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By Thomas T. Nagle and George E. Cressman Jr.
Firms need a solid and consistent
strategy to make their prices stick.
Many companies set their prices without doing anything to manage the pricing environment. They set list prices based on their own needs and then adjust transaction prices based on what customers say they’re willing to pay. Only a few exceptional companies question why someone is willing to pay no more than a particular amount or how that willingness could be changed. Consequently, few companies proactively manage their businesses to foster more
can achieve greater profits.
How much should a company charge for its products or services? Many companies don’t know how to answer this question and instead let customers and competitors drive their pricing decisions. To keep prices consistent and profitable, companies need to adopt a consistent pricing
structure. By strategically managing price structure, the pricing process, and value-based market communications, companies
profitable pricing. The difference between price setting and pricing strategically is the difference between reacting to market conditions and proactively managing them. 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. Exhibit 1 illustrates this broader perspective on pricing. 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 (Is the price quantity-based like gasoline, accessbased like health clubs, or performance-based like investment banking and some legal services?), the pricing process (Is the price fixed or just the beginning of a negotiation?), or the value message communicated (What’s the objective value created by the product’s differentiation?). To optimize long-term profitability, price setting must occur within the context of a structure that’s value-based and a process that’s proactive. In companies delivering good value that customers recognize, improving pricing processes and structures can quickly increase both margins and sales volume.
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. Charges for correcting files, adapting to late delivery of files, redesigning jobs to save on mailing costs, reducing color variability, and scheduling jobs at peak times all became either sources of revenue or incentives for customers to change their behavior to eliminate costs. 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 pricecompetitive 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
s Exhibit 1
The domain of strategic pricing
In a value-based price structure, prices change with the value delivered. While intuitively appealing, such structures are rare. Instead, internally focused companies usually build price structures that reflect their costs, while externally focused companies build structures that reward customers with greater purchasing power. In either case, they end up with pricing, and therefore profitability, that’s not proportionate to the value they deliver. 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
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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. Airlines are masters at identifying customer segments and establishing value-based segmentation fences. To reflect differences in value delivered to business and leisure travelers, they offer large discounts to passengers whose trips involve a Saturday night stay or are planned far in advance. They also give substantial discounts to senior citizens. Segmentation fences work well for pricing services and when the segmentation criteria is something verifiable, such as the buyer’s age (e.g., seniors), legal status (e.g., consumer vs. business, non-profit vs. for-profit), 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. General Electric successfully raised willingness to pay for its new GE90 series engines by pricing power by the hour. For the first time, an airline could lease a GE aircraft engine for a fee per hour flown that included all costs of scheduled and unscheduled maintenance. Without the uncertainty of maintenance cost, GE90 engines quickly became popular despite a significant price premium. Finding segmentation fences and price metrics that more closely track with value can drive both more sales and margin. Exhibit 2 illustrates the challenge and opportunity in designing value-based price metrics. 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. Real estate agents charge a percentage of the selling price of the customer’s house, only partly related to the level of service they deliver. 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. During the current business slowdown, a service provider discounted prices by tying them to an index of activity in their customer’s industry. Those who signed a three-year contract enjoyed immediate discounts of 18% to 20%. The contracts, however, committed customers to pay high-
s Exhibit 2
Designing value-based price metrics
er prices when increased business activity raised the index. 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. No one can identify who in the organization is ultimately responsible for the overall profitability of prices. In some cases, no one is. Consequently, pricing is temporarily adopted by some functional area to solve a near-term problem for one customer, one product line, or even one salesperson. Without criteria for making the best decision for the organization overall, pricing decisions become inconsistent. 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. Product managers are evaluated by how well each product achieves its sales goal. Because sales goals are evaluated quarterly, price promotions became a regular occurrence for many products at the end of every quarter. The tragedy of this process is that no one estimates the effect that discounting one brand is having on sales of the company’s
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To eliminate these perverse incen tives, 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. Rather than negotiating one deal and then trying to win approval for it at the appropriate level of sales management, a salesper-
One of the great misconceptions of
other brands. Perhaps the reason one brand is not meeting its sales goal is that another from the same company, selling at full price, is already winning the sales. Moreover, no one estimates how much of the quarterly sales gain is actually sustainable sales growth or simply a high-cost shift forward from the next quarter. 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 pres sure makes it necessary. Experience usually proves them wrong. In markets where customers purchase a product regularly or communicate with others who do, they learn from experience. Before long, they notice that discounts are larger and more forthcoming to buyers who negotiate aggressively. The smart ones take advantage of this situation. They institute policies to limit the seller’s exposure to satisfied users, requiring salespeople to work through purchasing agents. They begin courting competitors, offering them a piece of the business to gain negotiating leverage against their preferred supplier. And they form buying cooperatives to increase pressure on sellers to make concessions. In short, when sellers replace price policies with individually negotiated pricing, they create economic incentives for “good customers” to become “bad customers.”
