by Amy Fulford
CEOs often overlook the importance of pricing in generating attractive financial returns. Especially in recent years, companies have invested heavily in understanding and managing their costs. Of course, understanding and managing costs is important. However, many companies have hit – or, worse, crossed – the point of diminishing returns from cost cutting. Meanwhile, too few companies proactively manage pricing as a lever to improve profits.
The power of pricing
It only takes a quick look at the Profit Equation (Figure 1) to see that Price is the only variable that has a multiplier effect on profits. And, unlike Volume, Price can be impacted by management behavior. Another often overlooked aspect of the Profit Equation is that both aspects of Revenue – Price and Volume – are influenced by customer preferences and priorities. Yet, companies typically spend much more time understanding and cutting costs, rather than understanding customers and why they value certain products and services.
Back in 2004, research about pricing revealed that it can be the most powerful variable that impacts operating profit. The researchers evaluated the impact of a one percent improvement in four variables on operating profit. They built an “average income statement” from a composite of companies in the Global 1,200 index. Their analysis revealed that pricing can have a powerful impact on operating profit1 (Figure 2). Even if the impact on a specific company is not as significant as this example, a small improvement in pricing is likely to unlock value because pricing rarely is used as a tool to improve financial performance. Meanwhile, many companies have already achieved the maximum benefit from cost cutting – and some have cut costs to the detriment of the business.
Meanwhile, the researchers debunked a common myth espoused by CEOs: we’ll lower price and make it up in volume. The researchers looked at how much volume would have to increase to breakeven from a one percent reduction in price. They found that the “average” company needed to generate a 3.5 percent volume increase to breakeven from a one percent price reduction. Furthermore, the research revealed that the “maximum typical” volume increase resulting from a one percent price reduction is 1.7-1.8 percent – far short of the 3.5 percent increase needed to breakeven from the price reduction.2
Three levels of pricing
There are three different levels of pricing that companies should consider when evaluating their pricing opportunities:
- List Price is the published price that is visible to anyone. It represents the desired selling price.
- Invoice Price is the price that is negotiated with an individual customer. Often, the Invoice Price includes several negotiated discounts, and it may include upcharges for special services or accommodations, such as expedited freight or special packaging. Most often, the Invoice Price is less than the List Price.
- Pocket Price is the net amount a company collects for a given product. The Pocket Price is less than the Invoice Price because it accounts for the impacts of hidden discounts that companies allow after the sale. Extended accounts receivable terms and expedited freight that is not charged to the customer are examples of the hidden discounts.
Eliminating pricing mistakes requires making sure the List Price is as high as possible, while effectively managing the negotiation to Invoice Price and minimizing (or even eliminating) the hidden discounts that reduce the Pocket Price.
Three common pricing mistakes
Given the importance of pricing, it’s helpful to understand the most common pricing mistakes that companies make. Based on research conducted by enlight , the three most common pricing mistakes include the following:
1. Targeting the wrong customers by failing to understand the market dynamics that drive customers to purchase products. When targeting the wrong customers, companies do not understand who values their product the most or why they value it. The companies also don’t appreciate differences in what’s important to end users vs. influencers vs. channel partners. Companies make this mistake most often. In fact, 57 percent of the pricing mistakes found by enlight consist of targeting the wrong customers. Examples of this mistake include
- considering distributors or channel partners to be customers,
- emphasizing product attributes and benefits that are not important to customers and
- trying to be all things to all people instead of targeting specific customer segments.
When a company focuses on the wrong customers, its representatives often get feedback that the prices are too high because the customers don’t necessarily value what makes the products unique. However, if the company focuses on the customers that most value its products, those customers are often willing to pay higher prices because they understand the value they get in return.
2. Pricing too low by setting pricing without consideration for target customers and what they value. enlight‘s research revealed that pricing too low accounts for 33 percent of pricing mistakes. Typically, companies make this mistake because of one the following practices:
- cost-based or historically-based pricing methodologies
- customer-driven pricing methodologies
- volume-driven management
When a company prices its products too low, it obviously erodes the company’s financial performance by leaving money on the table with every transaction. Two possible negative impacts are more subtle and can have lasting impacts:
- Overinvestment: If the products are valued by customers and priced too low, the company creates a false sense of demand. Typically, when companies experience high demand, they invest in inventory and capacity (instead of simply raising price), which further erodes financial performance.
- Quality Problems: Eventually, the situation will create quality problems for the company. Either demand will be so high that the company cannot maintain quality and meet the high demand or the company will be forced to cut costs to improve financial performance, which will impact quality.
3. Pricing too high by also setting prices without consideration for target customers or what they value. enlight‘s research revealed that pricing too high only accounts for 10 percent of pricing mistakes, despite the fact that companies tend to worry that their products are overpriced. Typically, when a company prices its products too high, it must attract customers by heavily discounting prices.
When companies price their products too high, they make attractive profits on every transaction. However, customers are keenly aware of the value they get for their money, and once they conclude products are overpriced, they stop buying. Customers will remember that they were taken advantage of and will be reluctant to trust the company again.
Underlying causes and how to correct them
Understanding the types of pricing mistakes is important, but it’s equally important to understand the underlying causes of the mistakes. In enlight’s experience, there are three causes of pricing mistakes.
1. Setting the wrong initial price is a “one-time” decision that relates to a company’s pricing methodology and its target margins. Most typical pricing methodologies are flawed because they do not start by understanding the most important variables in setting price.
- Which customers value their products the most? Why?
- How much value do the products create for those customers?
The following are typical pricing methodologies employed by companies and the pitfalls of using them:
- Competitor-based pricing: based on actual or expected competitor pricing
Note: This methodology often is wrongly called market pricing.
It is a mistake to abdicate one of the most important (and potentially lucrative) decisions to a competitor.
- Customer-based pricing: based on specific guidance from customers
Note: This methodology also often is wrongly called market pricing.
Customers are focused on paying the lowest possible price. Customers will volunteer unrealistically low price guidance, especially in advance of a negotiation.
- Historical-based pricing: based on prior prices for similar products
Historical-based pricing is relatively arbitrary and often only continues the pricing mistakes of the past.
- Cost plus pricing: based on a markup over costs
The mechanics of cost-plus pricing often are flawed in one or more of the following ways:
- Using old cost standards
- Not correctly assigning some costs to individual products
- Ignoring some costs
- Setting low margin targets
Value pricing (often called market pricing) is the ideal methodology. Unfortunately, many companies view Value Pricing as too difficult and default to one of the other methodologies. Value Pricing requires that companies understand their collective customers well enough to set list prices based on the sum of the financial, functional and emotional value the customers enjoy when using the products.
2. Not effectively managing day-to-day pricing decisions is a dynamic problem that relates to negotiations with individual customers. Day-to-day pricing decisions often are flawed for one or more of the following reasons:
- inadequate value proposition
- no pricing rules
- no accountability
- insufficient or flawed data
- flawed incentives
Companies must establish the appropriate processes and polices to effectively manage day-to-day pricing decisions.
3. Allowing a disconnect between strategy and pricing is a common problem that goes unaddressed and leaves significant money on the table. Typically, strategy-pricing disconnects result when the company:
- competes on price instead of focusing on the value they create for customers,
- does not revamp operations to earn an attractive return at market prices or
- sends mixed signals and confuses customers.
There are three steps to correcting a strategy-pricing disconnect.
- Clearly define target customers and the value they get to determine the maximum possible price products can generate on a sustained basis. This step requires that companies understand and quantify the financial, functional and emotional value customers get from using the products and focus on the customers that value the products the most.
- Optimize the business model to ensure that the company can earn sufficient return at the prices that the products need to be offered. Companies must understand and optimize the factors that drive revenue and costs. Revenue drivers are the factors that cause a customer to purchase the product, influence whether the customer purchases one or 100 products at once and/or determine whether the customer is likely to be a repeat customer. Cost drivers are the costs that are necessary to successfully deliver the products that customers value.
- Align and reinforce the brand image to ensure the company sends consistent signals about who they are and why customers should buy from them. Communications, brochures and sales person interactions are examples of the signals companies send to customers. Of course, any marketing activity also constitutes signals. When the signals that a company sends are not aligned with its business strategy and with customer perception, it creates confusion that can erode price.
In conclusion, pricing is an incredibly powerful lever that typically is underutilized by companies. The most common pricing mistakes are either targeting the wrong customers or simply pricing too low. To correct these mistakes, take the following actions:
- Utilize a value-based pricing methodology to set the right initial price.
- Establish (and enforce) effective policies for managing day-to-day pricing decisions.
- Eliminate disconnects between a company’s business strategy and its product pricing.
- Michael V. Marn, Eric V. Roegner and Craig C. Zawada, The Price Advantage (Hoboken: John Wiley & Sons, 2004) 4-6.
- Michael V. Marn, Eric V. Roegner and Craig C. Zawada, The Price Advantage (Hoboken: John Wiley & Sons, 2004) 6-7.
Amy Fulford is the managing partner and founder of enlight , a Seattle, Washington-based boutique consulting firm. Before starting enlight, she was employed at The Boston Consulting Group, Alcoa Inc., Procter & Gamble and Huntington Bank. Fulford has worked in many industries and sectors, including transportation, building and construction, consumer products, financial services, distribution, manufacturing, nonprofit and professional services. Contact Fulford at [email protected] or www.enlightadvisors.com.