EXHIBIT 5-1 Typical Capabilities of Purchasing Versus Sales Capabilities of Purchasing Versus Sales
Influencing Customer Expectations and Purchase Behaviors
There can never—and I mean never—be a discount on a new car coming out of the factory in pristine condition.
Elon Musk1
As described in the previous chapter, Price Structure and Pricing Policy are closely related, both having the objective to align differences in price paid with differences in value received and cost to serve. Price structure involves establishing that alignment across macro segments of customers and applications. Although a price structure can sometimes be quite complex, involving multiple price points and even different price metrics associated with different applications, different levels of volume, and different customer locations, a particular customer would typically see only pricing associated with that customer’s intended application, volume requirements, and location. In contrast, price policy defines the rules and conditions for price discounts or surcharges that could be applied to a transaction within a segment. Pricing policies involving things like an upcharge for rush orders or a discount for must-take orders to which the customer commits far in advance of shipment, can and usually should be transparent because their goal is to influence customer behavior.
In consumer markets, for example, a retailer will sometimes offer a short-term price promotion (e.g., buy one, get one free) on a popular brand to stimulate store traffic. The risk is that regular customers, who buy the product weekly because they think it is a good value at the regular price, will stock up during promotions, undermining both revenues and store visits in the future. A policy limiting the quantity that a consumer may purchase at the promotional price would help to prevent that costly change in customer behavior. Amazon has a Subscribe-and-Save policy to apply an increasing discount when customers order more unique items to be shipped together on a regular basis. But this discount policy wisely does not apply to ordering more units of the same item.
When purchasing large quantities for a business, savvy purchasing agents often split their purchases among multiple suppliers based upon price, giving say 60 percent to the one with the best price, 30 percent to the one with the second best, and 10 percent to the one with the third best price. They then regularly switch company rankings in order to induce sellers into bidding wars that ratchet down their prices. Again, a policy choice can mitigate the incentive for such behavior. One policy option is for the seller to require that the buyer take any extra discount as a rebate to be paid at year end if the buyer’s total volume of purchases exceeds a target percentage of the buyer’s annual volume. That eliminates the incentive for the buyer to maintain an ongoing competition among suppliers for the preferred position because, if the buyer awards its lead supplier position for only a few months and then switches after receiving a better offer from a competitor, the buyer will fall short of achieving the annual volume necessary to qualify for the expected rebate. Moreover, once the buyer is essentially locked in for a year in order to get the best price, there is a financial incentive to give the lead supplier an even larger share of the volume.
The examples above illustrate an important challenge to the principle of value-based pricing: A customer’s willingness-to-pay an offered price is not determined solely by whether that price is fair or reasonable when compared to economic value. If customers come to expect that some change in their purchasing behavior will enable them to get the same product or service at an even better price, then the regular price becomes no longer acceptable. Sometimes that change in behavior can be a good thing for the seller (for example, when the customer agrees to commit to buy more or to accept a longer contract term in return for a better price). More often, the change in behavior is an unanticipated consequence of poor or non-existent policies that fail to account for the impact of the seller’s behavior on the buyer’s future price exceptions.
Expectations drive buyer behavior and nowhere more so than when responding to prices. For example, a retail consumer may believe that a new fall fashion is well worth the price asked for it in September, but not buy it if she expects that the store, following its past behavior, will have a 20-percent-off sale within the next month. A policy of regular, predictable discounting has trained many retail consumers to wait for the sale price. As a result, sales at regular prices are less than they would otherwise be, increasing the amount of inventory that ultimately will be sold at the lower sale price.
The same dynamic plays out—only more so—when businesses sell products and services to other business (hereafter referred to as B-to-B sales and purchases). Professional buyers have learned to hold their purchases from some suppliers until the last couple of weeks of each quarter when sales managers are often willing to discount more deeply to achieve their quarterly sales goals. Once customers recognize this pattern, they will delay purchases until late in a quarter and buy forward to cover their expected needs in the following quarter. Sellers often misinterpret the declining sales at regular prices and the increasing portion of their sales at discounted prices as a sign that customers have become more price sensitive. In fact, they are only responding to incentives for how to get a better deal on what they would otherwise have been willing to buy at higher prices.
Periodic, predictable discounting is just one of many ways that sellers undermine their pricing power by making decisions for short-term sales gains that adversely affect buyers’ expectations and future behavior. When sellers adopt a policy of making price exceptions when necessary to meet the lower price of a competitor, they create the expectation among buyers that creating a competitive process for their business will be rewarded. Consequently, buyers create purchasing policies that require multiple bids for each order or create a reverse auction for awarding an annual contract.
A pricing policy is a rule or habit, consistently applied, that defines the criteria under which a company will change a price for an individual customer, for a limited period of time or for particular transactions. To avoid creating customer expectations that a seller’s prices can be manipulated by adopting purchasing policies that disconnect price from value, sellers facing repeat customers need to anticipate the expectations that their pricing policies create for customers. Fortunately, a company can change its customers’ expectations by adopting pricing policies designed to influence those expectations positively. Some retailers have changed the expectations that it is better to wait for a sale by offering “30-day price protection,” enabling deal-sensitive shoppers to buy now and receive a credit for the difference between the price paid and a sale price offered within the next 30 days. Some B-to-B companies have wisely adopted a policy that they will not participate in a buyers’ reverse auction when, as often occurs, they would be allowed to see only competitive price offers but not differences in the quality, capabilities, and services that lower-priced bidders are willing and able to provide. In each of these cases, the goal of the pricing policy is to stop rewarding customer behaviors that erode unnecessarily the difference between the prices they pay and the value they receive.
Unfortunately, some companies evaluate their pricing decisions, particularly when deciding whether to make a price exception, considering only the effect of sales in the current quarter or on the likelihood of winning the next deal. As a result, they inadvertently create expectations that change customer behavior adversely. B-to-B companies caught in a cycle of increasing frequency of price exceptions usually attempt to regain control by creating rules regarding who in the organization has the authority to approve discounts of what magnitude. For example, a B-to-B sales rep may be granted the discretion to discount a sale only by up to 5 percent, but his regional manager can approve discounts up to 15 percent, and the vice president of sales by up to 25 percent. Unfortunately, as customers learn these rules from their own experience and that of other customers with whom they talk, they learn not to accept any offer that the sales rep can make, instead responding with demands, arguments, and even misinformation designed to motivate the sales rep to make the case to his management for a larger discount. Furthermore, many companies mistakenly believe their discount approval process serves as a discount policy, when, in fact, the approval process is a personnel policy that is filling in for a missing price-and-discount policy.
In business-to-business markets where large companies make high-volume, repeat purchases, buyers have generally moved far ahead of most sellers in adapting their behavior to achieve more favorable pricing. Under the rubric of “strategic sourcing,” they have developed sophisticated processes and policies to ensure they get the lowest prices possible while sellers, in contrast, often understand little about how their behaviors influence buyer’s expectations and reward more aggressive purchasing tactics. Exhibit 5-1 illustrates this contrast. Purchasing departments that practice strategic sourcing have goals and a long-term strategy for driving down acquisition costs, while their suppliers often lack comparable long-term strategies for raising or at least preserving margins.
EXHIBIT 5-1 Typical Capabilities of Purchasing Versus Sales Capabilities of Purchasing Versus Sales
Buyers at large organizations are usually full-time professionals who are separate from those who specify or use the product, while the seller’s counterpart is a rep whose main job is customer service. The purchasing professional is rewarded for cutting acquisition costs or establishing conditions that increase future leverage, while the typical sales professional is rewarded simply for making the next sale—and may be punished for losing it. The purchasing professional typically has access to a database of information about all the offers and counteroffers that the supplier has made to his company in the past, and often about the pricing and terms that other companies have received. Sales reps, in contrast, often have little knowledge of account history except for volumes purchased and are usually less well informed about the pricing of their competitors. Not surprisingly, sales reps often feel like the biblical David confronting a more powerful and better-armed Goliath.
