Many companies have a significant opportunity to improve their top- and bottom-line growth by improving their processes and execution on pricing. As these authors point out, senior management teams must summon the analytical skills and courage to confront their reluctance about changing prices and align their pricing more closely with the value of their products or services.
In the quest for faster growth and heftier profits, executives are finding that once-favoured strategies leave much to be desired. Cutting costs in a rush to meet the next quarter’s financial targets takes too much of a toll on both employees and company culture-and rarely leads to top-line growth. Developing new products is essential for growth, but predicting when the next breakthrough innovation will occur leaves much to chance. Investing in other strategies, such as branding and new distribution channels, can take several years to become profitable. Pricing, however, is a different story, and executives across industries are quickly learning it can be their single most effective strategic weapon.
In fact, a recent A.T. Kearney study of North America’s largest companies shows that a price increase of one per cent translates into a profit increase of more than seven per cent; in addition, a one per-cent price increase is three times as effective as a one per-cent cost reduction, so the case for increasing prices is compelling.
The most obvious advantage to pricing is that its effects are immediate. When shoppers didn’t flock to Wal-Mart at the beginning of last year’s holiday season, the company responded within days by aggressively cutting the price of two dozen popular items. By taking such quick action, it regained lost ground and reported an average same-store sales increase of 4.3 per cent over the previous December.
Other benefits, however, are just as important. New price structures can improve customer relationships-and can also be the best way to get rid of unprofitable customers. Also, the effect of a price increase flows 100 per cent down to the bottom line much more so than the benefits from a cost reduction or head-count reduction.
But there are complications. Pricing is an emotional exercise for a management team. The head of marketing worries that a price increase will result in customers leaving en masse. The CFO becomes terrified of revenue loss and the complexity of implementing a new pricing policy. And the CEO typically believes that losing any customer, even an unprofitable one, is inherently bad for business.
With the right approach, however, the benefits of a solid pricing strategy far outweigh such concerns. In fact, most companies have the ability to grow their top lines more than 10 per cent per year and their bottom lines more than 20 per cent per year. Some recent examples of such success stories include:
- A financial services company that developed a model predicts the cost of acquiring a new customer with 96 per-cent accuracy. The model helped the sales force screen customers and boosted price realization and productivity, leading to profit growth of 33 per cent.
- A food distribution company that increased profitability by 27 per cent in six months by modelling the product portfolios of its customer and helping its sales force target higher-margin items.
- A manufacturing company that increased pricing against competitors based on the superior performance of its products, leading to top-line growth of 11 per cent in 10 months.
This article will look at how companies of every size can identify new opportunities to price smarter and better, and grow their businesses at the same time.
The starting point for developing a new pricing strategy is to better understand how customers perceive the value of a product or service, and therefore what price they are willing to pay. On the surface, value is a subjective concept at best and impossibly vague at worst. This makes the process of determining and articulating it the single most challenging hurdle of a pricing strategy. Consider the challenges: if the seller cannot fully identify the value that its product or service brings to its customers, the set price will inevitably be off-mark. Similarly, if the customer is not familiar with the offering or its value, and is not given a clear and compelling case for the firm’s return on investment, a sale is unlikely.
Overcoming these hurdles requires an unwavering focus on three key principles of effective value-based pricing.
A. First, value must be defined from the buyer’s point of view, not the seller’s. Many companies make the mistake of overemphasizing the features of their products, when they should focus instead on the hard and soft benefits that the customer perceives. Additionally, a standalone product is rarely robust enough to create sufficient customer value for value pricing. Companies that implement valuebased pricing strategies often enhance products with services and flexible financial solutions. Enhanced products not only create more customer value, they are also tailored to specific customer segments.
B. Next, the value of the offering must be clearly superior to that of competing alternatives; otherwise, the price will end up being set either by the least sophisticated competitor or the most aggressive. And, in either case, the competitor won’t focus on customer value and will underprice, effectively destroying the market. This implies that if a company can’t meaningfully differentiate its product or service, it is unlikely to be able to use value-based pricing.
C. Finally, the company must be certain it has uncovered all sources of customer value and communicated these advantages to customers on their own terms. An interesting theoretical exercise is to hold a brainstorming session with your senior management team to estimate the maximum price you could justify for your product-you may be surprised by the sources of value you uncover (see Sidebar 1: How High Can We Climb? at end of article). This process can become complicated in business-to-business markets, where the company must clearly and explicitly understand its customers’ business models and strategic aspirations, as well as the economics of their business processes. Only then can the company effectively estimate, quantify and communicate how a product or service is going to benefit a specific customer.
