Conventional management wisdom suggests that price should reflect value. But what is the value that prices should reflect? And just whose perception of value should determine price? As these questions and the answers to them suggest, pricing is no longer only an economic challenge. As this author suggests, pricing today is also a marketing challenge, and in this article he describes how managers should deal with the qualitative – and quantitative issues in setting prices.
Our understanding of pricing has come a long way since 1890, when Alfred Marshall, the British economist, published Principles of Economics, his treatise on the economic scissors of supply and demand. Pricing is no longer a purely economic challenge to be addressed through studies of market elasticity. It’s a challenge that can’t be solved by lowering prices until customers make a purchase. And it’s a challenge can’t be solved by allocating costs and adding markups. Rather, pricing today must focus on value exchange.
While experts and executives agree that price should reflect value, the pricing-to-value mantra fails to clarify the actions and decisions executives must make. That is, what is the value that prices should reflect? Whose perception of value should determine price? And how can value be modeled and quantified? In other words, pricing decisions today requires actionable insights.
These insights must derive from a marketing orientation of the firm, with a clear economic understanding of value exchange. The marketing orientation focuses the purpose of the firm towards serving customer needs profitably – an orientation supported by the late greats Peter Drucker and Theodore Levitt. The economic understanding of value exchange reminds us that customers will purchase when the product delivers value in excess of its price after adjusting for alternatives. These are two very simple concepts.
Combined, the marketing orientation of the firm and the economic understanding of value exchange provide the foundation for developing insights required for executive decision making in pricing strategy.
Identifying the nature of a pricing challenge
Executives can structure pricing challenges into one of four types: price setting, price discounting, price structure, and overall pricing strategy.
1. Price setting refers to the challenge of setting the right price in the first place. Different price-setting approaches can be used for different products, and the appropriate approach for a product will evolve as the market evolves. Each of the dominant approaches to price setting shares an orientation towards capturing profitable customers through a mutually beneficial value exchange.
2. Discounting refers to the inevitable challenge facing firms when customers call for a lower price. Not all products must be discounted, but most executives discover that discounting can enhance profits. Unfortunately, discounts can also destroy profits. To navigate the quagmire of discounting decisions, executives should recall the core purpose of the firm, to serve customer needs profitably, and accept that different customers will place a different value on the same product. Successful discounting enables the firm to price the same product for different customers according to their willingness to pay, as long as the price remains above the marginal cost to produce. Evaluating the willingness to pay of millions of customers requires the development of a new corporate capability. Proper monitoring techniques, decision processes, analytics, and incentives must be implemented to enhance the firm’s discounting decisions.
3. Price structures refer to the strategic approach through which specific transactional prices are set. Unit pricing, two-part pricing, complementary pricing, versioning, bundling, subscriptions, and yield management are all different price structures. Each of these price structures can enhance the profitability of some markets, and each is inappropriate for other markets. The selection of the optimal price structure is, at its core, an economic challenge to be informed by an understanding of differences between customers within the market, the cost structure associated with delivering the product, and the market strategy of the firm.
4. Overall pricing strategy. Challenges arise in considering the actions of the firm in the context of its industrial environment, and the strategic resources of the firm. Competition, product evolution, and legal decisions all influence the latitude a firm has in setting its pricing strategy. Attaining the right fit between the firm’s resources and the market opportunity enables the firm to achieve higher profits, grow faster than its competitors, or both, simultaneously.
Various qualitative and quantitative analytical techniques have been developed to enable decisions that reflect both the marketing orientation of the firm and an economic understanding of value exchange. These analytical techniques go a far way in delivering the right answer to the right pricing question, one customer at a time, a million times a day. Each analytical technique provides tremendous insight into the nature of the pricing decision confronting an executive and the opportunity to improve results.
A good analysis requires both quantitative and qualitative insights. Despite the clarity delivered through quantitative analytical techniques, executives cannot overly rely upon the output of a single equation. Pricing is a strategic challenge, not an engineering challenge. Angus Maddison, professor of quantitative macroeconomic history at the University of Groningen, once stated that, “no sensible person would claim that [quantification] can tell the whole story.” Similarly, quantitative models in pricing enable terrific insight, but they must be informed and tempered by a qualitative understanding of the opportunity.
Setting price levels
A firm exists to serve customer needs profitably. If it can’t meet customer needs, the firm is irrelevant and will wither and die. If it can serve customer needs, then it is relevant to its customers and can hope to prosper, providing it can do so profitably. Hence, a primary responsibility of executives is to determine which customer needs the firm will fulfill, and how it will fulfill them profitably. Unless the executives can address this existential question, the firm is wandering in the dark.
As clear as this directive to serve customer needs profitably is, it isn’t sufficient for decision-making. We have to take the next step and prick the veil of value exchange. Using the guideline that good pricing enables a mutually beneficial exchange between a firm and its customers, we can examine what benefits both the firm and its customers with a number of quantitative and qualitative analytical techniques.
