EXHIBIT 6-1 The Six-Step Process for Setting Prices
Setting Prices that Capture a Share of the Value Created
Pricing is the moment of truth—all of marketing comes to focus in the pricing decision.
E. Raymond Corey, Harvard Business School1
To this point, we have explained and illustrated how to create the conditions necessary to sustain price points that reflect the value that one’s products and services create for customers. Now we need a process to select value-based prices at which the firm can expect to sell its products and services most profitably. Economic theory prescribes a process for setting an “optimal” price level against a known demand curve assuming “all others things being equal.” However, in reality, all other things can never be ignored.
Take the example of a pharmaceutical company that purchased an old prescription drug and hiked the price many-fold. The price change may have been considered economically rational—after all, the drug had few substitutes and consequently demand was very inelastic. Yet what the company failed to consider was the power of community-held norms of fairness in the decision and the resulting backlash against it, and the entire pharmaceutical industry in general, by an outraged public. The public pressure for legislators to do something eventually led to a congressional hearing on price gouging that may have occurred at the company.
When it comes to setting prices, the reality is that in most companies the task is a complicated process in which conflicting, function-specific objectives come into play. Financial managers may allocate costs to determine how high prices need to be in order to repay past investments and achieve margin objectives. Marketing and salespeople may analyze buyers and competitive offerings to determine how low prices should be in order to achieve their sales objectives. The pricing decisions that result are often politically charged compromises, and not a thoughtful, market-relevant implementation of a commercial strategy. An effective pricing decision should involve a blending of, not a compromise between, internal financial constraints and external market conditions.
Unfortunately, few managers have any idea how to facilitate a price-setting dialogue across the various functions. From traditional cost accounting, many learn to take sales goals as “given” before allocating costs, thus precluding the ability to incorporate market forces into the pricing decisions. From marketing they are told that effective pricing should be entirely “customer driven,” ignoring costs except as a minimum constraint below which the sale would become unprofitable. Perhaps along the way, these managers study economics and learn that, in theory, optimal pricing is a blending of cost and demand considerations. In practice, however, they find the economist’s assumption of a known demand curve hopelessly unrealistic. Consequently, price setting at most companies remains trapped between cost- and customer-driven procedures that are inherently incompatible.
Another price-setting trap that companies fall into is to assume that if their differentiation is “x” percent better than a competitor’s, then they can price at no more than an “x” percent premium. Yet if you had cancer and knew of a drug that was 50 percent more effective than the competition’s in curing cancer, would you refuse to pay more than a 50 percent premium? Suppose you are planning to paint your house and discover a tool that will enable you to finish the job in half the usual time—a 100 percent increase in technical efficiency. Unless you enjoy the drudgery of painting or place little value on your time, you would no doubt happily pay more than twice the price of a brush to buy this tool. Conversely, improving the accuracy of a common quartz wristwatch by 50 percent is unlikely to command a 50 percent premium—after all, quartz wristwatches are already accurate to within less than one second per day and the improved accuracy would be hardly noticeable to most people.2 As these examples illustrate, the price premium associated with the economic value of a product is often much greater (or much less) than the percentage improvement in performance.
The purpose of this chapter is to suggest how managers can break tactical pricing deadlocks and avoid the error of leaving money on the table by infusing strategic balance into pricing decisions. We describe a simple, logically intuitive procedure for setting prices that integrates the relevant customer, competitor, and cost data in a way that enables marketers to set more profitable price levels. The process is designed to be efficient and adaptable to most products, services, and market contexts. It integrates data on value estimation and segmentation, drivers of price sensitivity, costs, strategic objectives, and market response analysis in a way that can be supported by the organization and understood by customers.
Price setting is the ultimate intersection of value creation and value extraction, where the seller seeks simultaneously to capture a fair share of the value created, maximize long-term profitability, and enhance his or her market position. Because different customers have different motivations for purchase, there is rarely one “optimal” price that is right for every customer. One needs to look no further than the passengers on an airplane who individually hold tickets at many different prices for essentially the same basic service. However, every sold ticket shares two common characteristics: No one paid more than the value of getting to their destination, and no one paid less than the marginal cost incurred by the airline of transporting an incremental customer on the flight. The trick, of course, is to set the right prices in a consistent, repeatable manner.
In most cases, the process of setting prices is iterative, starting with a broad definition of feasible price points and then applying a series of “filters” to narrow down to the most market-relevant feasible price point for each market segment. Exhibit 6-1 illustrates the process that we typically use. It begins by defining a viable price range for each customer or application segment established earlier when creating a price structure (as described in Chapter 4).
Defining the viable price range starts with defining the highest and lowest price points that a business might sustainably charge for the product or service. The feasible price ceiling is defined by the product’s value proposition, as summarized by the Economic Value Estimation (EVE®) model described in Chapter 2. The total economic value represents the maximum theoretical price that a fully informed customer in a particular market segment would ever be willing to pay. When trying to win a new customer, it is the absolute upper limit of price that could possibly be achieved. For an incumbent supplier, it is the price that would have to be met to insure that an informed customer would not see a competitor’s price as a better deal. For purposes of illustration, we will describe the model from the perspective of a company trying to win new customers.