quantitative pricing research is that customers who have been using a product know what it’s worth to them without being told.
son can explore multiple alternatives with the customer, knowing which ones have been approved already. Giving salespeople clear direction regarding acceptable criteria for discounting empowers them to work with customers to find a deal that’s acceptable to both parties. Pricing by policy isn’t always preferable to ad hoc price negotiations. When each purchase is a unique product or service, it’s difficult to have an entirely standard formula. Freely negotiated pricing may also prove more profitable whenever customers purchase infrequently. Lacking information about their alternatives and the experience to evaluate them, they’re more likely to seek a satisfactory purchase rather than to find the best value in the market. Lastly, when the industry leader’s pricing is inconsistent and unpredictable, competitors may need to negotiate prices to remain competitive. Still, even when justified, ad hoc price negotiations introduce the risk that smart buyers will use any flexibility in pricing to disconnect prices from the value they receive. As customers learned that auto dealers exploit the uneducated buyer, they joined auto-buying groups, such as those offered at Sam’s Club or the American Automobile Association, that negotiate better deals. A.T. Kearny has a very successful, and rapidly growing, supply-chain management group that monitors industrial pricing practices and trains customers to manipulate sellers to get better deals. Freemarkets.com enables customers to create
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reverse auctions, where the buyer has all the information about the oﬀers but the sellers see only the prices. While each of these buying tactics is arguably unfair to sellers, they were created to protect customers from the equally unfair and inconsistent pric ing policies of the sellers.
Even when price structures reﬂect value and the pricing process forces customers to make price-value trade-oﬀs, valuebased 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 wellinformed buyers. One of the great misconceptions of quantitative pricing research is that customers who have been using a product know what it’s worth to them without being told. We interviewed long-time buyers of ad space, trucks, dedicated telephone lines, medical capital equipment, OEM parts, and ﬁnancial services that have spent millions each year on items without understanding their value. They o en had a preference for a particular supplier’s reliability, service, or diﬀerentiation, but had neither a quantitative nor a qualitative understanding of the economic value associated with that preference. Consequently, the highest quality suppliers in those markets were consistently vulnerable to suppliers who could oﬀer a precisely quantiﬁed price advan tage in return for forgoing qualitative advantages that seemed merely “nice to have.” Value quantiﬁcation is a good sales tool when buyers are fac ing extreme cost pressures and are, therefore, very focused on ge ing the most for their money. Since healthcare reimburse ment systems were changed to give hospitals and doctors a ﬁnancial incentive to practice cost-eﬀective medicine, pharmaceutical companies have been forced to go beyond their tradi tional claims that a product is more clinically eﬀective. Some now oﬀer purchasers elaborate tests to show that diﬀerentials in eﬀectiveness are worth the diﬀerentials in price. Value communication is possible for more mundane products as well. A supplier of long-haul trucks quantiﬁed the value of features contributing to driver comfort by quantifying their impact on driver retention. 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. Skytel a empted this in an advertisement
titled: Reason #8: Why you need Skytel if you have a cell phone. The reason: “Sometimes you’d rather be informed for 5¢ than interrupted for 10¢.” Since a pager message actually costs less, the implicit value message is that anyone with a cell phone would ﬁnd a pager to be a good value. 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. Michelin has traditionally raised the perceived value of its high quality by asso ciating it with the safety of a buyer’s family. Hallmark support ed the premium prices of its greeting cards by associating the purchase with the extent to which buyers “care to send the very best.” AT&T ran a campaign to convince small-business buyers not to switch to lower cost carriers by reminding them that “it isn’t just your telephone, it’s your business.” In these cases, the advertisers assume that customers believe they oﬀer a higher quality or more reliable product. The purpose is to convince potential buyers the diﬀerence is worth paying for.
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 strate gy 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 met ric 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 r w arded. The pricer’s challenge, then, is not to ﬁge ure 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 advertis ing, 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, str u ctu res, and communications that make value-based prices acceptable.
About the Authors
Thomas T. Nagle is a Group Leader in the Cambridge, MA oﬃce of Strategic Pricing Group, a member of Monitor Group. He is co-author of The Strategy and Tactics of Pricing, now in its fourth edition. He can be reached at firstname.lastname@example.org. George E. Cressman, Jr. is a Senior Pricing Strategist at Strategic Pricing Group, a member of Monitor Group. He can be reached at email@example.com. For more information, visit www.strategicpricinggroup.com.
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