Price Fixing

With economic recovery on the horizon, it's time to revisit the wisdom of rock-bottom prices.
Vincent RyanDecember 1, 2009

Call it the year of the fire sale: Squeezed by an historic recession, U.S. companies have slashed prices more deeply and cut deals more often than at any time in the past 50 years. Microsoft reduced the price of software leasing by 26%, PepsiCo created new low-price beverages and snacks, and solar-panel manufacturers braced for a 20% drop in retail prices. Even makers of heart-rhythm devices, like St. Jude Medical, saw prices fall as hospitals demanded discounts on pacemakers and defibrillators.

In their rush to revive demand and win sales, many companies simply threw out the playbook on customer segmentation and product value. “Companies moved away from value-based pricing to being highly reactive to competitors and relying on cost-plus pricing,” says Jamie Rapperport, founder and executive vice president of software firm Vendavo. “Many companies took business as long as it was priced above variable cost, in an effort to help cover their fixed costs.” Often the price cuts went hand-in-hand with head-count reductions and other cost-cutting moves.

But cost-cutting goes only so far. Now, with the economy finally swinging upward and customer demand beginning to thaw, companies should reconsider what they charge for their products. Pricing, after all, is one of the most effective levers of profitability. “There’s nothing you can do as a company as quickly to improve profitability — and nothing you can do as quickly to destroy profitability — as change your pricing,” says Andre Weber, a partner at Simon-Kucher & Partners.

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It’s a delicate art, however. “Commercial price discipline is important,” says Robert M. Patterson, CFO of PolyOne, a maker of specialty polymers. “But you can’t simply raise prices every year to improve profitability. You have to innovate, innovate, innovate to expand margins, grow profits, and win new business.”

Signals of Distress

There are five signs that your pricing strategy might be due for an upgrade or overhaul, says Reed Holden, founder of Holden Advisors: (1) unit-sales volume growth slows down, (2) discounts fail to drive incremental volume, (3) competitors introduce new offerings, (4) lower-cost competitors enter the market, and (5) competitors start missing their numbers. (See “The Price Is Wrong” at the end of this article.)

Declining gross margins may count as a sixth sign. One CFO describes a situation at his company in which anemic gross margins posed an issue, and a flawed pricing model was to blame. Not only did salespeople set prices, they would “give” on price to generate business, since they were compensated on the quantity of product sold. In effect, the company was engaging in cost-plus pricing, but its salespeople were shrinking the “plus.” (See “The Many Minuses of Cost-Plus” at the end of this article.) “Any internal savings gained from raw-material cost reductions or plant and labor efficiencies were, by definition, passed along to the customer,” the CFO says.

The company shook things up in 2007. It gave the job of setting prices to marketing, changed the sales incentive to gross-margin improvement (based on each salesperson’s revenue contribution), and trained salespeople to sell product on value. Disruptions like that often entail some pain, be it sales-staff turnover or even a drop in revenue, but pricing discipline does pay off. “We preserved cost savings for ourselves and our shareholders and did not give them away in price,” the CFO says.

Rethinking pricing may seem at first like a daunting, resource-consuming task. “Companies often feel they can do something in pricing, but they don’t know where to start,” says Weber.

A good way to begin is by plucking low-hanging fruit. For instance, a simple bell-curve analysis plotting every transaction and which price the customer paid can show where price is not being optimized — instances in which customers are not paying close to the amount they are willing to pay for a good or service, says Ralph Zuponcic, managing partner of business-to-business consultant Price-Point Partners. The analysis can help answer questions such as, Why are we selling our product to some customers at such a low price? (Move them up the bell curve.) What is the profile of customers willing to pay the higher price? (How can I get more of them?) How can I move the entire bell to the right? (Increase all prices.) The same analysis can be done with profit margin, says Zuponcic.

A company can also audit for “price leaks” — instances in which it doesn’t get the price it is entitled to, says Ryan White, managing partner at consultancy Price for Profit. “If a consumer is in a restaurant with a group of people and they have five drinks and the waiter charges them for six, they’re likely to point it out,” White says. “But if he charges them for four, they’re not likely to tell him. So the error never gets fixed.” Process, data, and software errors (not to mention the human kind) can all cause price leaks. For example, one of White’s clients had an enterprise-resource-planning system that was rounding down prices by truncating the last decimal place. Such leaks can amount to anywhere from 0.5% to 4% of revenue, says White.

Another transaction-by-transaction analysis that doesn’t stretch IT systems or resources is analyzing the net price, which is the price net of adjustments, rebates, and volume or other discounts. Such scrutiny can turn up outliers — the salesperson who always cuts by 30%, the product that never gets sold for list price — fairly easily.

In the B-to-B world, of course, excessive discounting can be price cancer. The goal should be “controlled variation,” White says. Jim Geisman, a principal at Software Pricing Partners, recommends viewing discounting as an investment. “Are discount dollars being invested in the customer segments and products that provide the greatest strategic value to the company?” he asks.

At NetSuite, an on-demand ERP software firm, CFO Jim McGeever controls discounting at a high level and sets floors on the rate per hour that can be charged for professional services. But he also wants to be flexible. Two customers that buy 1,000 seats of NetSuite’s hosted programs may have quite different usage levels, so McGeever’s team can charge less to the customer whose employees only occasionally log on to the system. The company has also worked with customers that are struggling financially by adjusting payment terms.

Three Choices

A company that wants to overhaul its pricing strategy more substantively will have to address a constellation of factors, including its market, target customer base, product life cycle, and overall strategy.

Analysis completed, however, Holden says the company will essentially have only three pricing strategies to choose from: skim (high price, at least initially), penetration (low price), and neutral (midtier price). Prices are relative to similar competitive offerings. That’s a simplification, but it’s amazing how many firms get it wrong, or fail to adjust when a market changes.