EXHIBIT 6-1 The Six-Step Process for Setting Prices
The feasible price floor for a product that is positively differentiated is the price of the next-best competitive alternative. Theoretically, the price floor is the variable cost of the product—after all, any price above the variable cost will allow the seller to earn a positive contribution margin on a sale. However, if the price is set below the price of the next best competitive alternative, we place the competitor in an untenable position in which its product creates a negative economic benefit for its customers—a situation that they can only address through a price drop. Therefore, to mitigate the risk of a price war, the value-based price floor, for practical purposes, is defined as the price of the next-best competing offer.
For a product that is negatively differentiated, the price ceiling will also be defined by the economic value, which in this case is below the price of the next-best competing alternative. For negatively differentiated products, the price floor is defined by the product’s variable cost. An example of a negatively differentiated product would be a mobile phone carrier that only offers local coverage and is not able to offer roaming services like the market leaders. In this case, the local carrier will set their price below the market leaders that reflects its lower value proposition, yet still high enough to cover its variable costs. These offers may still represent a good value for a segment of customers who rarely leaves the coverage area.
EXHIBIT 6-2 Illustration of the Reasonable Price Range
Taken together, the price ceiling and the price floor represent the “reasonable price range” in which a price can be set, as illustrated in Exhibit 6-2. Ultimately, setting the price will define how any differentiating value gets shared between the seller and the buyer. If buyers were able to keep all the added value, paying no more than the competitive price for a superior product or service, they could be easily won over—but probably not profitably. If sellers were to set prices that fully reflect the value of their positive differentiation, there would be no financial incentive for the customer to purchase that brand over a more generic alternative. In reality, prices for new products are usually set below the level of value delivered. The difference between the actual price and the maximum value can be viewed as “the incentive to purchase.” Done correctly, a price premium over a competitor can often be framed as a “dis-count relative to the value delivered,” a framing that can fundamentally shift the dynamics of value communication and price negotiation. The challenge is to figure out what balance between creating a financial incentive and earning a higher margin per sale is in the best interest of the seller.
The decision on how value should be shared between buyer and seller is not driven by altruism but rather by judgment about what is most likely to yield long-term, sustainable profits. Leaving more of the economic value on the table may, other things being equal, induce customers to migrate to a new product or service more quickly. But “other things” are rarely equal. Although a higher price is by itself a deterrent, a higher price per sale can simultaneously justify greater expenditures to win the sale. Does the customer understand the value of the differentiation offered? If not, educating the customer may win more sales at a higher price than offering the product at a lower price to someone ignorant of the true value. Or perhaps the customer understands the value story but also sees risk that may turn out not to be true. In that case, a money-back guarantee may be much more effective than a lower price. Price is all too often used as an inducement to overcome resistance that can be dealt with more cost-effectively, and therefore more profitably, in other ways.
If the product in question is already on the market and has an established price, we suggest using the current price as the starting point for analysis so long as it sits within the “reasonable price range.” For a new product, one might do some formal or informal research with a few potential customers about the product concept and its differentiating benefits to determine what they would expect to pay for such added benefits. As a last resort, one can choose a 50:50 sharing of the differentiating value as a starting point for the analysis. In the following sections of this chapter, we will describe additional considerations that will guide a further narrowing and refinement of the price range.
Step 1 defined an externally “Reasonable Price Range” consistent with economic value and the importance that customers place on it when making purchase decisions. It did not indicate where in that range a company might reasonably expect to operate most profitably. Should prices reflect the high value to a relatively exclusive set of buyers, even at the expense of restricted market share? Fazioli (pianos), Porsche (automobiles), and Festool (power tools) have been very successful pursuing that strategy. But other companies have been highly successful making lower prices a reason to buy from them. Ryanair (air travel), Old Style (beer), Samsung (electronics), and the so-called “dollar stores” (retailing) have all pursued that strategy successfully. Still others seek to get the highest price they can justify but only to the point where is does not exclude their product from consideration by most of the potential market.
It is essential that price levels be set in a way that supports and advances the broader marketing objectives of the firm. When a leading software maker dropped prices on its operating system by nearly 50 percent in 2009, the move was consistent with the company’s long-held goal of maintaining and growing market share. The critical question for the software company’s managers was whether the price cuts would result in higher profits over the long term. It is easy to envision scenarios in which a competitor’s response limits any volume gains from the price cuts, thereby reducing profitability. If the software maker’s primary business objective was to increase current profitability, it might have been better served by maintaining a premium pricing strategy, even at the expense of some lost volume.
To be useful, pricing objectives must be set relative to some reference point. Given the strategic importance of customer value to the overall pricing strategy, we define pricing objectives in terms of the share of differentiating value that the firm attempts to capture in its price. This decision should be driven by judgments about what will yield long-term, sustainable profitability. As noted earlier, a low price will, other things being equal, induce customers to migrate to a new product or service more quickly. On the other hand, if the product’s differentiation is likely to be sustained by patents or copyrights, a low price established to drive sales means foregoing considerable margin over the long run. Pricing low initially in the hope that one can raises prices later is difficult given the effect of the initial prices on buyers’ future perceptions of price fairness.
