Best Practices:  Pricing Strategies

Pricing Strategies: A Best Practices Overview

Few would argue that the Internet and other sophisticated technologies have radically changed the business environment, often in ways we can't even detect yet. And prices and margins in virtually every industry are facing downward pressures like never before. But what does the future of pricing strategy look like? That depends on who you ask.

We turned to three experts on pricing issues -- TEC speakers R. Sam Bowers and Douglas Gilliss and former TEC speaker Eric Mitchell -- to get their take on this issue. Interestingly, while they tend to agree on the symptoms of the problem and the overall diagnosis, they do not agree on the cure. All three acknowledge that new technology, unlimited access to information and increasing global competition are conspiring to "commoditize" entire industries and force prices into a seemingly endless downward spiral. Their opinions diverge, however, when it comes to the response they believe CEOs and companies should take to counter those relentless market forces.

When faced with constant demands from customers to lower prices, Mitchell and Gilliss support a value-added approach. In essence, they feel that companies can overcome commodity pressures and maintain high margins by finding narrower market niches to compete in and then focusing on adding value to the customer in order to differentiate themselves from the competition. When customers understand the difference you bring to the table, they willingly pay a higher price.

Not so, counters Bowers. He believes that the value-added mindset is a relic of the old economy, that in the new economy the process of commoditization is inevitable and unstoppable. By fighting it, you only make matters worse by raising your costs higher, which makes it impossible for you to lower price and still make money. In a world where customers have many vendors they consider to be equals, says Bowers, the only way to make money is by continually lowering your cost structure so that you can compete on price. Companies that continue to employ a value-added approach will soon cost themselves right out of business.

Which strategy is right for your business? Only you can decide. However, whether you adopt a value-added or low-cost approach, a well thought-out strategy will generate far better results than a knee-jerk response to competitive pressures or changing conditions in the marketplace.

Basic Pricing Strategies

According to Mitchell, developing a comprehensive pricing strategy involves five essential factors:

1. Competition
2. Customers
3. Financials
4. Perceived value
5. Marketing objectives

In addition, Mitchell also recommends giving due consideration to the following principles:

• Set prices according to your market, customer and competitive needs.
  
• Adopt a long-term pricing perspective.
  
• Find creative ways to reward retention.
  
• When in doubt, start high.
  
• Collect information about major competitors.
  
• When possible, set internal target prices.
  
• Convey target prices to your salespeople.
  
• Design and budget for promotional pricing.

What happens when a very large competitor decides to enter your niche? 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:

1. Study your customer base to determine which niches and distribution channels are most secure. Then focus all of your resources on dominating those areas.
   
2. 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.

For many companies, especially those in commodity industries, pricing is primarily a function of managing margins and costs. To support this process, Mitchell recommends conducting an annual profit-price review. This involves a half-day meeting with your management team to review your overall pricing strategy and accomplish three specific goals:

• Review the costs embedded in your pricing structure and eliminate the ones customers don't want or won't pay for.
  
• Review your volume discounts and adjust where appropriate.
  
• Conduct a bottom ten review to eliminate unprofitable customers.

Mitchell also recommends identifying a "captain of pricing," someone whose main focus is to track the effectiveness of your pricing strategies in the short and long term. Unless someone pays attention to it on a regular basis, pricing tends to get put on the back burner, which can cause you to leave a lot of money on the table.

Pricing for Long-Term Relationships

Over the years, Mitchell has seen a lot of changes in pricing strategy. He identifies three major pricing challenges in the current environment:

1. Justifying your price
   
2. Proving your price is fair
   
3. Pricing for a relationship

To justify your price, Mitchell recommends the following:

• Create a buyer review checklist. Publish a pamphlet or tip sheet that educates customers about how to buy your product or service. For example, "How to Buy from an Ad Agency" or "Ten Tips for Purchasing Data Storage Services."
  
• Make things real. Provide testimonials touting your product or service (especially true for service companies). Anything you can do to make your benefits more tangible will enhance your ability to maintain price.
  
• Provide references. Ask your clients to write letters of recommendation. Provide prospects with a list of satisfied clients to call.
  
• Provide an exceptional guarantee. One of the best ways to distinguish yourself from the competition is to offer a guarantee that far exceeds industry standards.
  
