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With efficient processes at full tilt, smart companies tailor prices to customers.
Cathy Lazere, CFO Magazine
April 1, 1998
In times of double-digit profit growth, companies seldom challenge a conventional approach to pricing. Apart from weighing costs and the importance of retaining favored customers, what else counts? But good times do not last forever. As companies grope for ways to sustain revenues through less bountiful economic times, some are emphasizing a more elusive factor in the pricing equation: the value that goods and services represent to customers.
It stands to reason that if the cost of goods and services exceeds the value to customers, then a company is probably in the wrong business. But if the value exceeds the cost, as it should, why let costs govern prices? Instead, say experts, value to customers should determine the prices they pay.
"The primary input into your pricing process should be the value that people place on your product," says Robert J. Dolan, professor of business administration at Harvard Business School, in Cambridge, Massachusetts. "Cost-based pricing never worked very well," agrees George Cressman, a consultant in the marketing development group at DuPont, the Wilmington, Delaware-based chemical, energy, and life science company. "Customers buy because you deliver value to them, not because of your cost structure. If anyone is going to succeed with a good pricing scheme, it has to be value-based. Clearly, various customers see the offering differently. So you can charge preferential prices based on the value you deliver to that customer," he says.
In some industries, the trend is more advanced. Airlines pioneered so-called yield management by charging different prices for passengers according to when they fly and how long they stay over, irrespective of costs. It's not uncommon these days for passengers seated next to each other to have paid vastly different fares. Hotels and car-rental companies have followed suit. In other areas with low margin, such as durable goods, companies turn to preferential pricing out of necessity. "Those companies in narrow-margin businesses feel the pain of bad pricing and the benefits of good pricing," says Sameer Dholakia, director of pricing solutions for Austin, Texas-based Trilogy. "Where it's hard to differentiate products, as in the tire industry, companies are leveraging pricing to the hilt."
Whatever label a company uses, charging customers different prices appears to make good sense. Each customer is unique. Each has a different set of needs, costs, and values that affect its price sensitivity and, ultimately, a supplier's bottom line. The U.S. power generation division of Asea Brown Bovari Ltd. (ABB) develops different pricing structures based on customers' needs and then works with those customers to address their needs. "We look at which customers will survive and prosper," says Jeff Fischer, the division's director of business development.
Fischer's division has established alliances and partnerships with customers that are utilities and municipalities. "The best way [to determine a price] is to look at their costs in the market and where they fit in the basic supply and demand scenario of a commodity market," he says. ABB then "looks at those customers to find ways of increasing their profitability. We let them reach into our organization without the cost of overhead and strip out S&A, contingency, and warranty costs."
ANOTHER TRICK Trim companies can cut costs only so far. "Everyone has driven costs out of their business. We've grown profitability through that trick; now we've got to come up with another trick. CFOs should view pricing as a major pillar of growing revenues as we move toward the millennium," says Marty Mayer of Mayer Associates, a consulting firm in Dedham, Massachusetts, that advises corporate clients about pricing.
A climate that favors preferential pricing completely reverses conventional approaches to pricing. "Ten years ago, 80 percent of customers bought at the standard price that fit a universal price program," says Michael V. Marn, director of pricing services at McKinsey & Co. in Cleveland. "Twenty percent of the volume was on an exception basis--very big or special customers were cut a special deal. Now the balance has shifted exactly the other way. Twenty percent of the volume is off the standard price list and 80 percent is sold on some special deal. It's an important trend," Marn notes.
Three overarching factors are fueling the trend:
Companies that are most successful with preferential pricing set discrete price ranges within which their salespeople can negotiate, but they also make sure their incentive system follows the logic of the pricing decisions. A good example is Xerox, the Rochester, New York-based document services company, which has been a leader in what they call "range pricing." "There has been flexibility at Xerox for a long time," comments Alan Pariser, vice president of U.S. customer operations pricing. "Over the past 10 years, it has been mechanized and combined with the order-entry process."
It is common practice in the copier industry for manufacturers to sell to dealers and dealers to negotiate with end-users. Xerox, however, employs a direct sales force that sells directly to end-users. "Before our system was in place, we didn't have a good way to give salespeople a degree of latitude in price," notes Pariser. "So we developed a system that gives the salespeople limited ability to grant discounts based on special situations."
Special situations include temporary promotions to dispose of surplus products and aggressive geographic promotions in particular regions. There is also latitude granted for trade-ins, packaged financing, and leasing rates. "It's negotiation within boundaries-- that's why it's called 'range pricing,'" notes Pariser.
Xerox sells a variety of copiers to businesses through a direct sales force. Models range in price from $2,000 to $350,000. Discounts range from 15 percent to 20 percent. Larger customers sign contracts with Xerox. "The principle is that every large deal stands by itself and must be profitable," says Pariser. "That doesn't mean we make the same margin on every deal. For small deals, the issue is, How do you take costs out of the business? The challenge is to expand our coverage through telemarketing, Web sales, and techniques other than direct sales."
Salespeople are reined in by discount guidelines, as well as by oversight by district sales managers and controllers, especially for the larger deals. A crucial part of Xerox's success has been its incentive program. Salespeople are compensated not by unit sales, but by revenues. "They're paid to sell more and get the highest price they can within the guidelines," says Pariser. "CFOs should learn that on the marketing and sales side, they need to have some room for negotiation, but it should be linked to sales compensation to maximize price, revenue, and profit to the company."