Becoming better prepared to meet the challenge of price negotiation with strategic purchasers is not a responsibility that sales reps, or even the sales organization, can meet on their own. It requires developing a long-term strategy supported by pricing policies that are applied consistently. To develop good policies for price negotiation, it is necessary to treat every proposal or request for a price exception not as a one-off event but as an opportunity to create or change a policy that would be applied to all similar situations in the future. The more often a company finds it necessary to make price exceptions, the more likely that its policies are poorly defined or in need of revision.
If a firm has few clearly defined or consistently followed policies, a lot of potential deals will end up as requests for price exceptions. As new, well-thought-out policies are put in place, customers and sales reps will learn that ad hoc exceptions to policies will not be granted. The only requests for special pricing that should be considered are those involving situations not already covered by a policy. Putting a “no exceptions” stake in the ground is a key to making pricing decisions that are profit-enhancing. Most discount proposals, whether to reduce price to win business or to increase price to exploit tight supply, have an immediate reward that is obvious but a corresponding cost that is delayed, diffused over more accounts, and less transparent. In contrast, pricing by policy forces companies to consider the impact on the entire market when making a pricing decision and reflects the “shadow of the future,” whereby today’s discounting decisions affect pricing power in future transactions. It should involve asking whether it makes sense to establish a policy that the proposed pricing option could be offered to all customers like this one and still be profitable.
Making the decision by policy forces decision-makers to think through the broader and longer-term implications of the precedents they are setting. Creating policies cannot be the responsibility of sales management alone, since they do not have the perspective on the overall market or the authority to make the trade-offs that may be required. Pricing policies need to cover more than just discounting. They should include the company’s pattern for passing along changes in raw materials costs (such as requiring that all long-term contracts allow for adjustments versus adjusting only after a fixed-price contract expires) and its pattern for inducing product trials.
Pricing policies should also deal with how a company will respond to low-price offers made to its customers by a competitor. Any pattern creates expectations for how the company will deal with such issues in the future, and thus can change customers’ future buying behavior. Policies also influence how your sales reps sell and which ones succeed. Who is most rewarded at the company, the sales rep who sells at high margins by understanding customers well enough to communicate value, or the rep who drives big volume at a few accounts by understanding his company’s management well enough to make the case internally for price exceptions?
Ideally, policies are transparent, are consistent, and enable companies to address pricing challenges proactively. If your policies are transparent, customers need not engage in threats and misinformation to learn the tradeoffs you are willing to make. Airlines have transparent pricing rules that we may not like (low prices only when purchased well in advance, charges for making changes, no transfer of tickets to another passenger), but we accept them because we know what they are. Consistency communicates that it is impossible to “game the system” by contacting multiple points in the company to find the best deal while mitigating a buyer’s fear that a competitor who negotiates harder may be getting a better deal. Communicating policies proactively is much less contentious than telling a customer reactively that a proposal of theirs has, after some delay for review, been rejected.
Despite all that we have written so far about creating a value-based price structure and avoiding “price exceptions,” nearly all companies in B-to-B markets and some in B-to-C markets will need in some cases to negotiate prices because the product application or the customer is genuinely unique. For some products, such as a contractor building a unique building (e.g., a new research center), a consulting firm bidding to develop a plan to solve a unique customer problem (e.g., how to develop the market for self-driving cars) or a manufacturer selling the same product to a unique and very demanding customer (e.g., drugs to national health authorities in countries with single-payer health care systems, or lawn mowers and snow blowers to a category-leading retailer like Walmart), price negotiation is unavoidable.
Once the door is opened for price negotiation, there are myriad opportunities for savvy customers to manipulate the process to their benefit— potentially undermining pricing and profitability across the entire market. Following is a list of four common tactics used by professional purchasers to disconnect price from value, and effective pricing policies that firms have successfully adopted to defend against them:
1. Commoditizing the Offers: Particularly in B-to-B markets, customers often refuse to discuss what differentiates the offers of various competitors. Instead, they distribute “specs,” short for specifications, of exactly what they require. They then solicit bids to meet or exceed that specification. In some cases, the bids are “closed,” meaning that no one knows what anyone else is bidding until they are opened. In the worst cases, competitors are invited to submit their bids electronically. Over a few hours, the bids are “open” for everyone to see what others have bid, but not who the other bidders are. During that time, they can revise their bids based upon the prices that others have offered. This is called a reverse auction. Suppliers generally hate them, in part because they are unprepared to deal with them proactively.
Policy Prescriptions: If the buyer is committed to buying from the lowest bidder, this is not necessarily a bad situation. If you really want such business, which you may if it involves significant volume and does not compete directly with your main market, look at the specs carefully and think about how you could reduce your costs by cutting quality and service levels to meet but not exceed the specs. Does your manufacturing process yield a certain amount of “rejects” that do not meet the standards for most customers but would for this one? Do you have inventory that is about to expire yet still meets spec? Could this customer’s service needs be met in a cheaper way? Calculate the lowest price that would make this business worthwhile without all those costs, and do not go below that price in your bidding.
Be prepared, however, for the customer to object to your adherence to their own specs after granting you the business, especially if you have previously been a supplier to the customer and have already established expectations about how you normally do business. At that point, it is essential that you have a menu of very profitably priced product and service “upgrades” that the customer can buy as needed. For example, the customer may not have specified order lead times in the spec so you set minimum lead times for this customer equal to those that would have been required by other bidders serving the customer from some distant, low-cost location. A customer who then wants to take advantage of your ability to deliver orders with shorter lead times must pay a “rush order” charge that reflects the value of your differentiated ability to offer that service.
If the customer is not committing to buy from the lowest bidder when running a bidding process, then specs that devalue differentiating quality and service are simply a sham designed to bring low-cost bidders into the process. Do not take the bait. Make a policy either to refuse to participate in sham reverse auctions or to bid your list prices. Now the customer must choose either to pay list prices or abandon the bid process and engage in a more honest Give-Get negotiation.
Whether you win the business upfront but then make money by eliminating unnecessary costs or selling the upgrades, or you force the customer into a negotiation that involves acknowledging the differences that are important to them, you need to prepare in advance. You will need to create an unbundled price structure (Chapter 4) that affixes a monetary cost to the levels of quality and service that differentiate you.
2. Double discounting of price increases: Some companies’ pricing strategies have suffered for years from the effects of poorly negotiated price increases. The seller in these cases establishes an across-the-board price increase—say 6 percent—that is presented to buyers. Buyers without power are forced to take it or leave it. Larger buyers, however, often make the case that since they deserve a volume discount, they should not have to bear the full increase. If they typically enjoy a 25 percent discount off list prices, they argue that they should get only a 4.5 percent price increase—25 percent off the 6 percent increase in list prices.
Only a little thoughtful analysis reveals that this is a bogus argument leading to a costly mistake that compounds as years go by. The large buyer who gets a 6 percent increase is already getting a discount on the increase relative to smaller buyers. For example, if the large buyer is currently paying $75 for what other buyers pay $100, a 6 percent increase for the large buyer is only $4.50 versus $6 for everyone else. By demanding a discount on the increase, a purchasing agent is demanding that the seller pay twice for the same volume.