There are three alternative strategic choices that one might adopt for a pricing strategy: Skimming the market, penetrating the market, or neutral market pricing.3 But the choice is not arbitrary. Given a firm’s relative capabilities and market position, usually only one positioning will represent the most profitable option and often only one positioning will be sustainable.
Let us examine the conditions under which each strategic choice might be most appropriate.
OPTION 1: SKIM THE MARKET Skim pricing (or skimming) is designed to capture superior margins, even at the expense of large sales volume. By definition, skim prices are high in relation to what most buyers in a segment can be convinced to pay. Consequently, this strategy optimizes immediate profitability only when the profit from selling to relatively price-insensitive customers exceeds that from selling to a larger market at a lower price. In some instances, products might reap more profit in the long run by setting initial prices high and reducing them over time—the “sequential skimming” strategy we discuss below—even if those high initial prices reduce immediate profitability.
Buyers are often price insensitive because they belong to a market segment that places exceptionally high value on a product’s differentiating attributes. For example, in many sports a segment of enthusiasts will often pay astronomical prices for the bike, club, or racquet that they think will give them an edge. You can buy a plain aluminum canoe paddle for $35. You can buy a Bending Branches Double Bent paddle (wood laminate, 44 ounces) for $149. Or you can buy the Werner Camano paddle (graphite, 26 ounces) for $249. The Werner Camano not only makes canoeing long distances easier but also signals that one belongs to a select group that has a very serious commitment to the sport.
Of course, simply targeting a segment of customers who are relatively price insensitive does not mean that they are fools who will buy at any price. It means that they can and will pay a price that reflects a large portion of the exceptionally high value they place on the differentiating benefits they expect from the purchase. Thus skim pricing generally requires a substantial commitment to communicate why the differentiating features of the product or service can be expected to yield benefits that justify a high price to at least some customers. If effective value communications are neither practical nor cost-effective, then the firm must limit its pricing to reflect what it can communicate or to what potential customers are likely to believe simply from what they can observe.
The competitive environment must also be right for skimming. A firm must have some source of competitive protection to preclude competitors from providing lower-priced alternatives with comparable benefits. Patents or copyrights are one source of protection against competitive threats. Pharmaceutical companies cite their huge expenditures on research to justify the skim prices they command until a drug’s patent expires. Even then, they enjoy some premium because of the name recognition. Other forms of protection can include a brand’s reputation for quality and prestige, access to a scarce resource, and preemption of the best distribution channels.
A skim price isn’t necessarily a poor strategy even when a firm lacks the ability to prevent competition in the future. If a company introduces a new product at a high price relative to manufacturing cost, competitors may be attracted by the high margin even if the product is priced low relative to its economic value. Pricing low in the face of competition makes sense only when it serves to deter competitors or to establish a competitive advantage. If a low price cannot do either, the best rule for pricing is to charge the most that you can while you are able. If and when competitors enter by duplicating the product’s differentiating features and, thus, undermine its competitive advantage, the firm can then reevaluate its strategy.
Sequential skimming can be a more appropriate strategy for products and services with low repurchase rates. The market for long-lived durable goods that a customer purchases infrequently such as the latest smartphone model, or products that most buyers would purchase only once, such as a ticket to a stage play, can be skimmed for only a limited time at each price because the buyers willing to pay the highest prices leave the market after making a purchase. Skimming, in such cases, cannot be maintained indefinitely, but its dynamic variant, sequential skimming, may remain profitable for some time.
Sequential skimming, like the more sustainable variety of skimming, begins with a price that attracts the least price-sensitive buyers first. After the firm has “skimmed the cream” of buyers, however, that market is gone. Consequently, to maintain its sales, the firm must reduce its price enough to sell to the next-most-lucrative segment. The firm continues this process until it has exhausted all segments with profitable volume potential. In theory, a firm could sequentially skim the market for a durable good or a one-time purchase by lowering its price in hundreds of small steps, thus charging every segment the maximum it would pay for the product. In practice, however, potential buyers catch on rather quickly and begin delaying their purchases, anticipating further price reductions. To minimize this problem, the firm can cut price less frequently, thus forcing potential buyers to bear a significant cost of waiting. It can also launch less attractive models as it cuts the price. Tesla seems to be using this strategy as it builds the market for electric cars. The first Tesla, the Roadster, was introduced in 2008 at a base price of $109,000 in the United States. The second Tesla model, the Model S, was introduced in 2012 at a price of $71,500, and was followed by the more recently announced Tesla Model 3 that was slated to start deliveries at the end of 2017 at a base price of $35,000. This variant to sequential skimming has been described as “pushing down the stack” and is used frequently in technology markets such as semiconductors and cellular phones.
