Pricing represents a strategy to increase sales volume at a profit, while incorporating and communica-ting critical messages about the value that the offering delivers to the customer. This involves much more than setting prices. Even organizations that invest considerable effort in establishing prices frequently leave money on the table. Let's take a look at the four principal pricing strategies and why they are limited--and often fail.
Price to Cover Costs
Companies use this strategy to set prices based on costs plus a reasonable margin. It makes sense to do this, because if you always price to provide a profit over your costs, you'll make money. Right? Not necessarily. There are two problems with this approach. First, your customers don't care about your costs. They care only about the value you deliver. By ignoring the value that you create for customers, cost-based pricing can keep prices lower than they should be, thus leaving money on the table and reducing profits. On the flip side, pricing to cover costs can actually keep prices higher than optimum, thus reducing sales. The second problem with cost-based pricing is that it allocates overhead and/or fixed plant costs into pricing calculations. Sounds reasonable, until you consider that often those costs appear to be variable when they aren't. If you have low utilizations, your allocations are going to be high, preventing you from dropping the price to increase sales and subsequently the utilization. Again, you either forfeit profits or sales. Sometimes both.
Pricing to Meet the Market
If you know that your costing systems inflate the true costs, maybe you use market-based pricing. Here, organizations let "the market" set the price. On the surface it sounds reasonable. After all, we know that the market alone sets prices. Here's the problem with Pricing-to-Meet-the-Market: We don't sell to markets--we sell to unique customers. And customers, being unique, often surprise us and do not behave like markets predict they will. In the end, "market-based" pricing is just guessing at price to close a deal.
Pricing to Close a Deal
Pricing to close a deal is what business and pricing should be all about. After all, if we can't price to close a deal, what good is pricing? The process should work to provide us with a profit, right? Well, not really. When you price to close a deal, it provides every customer every incentive to negotiate for lower prices. These customers put salespeople through a meat grinder of price negotiations. The process, in turn, gives salespeople every incentive to respond with lower prices. It undermines confidence in prices and leaves money on the table.
Pricing to Gain Market Share
In this strategy, prices are set low to gain share against a competitor. Again, this sounds like a good idea. We all learned that increasing market share leads to increases in profits. The reality is not that clear-cut. If you already enjoy high market share, it's true you're going to be more profitable. But, it's more likely that you are not the market share leader. In that case, using lower prices to go after market share is risky. You can't expect to catch your competitors by surprise. Even if you do, the advantage will be temporary. The most likely case is that the market leader will simply match your price. Lower prices eat into profits of both companies. Customers love a price war.
Yes, but we Need to Meet the Numbers
As business managers, we learn to set financial objectives and then drive the people in the business to meet those numbers. That's what our bosses expect. There are a number of problems associated with driving employees to meet financial or other objectives, especially if meeting short-term goals is allowed to eclipse long-term objectives. In almost all cases, we are talking about applying price discounts to meet short-term sales objectives. The record of applying price discounts to meet short-term sales objectives is not promising. In fact, the results are almost always unsatisfactory. It's not hard to see why. Discounting simply trains customers to hold off placing their orders in the anticipation of even deeper discounts. But there's a bigger problem than leaving money on the table. Rather than selling your product because customers derive value from it, you end up selling your products and services to meet your numbers. It's never sustainable to exchange short-term opportunism for long-term customer development. You may get a high from the adrenaline rush of the end of quarter madness, but you end up leaving so much money on the table, you might get asked to leave the game.
It's a game that almost all businesses play. Every year, managers set projections--a fancy name for goals--for the organization to meet. And by managers, we include everyone from the executive suite to team leaders and project managers. These projections get reported down the chain of command, workers get their marching orders, and everyone waits for the results to be reported up the chain of command. If it turns out that the company has hit its projections, satisfaction abounds. It's a sign that management understands the market and is in control of the business. It's considered satisfactory if the company outperforms the projections. It's taken as evidence of particularly talented managers. No one asks why the particularly talented managers missed their projections by setting the targets too low.
Cycles of Desperation
What happens if the results start coming up short of projections? Let's back up a step. When goals are set for the corporation, they trickle down to the divisions, business units, and the regions. These projections are based on guesswork. Managers prefer the term assumptions. The assumptions take the form of forward-looking estimates about interest rates, prices of raw materials, energy costs, manufacturing capacity, and distribution logistics. The assumptions also factor in the likely behavior of competitors. All these numbers are crunched, and the resulting spreadsheets are quite impressive. But managers can't have much confidence in assumptions driven by variables that are, by definition, uncontrollable and unpredictable. Then the managers consider the one resource that they can control: their sales force. Many business forecasts are driven by assumptions about the sales force's ability to deliver the numbers the managers promise. There are two critical problems with this reality. First, most managers typically overestimate their ability to get salespeople to deliver specific outcomes. But, the second problem is even more destructive. The business loses sight of what should be its main goal of delivering long-term value for its customers. Instead, its focus shifts to meeting numbers to keep managers and investors happy.
Take a look at the situation from the point of view of the sales force. When salespeople get their objectives for the year, they base their ability to deliver results on a number of assumptions of their own. Assumptions such as having the right product mix, delivering products on time, and getting a feel for what competitors do. This is where the wheels begin to fall off the wagon. Nothing ever happens as projected. Interest rates go up. Currency exchange becomes unfavorable. Product delivery is interrupted. Competitors drop prices (imagine that). Customers seem to get more price sensitive. When things don't go as expected, it leads to what we call "cycles of desperation."
Suppose that the salespeople have been trained to negotiate well. Or perhaps they have a limit to what price they can drop to. In either case, the results are the same. Salespeople do the best they can to hold the line. Do they get rewarded for that? Nope. What happens is that at the end of the period--month, quarter, or year--it's usually the same, and the organization is short of the projections. Managers finally get off their collective behinds and go out to do what is necessary to close the gap. That means closing business with customers--whatever it takes.
There's an old business adage that says that if the only tool you have is a hammer, all problems look like nails. So it is with managers who need to make the numbers. They have a problem and the only tool they have is price.
Reed Holden, DBA, and Mark Burton are leading pricing gurus and cofounders of Holden Advisors (holdenadvisors.com), a consultancy that works with business-to-business firms to design and implement value-driven pricing strategies that increase profitability in highly competitive markets. They are coauthors of Pricing with Confidence: 10 Ways to Stop Leaving Money on the Table (John Wiley & Sons, 2008).