Combined, these principles are the foundation for A.T. Kearney’s four-step pricing methodology, designed to boost both top and bottom lines. The steps are as follows:
1. Address underperforming customers
When companies map out their customers’ spending patterns, many discover that a disproportionate amount of time and energy is spent on customers who offer the least reward (see Figure 1 all Figures at end of article). For most companies, a small percentage of customers contribute the biggest percentage of the profits. The most talented sales reps are usually assigned to the largest, most profitable customers, despite the fact that they often have the longest tenure and are therefore the easiest to serve. Also, heavy discounts are frequently given to attract new customers, but are often allowed to languish at unprofitable margins. Everyone-from senior management down to the most junior sales rep-is loath to increase prices for a small, unprofitable customer for fear of losing its business.
The answer lies in systematically identifying each unprofitable customer relationship using a very tactical approach; the next step is to determine the best customer sales strategy for turning the situation around.
2. Align profitability and service levels
Service levels are perhaps the least-understood, and least-utilized, pricing tool available to the sales force. Sales reps inevitably complain when a price increase is proposed, but how many consciously reduce the service level to an unprofitable customer? Unfortunately, the answer is typically not many.
There are many opportunities to implicitly and explicitly increase price by altering service levels. Figure 2 illustrates the interaction between pricing and customer service levels. The objective is to maximize the price premium while minimizing customer service level and features, as well as the cost to serve the customer. For example, a financial services firm recently devised three tiers of service: an internet-based, self-serve tier; a tier to access proprietary research information and web-based meetings with portfolio managers; and a full-service tier with instant access to all of the firm’s resources. The company realized that many of its most unprofitable customers were receiving the benefits of the full-service tier, but weren’t paying their share to cover the costs. After the company realigned service levels with pricing levels, executives were surprised by how little customer attrition they experienced.
Also, it is important to establish sufficiently significant differences in the attributes and cost structures of each service level. Customers must appreciate the additional value they are receiving by moving up or down a level. Similarly, the effect on costs and margins must be sufficiently high for the sales force to respond as well.
3. Price for performance
The next step is to understand how well your product or service stacks up against competitive offerings. The starting point for this comparison is to understand the sources of value your product or service provides customers. It is imperative that this comparison be done from your customer’s perspective (see Sidebar 2: If the Price Sticks).
Once you understand your own sources of value, the next step is to compare your product’s performance against that of your competitors. Then, plot these results against the pricing in the marketplace. This will reveal where pricing is misaligned with product performance, and identify where you may have an opportunity to exploit differences in pricing or value versus your competitors. In addition, the analysis may help identify new market segments based on unique pricevalue combinations. For example, in many consumer products businesses, the private-label segment is often identified from this analysis as an opportunity to launch significantly lower-priced and reduced performance product lines to span the range of customer needs.
4. Implement systematically and meticulously
The last step is to implement the new pricing strategy. This usually requires an organizational approach as well as a management process. In both cases, management needs to hold its hands to the fire and ensure a systematic and meticulous implementation. Reinforcement from all corners must embolden the sales force: from the perspective of the sales rep, there is nothing worse than having to confront a customer with a price increase.
To illustrate this, consider the case of an automotive parts manufacturer. The company had several objectives in rolling out its new sales strategy. First, it wanted to make sure that it left no stone unturned before forcing a price increase on a customer. Next, it wanted to be clear with the sales force about what steps to take, and when. Finally, it wanted to give appropriate latitude for the sales force to accomplish the company’s objectives. As a result, the company created a decision template for making pricing decisions (see Figure 3).
Today, the company rigorously trains its sales reps in developing a sales strategy for each customer. It also formed a pricing committee that conducts peer reviews of its customer pricing and margin levels every six months, ensuring that the pricing improvements will not erode over time.
When implementing a new pricing strategy, it is important to keep the following points in mind:
Simplicity. Everyone needs to be able to understand the pricing structure and to communicate it effectively to customers and stakeholders. In addition, the pricing structure must be practical enough that it is relatively easy to implement. Therefore, soft benefits will generally be captured in a fixed pricing mechanism, while hard benefits can be captured in a variable pricing mechanism.
Certainty. The sources of value, especially when linked to a variable pricing mechanism, must be easy to track and measure. The metrics must be clearly understood, and the data source, calculation method and baseline need to be agreed upon in advance so that the arrangement is solid and the positive working relationship continues.
Alignment with market and strategic positioning. The pricing structure for a solution should reinforce the market and brand positioning of the offering. By its nature, value-based pricing aligns best with a premium positioning in the market, but how the pricing structure is set up can also help further differentiate a solution. For example, if a company’s solution is similar to that of a competitor’s on four out of five main features, but it is clearly differentiated on the fifth, the pricing mechanism should directly tie into and emphasize that unique feature.
Sharing upside potential. The pricing structure should enable a company to take advantage of both the current and future value of the service and create an opportunity to share the upside potential in value creation with customers.
Leaping the pricing hurdle
Companies large and small have a significant opportunity to improve their top- and bottom-line growth by improving their processes and execution on pricing. Senior management teams must summon the analytical skills and courage to confront their reluctance about changing prices and aligning their pricing more closely with the value of their products or services. In the end, they will likely find that the benefits are higher than they anticipated and the risks are manageable.