Dell Computer, for example, was the master of penetration pricing in the 1980s and ’90s, Holden says. But when PC sales growth slowed in Europe, Asia, and the United States in the middle of this decade, Dell lost revenue and profits. “When markets are mature, price becomes inelastic,” says Holden; lowering the price will not create more demand, and it will often eliminate profits.

The same kind of strategic mistake is being made in wireless telecommunications services. Wireless carriers are focused on net customer additions and are slashing prices, says Weber of Simon-Kucher. But penetration pricing makes sense only if the product is “sticky” (hard to switch from), such as video-game devices. Because the U.S. mobile market is nearing saturation, there aren’t many good new customers to be had. Indeed, “the industry is [inadvertently] encouraging customers to move back and forth,” Weber says, “because the new customer gets the better deal.”

In some B-to-B markets, penetration pricing can be ineffective because there is little or no price elasticity. “A customer isn’t going to go to the shelf and spontaneously decide between buying 10 widgets or 15 widgets” because of a price difference, says White of Price for Profit.

Strategies that target customers who are less sensitive to price, as some skim strategies do, are often overlooked. While not technically using a skim strategy, Starbucks lowered prices last summer on products like iced coffees, where it now competes with McDonald’s, but raised prices on other drinks like Frappuccinos and caramel macchiatos, points out Rafi Mohammed, a pricing strategist who is author of the forthcoming book The 1% Windfall. High-margin pricing makes sense for mature products that have loyal customers and few competitors, notes Holden.

Margins and Errors

For any of these strategies to succeed, a company must be conscious of the value that its product delivers. At NetSuite, the average selling price of its ERP system for new customers continued to rise during the recession, in part because the system’s growing robustness began to attract larger firms. NetSuite’s low total cost of ownership is a value advantage, so McGeever doesn’t have to offer drastic price cuts to win new business. Indeed, “when we sell to large companies, we often have to be careful our prices aren’t so low that we aren’t taken seriously,” he says.

How do you measure the success of strategic pricing initiatives? As it turns out, profit margin is not necessarily the best metric, argues Mohammed. Cost cuts and efficiencies can boost margin and yet have nothing to do with price. Mohammed says the measurement should be total profits and growth. Is the company making more money than it did before the changes? Is it serving more customers?

“If you sell products that have high margins, you may be leaving opportunities on the table to sell to more people at lower price points,” says Mohammed. For example, earlier this year the Magic Mountain theme park in Los Angeles gave ticket-price discounts to customers who brought in two empty soda cans. The tactic attracted the most price-conscious customers, who might otherwise not have come.

For many CFOs, moving away from a “let’s just cover costs” mind-set or a one-trick strategy of “aggressively pricing to win market share” can be a big step. But they may have to do it if they want to play a larger role in pricing. As the economic recovery takes hold, focusing on “revenue causality” is key, says Vendavo’s Rapperport. That means understanding, for a given market segment, how much of any changes in revenue (and profitability) is due to price increases and decreases, product mix, currency fluctuations, new customers coming in, or old customers leaving.

Only with that information in hand can finance begin to steer the organization out of price-chopping mode and toward a saner, more sustainable — and more profitable — pricing strategy.

Vincent Ryan is a senior editor at CFO.

The Many Minuses of Cost-Plus

Many companies employ cost-plus pricing, simply adding a desired margin to the cost of a product. But cost-plus has little to do with market reality, says Reed Holden of Holden Advisors. Because costs are often averaged across product categories, more-profitable products and services can appear less profitable than they really are. “If a competitor is highly specialized and understands the true costs better, it can attack you in your most profitable areas,” Holden says. “And you will be led to believe it isn’t wise to respond when it is.”

Cost-plus is useful for one thing: setting a price floor, a minimally acceptable return on investment. The ceiling, of course, is the perceived value of the product. Measuring the perceived value is hard to do; it’s a specialized form of market research. A key part of that research involves “value mapping,” which tells a company what the customers’ perceptions of its product’s value are versus its competitors’ products.

Some companies have lost sales volume and salespeople when switching from cost-plus pricing to a value-based approach, but gross margins often improve dramatically. One company eased its switch by developing a proprietary tool that demonstrated how the use of its products can lower a customer’s total costs, which helped persuade customers that the company’s not-quite-so-low prices were still a good deal. — V.R.

The Price Is Wrong

Any one of these five signs could mean it’s time to change your pricing strategy, says Reed Holden of Holden Advisors.

1. Unit-sales growth slows down. When sales volume stalls, it may mean that the market is saturated, competitors are swiping your customers, or your pricing is out of line with your product’s perceived value. If the market has moved beyond a high-growth phase, it may be time to switch from aggressive penetration pricing to a more stable and profitable stance.

2. Discounts fail to drive incremental volume. If discounting doesn’t drive more sales or increase total profits, why do it? During the recession, many companies overused discounts to keep customers. Continuing to discount during the recovery just because customers expect it is a recipe for disaster.

3. Competitors introduce new offerings. A new player’s offering may change the value equation in the market. “If the competition has leapfrogged you on value and continues to price low, you may not be able to maintain your current strategy,” says Holden. A niche product may be called for, or marketing may need to work on stressing other product differentiators.

4. Lower-cost competitors enter the market. If a market is in high-growth mode, the first company to adopt penetration pricing could gain economies of scale and have an ongoing competitive advantage, Holden says. Will your resources and cost structure allow you to compete in a price war? If not, lower-value “flanking” products may be needed to protect more-differentiated offerings.

5. Competitors start missing their numbers. This circumstance could indicate changes in the market related to customer preferences and buying habits. Or, your competitor may have developed a weak spot that you can exploit. — V.R.