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Price strategy is emerging as the most important resource for companies to increase their competitive advantage. The vast majority of companies have spent years achieving gains through cost cutting, outsourcing, process re-engineering and the adoption of innovative technologies. However, the incremental benefits from these important activities are diminishing, and companies need to look at other areas to improve their business results. Today, companies are looking to serve well-defined market segments with specialized products, messages, product variants and services, and to earn superior profit margins while doing so. Savvy companies are implementing price optimization schemes and focusing on building their organization to serve their most profitable customers. Many are even “firing” customers who are unprofitable. All too many companies, however, use simplistic pricing processes and cannot even identify their most profitable customers or customer segments. This lack of information means that all too many management teams have their sales staff focusing the bulk of their time servicing the least profitable of their customers. Some companies even embrace policies and pricing strategies that drive away their best customers, and then they wonder why their profits are not growing. In the course of our engagements, we have seen examples of good and bad pricing policies. The following is a list of ten of the most common mistakes companies make when pricing their products and services.
Mistake #1: Companies base their prices on their costs, not their customers’ perceptions of value.
Prices based on costs invariably lead to one of the following two scenarios: (1) if the price is higher than the customers’ perceived value the cost of sales goes up, discounting increases, sales cycles are prolonged and profits suffer; (2) if the price is lower than the customers’ perceived value, sales are brisk, but companies are leaving money on the table, and therefore are not maximizing their profit. Costs are only relevant in the pricing process because they establish a lower boundary for the price. In certain circumstances, there are strategic reasons a company may decide to sell a product below its cost for a period of time, or to a certain market segment as a “loss leader.” However, when a price is set according to the perceived value of the product or service, sales are brisk, and profits are maximized.
Mistake #2: Companies base their prices on “the marketplace.”
The marketplace is often cited as the “wisdom of the crowds,” the collective judgment of the value of a product. But by resorting to “marketplace pricing,” companies accept the commoditization of their product or service. Marketplace pricing is a resting place for companies that have given up, where profits end up being thin. Instead of giving up, these management teams must find ways to differentiate their products or services so as to create additional value for specific market segments. The marketplace is full of companies that have managed to drag themselves out of commoditization and establish a unique value proposition. They have then gone on to capture that unique value at prices higher than those of “the marketplace.” The best-known case of reverse commoditization is Starbucks in its early days. By rethinking the entire experience consumers engage when they consume a cup, the company has produced prodigious growth and outsized profits. A Starbucks cup of coffee delivers a unique value proposition that engages millions of consumers daily (including this author!), and they happily pay $3.00 to $4.95 for what used to be a nightynine-cent cup of coffee. More recently, Starbucks has surrendered its vision of innovation supporting premium prices. It has allowed other companies to encroach on its claim of superior taste and a better experience. It has begun to count on price cutting as its primary mechanism for creating customer value.
Mistake #3: Companies attempt to achieve the same profit margin across different product lines.
Some financial strategies support a drive for uniformity, and companies try to achieve identical profit margins for disparate product lines. The iron law of pricing is that different customers will assign different values to identical products. For any single product, profit is optimized when the price reflects the customer’s willingness to pay. This willingness to pay is a reflection of his or her perception of value of that product, and the profit margin in another product line is completely irrelevant.
Mistake #4: Companies fail to segment their customers.
Customer segments are differentiated by the customers’ different requirements for your product. The value proposition for any product or service is different in different market segments, and the price strategy must reflect that difference. Your price realization strategy should include options that tailor your product, packaging, delivery options, marketing message and your pricing structure to particular customer segments, in order to capture the additional value created for these segments. An innovative software company priced their desktop version at $79.00 per seat, a figure that “felt right” for the executive team. Sales stagnated. Research showed that there were two distinct market segments: consumers and professionals. The $79.00 price was too high for the consumers who were interested in purchasing the product, and too low for the professionals. It communicated “not a serious tool” for the professionals who were interested in its value proposition. As a result of this research, the company decided to focus on the professional marketplace, and raised the price to $129.00. Sales soared.
Mistake #5: Companies hold prices at the same level for too long, ignoring changes in costs, competitive environment and in customers’ preferences.
While we don’t advocate changing prices every day, the fact is that most companies fear the uproar of a price change and put it off as long as possible. Savvy companies accustom their customers and their sales forces to frequent price changes. The process of keeping customers informed of price changes can, in reality, be a component of good customer service. Marketplaces change radically in a short period of time. It is important to recognize that the value proposition of your products changes along with changes in the marketplace, and you must adjust your pricing to reflect these changes.