When buyers use this tactic repeatedly and the seller falls for it, their discounts quickly compound. One client saw its prices for volume buyers drop to less than 50 percent of list price in only seven years. To compensate for this loss, the company began asking for higher increases to create room for erosion with large buyers. As a result, it lost progressively more of its medium and small customers, making it ever more reliant on and vulnerable to intimidation from its largest buyers.
Policy Prescription: When increasing prices, there must be no exceptions. If more powerful buyers must have a concession, give it without undermining the integrity of the price increase. For example, rather than discounting the price increase by 25 percent, give the powerful buyer a three-month delay before it will take effect. This is also a very useful tactic for buyers who have been paying unjustifiably lower prices that must be corrected. Begin by telling them what their new price needs to be to make them worth serving. You must be prepared to justify that price as fair, given what others pay, and you cannot back down without undermining the principle of pricing by policy. However, if the buyer signs a new contract to buy for some period in the future, say one year, you could agree to implement the increase in stages: 25 percent of the increase immediately and 25 percent at the beginning of each of the next three quarters. Ultimately, in the last quarter of the contract, the customer is paying the higher price aligned with what other customers pay, but the purchasing department can show “savings” in the current contract relative to market prices.
3. Discounting for volume. Sometimes buyers will offer a seller incremental volume in return for a price concession. There is nothing in principle wrong with accepting or, even better, proactively proposing such a deal. In practice, however, sellers often get taken. Here’s how. A buyer who offers to purchase 10 percent more volume in return for “only” a 2 percent price discount is actually getting a 22 percent price cut on the incremental volume! If the buyer is currently spending $10,000 per year and offers to purchase 10 percent more volume, he would be buying $1,000 of additional product at the pre-discounted price. If the buyer receives a 2 percent discount on that $11,000 worth of product, he pays $220 less, which is 22 percent off the $1,000 of what would otherwise be incremental revenue.
Is the incremental volume really profitable at such a low price? If sellers actually calculated that incremental discount, many would never be willing to make such a large concession. Actually, the long-term cost of the concession is even higher because the lower price concession becomes incorporated into the starting point for all future negotiations.
Policy prescription: If you’re going to give a discount for volume, focus the discount on the incremental volume and give it as a rebate. For example, instead of offering a 2 percent discount on all of the volume, including what you have already won, offer a 10 percent rebate on the year-to-year increase in volume. This focuses the customer on the real value of the concession, it creates a much stronger incentive for the customer to reject a competitor’s offer to try their product, and it costs less! Making the discount into an end-of-year rebate instead of an upfront discount has the added advantage of protecting you from duplicitous buyers who promise more business to get the discount, but never order the promised incremental volume. With the discount focused entirely on the increment, they don’t get the savings until they have bought the required volume, and the lower price doesn’t get incorporated into the buyers’ expected price level.
4. Discounting to compensate for past failure. There is no situation in which sellers are more vulnerable than when their firm has failed to meet its commitments. Failure to deliver on time or to deliver the promised quality clearly undermines the case that your firm deserves either a higher price or a higher share of a customer’s business. Sophisticated purchasers will exploit that vulnerability by demanding an exceptional price concession to compensate for your prior failure.
There are two things that make this a powerful weapon for the purchaser. First, the seller does owe the customer something for having failed to meet its obligations. Second, by making that “something” a price concession, the seller exploits a common psychological bias that makes forgoing revenue less psychologically painful than making an equal-sized expenditure, even though each would affect bottom-line profit equally. The problem with the price concession is that it gets built into the price from which future negotiations begin—making it potentially an indefinite purgatory.
Policy Prescription: Make it a policy to negotiate with the customer a fair compensation for the cost of any legitimate failure, but pay that compensation as a lump-sum payment, rather than letting it reduce your established price point. If that is not financially possible, then make the compensation a “credit” that the customer can take for a portion of each future invoice until the agreed-to compensation is exhausted. This preserves the integrity of the price and automatically terminates the “discount” after the agreed amount is reached. For a customer who is upset about a past failure, you might even build a penalty (e.g., a 5 percent invoice credit for every week of delay in delivery beyond the promised date) into the contract. While these options may feel more painful than a simple price concession because they make the cost explicit, they are actually less costly because they expire automatically and maintain the principle that your price is justified by the quality or service that a customer can usually expect you to deliver.
Analyzing pricing challenges and developing policies to deal with them is an ongoing process, and one that is generally the responsibility of a pricing staff overseen by a group of managers with collective responsibility to preserve or improve profitability. Over time, a company’s policies can become a source of competitive advantage—creating expectations that drive better behavior on the part of customers, competitors, and sales reps and empowering sales reps to offer creative solutions more quickly and with less wasted effort selling their ideas internally. Still, building that set of policies takes time, and policy-based pricing will lose organizational support if few of the initial applications produce positive results. To avoid that problem, the remainder of this chapter will identify the common challenges that call for policy-based solutions and describe successful policies that we have seen for dealing with each of them.
The most common, and therefore, most important domain for policy development falls into the arena of responding to price objections from customers with whom pricing involves a process of negotiation. The lack of policies for dealing with price objections is not only a challenge for companies that sell directly. Consumer goods manufacturers face just as much price pressure from powerful retailers as they do from consumers who switch to alternatives because of price.
To illustrate the problem created in price negotiation by non-existent or poorly enforced pricing policies, think about how the process commonly plays out badly for the seller. Imagine that to cover the increased costs of raw materials, your company announces a 5 percent price increase. When sales reps attempt to get their next orders at those higher prices, purchasing agents confront them with the assertion that the increase is unacceptable. How each sales rep responds to that resistance is critical to the success of this and any future price increases. Unfortunately, most companies lack consistent policies for how to respond, so that the mistakes of even a few can leave the company worse off than if it never even attempted the increase. The reason is that the response will create an expectation among the company’s customers about how to get a better price.
Let’s look first at what happens when a company has poorly defined or unenforced pricing policies for discounting, leaving sales reps with no authority or guidance on how to react to a customer’s insistence on a lower price. Imagine that when confronted by the purchasing agent, a sales rep looks flustered and says only that he cannot change any pricing without the approval of his manager. This simple statement will make all future negotiations much more difficult. The sales rep has communicated to the purchasing agent that: (i) his company makes price concessions to some customers; (ii) to get a concession requires resisting any offer until a sales manager is involved; and (iii) that the customer is speaking to the wrong person. In short, by communicating that it makes exceptions, the company and the sales rep have lost their price integrity: The belief that the initially quoted price is actually a fair market price that other customers pay for the same thing. Exhibit 5-2 illustrates this downward cycle of reactive, ad hoc discounting.
EXHIBIT 5-2 Cycle of Reactive Price Negotiation
Given that lack of integrity, the purchasing agent realizes that either she must figure out how to exploit it or she will be paying higher prices than competitors pay. A purchasing agent’s worst nightmare is that someone discovers that a competitor is buying the same product from the same supplier for less than she was able to negotiate. On the other hand, ad hoc discounting creates the possibility that adroit negotiation might enable the buyer to achieve an even better price than competitors. The greater the perceived potential to win a better discount, the greater the return to an investment in strategy of aggressive price negotiation.
Buyers exploit a lack of price integrity by adopting negotiation tactics that undermine value-based pricing. These usually involve purchasing policies that shift the negotiation from one where the seller manages the buyer’s expectations to one where the buyer manages the seller’s expectations. The expectation that the purchasing agent wants to create is that the buying company views the seller’s product or service as essentially a commodity for which there are easy, cheaper substitutes. Creating this expectation involves minimizing direct contact between sales reps and users who could acknowledge the value of differences. It also involves creating at least the impression of a highly competitive market for the customer’s business.
We have seen many cases where a seller lost market share at a large customer because it became more flexible in negotiating price exceptions. Once customers learn that their price is dependent upon creating substitutes, they have a motivation to solicit bids from cheap competitors, even if they have no intention of ever doing business with them. In other cases, they will “diver-sify” their purchases among two or three qualified suppliers and then create an ongoing competition among them by giving more share to whichever supplier offers the lowest price. Of course, they give their preferred supplier a “last look” chance to match lower bids to retain a larger share. But every time the preferred supplier matches, it reinforces the idea that it is better to maintain multiple competitive suppliers despite a preference for one, and undermines the idea that whatever differentiation makes the preferred supplier preferred has economic value.
Seeing this erosion of market share and customers’ willingness-to-pay for differentiation causes sellers to believe that their products and services have become more commoditized. Because they fear additional sales loss, they discount more, often cutting expenditures for the differentiation that customers appear not to appreciate. When a company with poor policies that have undermined its price integrity is the market leader, the damage is compounded. Competitors never know the real price against which they are competing, since there is no consistency. Their information about what the market leader is offering on any particular deal comes from the purchasing agent who has an incentive to underrepresent competitors’ prices and forgets to mention any restrictive terms to qualify for them. As a result, competitors will on average imagine that the leader is pricing lower than it is, and so they will price lower than necessary to win sales.
Now consider the impact on expectations when aggressive negotiation is met with strong pricing policies that maintain price integrity. Your company has announced a 5 percent price increase to cover rising raw materials costs. When confronted by the purchasing agent, the sales rep knows that his company will back him in holding firm on the increase, even at the cost of a sale. He confidently explains to the purchasing agent why all suppliers will face the same cost increases and so cannot maintain their same quality and service levels without passing it along. The goal is to make clear that the buyer will not be put at a competitive disadvantage by accepting the increase.
Many purchasing agents will still refuse to accept the increase at that point unless the firm’s price integrity has already been proven in the past. Some may only be bluffing or may be prudently planning to check what other suppliers are doing before deciding to accept the increase. Others, however, may be operating under a mandate to keep total costs from increasing. Although your price increase is creating a problem for these buyers, it is the seed of an opportunity to change their behavior by changing their expectations. That begins a virtuous cycle of Proactive, Policy-based Price Negotiation illustrated by Exhibit 5-3.
The sales rep who works for a company with pricing policies can be armed with more than just the confidence that he can lose the sale. He can also be empowered with pre-approved value trade-offs and discount policies that in a policy-free company would require review by someone higher up. The sales rep can build credibility with the customer by offering the customer win-win, or at least win-not-lose, trade-offs. For example, if the purchasing department could get the multiple users in the company to place one consolidated order each month rather than many smaller orders, the sales rep explains, his company can cut the buyer’s shipping costs. If the purchaser would buy a wider variety of products from the seller under a multi-year contract, it would be possible to reach the volume threshold for an end-of-year rebate. If the purchaser would allow the seller’s technical people to talk with the users, they might be able to suggest some process improvements to cut waste by more than enough to offset the price increase.
EXHIBIT 5-3 Cycle of Proactive Policy-Based Price Negotiation
To take advantage of these trade-offs, the purchasing agent would need to change purchasing behavior to focus more on understanding what creates value in his firm and to optimize the trade-off between what the firm buys and the sellers cost to provide it. To make the trade-offs, the purchasing agent would need to bring actual users into the decision process to evaluate them. If the policies are well designed, she will learn either that savings can come from working with this supplier rather than by threatening him, or that she already has a deal that represents the best overall value for her company. Once she develops the expectation that the best way to minimize cost is to work with her sales rep and that there is no reward to be had from deceiving him, she will become more open with information that enables the seller to identify other trade-offs that could be mutually beneficial. As buyers come to trust the process, there is no need for the seller to maintain multiple suppliers simply to gain leverage in price negotiations. This does not mean that the process will be free of conflict, anger, or occasional threats. But it will force the interactions to focus on value.
Regaining the ability to capture value when negotiating prices requires more than training the sales force on “SPIN selling”2 or any other sales program. Value-based sales tactics need to be backed by a pricing process that is consistent with those same principles. Unless a company is selling a unique product to each customer, pricing should not be driven by a series of requests for one-off price approvals from the sales force, since the sales force then becomes little more than a conduit for strategies designed by the customers. Changes in price should be driven by consistent policies designed to achieve the seller’s market-level objectives. When the policies are aligned with those objectives and clearly articulated for the sales force, the sales reps (as well as distributors and channel partners) are empowered and motivated to sell on value rather than on price.
Given the growing power of some buyers, and the increasing transparency of pricing to all buyers, any profitable and sustainable solution for dealing with price objections must be codified in policies. But what policies? The answer to this question depends upon the type or types of buyers from whom you are encountering the objection. Exhibit 5-4 illustrates four general types of buyers, who differ in the importance to them of differentiation among suppliers within the product class (for example, how important is durability or immediate availability when buying office furniture), and the cost of search among suppliers relative to the potential savings. You need policies that enable your company to respond appropriately to price objections driven by the different motivations of these different types of buyers.
Value-driven buyers purchase a disproportionate share of sales volume in most business-to-business markets. They have sophisticated purchasing departments that consolidate and buy large volumes, and they can afford the cost to search and evaluate many alternatives before making a purchase. They are trying to manage both the benefits in the purchase to get all the features and services that are important to them, as well as to push down the price as low as possible. The policies that the sales rep needs to deal with value buyers are ones that empower him or her to make trade-offs, while at the same time offering a defense against pressure on price alone.
The key to creating value-based policies is to understand every way in which your product or service might add more value to the customer than the product or service of a competitor, and every way that a change in a customer’s behavior could add or reduce the value to you. Then create a set of pre-approved trade-offs. For example, if a source of your value is higher-quality service that competitors do not offer, you need to find a way that the service can be unbundled even if that is not the way you prefer to deliver your product. It may not even save you any money to unbundle it. But it gives the sales rep a low-cost alternative to walking away or simply giving in on the price without any cost to the buyer for the concession. With that lower cost option, the rep can call the bluff of purchasing agents at companies that do in fact value your differentiation. If too many buyers are actually taking the low-service, lower-price option, it is time for management to reconsider whether the service differentiation is really worth what they think it is.
EXHIBIT 5-4 Buyer Types
The other option is to think of things the customer can do for you that would justify a discount. For example, could you create an end-of-year rebate based upon the customer buying more broadly from your product line, increasing volume by at least 20 percent (but reward for only the incremental volume, as described earlier in this chapter!), establishing a regular steady order that will not be changed less than seven days before the shipping date? Each of these illustrates a principle that we call give-get negotiation. The policy for dealing with value-driven buyers is that no price concession should ever be made that does not involve getting something from the other side. The price concession need not be fully covered by any cost savings to the seller, but it should eliminate any differentiation that the buyer claims not to value. This principle, which if the sales reps are empowered with pre-approved trade-offs can be established at the moment when the purchaser raises the price objection, educates the buyer that there is always a cost to price concessions. That cost puts a limit on the buyer’s willingness to pursue price concessions indefinitely. Once purchasers understand these new rules of the game, it also creates an incentive for them to think of new trade-offs that they might propose (for example, partnering on developing a new product) that would warrant consideration by the seller’s management as a new policy.