Companies that sell business-to-business usually have an easier time with preferential pricing than companies that sell to consumers. "Banks are in the Dark Ages regarding pricing based on the economics and behavior of [retail] customers. They're leaving a lot of money on the table. By getting pricing right, financial service firms can increase their margins from 25 percent to 50 percent," says Jeffrey S. Infusino, a vice president with Mercer Management Consulting Inc. in New York. "CFOs are missing out on an opportunity to help their institutions. Marketing people are not looking at the whole P&L and individual customer behavior. It's an opportunity for CFO and marketing to partner," he adds.
To implement preferential pricing, retailers and financial service firms must do more than change existing mind sets. Beyond reams of their own product data, they need to consider the whims and price sensitivities of millions of potential customers, a task far more daunting than consulting with a sales force about the value of the product to a few hundred distributors.
Companies that implement preferential pricing should proceed with caution, paying close attention to coordination of systems, market, legal, and incentive issues. By targeting the right customer base, test pricing if possible on a select sample, and monitoring what the competition is doing, companies can avert unrealistic prices that harm revenues. "Make preliminary selections of customers you want to target. Understand the customer's business. Know your customer's business as well as your own," suggests George Cressman of DuPont.
Setting the right price can soften or even avert adverse market reaction to price changes. "Cutting the price for a premium product can be just as dangerous as overpricing," warns Mercer's Infusino. A name brand's market share could be eroded, for example, by incentives that are too generous.
One major issue is how much authority to give the sales force. Should control be centralized or decentralized? What range should salespeople be given? How do you keep checks and balances in place? And how should you provide incentives to the sales force to avoid excessive discounts that eat away your profit margins?
DuPont, for example, keeps a tight, centralized lid on pricing. "If you grant the field pricing authority, you always end up at the bottom of the range. When push comes to shove, if the salespeople have the ability to manipulate the price, our experience is that they will," warns Cressman.
The specter of litigation also haunts the issue of preferential pricing, which, by nature, discriminates in favor of certain customers. These fears are exaggerated, according to Sachnoff & Weaver's Zelek. "It's a fact of life that marketplace pressures are leading to account-specific pricing," he explains. "Some companies don't want to do it if they can avoid it. It's not riskless. If done carefully, there's a great deal of flexibility."
The potential cry of discrimination if different prices are charged to different customers can be mitigated if the discount is open to all comers. "There is no discrimination if the reason for the difference in price is based on something available to almost all customers, such as a prompt-payment discount," explains Zelek.
Rigors of competition also supply a credible defense against disgruntled ex-customers. If industry practice mandates price differentiation, you're off the hook. "You need to price differentiate in order to remain competitive," suggests Zelek.
Cathy Lazere is a freelance writer specializing in corporate finance.
A MEASURE FOR MEASURES
VWR IMPROVES PRICING WITHOUT BOOSTING PRICES
------------------------------------------------------------------------ -------------------- Customized pricing is a key strategic competitive issue for us," says David Bronson, CFO of VWR Scientific Products Inc., a $1.2 billion laboratory equipment and supply company in West Chester, Pennsylvania, whose customers include major pharmaceutical companies, industrial laboratories, and microelectronics firms.
Ten years ago, VWR and others in the lab-equipment industry faced an oversupply of capacity. To become more competitive, VWR established partnerships that allow customers to outsource their purchasing function to VWR. "We became very much integrated with our customers," says Bronson. "The pricing reflects the addition of value-added services." These services help customers cut the cost of procurement, including order and inventory management and delivery.
The average infrastructure cost for VWR's customers was estimated at $130 per order. Large customers might place 150 to 250 orders per day. "To the extent we reduced that $130 down to $20 or $30 is more important to them than the price they're actually paying for a beaker," says Bronson. Besides beakers, test tubes, and other means to measure liquids in laboratories, VWR distributes products ranging from glassware to lab chemicals.
VWR's sales organization has latitude in pricing but is closely monitored by the finance function. "This is a thin-margin industry," notes Bronson. "A tenth of a point is meaningful. We look at that on a day-to-day basis."
VWR bases its field sales incentives on achievement of gross margin quotas. The company has five call centers where a pricing management function keeps contracts current and accurate.
For its own purchasing managers, VWR imposes controls and performance measurements similar to those for its sales reps. VWR negotiated annual supplier price increases in place of more frequent ad hoc increases. Annual increases enable the company to manage margins and price changes to their own customers more effectively. In addition, standardized EDI makes supplier relations more efficient and less costly.
Bronson's advice to other CFOs: "Get involved in the controls built into the systems and controls built into the management of pricing. Have a feedback mechanism that can give you assurance on a daily basis that margins are being managed closely. Once you give away some margin, it's very difficult to get it back from the customer." --C.L.
TOOLS OF THE TRADE
Effective software holds the key to preferential pricing
------------------------------------------------------------------------ -------------------- Companies can't switch on preferential pricing and leave the room. It's an ongoing process. "When I was a CFO, I knew a lot about what was going on when the initial price was set, " notes pricing consultant Marty Mayer of Mayer Associates. "But CFOs lose sight after the initial price is approved. The revenue stream starts to come in, and they accept it as OK."
In this ever-changing scenario, good software systems are critical. Incomplete data can cause bureaucratic headaches, even catastrophes. "The finance group gets stuck with hundreds of disputes involving special discounts," notes Sameer Dholakia, director of pricing solutions for Trilogy, an Austin, Texas-based software firm. "Pricing errors hit the finance department and can amount to as much as 1 percent of revenue."
To prevent such errors, Dholakia recommends pricing software systems with four essential features: