This article By: George Cressman & Thom Nagle is one of PPS' favorites from its Pricing Advisor Newlsletter Archives
Pricing strategically involves managing customers' expectations to induce them to pay for the value they receive. Pricing strategy is the coordination of multiple activities to achieve a common
objective: profitable prices.
If managers think about pricing only when they must set a price, then pricing becomes a tactical exercise of matching price to customers' willingness to pay. When, however, managers think of pricing as a process of capturing value, then pricing strategy involves managing everything that raises willingness to pay closer to the value received.
Ultimately, prices must reflect customers' willingness to pay, but managers can change willingness to pay by manipulating the pricing environment. They can change willingness to pay via the price structure, the pricing process, or the value message communicated.
In a value-based price structure, prices change with the value delivered. While intuitively appealing, such structures are rare.
A printing company built its reputation on quality work with high levels of customer service. Despite this commitment, both the company and its customers thought of the product in terms of
units of printing, with services seen merely as "value-adds."
Because this company set prices for the commodity, but gave away the differentiating services, it was often on the defensive when a potential customer compared the company's bid for the same
print job with one from a less service-oriented competitor. As a result, the company's prices were beaten down in price negotiations. Despite a strong market share, its costs were high and its profits disappointing.
The solution to this company's problem was to determine which of its services added differentiating value for customers and then charge for those services separately. Once the company started thinking in terms of value, services that had been taken for granted became
sources of profit improvement. Offering customers a lower cost in return for accepting lower service forced customers either to acknowledge what they valued or to do without it. By unbundling service elements
and charging for them, the company became more price competitive for jobs requiring little added service, while recovering the costs and capturing the value of differentiation from customers who needed it.
Price structure can be made more value-based either by selecting price metrics that vary with value received, or by establishing segmentation fences that limit discounts only to those customers that get less value.
Price metrics are the units to which the price is applied.
Film distributors can choose to charge theaters a fixed charge per day, a daily charge based on the number of seats in the theater, or a percentage of the receipts earned from showing a film. They usually use the last because it better reflects the value to the theater owner of showing the film. Segmentation fences are criteria that customers must meet to qualify for discounts.
At movie theaters, the segmentation fences are usually based on age (with discounts for children under age 12 and for seniors), each of whom is assumed to be more price-sensitive. Segmentation fences work well for pricing services and when the segmentation criteria is
something verifiable, such as the buyer's age, legal status, or location of purchase. When the obvious segmentation criteria aren't easily verifiable, or when the product could be purchased by a buyer who qualified for a discount and resold to one who did not, segmentation fences break down.
In most cases, where fences alone prove inadequate to segment markets, successful pricers must develop metrics to track value. Finding segmentation fences and price metrics that more closely track with value can drive both more sales and margin. The trick is to find
metrics that allow prices to vary automatically, keeping customers in the "price=value" range. Not all value-based price metrics are related to the product or service delivered. Better metrics may be related to the customer. Software suppliers will send one disk to load on the company
server, but will charge for it based on the number of workstations on which the customer will use the software.
When value is affected by economic conditions in the buying firm's industry, a value metric may be tied to some objective measure of those conditions.
The key to creating a more profitable price structure is to study how segments differ in what drives value for them and what drives cost to serve them. The challenge then is to create a price structure with fences and metrics that automatically charges more when a sale creates more value for the buyer or predictably higher incremental costs for the seller.
The Pricing Process
A value-based price structure is not, by itself, sufficient for successful pricing. The process for setting price levels within that structure must also be proactive. Many companies have no formal process for making price changes or granting price exceptions. This creates conflict not only
within the firm, but also between the firm and customers who become aware of the inconsistency. One large consumer packaged-goods company uses objective criteria for establishing list prices.
The actual price, however, depends on how much each product manager decides to "price promote" the product-either to the consumer or to the trade. The tragedy of this process is that no one estimates the effect that discounting one brand is having on sales of the company's other brands. Consequently, the company often undermines its profitability by competing with itself.
Companies in B2B markets commonly have even more reactive pricing processes simply because, by selling directly, they can more easily get away with inconsistent rules. Many have eschewed fixed-price policies and strict criteria for discounting, relying instead on non-policies
that make any price negotiable so long as the sale meets some minimum profit criteria. By allowing these reactive, ad hoc decisions, managers often think their companies can respond more quickly to market conditions while limiting discounting to situations where competitive pressure makes it necessary.
Experience usually proves them wrong. To eliminate these perverse incentives, managers must create prices that customers perceive as
having integrity. That requires setting prices and discount levels proactively, by policy, not in reaction to individual customer misinformation and manipulation. The development of a fixed price policy must be centralized. This ensures consistency across customers who might cross-ship products or exchange information about prices. Ironically, centralization of pricing policy empowers the sales force to be more responsive in difficult negotiation.
Even when price structures reflect value and the pricing process forces customers to make price/value trade-offs, value based pricing will have limited success unless the company's marketing program effectively communicates the value. Buyers who are ignorant of the monetary value
of a firm's product and service differentiation generally tend to underestimate it.
The purpose of value communication is to raise uninformed buyers' willingness to pay to a level comparable to that of well-- informed buyers.
Value quantification is a good sales tool when buyers are facing extreme cost pressures and are, therefore, very focused on getting the most for their money. A packaged-goods manufacturer quantified the value to retailers of its product's fast turnover, thus justifying its higher wholesale price. A telecom company quantified the value of its superior
reliability by estimating the revenue loss to customers of interruptions in their data lines.
It's harder to communicate value when products are sold through distribution channels, unless the channel is willing and able to do the task. Otherwise, the seller's only direct contact with the buyer may be via a short, generic advertisement or the external information on the packaging. In such cases, value communication is more likely to be suggestive rather than precisely quantified.
Some end benefits resulting from the purchase or use of a product aren't readily quantifiable. Relating the purchase and use of the product to qualitative benefits can nonetheless effectively
influence customers' willingness to pay.
Keys to Success
Successful pricing depends on much more than simply selecting the right price level. Even when the level of price is justified by the value delivered, other elements of pricing strategy can undermine its viability. If price metrics don't track value, a significant share of customers will object and refuse to pay the price. It would be wrong to lower the price across the board, however, because many other customers may find the price totally justified by value received.
The challenge is to find a metric that tracks with differences in value or a fence that enables price discounts to stay targeted where needed to make the sale. If customers are always looking for discounts and withholding purchases until they get them, the problem may not be that the price is too high. It may be that customers have learned that price resistance is rewarded. The pricer's challenge, then, is not to figure out how much to discount; it's to reestablish price integrity.
If customers want a company's superior product or service, but consider the price premium too large, the problem may be one of customer perception rather than of economic reality.
The pricer's challenge then is to coordinate the company's advertising, sales, and distribution network to justify the price.
Although each of these appears as price resistance, changing price is not the most profitable solution for any of them. Successful pricing involves developing processes, structures, and communications that make value-based prices acceptable.