OPTION 2: PENETRATE THE MARKET Penetration pricing involves setting a price low enough to attract and hold a large base of customers. Penetration prices are not necessarily cheap, but they are low relative to perceived value in the target segment. Hyundai, for example, used a sustained penetration pricing strategy to enter the U.S. market in which the company offered high value in the form of reliability, ten-year warranties, and well-appointed interiors at prices far below those of Japanese makers of similar quality cars. Similarly, T.J. Maxx and Marshalls stores have positioned themselves as offering products of the same or better value as their competitors at lower prices.
Penetration pricing will work only if a large share of the market is willing to change brands or suppliers in response to a lower price. A common misconception is that every market will respond to lower prices, which is one reason why unsuccessful penetration pricing schemes are so common. In some cases, penetration pricing can actually undermine a brand’s long-term appeal. When Lacoste allowed its “alligator” shirts to be discounted by lower-priced mass merchants, high-image retailers refused to carry the product any longer and traditional Lacoste customers migrated to more exclusive brands. Lacoste has since restored its prestige brand status by revamping its look, signing endorsements with leading tennis stars, managing its pricing more tightly, and using outlet stores for discounted products so that the brand image is not diluted in its premium retailers.
Warehouse clubs such as Sam’s, Costco, and B.J.’s Wholesale Club have designed retail formats that use penetration pricing to attract only buyers willing to purchase in large quantities. Charter vacation operators sell heavily discounted travel to people who do not mind inflexible scheduling. T.J. Maxx and Marshalls target those price-sensitive customers willing to shop frequently through limited and rapidly changing stocks to find a bargain. Xiameter, a division of Dow Corning, has been able to win a large share of price-sensitive buyers with previously unachievable prices for silicones by eliminating costly services and delivering only in the most cost-effective shipping quantities.
To determine how much volume one must gain to justify penetration pricing, a manager must also consider costs. Conditions are more favorable for penetration pricing when incremental costs (variable and incremental fixed) represent a small share of the price, so that each additional sale makes a large contribution to profit. Because the contribution per sale is already high, a lower price does not represent a large cut in the contribution from each sale. For example, even if a company had to cut its prices 10 percent to attract a large segment of buyers, penetration pricing could still be profitable if the product had a high contribution margin. In order for the strategy to be profitable in a case where the original contribution margin is 90 percent, the sales gain would need only exceed 12.5 percent. The lower the contribution per sale, the larger the volume gain required before a penetration price is profitable.
Penetration pricing can succeed even without a high contribution margin if the strategy itself creates sufficient variable cost economies to be self-funding, enabling the seller to offer penetration prices without suffering lower margins. The willingness of price-sensitive shoppers to change brands enables the so-called “dollar stores” and similar discounters to vary the products and brands they offer depending on who gives them the best deal, thus increasing their leverage with suppliers. The penetration prices of Save-A-Lot grocers (a division of Supervalu Inc.) enables them to maintain such high turnover, high sales per square foot, and high sales per employee that they can offer rock-bottom prices and still earn higher profits than traditional grocers do.4 To cite a manufacturing example, as personal computer users became more knowledgeable buyers willing to buy without first visually inspecting the product, manufacturers such as Dell used penetration pricing to sell high-quality products to knowledgeable buyers online while still earning exceptional profits per sale from the savings associated with direct sales and distribution.
Of course, for penetration pricing to succeed, competitors must allow a company to set a lower price that is attractive to a large segment of the market without their matching it. Competitors always have the option of undercutting a penetration strategy by cutting their own prices, preventing the penetration pricer from successfully offering a better value. Only when competitors lack the ability or incentive to do so is penetration pricing a practical strategy for gaining and holding market share. There are three common situations in which this is likely to occur:
The telecommunications industry offers an illustrative example of successful penetration pricing. As regulators opened telecom markets to competition in most developed countries, new suppliers successfully used penetration pricing to capture market share. The low variable costs of carrying a call or message make such a strategy desirable. Regulatory constraints and the unwillingness of large, established competitors to match the lower prices of new entrants on their large installed base of customers enabled the strategy to succeed. Still, many telecom managers would question whether a heavy reliance on penetration strategies is sustainable indefinitely because it conditions some portion of the market simply to seek deals rather than good value.
OPTION 3: NEUTRAL PRICING Neutral pricing involves a strategic decision not to use price to gain market share, while not allowing price alone to restrict it. Neutral pricing minimizes the role of price as a marketing tool in favor of other tactics that management believes are more powerful or cost-effective for a product’s market. This does not mean that neutral pricing is easier. On the contrary, it is less difficult to choose a price that is sufficiently high to skim or sufficiently low to penetrate than to choose one that strikes a near-perfect balance.
A firm generally adopts a neutral pricing strategy by default because market conditions are not sufficient to support either a skim or penetration strategy. For example, a marketer may be unable to adopt skim pricing when buyers consider the products in a particular market to be so substitutable that no significant segment will pay a premium. That same firm may be unable to adopt a penetration pricing strategy because, particularly if it’s a newcomer to the market, customers would be unable to judge its quality before purchase and would infer low quality from low prices (the price–quality effect described in Chapter 3) or because competitors would respond vigorously to any price that undercuts the established price structure. Neutral pricing is especially common in industries where customers are quite price sensitive, precluding skimming, but competitors are quite protective of volume, precluding successful penetration.