Exchange value models, market research, and in rare cases economic profit optimization each enable the determination of a price that benefits both the firm and its customers.
Each of these approaches to pricing relies on a common set of assumptions and goals: Customers make purchase decisions by trading off value for price. A product that delivers higher value can capture a higher price. A product that delivers less value must be priced at a lower level to attract a customer. The right price is one that reflects the ability of the product to address a customer challenge in comparison to their alternatives. Moreover, the right price extracted from customers must exceed the firm’s cost to deliver.
Any price which lies between the customer’s willingness to pay and the firm’s cost to produce will enable a mutually beneficial exchange. Prices that more closely approach the customer’s willingness to pay will yield a higher profit for the firm. Hence, executives that seek to maximize their profits, either for growth or change, need to prick the veil of value to determine the best price.
Managing price discounts
Almost at the instant that a price is determined, executives have to address the challenge of discounting. Sometimes, even before a price is set, discounting practices will influence the pricing decision.
Discounting is a managerial headache that perniciously invades every firm. Executives with a command-and-control attitude might respond to all discounting requests with an immediate “NO.” Unfortunately, demanding all customers pay full price is more often a mistake.
Discounting is a natural response to a market reality: customers vary. Different customers place different values on the same product.
Because different customers value products differently, the law of one price becomes a death knoll for a firm. If the firm sets the price low enough to attract all potential customers, the price would be much lower than necessary, and the important profits needed for maintaining a healthy and growing firm will evaporate. If they set the price at a level corresponding to the highest price a customer will pay, the firm will sell very few units relative to their potential sell through.
Discounts, when properly structured, enable the firm to extract the full list price from customers with a higher willingness to pay, while simultaneously attracting customers with a lower willingness to pay at a lower, discounted price, which is still profitable at the margin.
This definition of the role of discounts contains a key challenge: they must be properly structured. Discounts are a managerial headache precisely because of the challenge in ensuring their proper structure. If they are poorly structured, customers that are otherwise willing to pay full price will masquerade as bargain hunters and demand a lower price. When this happens, the firm has effectively returned to the law of one price, and the death bell will toll. To navigate this quagmire, executives can use of a variety of quantitative and qualitative analytical techniques to inform discounting decisions.
Establishing Price Structures
Unit pricing, two-part pricing, complementary pricing, versioning, bundling, subscriptions, and yield management are all different price structures. Each is appropriate for some markets and inappropriate for others. Determining which price structure is right for a firm requires an economic understanding of the cost structure and the systematic variations in willingness to pay between different customers.
Price structures enable executives to align their prices with customers’ willingness to pay without resorting to discounting. Price structures rely on a clear segmentation hedge to separate utility-sensitive customers, or those willing to pay a higher price, from price-sensitive customers, or those only willing to pay a lower price.
The segmentation hedge associated with discounting is a leaky sieve at best. Utility sensitive customers will masquerade as price sensitive customers if they can, and therefore discounts will often be granted wrongly. In contrast, good price structure defines a clear tradeoff between value and price for customers, allowing utility-sensitive customers to self-select the amount of value they demand while allowing price sensitive customers to forgo value in exchange for a lower price.
In selecting one price structure over another, a firm is making a strategic marketing decision. As with other strategic marketing decisions, the price structure must be attractive to the target market and aligned with other marketing mix variables. Given an understanding of the economics of alternative price structures, executives can examine the tradeoffs between different structures to identify the best solution. And again, quantitative and qualitative analytical techniques can be used to inform the price structure selection.
Overall Pricing Strategy
Pricing isn’t done in a vacuum. Every pricing decision a firm makes influences not only customer reactions, and the firm’s profits, but also the industry in which it operates. Reflexively, every change in the industry, whether driven by competitor actions, product evolutions, or legal decisions, influences the pricing decisions of a firm.
To align pricing strategy with the larger environment, executives must understand their strategic resources. That is, in what ways is the firm similar to competitors; in what ways is it different, and why are these differences relevant to the market? A firm may be able to survive by being relatively similar to its competitors, but to truly profit and deliver above-average performance, it must in some way be different from its competitors. But being different implies risk. In order to turn risk into profit, these differences must be strategic. That is, they must be relevant to the market. When the firm understands where its strategic resources lie, it is in a position to align its pricing strategy with its overall strategy.
Qualitative analysis largely informs our understanding of these external influences and strategic resources. But even with these larger pricing strategy challenges, a number of quantitative models have been developed to clarify the decision alternatives and tradeoffs.
Understanding Value Exchange
Each of these four types of pricing challenges can be addressed through the marketing orientation of the firm and the economic understanding of value exchange. Moreover, quantitative and qualitative analysis can be used to further clarify the alternatives and tradeoffs. Our understanding of pricing has come a long way, and it is time for executives to grasp this modern understanding to improve the results of their decisions.