The fear that too many companies have is that if they adopt give-get tactics rather than simply conceding to price objections with an ad hoc deal, they will lose too many value-driven customers, or that customers will automatically choose the cheapest, most basic offering. The problem with this thinking is that if you never test it, you never know whether the objections are driven by a lack of value or simply by the expectation that objections are rewarded with price concessions. Moreover, because value buyers know their market, they sometimes do not even give you the benefit of a price objection. You just lose their business because your product or service levels are beyond what they need.
By proposing trade-offs, you can learn what value buyers value. By listening to how they respond to proposed trade-offs, you can gauge whether the problem is that you are offering too much or that you are uncompetitive for the same things. If your proposed trade-offs are rejected and you lose business, then your prices may not be competitive. In that case, it is better to lower your price proactively by policy than to wait for each customer to object. Price integrity is worth more in the long run than the extra revenue you can earn for a while from the customers who are slowest to recognize that you no longer offer a good value.
Brand-driven buyers are those for whom differentiation, particularly of the type that is difficult to determine prior to purchase, is valuable but the cost to evaluate all suppliers to determine the best possible deal is just too high. Perhaps the buyer is new to the market and just lacks the experience to make a good judgment. The buyer will buy a brand that is well known for delivering a good product with good service without considering cheaper but riskier alternatives. Other times, the buyer may have had positive past experience with a current supplier and the cost to evaluate another supplier versus any potential savings is too high; consequently, the buyer becomes “loyal” to the seller.
A price objection from a brand-driven buyer, or a customer satisfaction survey showing a decline in such buyers’ beliefs that the company offers fair value for money versus competitors, is something to take very seriously. It can signal one of two things: That the brand buyer has been disappointed by the supplier relative to expectations; or that he has learned something about market prices that leads him to expect that the price he is paying for security is excessive. A price concession is never a good response in the first case and may not be in the latter.
If the issue is disappointment, it is important to understand the nature of it and make recompense, rather than giving a price concession going forward; such a concession signals to this customer that it is reasonable to expect such disappointment in the future, and the adjusted price reflects that less-than-adequate result. A client of ours in the printing industry failed to print and ship the client’s catalog when promised which, since the catalog was for seasonal merchandise, represented a serious breach of trust. The customer opened the catalog bid to other printers for the next year and the sales rep, having been berated by the customer, felt certain that the only way to keep the account was to slash the price. After understanding the high value that this customer placed on the quality and technical relationship that they had built up over many years with the printer’s technical personnel, we proposed a different approach.
The president of the printer went to see his counterpart of this midsize catalog company to express personally that what happened reflected an unacceptable misunderstanding of how important the promised mail date was to their business. He explained how, because the client was not one of the largest in the printing plant, their job had been given lower priority when problems arose. The president explained that they now realized what a poor policy that was for sequencing jobs. The president indicated that if given another chance, his company would put together a proposal by which the client could purchase the right to be, during the weeks of time-sensitive print runs, the top-priority job in the plant. The deal would involve a sizable financial guarantee from the printer that its job would ship exactly as promised. By way of apology and to prove its commitment, the printer would give the client a large credit that would offset all of the cost of this service in the first year of a new three-year contract.
A few days later, the sales rep and the vice president of sales arrived with the proposal, including the option to “own” their desired time on the presses for what amounted to a 24 percent premium over the already high rate this customer had been paying. The proposal also gave the customer the promised credit to compensate for the prior year’s failure. After some further negotiation that slightly increased the size of the credit, the customer accepted the deal and expressed appreciation that the printer was finally giving their relationship the respect that they felt it deserved. Allowing this customer to negotiate a larger credit was acceptable because it was based upon the value lost by the past failure while still preserving the policy that the price the customer would pay reflected the value going forward.
Of course, if this buyer’s objection were driven not by any disappointment in the service but by a belief that it was already being exploited on the price, the solution would have needed to be very different. One way to avoid that problem is to understand the value you are delivering and have a policy to never let the price premium for the relationship buyer exceed that value. As important is the need to ensure that the buyer recognizes the added value that you are delivering. The key to doing that is to track all the value-added services that the customer gets and associate a quantifiable value to them. For example, a company can itemize differentiating features and services with prices for each on its invoice; it can also tabulate the number of no-charge customer support calls fielded each month or any other services delivered. Then, at the bottom, show a credit for the sum of those charges reflecting the fact that they are covered in the all-inclusive price.
Price-driven buyers are the polar opposite of brand buyers. They genuinely are not looking for a feature or service that exceeds some level that they specify in advance. The clearest symptom of a price buyer is the “sealed bid” or “reverse auction” purchasing process. The buyer commits in writing to the specification of an acceptable offer and is distinctly unwilling to invest time in hearing about the value of an offer that exceeds those specs. He wants a proposal that simply communicates your capability to achieve the specs and your price. If managed appropriately, price buyers can be useful as a place to unload excess inventory, to fill excess capacity, or generate incremental profitability, but only if the risks are recognized and managed.
The most effective policy for dealing with price buyers is the following: Strip out every cost that is not required to meet the minimum specification; design the low-cost offer in a way that makes it unattractive to your existing customer base; and be prepared with a credible justification when existing customers inquire why someone else is receiving a lower price. Many branded pharmaceuticals companies have traditionally ignored developing markets such as India and Southeast Asia because of low prices, but rapid growth in those markets has caused big pharma to take a new look at how they could generate incremental revenue from patented drugs.3 They have done so by licensing reputable local suppliers to make local versions, without the use of the brand name or distinctive shape and often combined with local ingredients that have not received approval as part of the formula in higher-priced Western countries. The companies earn incremental revenue from these price-buyer markets with minimal investment while effectively fencing off their more lucrative markets.
Sometimes value-driven buyers, and even brand-driven buyers, will masquerade as price-driven buyers in an attempt to extract reactive concessions from their preferred supplier. They hold a reverse auction, for example, that is widely open and they share the prices among the bidders with the sole goal being to get lower pricing from their existing supplier. There are a number of tip-offs to look for to determine whether this is a sham. One is that the buying company still spends a lot of time evaluating the differences among suppliers before the bid. Second is that its RFP is vague about the details of product and service specifications. Third is a lack of commitment to buy from the lowest-price bidder who meets the specs. If any of these happen, then there is reason to believe that the buyer is not really ready to make the final decision solely on price.
There are two common policies that expose value and relationship buyers disguised as price-driven buyers. One is to adopt and publicize a policy never to respond with a bid unless minimum acceptable product and service specifications are fully defined, enabling you to infer which lower-quality bidders will be excluded and to understand exactly what the buyer is willing to give up. The other approach, recommended only when the volume at stake is very large, is to submit a bid that you can deliver profitably within the ill-defined spec but is explicit in stating the lower quality or service levels that reflect the “gives” you expect from the buyer in return for a lower price. If the customer wants what they have had from you in the past—such as the ability to place rush orders, to order shipments that are less than one truckload, and to demand longer payment terms—you will enforce firm policies that will trigger additional charges for those services. Either of these policies by a supplier with an existing relationship will usually result in a return to more traditional give-get negotiations.
A common error that we see in dealing with genuine price buyers is the attempt to make them into value buyers by offering them a “promotional” price. The argument is that by giving a proven price buyer more quality or service than they have paid for, particularly when the users could really benefit from it, these customers will see what they have been missing and be willing to pay more in the future. In practice, exactly the opposite occurs. If price buyers learn that they can get priority service or superior quality when they really need it without paying for it, they have no incentive to ever change their policy of price buying. A better strategy is to let the price buyer know that you can deliver a much higher level of quality and service. When the price buyer needs a rush order or technical support because the low-priced bidder shipped defective product or failed to ship at all, a strategic pricer should have a policy to fill the order, but only at the highest list or spot price, perhaps including charges for a rush order, services, or anything else out of the ordinary. When the buyer has seen the cost of not dealing with a higher-quality supplier, the seller may offer the customer a contract retroactively that would cover those services going forward at prices equal to what other buyers pay. If the price buyer declines the offer, at least you will have earned a good profit as an emergency supplier.
