Core Competencies For
Power Pricing
By: Hermann Simon
Author: Power Pricing
Hermann Simon is Chairman & CEO of Simon Kucher & Partners. He has consulted extensively in Europe, North America and Asia. His recent book Power Pricing was preceded by Price Management and Hidden Champions.
From Power Pricing by Hermann Simon and Robert Dolan. Copyright 1996 by Hermann Simon and Robert Dolan. Reprinted by permission of The Free Press, an imprint of Simon & Schuster, Inc.
Introduction
"We have to get our prices up." This is a common refrain in businesses around the world today as competitive pressures have sliced margins. Often, however, the exhortation which follows is an unrealistic one for example, "Boost prices, sales volume, and profitability each by ten percent in the next year!" Opportunities to do this are rare; but opportunities to improve profit dramatically by better pricing are the norm.
Consider the CEO of a $10-billion company meeting with the marketing managers of his various divisions. "Get me a nickel, get me a dime every day. Find a way to convince the customer that we are worth it. Pick up these nickels and dimes all around the world every day---they drop right to our bottom line---and pretty soon we are talking big improvements to our net income." What about this dime? Does it really mean "big improvements to our net income"? Suppose your average price is $ 10 per unit. Now add a dime to it, to make the price $10.10, a 1% improvement in average price realization. Not necessarily by getting the price on every single order to improve by 1% but some 2%, some 5%--just average out to 1% and hold your sales volume.
What would that be worth to you? How much leverage is there in that? How much would it improve your net income?
A 1994 survey found only 12% of firms doing "any serious pricing research" and one-third of these had no strategy for using the research results. Our general experience squares with these survey findings. Many firms abrogate pricing responsibility—” the market sets the price" or "we have to match our competitor"; others use an inappropriate rule of thumb such as taking a standard mark-up on cost. These firms leave "nickels and dimes" and in some case thousands of Deutschmarks, Swiss francs, yen, dollars, and other currencies with customers around the world because they do not understand and capture the value they create for individual customers.
"Vertical" product proliferation in the form of "good, better, best" strategies are common strategies. AlliedSignal's Autolite spark plugs come in three grades: carbon, platinum, and double platinum. Kodak markets three grades of consumer film: Funtime Film "for casual picture-taking," its mainstay Gold Film, and a high-performance Royal Gold Film that they advertise as "extra clear and extra sharp for extra special moments." Similarly, firms offer complementary products. Intuit markets not only its Quicken home-finance software but also the checks to put in the system, a Quicken credit card, and electronic bill-paying services. The razor and blades, cameras and film, hardware and software, products and technical support scenario of tied, complementary products is commonplace.
This trend to offering interdependent products complicates pricing--because the price of the individual elements cannot be set independently. A product's role in the portfolio must be established and pricing considered at the product line rather than at the individual product level.
Market interdependence also is impacting pricing. Pricing is relatively simple when markets can be separated and a price individually determined for each. Historically, pricing has tended to be a highly decentralized decision with individual country managers setting prices in pursuit of their own objectives. However, today, as products are standardized across the world and global brands become the norm, treating markets individually risks shrinking worldwide profitability, because gray markets are emerging as third parties buy, sell, and ship around the world to take advantage of differences in prices. Second, individual customers have moved to worldwide procurement, further narrowing the flexibility of pricing managers as they try to set prices across markets.
The second related cause of complexity is information: better information creating smarter, more powerful customers. Buying services emerge as intermediaries for end users in industries such as automobiles because of their ability to access and process data. Information technology allows for international tracking and transmittal of pricing information, creating the need for harmonized world pricing. Buying groups have formed in a wide variety of situations from independent funeral home operators sharing information and pooling casket purchases to major corporations joining with one another to negotiate ticket prices with airline companies. For many companies, purchasing has become a strategic function. The acrimonious situation starting in the mid-1990s and continuing for years involving General Motors in the United States and Volkswagen in Germany was not about the "defection" of a great car designer or marketer, but rather about Volkswagen's spiriting away of GM's Vice President of Worldwide purchasing manager, Ignacio Lopez, and GM's allegation that Lopez took supplier pricing information with him.
The forces of interrelatedness and information have created more complex price schedules. No longer able to charge customers different prices just because of their geographic separation, firms attain price customization by applying the same pricing schedule to all customers, fully aware that because of the specific terms and conditions of sale different prices are received in the end.
The net result of this is that being simply "good" in your pricing thinking has become very costly. Customary rules of thumb are inadequate in dealing with this environment. Becoming astute in pricing analysis and judgment can pay big dividends. The goal of this article is to help your firm attain maximum financial performance by improving its pricing thinking and to show how that improved thinking can translate into improved net price realization.
Becoming A Power Pricer
Four dimensions help to define the power pricer:
1. viewpoint on pricing
2. fact files to support pricing
3. tools and scope of analysis
4. determination and implementation
Viewpoint on Pricing
The three profit drivers are sales volume, price, and costs. Specifically:
Profit = sales volume x price-costs
Sales volume inevitably gets everyone's attention. What actions are we going to undertake to move product? What investments are required in sales force, advertising, and production capacity? Sales volume is seen as a controllable outcome of company actions. Recently, the "costs" part of the equation has received the spotlight in many companies as companies like AT&T are "rightsized" and processes are "reengineered" in an attempt to "get the costs out." The attitude is that sales volume and costs can and should be managed vigorously. Pricing, however, is often the third front in the battle for profitability, as the scarce resources of management time, energy, and imagination are siphoned off to the first two fronts of sales volume and costs. The power pricer does not treat price like a third front; rather, he brings it to the fore. The power pricer believes price can be managed as effectively as other profit drivers and recognizes the extraordinary leverage that price offers.