Although neutral pricing is less proactive than skimming or penetration pricing, its proper execution is no less important to profitability. Neutral prices are not necessarily equal to those of competitors or near the middle of the range. A neutral price can, in principle, be the highest or lowest price in the market and still be neutral. For many years, Sony TVs were consistently priced above competitors, yet they captured large market shares because of the high perceived value associated with their clear screens and reliable performance. Disney theme parks are premium amusement destinations, yet they still attract a large number of visitors, many more than their competitors do. While Disney adroitly segments this market, offering some higher-priced options such as priority admission, its regular prices represent good value for the money.
The next consideration when determining where to set price levels is the relationship between changes in price, volume and profitability. Economic theorists propose pricing based upon estimating the “demand curve” for a product and then “optimizing” the price level given the incremental cost of production. In a relatively small number of markets, this advice is practical. When a company lacks competition so that the demand curve for its brand is the market demand, the effect of price on a firm’s sales is more predictable than when it must also account for the effect of price on customer choice between competing brands. It is also possible in some highly competitive markets to estimate demand because large quantities of data are accessible. Manufacturers of leading brands of beer and soft drinks can measure quite accurately the effect of price on sales of a brand, or even a package size, because they can now acquire “big data” from retail stores that enable them to control for changes in almost all of the other factors that can affect brand price elasticity for their product: The type of retailer, the prices in nearby stores, the day of the week, the time of day, and even the weather. This enables them to optimize prices for the sale of small package sizes in convenience stores that occur at the end of a workday, while optimizing differently for larger package sizes sold on weekends in grocery stores. They can quickly re-optimize in response to changes by competitors.
Unfortunately, while price optimization against a known demand curve is ideal in theory, it is in practice usually impractical. The reason lies in the assumption that a “demand curve” is something stable, enabling one to measure price elasticity at a point in time and then use that estimate going forward to predict the effect of price changes on sales. Unfortunately, the demand for individual products or brands within markets is rarely stable or easily measured. The reason: Sensitivity to price depends as much on ever-changing purchase contexts and perceptions as on underlying needs or preferences. For example, contradicting the assumption of a demand curve, the amount of a product that customers will buy at a price point is strongly affected by the prices they paid recently. When gasoline prices are rising, the demand for premium grades of gasoline will fall quickly by a much greater percentage than demand for regular grades. But when prices decline back to where they started, demand for premium grades will not recover quickly. That is, demand when prices are going up is generally much more “price elastic” than when prices are coming down.
Still, one cannot deny the fact that the profitability of a price increase will depend upon whether the loss in sales is not too great, while the profitability of a price decrease depends upon whether the gain in sales is great enough. Economists refer to the actual percentage change in sales divided by the percentage change in price as the “price elasticity” of demand, as expressed in the following equation:
E = (%ΔQ)/(%ΔP)
Where E is price elasticity, Δ indicates “change in,” Q stands for sales quantity, and P is price.
Price elasticity, E, is generally a negative number since positive price changes (price increases) generally lead to sales declines while negative price changes (price reductions) generally lead to sales increases. The greater the absolute value of E, the more “elastic,” or responsive, demand is to price changes.
Actual elasticity depends in part upon how effectively marketers manage customer perceptions and the purchase context, as described in Chapter 3. Moreover, many factors that influence price elasticity are not under the marketer’s control, making precise estimates of actual price elasticity very difficult.
BREAKEVEN SALES CHANGE CALCULATION Because price elasticity is so difficult to measure precisely in most markets, we have found that instead of asking “What is price elasticity for this product?” it is often more practical and useful to ask “What is the minimum elasticity that would be necessary to justify a particular price change?” that has been proposed to achieve some business objective. To put the question in less technical jargon, we ask “What percent change in sales would be necessary (which is the same as asking what price elasticity would be necessary) for a proposed price change to maintain the same total profit contribution after a price change?” We refer to the answer as the breakeven sales change associated with a proposed price change.
If we create a graph of breakeven sales changes associated with different potential price changes, we can create a breakeven sales curve that looks much like a demand curve, as shown in Exhibit 6-3. In fact, it is a representation of how much demand is needed to maintain current profitability as prices change. If actual demand proves to be less elastic (steeper) than the constant profit curve, then higher prices will be more profitable. If the actual demand proves to be less steep (more elastic) than the constant profit curve, then lower prices will be more profitable. Technical details about how to calculate a correct breakeven sales change for any particular product and pricing decision are described in Chapter 9.