Convenience-driven buyers don’t compare prices; they just buy from the easiest source of supply. Convenience buyers are value, loyal, or price buyers in categories where they spend more or buy more frequently, but will pay a price that is much more than the economic value defined in the market for a relatively small or infrequent purchase. They expect to pay a premium for convenience, so price objections from them are rare.
A subset of value buyers is what we call power buyers, who control so much volume that they have the power to deliver or deny huge amounts of market share. They expect to get better prices than any other buyer because of that power. As one supplier reported being told by a purchasing agent at a large retailer, “We expect your price to us to cover your costs. Earn your profits from somebody else.” The worst of these were the large auto firms, which bankrupted many of their suppliers before bankrupting – or nearly bankrupting – themselves. Other power buyers—such as Walmart or Home Depot—have used their power to force suppliers to become more efficient and, in the process, those power buyers have grown both by capturing more market share in their original markets and expanding into new product lines. Power buyers have also arisen in the market for hospital supplies as integrated hospital networks and as “buying groups” of independent hospitals. Buying groups are not really buyers, but associations of buyers that increase their power to negotiate deals collectively by refusing to buy from suppliers that have not signed a contract with the group. Dealing with power buyers reactively is risky; a seller is almost certain to suffer a decline in profitability as a result.
So how can a seller deal with power buyers proactively? First, stay realistic. The effect of power buyers is to reduce the value of brands. Many companies that were seduced by the large volumes offered by power buyers have consequently experienced significant margin declines. Their mistake was to think of power buyer volume as purely incremental, leading them to cut ad hoc deals without thinking about the effect on the overall market. If a brand has enough value to consumers that they will go to a store that has it rather than accept whatever is offered at a big-box store or from a buying group, then the brand has value beyond the retailer’s margin on that product. The brand can draw store traffic. Retailers competing with the big-box stores will pay more than the power buyers precisely because the brand can draw a buyer to them. For example, Benjamin Moore paints have high value to local hardware stores and home centers, not just because they have high customer loyalty, but also because they are not available at Home Depot or Lowe’s.
Still, in many markets, power buyers control so much volume that one cannot grow without them. For brands without broad customer recognition and preference, the broad distribution and access to volume that power buyers offer may be the key to profitable growth. Even companies such as Procter & Gamble with strong brands have found dealing with power buyers profitable, but not on their terms. Here is how others have made the choice to deal with power buyers and still preserve their profitability.
Make power buyers compete. Many companies with strong brand preference miss a big opportunity by framing the strategic issue poorly. They ask themselves whether they should continue with their traditional retail channel, targeting customers who are less price sensitive, or sell to retail power buyers at lower margins to win high volumes. But a third way to win the business of a power buyer, without making a price concession, is to offer one of them a way to drive store traffic. This generally involves giving the power buyer something that they can sell exclusively. For example, the retailer Target has been willing to do deals at the margins expected by famous designers of jewelry, women’s accessories, and home goods in return for exclusive designs that attract customers who might not otherwise be willing to drive to a “big-box” retailer.
Quantify the value to the power buyer. There are many ways that a brand can bring differential value to a big-box retailer. Even if the retailer already has someone as a customer, the brand can drive store visit frequency. Disposable diapers are very valuable to Walmart because their bulk requires frequent visits from a high-spending demographic group, new parents. Diapers are placed strategically in the back of the store so that each visit takes the new parents past other items that they might be tempted to buy. A large manufacturer capable of serving all of a big-box retailer’s volume across multiple locations also has the advantage of reducing the retailer’s vendor management costs.
Eliminate unnecessary costs. The most difficult challenge to manage is trying to serve both high-volume power buyers who are unwilling to pay for your pull marketing efforts, and non-power buyers who value your brand because you support its marketing. One option is to specialize in serving only power buyers, enabling the company to eliminate costs of marketing and distribution. Shaw Industries, the largest carpet supplier in North America, has a core competence in eliminating unnecessary costs from carpet manufacture. To leverage its economies of scale, it sells massive volume though big-box retailers and large retail carpet buying groups.
Segment the product offering. There is no need to offer exactly the same product through a power buyer and through traditional channels where there is a conflict. In the case of some packaged goods, only large sizes are available through other big-box retailers. Toro, the maker of high-quality lawn mowers traditionally sold through local lawn and garden centers declined for many years to pursue the business of big-box stores. Ultimately, however, the company came up with a strategy that has worked to serve both types of retailers. Toro sells a high quality, but entry-level, mower in high volumes to Home Depot. For repairs and maintenance, buyers are referred to the traditional lawn centers where the specialized retailer not only earns margins from after-sale serving, but also has the opportunity to up-sell consumers to the more expensive machines. Selling different packages and models through different channels cannot entirely prevent cannibalization, but a thoughtful strategy can often reduce it to acceptable levels.4
Resist “divide and conquer” tactics. Power buyers get their power from their ability to deny a brand or product line any volume through their stores or buying group. The key to their success is to structure the discussion as being about the pricing of each of the manufacturer’s products individually. As a result, they maximize the competition for each product line and minimize any negotiating benefit that the supplier gets from offering a full line. Thus a large hospital buying group will tell a medical products manufacturer with nine product lines that there will be nine separate buying decisions, occurring at different times, for each product line. The implication for the seller is that, in the absence of the best price for each, it could end up with a few orphaned products that are excluded from the buying group’s distribution channel.
If you have a product line with some strong brands, you do not need to react passively to purchasing policies that undermine your advantages; proactively set policies of your own. When a large medical products company was confronted with these divide and conquer tactics, it simply returned multiple bid forms for each product with different prices, adding a line to the top margin of each specifying the conditions under which those prices would apply. The lowest applied only if all the manufacturer’s products were approved by the buying group, while the highest would apply if only a subset were approved. The hospital buying group hated this tactic, but the seller maintained its policy, explaining how the value of the channel to it was vastly reduced without complete acceptance of its product line. Recognizing the cost of losing all the seller’s products, some of which had large market share among members, the buying group approved all the products.
Perhaps the most important thing to remember in dealing with power buyers is to be emotionally prepared for them to be bullies who have seen intimidation tactics succeed. If you are confident of the value you offer and you are willing to unbundle differentiation that you know the customer values, be prepared for the fact that someone high up in purchasing may become furious. He may demand to speak to your CEO and threaten unspecified consequences of a damaged relationship with his company. If and when that happens, remember that power buyers who do not need you rarely get mad; they can easily get others to supply them. The power buyers who get mad are those that need something from you as a supplier and are frustrated that they are not going to get the lop-sided deal that they expected.
One of the most difficult discussions to have with a customer involves telling them that you will increase their prices. One of our clients in the New York metro area actually had a customer in the habit of throwing things—particularly shoes—at sales reps who proposed pricing that he did not like. Other customers would quietly ignore the increase when placing an order but, when paying bills, adjust them to reflect the old prices and return the invoice with a check marked “paid in full.” As a result of being cowed by such antics, this company typically realized on average less than half the amount of the increases, with customers who already paid the lowest prices being the ones who avoided paying more. There are two very different occasions that call for increases, and well-designed policies can help to make all of them more successful.