The power pricer does not let "the market” or "the competition" set his price. His viewpoint is that given a customer's wants, his offering and its presentation, along with competitive products and prices, create a value for his product. He coordinates this "value creation" with pricing, his "value extraction" activity, and understands the system relationship among his profit drivers. Price is a key element of his profit system and he does not give up control of it to someone or something else; nor does he see it as less manageable than the other profit drivers.
Fact Files
A power pricer has data that are more accurate, timely, relevant, and dis-aggregated than everyday pricers. There is precision in what he does. He understands what is happening nowmnot just what happened two months ago; he knows a product's value to the customer-not just its cost, and he understands what's happening at the individual account or key market segment levelmnot just at a broad market aggregate.
The figure below shows the central role of perceived customer value in pricing. Starting at the top of the diagram, the firm's initial analysis has two components --- competitive analysis (left) to identify differentiation opportunities, and consumer analysis (right) to identify consumer wants and important segmentation of the market. Based on this, decisions are made that create the perceived value of the firm's offering in the market
place: first the target market is selected, and then the value-creating elements of the marketing mix assembled, i.e., the product itself, communication efforts to support its marketing and distribution to create convenient availability, and other support.
These efforts in concert with the offerings of competitors determine the value that a customer perceives in the firm's product. This perceived value is the maximum price the customer will pay. Knowing these values for members of his target market shows the power pricer the trade-off between price and sales volume. These values vary by customer. The power pricer understands this variation and the source of it. This requires data on customers' viewpoints and competitors' performance and pricing.
The dotted line at the bottom of the first figure shows that the firm's price may impact competitive offerings either their prices or their value creation activities. The power pricer understands his competitor's cost structure, capabilities, and business model and systematically tracks competitors' actions and reactions. He takes advantage of his experience in the marketplace, carefully observing and generalizing from market activities to develop a deep understanding of how the market works.
His pricing fact file also has relevant internal data, e.g., production, marketing, and service costs information- -reflecting both current levels and trends. Recent work on activity-based costing has shown the criticality of this information. In many cases, understanding the true costs of serving an account results in recognizing that a price increase is war-ranted2 Even if the price increase results in a lost sale, the firm may be better off because the revenue received from the account does not cover the true cost of the activities associated with servicing it.
In short, good pricing decisions require facts about one's own cost of doing business, the consumer's evaluation processes, and competitive activity.
Tools and Scope of Analysis
Building from the fact files, the power pricer undertakes a systematic analysis of customers and competitors to enable him to assess the outcome of alternative pricing scenarios. The first question is what sales level will a price generate? Then follows a consideration of the profitability impact. Tools such as break-even analysis and market simulations are used to assess the advisability of a price increase or decrease. The scope of the analysis extends beyond customer reaction to competitive reaction and the impact of price on industry profitability, not just market share.
The power pricer maps out the likely evolution of the industry and understands how today's pricing actions impact future price levels---understanding, for example, that a low price used to build share today may undermine the future profitability of the industry because price increases will be hard to implement. In short, he defines the price problem right-focusing on long-term profitability, not on short-term market share.
Managing price is not an easy task. The power pricer assembles a team from throughout the organization to do the job. If CEO-level involvement is needed to sell through a price decision to a major customer, the CEO becomes part of the price management team. The fact file is assembled by broad participation of functional people in touch with the right data. Technologists, sales people, market researchers, manufacturing and operations, and financial analysts all typically have data to be brought together in a coordinated way. Pricing right is a priority and the company is determined to get the value to which it is entitled.
Pricing goals are clearly understood and holders of final pricing authority have incentives which are aligned with these goals. The power pricer with a profitability goal, for example, does not delegate pricing authority to a sales force compensated on sales volume.
The Mistakes Avoided
These characteristics of a power pricer enable him to avoid three common costly pricing errors:
1. A firm focusing on customer value does not make the error of divorcing pricing from the rest of the marketing mix. For the power pricer, value creation through product, communication, and distribution goes hand in hand with value extraction through pricing.
2. The fact file at a disaggregate level helps overcome the tendency to too much uniformity in:
a. prices across customers
b. prices over time
c. gross margin percentages across products
The value that customers place on a product can vary tremendously; failing to customize pricing to that situation "1eaves a lot of money on the table." Although it is not always easy to implement a pricing schedule to adapt fully to customer-value variation, big profit opportunities are often lost through failing to understand the value variation or being insufficiently insightful about what to do about it. Often, "finding the optimal price" is the wrong way to define the problem. But properly seeing it as "defining the optimal pricing structure" yields big profit opportunities.
While it is generally not a good idea to be changing prices every day, our experience is that prices on average are too sticky, i.e., they have too much inertia. Customer wants and competitive offerings are always changing. Costs are dynamic as well.
Price change reviews should be regularly scheduled to review prices in light of such changes to keep the price-value equation from getting seriously unbalanced in either direction.
Finally, uniformity in gross margin percentage across products is common and typically stems from the cost-driven pricing rule, a failure to understand the customer-value side. Understanding value and costs at the appropriately disaggregate level allows more precise and profitable matching of prices and value.
3. The attributes of a power pricer preclude him from not learning about the underlying drivers of the marketplace. The everyday pricer sees things changing all the time in the marketplace and believes history therefore irrelevant. The power pricer's understanding is deeper. He knows that changes in easily observable behavior are manifestations of an underlying, stable reality, and he seeks to grasp the underlying reality and drivers of change. Continual learning is thus a by-product of his participation in the marketplace.
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