Mistake #6: Companies often incentivize their salespeople on unis sold or revenue generated, rather than on profits.
Volume-based sales incentives create a drain on profits when salespeople are compensated to push volume, even at the lowest possible price. This mistake is especially costly when salespeople have the authority to negotiate discounts. They will almost always leave money on the table by: (1) selling lower priced products, and (2) dropping prices to “clinch the deal.” When their “job” is to get the deal, regardless of profitability, salespeople will do exactly that. And, as a result, your profitability will diminish. Companies need to redefine the salesperson’s “job” as maximizing profitability, and incentivize profitability, while also providing the salespeople the necessary “tools” to do so. These tools include information on profitability on each of the products your company sells, strict control of the awarding of discounts, and alternative choices and configurations to enable the salesperson to manage the inevitable negotiation about price.
Mistake #7: Companies change prices without forecasting competitors’ reactions.
Any change in your prices will cause a reaction by your competitors. Smart companies know enough about their competitors to forecast their reactions, and prepare for them. This avoids costly price wars that can destroy the profitability of an entire industry. Savvy companies understand that any significant lowering of your price – which may drive increases in volume – will provoke a reaction from your competitors.
Mistake #8: Companies spend insufficient resources managing their pricing practices..
There are three basic variables in a company’s profit calculation: cost, sales volume and price. Most management teams are comfortable working on cost reduction initiatives, and they have some level of confidence in growing their sales volume. But good price setting practices is seen as a “black art.” Consequently, many companies resort to simplistic price procedures, while the same companies use highly sophisticated procedures and technologies to track and control their costs in minute detail and in real time. Likewise, companies may confidently forecast what effect marketing campaigns and “the number of feet on the street” have on sales volume. Managers feel comfortable with these two hard data sets. Therefore, they spend nearly all their time on the issues of sales volume growth and cost control, overlooking the vital role of pricing strategy. They erroneously believe that pricing is not important, or that hard data and rigorous methods are not available to enable them to control pricing. In fact pricing is of outmost importance, and a key element of the marketing mix. Good pricing strategies use hard data generated by modern methods such as Value Attribute Positioning, Conjoint Analysis or Van Westendorp’s Price Sensitivity Meter, to generate accurate hard data on the perceived value of a product or service, thereby enabling mangers to maximize their profits by optimizing their prices.
Mistake #9: Companies fail to establish internal procedures to optimize prices.
In some companies, the hastily-called “price meeting” has become a regular occurrence-a last-minute meeting to set the final price for a new product or service, or a semi-regular review of the company’s price list. The attendees are often unprepared, and research is limited to a few salespeople’s anecdotes, perhaps a competitor’s last year’s price list, and a financial officer’s careful calculation of the product’s cost structure across a variety of assumptions. A more productive approach to price optimization requires data, analysis and discipline. These are the same ingredients that drove the cost-cutting success of the 1980’s and 1990’s, when companies systematically studied, reviewed and re-engineered their processes to eliminate redundancy and to reduce costs and cycle times. Price optimization requires, and deserves, the same level of attention and support.
Mistake #10: Companies spend most of their time serving their least profitable customers.
Most companies do not even know who their most profitable customers are. While 80% of a company’s profits generally come from 20% of its customers, a careful review of the data often will show surprises, since a company’s largest customers are often only marginally profitable. Failure to identify and focus on their most profitable customers leaves companies undefended against wIier competitors. Such failure also deprives the company of the loyalty that more attention and better service would provide. It can also mean that the company cannot actively seek out more profitable customers because they identified or profiled them. These companies base their decisions on anecdotes, stories, whispers and hearsay rather than hard data about customers and competitors.
The optimization of pricing strategy is as important as the management of costs and the growth of sales volume. Since most companies have never done it, rigorous price optimization has emerged as an important source of competitive advantage and increased profitability. The iron law of pricing states that different customer’s will ascribe different values to your products and services. Savvy companies do the research to identify the various market segments they serve, and they re-engineer their marketing, packaging, and service operations to excel at meeting their needs. They use that research to align their prices with the value perceptions of their customers. In this way they win customer loyalty, lower costs of sales, and above all, enhanced profits.