higher prices.

Most of all, you need confidence in the product's ability to command a premium price justified by the value it provides to the customer. Paying a premium for your product is the greatest accolade a customer can award you. To earn that compliment you must deliver value. When you are confident in the value you are providing you can be sure of your prices: good medicine is never sold at discount.

Think smart.

This article featured in Market Leader, Spring 2006.

NOTES & EXHIBITS

FIGURE 1