The most important increase to achieve quickly is the one that results from a large, sustained increase in variable cost of production or a shortage of industry capacity. These should be the easiest price increases since all suppliers are facing the same problem. There is no real alternative for the customers, regardless of how difficult the increase may prove for them. Problems arise, however, from poorly designed policies that fail to manage expectations. Good policies can influence expectations in ways that help such increases get a better reception.
Even when customers realize that a price increase is ultimately inevitable, none wants to be the first to take it. They do not want to be the first to tell their customers that their prices are increasing, or the first to tell their investors that their margins have declined because of rising prices. That means that they need to trust that their competitors are all taking the same hit. The only way to get the first large customers to go along is to make them confident that doing so will not put them at a competitive disadvantage. Your policy must be that you will not back off the increase for anyone without doing so for everyone who is a customer in the same industry.
There are a few things you can do to create the expectation that taking the increase will not put them at a competitive disadvantage. First, before you announce the increase, let it be known publicly why the increase is necessary for the industry as a whole based upon costs that the industry is incurring or demands on capacity. Listen carefully for similar sentiments that all of your major competitors recognize the same need before proceeding. Second, announce the size and effective date of the increase, stating exactly which product lines are increasing by how much. Explain the cause and effect relationship (for example, energy accounts directly or indirectly for X percent of costs and that translates into Y percent price increases). The public announcement reinforces that this is an across-the-board increase and insulates your sales reps from any personal responsibility for it.
Third, if customers are fearful that their competitors will not have to take the increase or will not take it as quickly, empower them to give your most important customers a transition guarantee. If you are the supplier to their competitors, you guarantee that if you agree to a lesser or delayed increase with any of their major competitors for the same product and service, they will get the same concession retroactively. If they are concerned that a competitor who is served by one of your competitors will not get the increase, you might agree that you will delay their increase until the effective date of a competitor’s increase. All of these will help create the impression that the cost increase problem is one that you are willing to solve together in a way that recognizes their legitimate business needs as well as yours. Because it is easier for any individual customer to accept the increase given these conditions, it is more likely that all will ultimately accept it.
Under no circumstances should you back off on the full increase for customers who are more resistant while leaving loyal customers to take it, a common practice. Although such a policy can generate greater return in the immediate quarter, it reinforces that resistance pays and outrages loyal customers whenever they learn that they have been taken advantage of. On the other hand, if a major competitor fails to initiate a comparable price increase, a general rollback may be necessary. If so, contact your customers proactively to let them know that you are protecting them by temporarily suspending the increase out of concern for their competitiveness. The increase will automatically be reinstated when it can be accomplished without putting them at any disadvantage. This builds trust with your customers, keeps the price increase agreement with them in play, while letting your competitor realize that there is nothing to gain from delay.
Finally, there are situations where you can safely make concessions for good customers, but only ones that involve the timing, not the fact, of an inevitable increase. For example, you can build loyalty by being sympathetic that they may have fixed price commitments with some of their customers. For volumes necessary to fulfill those contracts, you can legitimately agree to share the pain until those commitments have been fulfilled. Thus, a customer receives a concession for some volume in the near term by agreeing to the increase going forward.
In markets where volume comes mostly from repeat purchasers, it is difficult to transition from poor policies to good ones all at once. Customers have already developed expectations that they can get rewards from certain behaviors. They will continue those behaviors for a while until their expectations change. The change takes time within the seller’s own company, too; marketing and sales management needs that time to develop good policies, and the plans to carry them out. We have seen the move to policy-based pricing fail when management implements a rigid fixed-price policy of no more discounting before developing policy-based discount options and a plan for the transition.
To minimize the risk of transition and create time to test new policies for managing discounts consistently, one needs to begin with policies for managing the transition. Chapter 11, on price management, describes a technique called price banding that enables managers to estimate how much of the price variation is illegitimate, both on an aggregate and a per account basis. The first policies should focus on managing the outliers: “Outlaws” who now enjoy prices much lower than other customers for the same products, service levels, and commitments, and the “at-risks” who are paying more than can be justified relative to the average.
The first step is to identify the outlaws and how they got that way. The reason to start here is because they are the least-profitable accounts, so there is less at risk if they take their business elsewhere. These outlaw accounts pull down other customers over time—either as a result of information leaking into the market about their pricing or because their competitive advantage in purchasing enables them to take share from others who buy at a higher price. If an outlaw is in a unique industry or different market from other customers and the low price reflects low value and low cost to serve, then an amendment is called for in your price structure that articulates objective criteria to qualify for the price and defines fences necessary to keep it from undermining your general price level. When there is no logical rationale for the low prices these accounts pay, an effective fence means to make an outlaw and others like him legitimate. That requires figuring out how the outlaw got such pricing in the first place and creating a policy to correct that mistake. If the original reason for such low pricing no longer exists (for example, a service mistake in the past led management to allow a discount to compensate, or the price reflected expectations of volume that never materialized), the customer needs to be confronted with that reality. Most importantly, the customer needs to be contacted by someone above the sales rep (the level dependent upon the size of the customer) to communicate that, while the customer has had a much better deal than others in the past, top management is unwilling to continue pricing that is unfair to other customers and unhealthy for the supplier.
With the bad news delivered unequivocally by management, the sales rep is now free to initiate a give-get negotiation in an attempt to save the account. He can contact the customer to learn whether there might be some trade-offs they would consider, to mitigate the size of the mandated increase. Various concessions on the part of the customer consistent with those made by other customers could reduce some costs. With the ability to use a second or third source as a bargaining chip now unnecessary, the buyer might even be willing to sign up for an exclusive supply contract to qualify for a discount that would reduce the impending increase.
Finally, the firm may create a policy authorizing a period of transition to a legitimate pricing level in steps. An outlaw buyer who agreed to either an exclusive contract or minimum “must take” volumes under a long-term contract (say 18 months), would then be allowed to take the necessary price increases in steps: One-third of the increase becoming effective immediately, one-third in six months, and the last third in 12 months. What makes this effective is that the purchasing agent will be able to argue that he precluded an average increase over the contract that would have been twice as large as originally proposed and pushed realization of most of it to the back end. What is important to the seller is that by the end of the contract, the buyer will be purchasing at a price comparable to what other customers pay.
Of course, some of these outlaws will be genuine price buyers who may not accept any increase. Walking away from such customers, and publicly acknowledging it as a good business decision, signals your resolve externally and internally. It will communicate a new-found commitment to doing business only with good business partners, and put others who may be masquerading as price buyers on notice that there is a potential cost. Unless your industry has excess capacity, it might also strain your competitor’s capacity with low-margin business. If that makes it more difficult to serve some of their higher-margin customers well, if only during a transition period, it gives you the chance to win some more profitable volume.
Pricing policies are most likely to be abandoned when the market enters a recession and sales turn down. Revenue then seems much more important than preserving profitability in the future. But unmanaged price-cutting in a recession not only undermines price levels that you will want to sustain in the later recovery, it can trigger a price war that makes all competitors worse off while still in the downturn. Fortunately, if a company thoughtfully manages pricing by policy though the downturn, it can minimize the damage in both the short and long run.
First, you must enforce a firm policy not to use price to take market share from close competitors during the downturn, since they can easily respond with price cuts of their own. (But you can and should retaliate selectively against price-based moves by close competitors, as explained in Chapter 7 on managing price competition.) At one point during a recent recession, a large supermarket chain initiated a price war that increased its share of revenue but tanked its share of profits. Smarter competitors, such as Winn-Dixie, promoted their lower-priced brands to help thrifty shoppers cut costs, and weathered the recession with much less damage to their profitability.5
In business markets, the value that some products can justify is tied to the health of their customer’s markets. For example, the value of a page of advertising in a magazine or space at a trade show is related to the size of the market for the product being advertised. In 2009, the return from advertising real estate was not what it was in earlier years. In such markets, particularly when variable costs are low, sellers sometimes “index” their pricing for customers willing to make long-term commitments, with the index tied to conditions in their customer’s market. Such a policy supports customers and maintains volume during difficult times, while establishing an automatic mechanism for price increases when customers can better afford them. An alternative is to unbundle elements of your product or service that the customer can no longer afford (such as, new product development and technical support), even though they value them. The point in all these cases is that these price-discounting options can be designed to expire when they are no longer needed and do not directly threaten competitors.