EXHIBIT 6-3 Constant Profit Curve Associated with Different Price Changes
The key to price optimization with limited information is to hypothesize price alternatives (e.g., pricing near-competitive prices versus a 10 percent price premium that reflects the value that most customers should enjoy from the differentiating features of the product or service). Then, rather than asking “ How will sales volume change following this price change?” which is devilishly difficult to answer with confidence, we suggest that managers answer a pair of questions with more readily achievable answers to guide their pricing choice:
These are actually much easier questions to answer. As illustrated in Exhibit 6-4, the changes in sales necessary to make a change in price profitable depends essentially on the size of the incremental contribution margin associated with those sales. When performing a breakeven analysis, additional complexities can be introduced, such as what happens if the variable costs change as volume shifts; what if higher sales volumes lead to incremental fixed costs (to expand production capacity, for example); or what if a competitor changes its price? Another important consideration is the existence of substitutes and complementary products within the firm’s own product line. It is easier to justify skim pricing when some customers who are deterred by the skim price will substitute a lower-priced offer from the same supplier rather than defect to a competitor. The suppliers of smartphones thus skim price their leading, full-featured option without putting all of the potential margin of a sale at risk. These scenarios can be evaluated through a similar analysis, and all calculations are described in detail in Chapter 9.
EXHIBIT 6-4 Breakeven Sales Changes Required Given Different Contribution Margins
The major benefit of a breakeven analysis is its practicality. Very few pricing decisions are made with the luxury of knowing in advance how customers and competitors will react. Even the most rigorous research techniques used to measure expected customer response to price change (described in Chapter 8) rely either on making inferences from past data or rely on customer responses to surveys, both of which are only imperfect predictors of the future. Most managers must make decisions with less quantitative information, relying on subjective judgments and after-the-fact measurement of effects. Incremental breakeven analysis is an approach that leverages knowable data such as current costs and sales volumes to establish clear, indisputable benchmarks that any price change has to meet in order to be profitable. It is a very effective initial step to grounding an internal debate on whether to raise or lower prices.
After establishing the breakeven sales change necessary for a potential price change to be profitable, it is necessary to make a judgment about whether that sales change is likely to be achievable. Sometimes an estimate of past price elasticity can be gleaned from historical transaction data, especially in the case of high transaction volume goods such as groceries or gasoline or common grades of steel. Sometimes examples of past “natural experiments” can be found in such data where prices were changed and the market had an opportunity to react. These price changes could take the form of changes in list price, temporary price reductions, or competitive price moves that changed the relative price position of competitive products. Even when such natural experiments exist, management still needs to make a subjective judgment about the applicability of the price elasticity measured in the past to estimate the likely effect of a price change now. Are market conditions similar now to those in the past or have they changed? Generally, both consumers and businesses become more price sensitive during poor economic conditions than during times when incomes and profits are rising. Has the competitive set changed? If competitors have now copied some of what was your firm’s differentiation, it is reasonable to assume that customers will have become more price sensitive in their brand choice. On the other hand, if competitors have recently had well-publicized quality problems, then it is reasonable to assume that price elasticity might be less than in the past.
One should not avoid incorporating qualitative judgments as well. For example, it is reasonable to ask sales reps whether they would be willing to accept an increase in their sales goals equal to the breakeven sales change in return for granting the additional discounting authority for which they have been asking. Although subjective and subject to bias, their response is still valuable information that may be less precise, but more informed, than “hard” quantitative estimates that were based upon surveys rather than upon actual behavior. It is also reasonable to make some inference from public information from the success or failure of price increases for other product lines similar to your own and sold to the same customers.
In cases where historical transaction data is not available, where there have been no prior price changes to study, or where market conditions are significantly different from those during which past transaction data is available, it can be beneficial to perform research to estimate the potential impact that a price change might have on future demand. Techniques for estimating price elasticity range from the most sophisticated and costly to the least effective but easy to implement; broadly speaking they are: Controlled-price experiments, purchase-intention surveys, structured inferences, and incremental implementation .
A thoughtful choice from among these options involves trade-offs between the cost to implement and the quality of data gained to aid in making the pricing decision. Chapter 8 describes these methodologies in detail.
Finally, unless one has the benefit of “big data” to estimate price elasticity with confidence, it is generally wise to implement price changes incrementally. This approach often works well for products for which price changes are not very costly to make or to reverse, such as frequently purchased products and B-to-B products, without long contracts. In this approach, managers simply test customer response by making limited price changes in a series of small steps. The goal is to gradually arrive at a profit-maximizing price point by calculating breakeven sales changes and testing the market to see whether sales changes are on the profitable side of that breakeven point. For example, a maker of distinctive pre-manufactured homes slowly repositioned its brand from being a cheaper alternative to being a premium-priced product with distinctive value in design and reliability. During that period, it raised prices a few percentage points more each year than the prices of similar traditional homes and tracked the effect on its sales relative to the industry. When the changes no longer improved profits, the manufacturer stopped making them.