• Shout your value. Never assume that customers know you and your reputation. The burden of proof rests on your shoulders.

To enhance the perception of fairness for your price:

• Use precision pricing. Identify your best product -- the one with the highest perceived quality -- and promote it at a very small discount. This creates an image of fairness for your other products that customers see as more of a commodity.
  
• Offer a "de-featured" brand. For example, Marriott now offers Residence Inns and Fairfield Inns at significantly lower prices than their flagship hotels. Although the quality and service are lower, the cheaper rates create a perception of fairness for the higher-priced hotels.
  
• Reward volume buying. Offer discounts to customers when they reach a certain volume. Extend their payables dating or offer other incentives that don't necessarily change your price but still create a perception of fairness.
  
• Unbundle your services. Set a price for all the services you currently don't charge for, such as free delivery or free service calls. Include the cost of those services on the invoice but don't add them to the actual total. This lets customers know that your price includes more than what they think they're paying for.
  
• Offer incentives. Give your best customers small product rebates at the end of a quarter. Offer discounts on slow-moving items.

To price for a relationship (rather than a one-time transaction), says Mitchell:

• Create different categories, or tiers, of pricing that motivate customers to do more business with you but also save them money over the long term.
  
• Bundle your products and services. Even if you don't lower your price, the customer assumes that it must be a good deal because you took the trouble to bundle it.
  
• Simplify the pricing presentation. Make it easy for customers to understand your pricing proposition and determine whether or not it's fair.

"The key is to make short-term pricing decisions with a long-term perspective," advises Mitchell. "All pricing decisions should be based on your company's need for stability, controlled competition in key markets and the loyalty of established customers."

How to Win a Price War

Gilliss defines a price war as more than just trying to steal market share by offering a lower price. Instead, it consists of a long-term marketing/costing problem that requires looking at who you are, what business you are in and how you serve that marketplace. To win a price war, he recommends three strategies:

1. Don't fight. Instead, pick your battles by narrowing your focus. Maximize your strengths by putting all of your resources in an area where you can absolutely win.
   
2. Pick your battles and maximize your strengths. Narrow your niche until you can dominate it. Dig in where nobody can compete with you.
   
3. Create alliances to eliminate enemies. Form an alliance with your sales team by helping them fully understand who they're dealing with and what they're delivering. Also, find ways to align with companies who use the same kind of product or service and can naturally refer customers to you.

Your ability to get the price you want depends to a large extent on how your customers perceive your product and service offering. To enhance your customer's perception of value, says Gilliss:

• Analyze failures, returns, and customer complaints.
  
• Generate enough profit to enable you to provide high levels of service.
  
• Identify what you do that is different from your competitors and concentrate on those areas.
  
• Stay consistent with what you deliver.
  
• Never quote price without a value statement.
  
• Track and measure customer service.
  
• Offer unique and powerful guarantees.
  
• Help your customers get maximum value from your service offering.

"People buy because of who you are, not what you do," explains Gilliss. "Find out where your company really makes money and be very careful about diluting that. Above all, be selective about who you take on as customers. In the 21st century, making money will have more to do with the customers you don't take on than those that you do."

Value Pricing in a Commodity World

These days, it seems that every customer wants it better, quicker, faster and cheaper.

One way to combat the seemingly relentless pressures on pricing, suggests Gilliss, is to base your pricing structure on the value you deliver to customers, not on the cost of goods and services you sell. To help customers understand your unique value:

1. Differentiate, differentiate, differentiate. Ask, "What do we do that is better, faster, easier, etc., than our competition?" Then create a profile of the ideal customer for those benefits and focus all of your resources on serving that customer.
   
2. Provide real value. Solve the customer's problems and meet their specific needs by understanding the four principles of value:
   

• Value, not price, is always the issue.
  
• The customer (not you) defines the value.
  
• Value and service are your only real product; it's difficult to differentiate on the product itself.
  
• It's not what you sell; it's how you sell it.
  

1. Focus on the customer's customer. It's your job to educate the customer about how to make money with the goods and services you sell. Don't expect them to figure it out on their own.
   

According to Gilliss, customers make buying decisions based on the "components of value" you offer. Examples include time, expertise, information, convenience, quality, guarantees and payment terms. The challenge is that each customer values different components. To avoid commoditization, identify the specific items of value for each customer, set them up in order of importance, and then reduce your value to quantifiable terms. Remember that value, not price, is always the issue.

