According to pricing expert Eric Mitchell , profit is a function of three factors — price, margin and cost. Of these, pricing represents perhaps the most difficult to get right. Part of the problem, notes Mitchell, is that many CEOs approach pricing as a tactical activity, something you do just before taking a product or service to market. In reality, pricing is a strategic function that encompasses far more than just the cost of making and delivering the product.
Before developing a pricing strategy, Mitchell recommends giving serious thought to five critical factors:
- Competition. Who is your competition, what is their cost structure, and how do they price? This information is especially important if your business submits bids or responds to requests for proposal in order to make a sale.
- Customers. According to Mitchell, no two customers buy for the same reasons. Plus, they often perceive different value from your product or service. In today’s world, more and more companies are implementing different pricing structures for different categories of customers.
- Financials. What are your gross margins? What do they need to be? Does your cost structure allow you to achieve those margins? The higher your margins and the lower your costs, the more flexibility you can have in your pricing strategies.
- Perceived value. Do your customers consider you a value-added provider or a commodity? Do they see you as different from your competitors? If so, are they willing to pay for the difference(s) you offer?
- Marketing objectives. Is your goal to increase market share? Drive out competitors? Introduce a new product? Open a new market? Boost profits? Most important, what does the ideal customer for your business look like, and are you putting together a pricing package to attract that kind of customer? Pricing PrinciplesWhen developing a comprehensive pricing strategy, says Mitchell, it pays to heed the following principles:
- Set prices according to your market, customer and competitive needs. Do not set prices based upon your costs or profit goals. Costs do not determine what your customers will pay; they simply establish a floor below which you cannot make a profit.
- Adopt a long-term pricing perspective. Every pricing decision should be based on your company’s need for stability, controlled competition in key markets, and the loyalty of established customers.
- Find creative ways to reward retention. In many businesses, 80 percent of sales come from 20 percent of the customers. Rewarding retention will insure that key accounts do not exert uncontrolled downward pressure on your margins.
- When in doubt, start high. In general, customers buy new products based on their new technology, performance, capabilities and reliability. For that reason, price is often a secondary consideration. Established and familiar products are more price-sensitive than new products aimed at new markets.
- Collect information about major competitors. Review trade publications, collect price lists, spot-check sales information from the sales staff, and interview personnel newly hired from competitors. Compile the information in a database and comparatively analyze it against your own price/product offerings.
- When possible, set internal target prices. Regularly review your costs, pricing history, competition and market trends to help you select target prices with key customers.
- Convey target prices to your salespeople. If an account is important to your company, establish special pricing controls when you set a target price. For example, you may give salespeople (or your sales manager) discretion to drop the cost up to five percent below your target price. Be very clear about how low they can go with any given customer or class of customers.
- Design and budget for promotional pricing. When properly designed, promotions can often improve market share without risking a competitive price retaliation. Promotions can be rotated among products/product lines and tested geographically prior to a national roll-out. This strategy reduces the risk of giving away too much price in a promotion and allows for market feedback. Keep in mind, cautions Mitchell, that price promotions will not cure inferior products. Use pricing promotions only as tactical devices, not as a strategic tool for turnaround. Fighting the Wal-Marts of the WorldWhat happens when Sam Walton or some other “600-lb. gorilla” moves in next door and decides to gobble up your market for lunch? The last thing you want to do is lower your price and battle the big boys head-to-head.”In the ’90s, when the huge retailers first began entering smaller markets, they tended to use their brand as the primary competitive weapon,” explains Mitchell. “Now they use a combination of brand — which consists of image and a promise of service — and low price to come in and squash the small players in an industry. In a very short time, large companies have learned they can use low price to steal market share from smaller competitors.”Instead of trying to compete on price with someone who can sell a product for less than it costs you to make it, Mitchell recommends a two-pronged approach:
- Study your customer base to determine which niches and distribution channels are most secure. Then focus all your resources on dominating those areas.
- Attack on service. Huge companies may have economies of scale but they can’t respond as quickly as small companies or provide anywhere near the same level of service.”The key is to find a niche you can excel in and defend it with everything you have,” advises Mitchell. “Focus on delivery, performance, response time, engineering specs or some other service area that the big guys can’t match. Make your service tangible by offering a guarantee that eliminates low cost as a factor in the buying decision. Make the big boys the commodity and pitch them as the bad guys while positioning yourself as the value-added provider.”Annual Pricing ReviewFor many companies, especially those in commodity industries, pricing is primarily a function of managing margins and costs. In particular, says Mitchell, it involves cutting out costs that customers don’t give you credit for.”Increasingly, we live in a price-driven costing world, where more and more companies are price-takers, not price-makers,” states Mitchell. “If you don’t have any room to move your price, you’d better focus on your margins. That means identifying things embedded in your cost structure that don’t matter to the customer and eliminating them from your product/service offering.
“As CEO, you need to establish and ‘own’ a minimum margin. By that I mean when salespeople come to you and say that clients will walk if you don’t lower the price, you need to set a rock-bottom margin and let them walk away if they refuse to meet it. Create a minimum target and a series of average targets for different customer groups and make sure your salespeople adhere to those targets. In this way, price management becomes margin management.”
To support this process, Mitchell recommends conducting an annual profit-price review. This involves a half-day meeting with your CFO or controller and other management team members to review your overall pricing strategy and accomplish three specific goals:
- Review the costs embedded in your structure. Ask three critical questions: Are we doing things the customer doesn’t value? Are we doing things for free that we ought to be charging for? Are we doing things that we can’t charge for but the customer takes for granted? If you answer yes to any of these questions, your cost structure needs adjusting.
- Review your volume discounts. Over time, some high-volume customers tend to do less business with you, for a variety of reasons. However, unless someone pays attention, they continue to get the same pricing discounts. The goal with pricing discounts is to encourage customers to add more volume, not buy less. If your pricing program isn’t helping to grow your business, cut back on it or develop a new one.
- Conduct a bottom ten review. Identify your ten worst customers and evaluate whether it makes sense to continue doing business with them. If not, let them take their business elsewhere, so you can free up more resources to focus on your more profitable customers. Before cutting someone loose, however, charge them what you need to make a profit and see if you still get the business.Finally, Mitchell suggests identifying a “captain of pricing,” someone whose main focus is to track the effectiveness of your pricing strategies in the short and long term.”This person should have a wide range of responsibilities, including researching competitor pricing, making sure you respond quickly to quotes, bids and proposals, keeping up to date on pricing trends and helping you implement day-to-day margin management,” he explains. “Without someone paying attention to it on a regular basis, pricing tends to get put on the back burner. When that happens, you can end up leaving a lot of money on the table.”