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August 19, 2012

6

When Ignorance Isn’t Bliss – The Power of Pricing

by Jeremy Arnone

Historically, companies have driven earnings growth via robust demand, first domestically and then internationally.  As worldwide economic growth has decelerated the past 10 years, companies have increasingly relied on cost-cutting programs to buoy earnings.  However, with much of the easiest cost cutting already occurred (we can hope), many companies are unsure where next to find an earnings boost.

When it comes to ways to drive earnings growth, pricing always takes a back seat to higher volume (demand) and reducing variable costs (such as me or you).  This despite the fact that a 1% increase in price leads to an average 8% increase in operating profit, 50% higher than a similar decrease in cost, and 300% higher than a 1% increase in volume.

Source: McKinsey, Inc.

On the other hand, a decrease in price has the exact same effect on earnings.  For example, a 5% fall in price would require a nearly 20% increase in volume to make up the decrease in earnings.  Whether because of “market conditions,” a Sales team “closing the sale,” or an attempt to spur volume, it’s almost impossible to increase demand sufficiently to justify significant price cuts.

So why does pricing not get the respect (and fear) it deserves?  I think there are several reasons.  Because most companies don’t understand the power of pricing, it’s not prioritized.  In addition, pricing is hard; few companies have the knowledge and experience to tackle it effectively.  Plus, many companies have a “gut feel” that raising prices is bad for their long-term health, and isn’t a customer-friendly approach.  And lastly, driving growth via pricing just isn’t as sexy as entering new markets and attracting new customers.  “Board, our strategy this year is to raise our prices by 3%.  Questions?”

To see how this might work in action, I’d like to share the growth challenges confronted by a large B2C merchant.  The data is disguised to ensure confidentiality.

Challenge

The company is looking to improve customer acquisition.  Management has preliminary discussions about lowering prices, increasing shipping discounts, and spending more on marketing.  With the main selling season just 6 months away, the company needs to make a decision quickly.  What should it do?

Discovery

We started by running a series of pricing tests, to understand the impact on share, sales, and margin of different price points.  Here’s what we found:

This analysis showed that, contrary to the team’s assumptions, the price which would drive the greatest sales was not the same price that would drive the highest share.  In fact, the price difference was almost 20%.  And the margin-maximizing price point was nearly 40% higher!

This analysis also showed a major problem.  While the company’s advertised price was at the high end of the range, their margin performance was closer to the low price.  Why?  Because while the company was using the higher price in its marketing and sales collateral, it was offering a series of promotions and discounts to close the sale.  In other words, they were getting the (lower) share of a high price and the (lower) margin of a low price, the worst possible combination.

Our recommendation was to reverse this relationship, to advertise the lower price and then work to increase the price during the conversion process.  This would increase the volume at the top of the conversion funnel and, if managed well, increase the final price paid without a significant impact on conversion.

We also recommended a segmentation strategy which better identified prospect and customer segments.  We saw very little variation in the price paid across the customer file, which can indicate an inefficient matching of needs and willingness to pay.

Finally, we suggested a more consistent use of value-add offerings.  There were a variety of internal and external products and services which could complement the existing product to improve conversion, net price, and customer satisfaction.

Impact

Through the use of web analytics and the customer database, a customer segmentation project was initiated.  Based on existing behavior and purchase histories (standard RFM augmented with clickstream, demographic, and survey data), a number of high-level segments were created.  The use of discounts on the site and with the Sales team was reduced, while advertised prices were lowered closer to the share-maximizing level.  Key parts of the website – with a focus on the order process – were changed to improve the check out process, reducing the number of steps required to complete an order while also adding in upsell and cross-sell opportunities where appropriate.   This had a significant impact on the net price paid, which we see below, and yielded significant increases in market share, sales, and earnings.

Implications

In the overall marketing mix, price is the most important item that can affect a company’s profitability. How to set prices and measure their impact on a company’s business model, however, is less clear. Too many times, the focus of pricing is related to short-term competition or internal cost structure.  To develop an effective pricing strategy, it’s important to integrate meaningful customer input based on company and competitive offerings, in order to answer the following types of questions.

  • Is our goal market share, revenue, or profitability, and do we know the optimal price for each?
  • What is the value we provide to customers, and does our pricing reflect this value?
  • What do we know about our customers and can they be segmented based on willingness to pay?
  • How do we leverage non-product components to increase the value (and price) of the product?

Management must create an environment that encourages marketing, product, and finance to develop the necessary inputs and to work together to develop the optimum strategies. This is no easy task, but the benefits of a comprehensive pricing strategy compared to on-going reactive pricing can be tremendous.

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6 Comments Post a comment
  1. Ryan Hess
    Aug 20 2012

    Really powerful post, the McKinsey graphic was especially impactful, had no idea that such small changes in prices would have such a big impact on earnings. The main condition is gross margin, but I see that your second graphic shows this as well.

    Very well done!

    Reply
  2. Peter Jansen
    Aug 20 2012

    Pricing done right is rare, most companies (and individuals who work as contractors) are better off with higher prices and fewer customers, but no one wants to “shrink” and so they keep prices too low and charge the same to everybody. Dumb!

    Here’s some additional info you might find interesting. http://www.iveybusinessjournal.com/topics/strategy/pricing-for-growth-and-profits

    Great post!

    Reply
  3. Todd Knight
    Aug 20 2012

    Thanks for your advice. I’ve taken bits and pieces and applied it to my own business. Thanks again!

    Reply
  4. Jessica Caviness
    Aug 20 2012

    Hi Jeremy, love your blog. I like the book reviews and recipes most, but this post was interesting because I have my own (very small) business and I never know if I’m charging enough. I’m probably not your ‘target audience’ for this post since I don’t have all the resources you mention to help figure out the best price. Are there any other ways to figure this out? Thanks!

    Reply
  5. Carole Kristly
    Aug 20 2012

    Erik Sherman at Inc.com has a similar perspective – although without the charts and data you share. Check it out. http://www.inc.com/erik-sherman/when-its-time-to-raise-prices.html

    Reply
  6. Sandra Qui
    Aug 21 2012

    Hi Jeremy, can you clarify how you increased the net price via segmentation? I don’t understand how that would help, exactly.

    Reply

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