The ultimate goal, says Gilliss, is to climb out of the commodity box so that you can engage in value pricing. With value pricing:

• You get high-margin (premium) pricing.
  
• Price is compared to the customer's increased profits.
  
• The price is recoverable by the increased profits.
  
• Price is not discounted.
  
• Price is application-specific based on the customer's improved profits and yield.

"The secret to value pricing lies in addressing the customer's perception, not yours," notes Gilliss. "The name of the game is not what you sell, it's how you sell it."

Pricing Strategies for a New Economy

Bowers believes that the defining element of the new economy is a fundamental shift in the way goods and services get exchanged. He also believes that we have moved from a world where products and services are sold to a world where they are bought -- a subtle but very important difference. When customers are buying (as opposed to being sold) three critical factors exist:

• Customers have already researched the product or service, either through the Internet or their engineering or purchasing department.
  
• They have already found at least two or three alternative vendors, any of which they feel comfortable buying from.
  
• They know exactly what they want and how much they are willing to pay for it.

Once these factors exist, any hope of selling the customer on your value-added flies right out the window, never to return. The only thing left to dicker about is price. You can't fight the trend of commoditization and you can't beat it. What you can do is learn to manage the process so that you still turn a healthy profit. In order to do so, however, you must come to grips with the realities of the new economy:

New economy reality: The only way to increase profits is by lowering costs.

• Old economy thinking: You can raise price (or at least maintain margins) by adding value and convincing customers you are "special."

New economy reality: The only way to compete is to improve your quality and productivity so you can lower your price.

• Old economy thinking: When asked to lower price, the best strategy is to do more for the customer.

New economy reality: When customers demand lower prices, do less, not more.

• Old economy thinking: A great relationship with the customer allows you to charge more.

New economy reality: Customer loyalty is dead.

Does this mean you should completely forget about trying to differentiate yourself or stop trying to stand out from the crowd? "Not at all," says Bowers. "You still need a quality product or service or you won't even get into the game. And you still need to constantly look for new and innovative ways to solve customer problems and serve their needs. But once the customer makes the decision to buy, you must stop playing the value-added game and stop selling. All that does is increase your costs and lower your ability to make a profit."

To many, this sounds like a bleak -- rather than a brave -- new world. However, Bowers believes you can make money in the new economy by adopting these strategies:

• Accept the reality of commoditization.
  
• Acknowledge that the customer has already made the decision to buy.
  
• Think less, not more.
  
• Stop selling and start negotiating.
  
• Eliminate the idea of fixed costs.
  
• Become world-class at cost accounting.
  
• Focus on net profit, not gross margin.
  
• Just say no to unprofitable deals.

Making a Profit in a Commodity World

The secret to making money in a commodity world, suggests Bowers, is to proactively manage the process of commoditization. Specifically:

1. Stop selling and let the customer buy.
   
2. Focus on reducing costs.
   
3. Manage your "Kenny Rogers" line.

When customers are ready to buy, most companies send in their highly trained (and very expensive!) salesperson to try to convince the customer how special they are. Instead, says Bowers:

• Acknowledge the customer has already made the decision to buy.
  
• Stop trying to prove you are "special."
  
• Send in a negotiator, not a salesperson.
  
• Focus on meeting specs at the lowest price.

To reduce costs, says Bowers:

• Make it easy for customers to find you.
  
• Stop making cold calls.
  
• Eliminate unnecessary collateral expenses.
  
• Stop entertaining customers.
  
• Retrain your sales force (or consider eliminating it altogether).

Every business exists on a continuum. On the right-hand side you have high-margin, value-added products and services, on the left-hand side are low-margin, commodity products and services. In between, there is a certain point at which you can no longer make a profit. That point represents your "Kenny Rogers" (know when to hold 'em, know when to fold 'em) line. In a commodity world, asserts Bowers, you can't afford to accept business to the left of this line.

The main challenge with the Kenny Rogers line is that customers keep trying to push it to the left. In other words, they keep asking for lower and lower prices, often to the point where your margins shrink to zero or less. To make money under such conditions, argues Bowers, you have to manage your cost structure by deliberately moving your Kenny Rogers line to the left before your customers ask you to. This requires constant innovation to increase productivity, reduce costs and improve your ability to buy from your vendors -- all so that you can lower your costs before your customer demands it.