Although by the time you set a price, you should already have segmented your market to reflect the differences in value for different applications or occasions, there will remain differences in the prices customers will pay even within segments. The drivers of those differences were described in Chapter 3 and are summarized in the box below. They affect what we call “price sensitivity:” a term for the effort and attention that customers will devote to making a purchase with the largest gap between the value they receive and price they pay. For example, even within the same application segment, knowledgeable and highly sophisticated purchasers (such as professional purchasing agents and dedicated bargain hunters), will be much more likely to change their behavior in response to a change in price than will less well-informed customers. The later will risk getting less for their money in return for making the simple decision to buy the well-known brand or the next brand they encounter. Similarly, customers purchasing larger quantities who have a more urgent need to achieve an objective, or who are making the purchase to achieve a higher-valued end benefit, will pay more.
If a large share of a segment is made up of people who are driven to high-price sensitivity by one or more of these factors, then pricing further below value to win business, or lowering price closer to value to retain business, will be important to motivate the desired customer purchase behaviors.
Factors That Influence Price Sensitivity
Researchers have identified a list of factors that influence a buyer’s price sensitivity, including the following:
In considering these price sensitivity factors, marketers should seek to understand which of them are relevant for their particular products, and for which segment of customers, in order to influence them favorably through price and value communications. One of the major differences between tactical and strategic pricing is that tactical pricing assumes that price sensitivity is a constant that cannot be influenced. That assumption, which often is made implicitly, simplifies price setting by reducing it to a measurement task. But experienced marketers understand that this simplification comes at a cost, because thoughtful price and value communications can often decrease price sensitivity and support higher prices with less adverse volume impact than would otherwise have been expected.
Consider the example of the Toro Company. The value obtained from purchasing one of their snow blowers depends on the amount of snowfall that a customer is likely to experience—a big uncertainty. In addition, several of the sensitivity factors listed above tend to amplify a buyer’s reluctance to make a purchase: The machines are very expensive, the cost is fully borne by the homeowner, and perhaps most intriguingly, there is a risk perception held by homeowners that the year they purchase a snow blower will be the year that it does not snow! Unfortunately, it is not in Toro’s or retailers’ interest to take on a huge inventory of snow blowers in anticipation of when a snowstorm might arrive and customers come rushing in.
Traditionally, suppliers in markets such as these would simply offer an “early-bird” discount to induce most buyers to purchase well before the snow falls. Toro, however, took a more innovative approach and developed the “S’No Risk Guarantee” whereby the company would rebate a portion of the purchase price should the season’s snowfall come in below average.5 With its new rebate policy, Toro in essence aligned their price with the value delivered— the less snow to remove, the lower the effective price of the machine. Toro also gave consumers a reason to make their purchases without having to give an “early bird” discount even in years when its snow blowers might end up creating high value that justifies much higher pricing. Additionally, by making the offer conditional on the homeowner making a purchase prior to the start of winter, they eliminated the chaotic impact of demand spikes that regularly occur on the day of a major snowfall.
Based upon the estimate of economic value, the strategic choice, and the evaluation of possible price elasticity relative to the breakeven, it is possible to use judgment to define a relatively narrow “Viable Price Range”. Within that range, it is important to take account of the price sensitivity effects and determine whether there is a cost-effective marketing campaign that could mitigate or leverage one or more of them to influence price sensitivity. Then, ultimately, management must pick a price level within the viable range that, in their subjective judgment, is most likely to win sales profitably.
The final task in setting a new price level is to communicate the rationale for the change, especially when there is potentially an issue of “fairness.” Perceived fairness is one of the most powerful factors driving price sensitivity. Done correctly, communicating fairness can have dramatic effects. For example, a well-known medical device manufacturer successfully implemented a 40 percent price increase for one of its key products by carefully communicating a rationale for the change. The company recognized that it had made a tactical mistake by not raising prices annually along with industry practice, so it notified customers three months in advance of the increase to allow them to plan for the new prices. Not surprisingly, some customers “bought forward” at the lower prices, loading up before the price increase. But, giving them that option to mitigate the immediate effect of the change made the company’s decision seem fair and reasonable, while also making it more difficult for the firm’s competitor to exploit the increase to gain share.
To further communicate fairness, the company’s letter to customers explained that it had not taken an increase in eight years and noted that the new price was still less than what it would have been had its past prices increased in line with the medical device price index. Finally, the sales force met with each major account to explain that, prior to the price increase, the product was not generating sufficient returns to fund continued research and development (R&D). This was important to hospitals and doctors who relied on the company, a technology leader, to continually incorporate new technology. To reinforce the inherent fairness of the price change, they committed to invest much of the additional profit in R&D that would benefit customers in the form of new products.
Just as there are different reasons for price changes, there are different approaches to communicating fairness. In some instances, rising raw material costs require a price increase. In such situations, customers are concerned about whether the vendor is being opportunistic by raising prices more than is justified and whether all customers, particularly competitors, are being treated equally. To communicate fairness in these situations, first send a letter, email, or press release to all customers simultaneously that explains why across-the-board price increases are necessary. Tie the increase clearly to the cost increase (for instance, “Energy prices have increased 24 percent; energy accounts for 10 percent of the price you pay, so prices must increase by 2.4 percent”) and be prepared to provide documentary evidence. Where possible, consider indexing prices to an objective measure of raw material costs such as a published commodity price index. Customers, and competitors, too, are more likely to accept a price increase if they know that prices will come back down when costs are lower. Indexed pricing is especially useful in times of significant price spikes because indices can be adjusted monthly or weekly depending on the frequency of raw material price changes.