But what can a company do to gain volume during a downturn when demand from its current customers is shrinking but taking share will only trigger a price war that will shrink the market further? As discussed in Chapter 4 on price structure, there are various ways to attract a new, more price-sensitive segment, without cutting price to most of your existing customers. Moreover, when you have excess capacity, the cost to serve a new segment is minimal. Although you want to maintain policies that protect margins in the market where you are investing for long-term growth, you have nothing to lose from price competition, even of the ad hoc variety, in markets from which you hope to gain incremental business in only the short term. For those markets only, a policy of one-off pricing to fill excess capacity can be worth pursuing if the business can be carefully fenced.
For example, one high-end chain of hotels in Europe, which would never consider serving tour groups in good times, approached tour companies catering to small groups of high-income travelers with some very good deals. They brought in both incremental revenue and introduced their chain to a market segment of people they would want to have as nightly guests, while still enabling themselves to exit the tour segment in better times. Our commercial printer client approached direct mail advertisers accustomed to accepting poor quality from printers who use inferior presses. For mail circulars and newspaper inserts only, they offered better quality that nearly matched what advertisers were paying already. The low-end competitors could not match the offer, and the company won some incremental contribution that kept its press operators employed during some lean months.
A discount to induce product trial is a legitimate means to gain sales, but if poorly managed it can have the effect of depressing margins, as regular customers learn how to qualify for them as well. For search goods, a promotional discount is the incentive for the customer to investigate the supplier’s offer. For experience goods, it is the incentive to take the risk of what could turn out to be a disappointing purchase.
The size of the promotional discount necessary to induce trial can be mitigated by policy. A liberal returns policy if the customer is unsatisfied is one way to take away the risk of trying a product at full price. Bowflex does not discount its unique, high-end exercise equipment. But it combines direct-to-customer value communication with a money-back guarantee within the first six weeks of delivery. When product performance can be measured objectively, a performance-based rebate policy can accomplish the same thing. Rebating is becoming a common means for pharmaceutical and medical device companies to win acceptance of higher-priced products with as yet unproven differentiating benefits. When Velcade, a cancer treatment, was deemed not cost-effective and rejected for payment by the British National Health Service (NHS), the company did not reduce its price. Instead, it came back with a new offer to guarantee effectiveness without lowering its premium price. The company would refund the entire cost of the drug for any patient who did not show adequate improvement after an initial period of treatment. The guarantee won approval for payment within the NHS and created the potential for the company to earn higher profits if justified by superior performance.6 By putting money on the line, the seller raises expectations that the product probably will produce the superior treatment outcomes that the company claims, increasing trial of the product even at a higher price.
For consumer products, promotional pricing is one of the most important issues for which a company needs pricing policies and a process for reviewing their effectiveness. Even companies that have established brands with large market shares face the problem that a high percentage of buyers will leave the market or, particularly in the case of food products, will become “fatigued” and look for something different. Consequently, manufacturers must constantly win new customers to maintain a fixed market share. Promotional discounts are often a very cost-effective way to educate consumers, particularly for frequently purchased consumer products, which are usually experience goods.
The easiest way to induce trial with little additional cost of administration is simply to offer the product at a low price for a time, say one week each quarter. For frequently purchased products sold through retailers, the sales increases resulting from such “pulsed” promotions are usually huge—easily justifying the deal if looked at in isolation. But there are various reasons why a company might want to ban such promotions as a policy. First, there is some evidence that when a product is bought at a promotional price, it depresses willingness-to-pay for the product in the future. Second, both consumers and retailers will stock up on the product when promoted, giving the appearance of a big increase in volume that simply depresses sales in later periods. There are categories, usually among food products, for which stocking up is a good thing. The more inventory people have of sodas and snack foods, for example, the more they consume. For most products, however, stocking up at promotional prices simply reduces the average price that customers pay while educating them to wait for the discount.
Consequently, a policy of limiting the availability of promotional discounts and targeting them to prospective buyers is often advisable. One way to do this is with coupons. Coupons have the advantage of limiting the ability of already loyal customers to stock up. With new scanner technology, retailers offer manufacturers the ability to print coupons on cash register receipts for customers who have bought competing products, or a combination of items that indicate that they might be good prospects for something that the manufacturer wants them to try. Rebates can be offered on the item but be limited to one per family.
Many service companies are in need of more disciplined policies for pricing to induce trial. Cable TV companies offer large discounts to sign up new subscribers for a year, as do newspapers and magazines, and mobile telephone services. The problem in many of these cases is that, at the end of the discount period, they have to go back to the customer and ask for a much higher price to continue the service. A high percentage of those customers balk, knowing that either they can win an incentive from another supplier to try that supplier’s product for a while, or can wait a week or two and sign up for another incentive from the same supplier who just tried to raise their price. None of this should be surprising given what we have learned from the study of behavioral economics.7 Once someone spends six or 12 months enjoying a service at one price, renewing it at a higher price is viewed as a “loss” to be resisted. No services company should ever use a discount on the service price as its means to induce trial. Instead, it should create an inducement that maintains the integrity of the price and builds the habit of paying it. For example, a far better inducement to purchase is a “free” gift for signing up—such as the choice from a list of new best sellers for signing up for a magazine, or $100 in pay-per-view credits for signing up for a year of cable TV. After the initial commitment, the incentive is gone but the customer is paying the monthly cost that reflects the value. As a result, there is no perception of “loss” that drives away subscribers at the back end.
Good policies cannot magically make pricing of your product or service profitable, but poor ones can certainly undermine your ability to capture prices justified by the value of what you offer. Good policies lead customers to think about the purchase of your product as a price–value trade-off rather than as a game to win at your expense. As such, they are an essential part of any pricing strategy designed to capture value and maintain ongoing customer relationships.
1. Reuters, “Tesla’s Elon Musk directs staff to give no more discounts on new cars,” September 30, 2016. Accessed April 21, 2017 at http://tech.economictimes.indiatimes.com/news/technology/teslas-elon-musk-directs-staff-to-give-no-more-discounts-on-new-cars/54596279
2 . Neil Rackman, SPIN Selling (McGraw-Hill, 1988).
3. Laura Lorenzetti, “Why Drug Companies Are Betting Big on ‘Phar-merging’ Countries,” Fortune.com, August 14, 2015. See also Laurence Capron and Will Mitchell, “The Company Outsmarting Big Pharma in Africa,” Harvard Business Review (August 2012).
4. Dan Mitchell, “Manufacturers Try to Thrive on the Walmart Workout”, New York Times, February 20, 2005.
5. “Winn-Dixie CEO: Supermarket Pricing Rational, No Price War,” Dow Jones News Wire, May 12, 2009.
6. “NICE Responds to Velcade NHS Reimbursement Scheme,” PMLive. com, June 7, 2007.
7. Daniel Kahneman, Jack L. Knetsch and Richard H. Thaler, “The Endowment Effect, Loss Aversion, and Status Quo Bias,” Journal of Economic Perspectives 5(1) (Winter 1991), pp. 193–206.