To manage your Kenny Rogers line:

• Don't let fixed costs determine your Kenny Rogers line.
  
• Unbundle your products and services.
  
• Don't assume competitors have the same cost structure.
  
• Be prepared to open your books.
  
• Constantly improve your ability to buy.
  
• Stay ahead of the curve.

If you can run ahead of your customers' demands to lower prices, you can put some money in your pocket or gain market share with your lower cost structure. Once customers start demanding lower prices, you can afford to move with them.

"In today's world, customers and competitors can move your Kenny Rogers line to the left in a heartbeat," concludes Bowers. "Your job as CEO is to create a long-term plan to manage that process. Harness your company's energy and resources on the left-hand side, and get creative at improving productivity and lowering costs."

Staying Vendor-of-Choice in a Commodity World

As the vendor who is already doing business with the customer, you can usually charge a little more than competitors, primarily because the customer doesn't want to go through the hassle of replacing you. However, this doesn't mean the customer thinks you're better than competitors #2 or #3, cautions Bowers. Your only advantage is that the customer feels comfortable with you and would rather not make a change unless someone comes in with a significantly lower price.

In this environment, three critical pricing questions arise:

1. How much can you charge over and above the competition before your customer considers switching?
   
2. How low do competitors have to come in before they can seriously challenge your position?
   
3. What would a competitor have to do in order to lower their cost structure enough to offer that price?

When you're the vendor in place and one of your competitors suddenly offers a much lower price, don't automatically assume they are willing to lose money on the deal. And don't assume they're offering an inferior product or service. The competitor may have found a way to lower their cost structure, which means they can now make money at a level you can't afford to go. Or, their price doesn't include the same level of service as yours, which means your current offering may include things the customer doesn't want or need.

Either way, advises Bowers, don't rush back in and try to convince the customer how special you are. Instead focus on lowering costs and moving your Kenny Rogers line to the left.

If you're vendor-in-line number two or three and you want to dethrone vendor #1, you can't just match their price, you have to beat it. That requires purposefully and deliberately moving your Kenny Rogers line to the left so you can offer a lower price and still make money. Overall, the ideal strategy is to become the vendor in place and then continue moving your Kenny Rogers line to the left faster than your competitors and your customers. When you reach that position, you then have two equally good choices:

1. Use your position to put money in the bank until your customers and competitors catch up to your new Kenny Rogers line.
   
2. Use your lower cost structure to take clients away from competitors.

"Whether you're the vendor in place or trying to attain that position, the name of the game is to get good at moving your Kenny Rogers line to the left," concludes Bowers. "In a cost-conscious, commodity world, it's the only way to make money."

Contributing Experts:

R. Sam Bowers

R. Sam Bowers is president and founder of Service Sales Institute. He helps entrepreneurial companies strategically determine their long-term positioning and assists in developing their tactical sales and marketing programs. A former president and COO for a division of a $400 million services company, Bowers has also been a salesman and training manager in the computer industry as well as an associate professor of economics. A former TEC Chair, Bowers has given more than 300 TEC presentations and is a member of the prestigious "TEC 200 Club."

Doug Gilliss

Doug Gilliss, M.B.A., J.D., is operations manager for Negotiation Services International, a training and consulting firm specializing in helping business executives to successfully resolve their most challenging negotiations. He designs negotiation strategies for major contracts and trains executives and sales personnel to use effective negotiation techniques. A former business litigation attorney, he has trained and consulted with thousands of business managers for the last 16 years. Gilliss has spoken to nearly 200 TEC groups on the subjects of negotiations and pricing strategies.

Eric Mitchell

Eric Mitchell is president of The Professional Pricing Society, the only association dedicated to supporting price decision makers and price management personnel. He is also the founder of the Professional Pricing Society and editor of its publication, The Journal of Professional Pricing. A leading consultant on pricing strategies, Mitchell has published The Pricing Advisor for 17 years, and has also authored seven workbooks including "Profitable Pricing Strategies," "The Complete Pricing Workbook" and "The New Product Pricing Workbook." A (former) TEC speaker for more than a decade, he continues to give workshops and keynote speeches to corporations and associations around the world.

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