Second, avoid being opportunistic by attempting to gain share by compromising on the increase. It can be tempting to waive a 5 percent increase for customers willing to give you 20 percent more volume, particularly in industries with excess capacity. But such an action may well be short-sighted if your competitors cannot afford to lose volume any more than you can. Although being opportunistic may lead to a short-term volume increase, it will surely invoke a competitive response and send a clear message to customers that the rationale for the price increase was not legitimate. In addition, we would caution against waiving all or part of price increases for your largest customers. Not only is the impact of the price increase diminished, but the diminished impact compounds over the course of several increases.
Third, consider non-price mechanisms to “raise” prices and lessen the customer impact. When faced with a sluggish economy or input cost increases, sellers often turn to less visible mechanisms such as adding a new “fuel recovery” charge to bills for services or reducing package sizes for consumer products. These changes are often barely perceptible to consumers and the familiar price point that consumers are accustomed to remains intact. And in some instances, these non-price adjustments can be remarkably effective. In an attempt to absorb a cost increase, a yogurt maker recently decreased its package size and actually saw its sales soar. The reason? The manufacturer emphasized the now lower calorie count per single-serve package and diet-conscious consumers viewed this as a benefit!
Another mechanism to mitigate the effect of price increases is to use a lower-priced brand (in groceries it is often a “house brand”), to provide a ready alternative for price-sensitive consumers who are at risk of either switching suppliers or reducing the quantity purchased. Another tactic is to incentivize buyers to adopt low-cost behaviors such as online purchasing (common among airlines who waived reservation charges online while cutting payments to travel agents) or encouraging a shift to “off peak” purchase (common among health clubs and cruise lines) to improve capacity utilization. Finally, in some cases, it is possible to switch product formulation: When cotton prices rose, some clothing manufacturers adjusted the fiber content in their garments by substituting cheaper synthetic materials as a way to manage the cost increase.6
Another situation that requires communicating fairness occurs when a company increases prices after underpricing its products relative to the value delivered. This occurs frequently when companies begin to assess the economic value of their products for the first time and discover that they have justification to increase prices for some products if they communicate value more effectively. The fairness issue stems from the fact that the company was not charging for value in the first place, so why start charging for it now? This is a legitimate question, the answer to which should be that over time, all prices will be adjusted to align with value. In some cases, this will mean lower prices and in others, higher prices.
To ensure that customers do not think that price increases are being forced on them, offer them options on how they can adjust to the new prices. For example, when large customers resist the price change, offer them the ability to “earn” lower prices by, for example, signing longer-term supply agreements, committing to full-truckload shipments, or other activities that can lower costs. Just be careful in cases where there is industry over-capacity—competitors will likely retaliate to recapture any lost share. Alternatively, be prepared to unbundle the core offering from services and other value-added features in order to provide a lower-value option at the old price. Whichever approach the company adopts, it is critical that customers pay for the value received. By providing choices for how that happens, you increase the perception of fairness and improve the odds that the price change will be successful.
Setting market-relevant prices requires a combination of both art and science. In spite of the many sophisticated tools and analytics available to marketers, price setting usually comes down to using informed judgment to find a price that balances costs, customer value, strategic goals, and potential competitive responses. The process we have described in this chapter is designed to create a structured dialogue that leads to informed conversations that “take the emotion out” from a complex and fraught price setting decision. When followed by managers who are informed about their markets and possess basic pricing knowledge, this process will help lead to sustainable and profitable prices.
1 . Raymond E. Corey, Industrial Marketing: Cases and Concepts (Englewood Cliffs, NJ: Prentice Hall, 1962).
2 . Michael Lombardi, “The Accuracy and Stability of Quartz Watches,” Horological Journal (February 2008), pp. 57–59.
3. For a more detailed discussion, see Gerard Tellis, “Beyond the Many Faces of Price: An Integration of Pricing Strategies,” Journal of Marketing 50 (October 1986), pp. 146–160.
4. Janet Adamy, “To Find Growth, No-Frills Grocer Goes Where Other Chains Won’t,” Wall Street Journal, August 30, 2005. Accessed February 7, 2017 at www.wsj.com/articles/SB112536840884226388.
5 . “Toro S’No Risk Guarantee Offers Money Back,” Green Industry Pros, August 1, 2013. Accessed February 7, 2017 at www.greenindustrypros.com/news/11076597/toro-sno-risk-guarantee-offers-money-back-snowthrower.
6 . Adrianne Pasquarelli, “Designers Cotton to Synthetic Materials,” Crain’s New York Business, February 27, 2011. Accessed February 7, 2017 at www.crainsnewyork.com/article/20110227/SUB/302279977/designers-cotton-to-synthetic-materials.