Strategic Pricer Blog

Lately I have been asked a common question, “We’re in a recession and my volume is off; should I lower prices?”  Of course, the answer is never simple, but there are a number of questions that can help us think through the problem and come up with a reasonable answer.

1.    What is happening with prices in general?  What is happening with your raw material prices?  Although the Producer Price Index is often quoted as a single number, it is made up of thousands of price indexes for commodities and labor.  It is important to consider what is happening to your raw material and labor costs.  If your costs are not decreasing, any price decreases you offer will just lower your profit, and those price decreases may be a greater reflection of your fear rather than the real market dynamics.

2.    What is happening with demand for the types of products you sell?  If demand is decreasing, will it be stimulated with lower prices?  How do you know?  I think about the restaurant business as an instructive example.  We have read how much restaurants are hurting due to a dramatic reduction in the number of diners.  Some chains have lowered prices to try to win more business, but what they are getting are lower margins and fewer diners.  It appears that people are not choosing between restaurant options based on price, they are choosing not to eat out at all.  In that case, lowering prices just further lowers profitability.  Conversely, those that choose to eat at restaurants do seem to be
ordering less of the higher priced wines.  In that situation, rather than reducing your prices on high-end wines, consider offering fewer of those and adding more moderately priced wines.

3.    What is happening with supply?  If the supply of products in the market is still as high as it was when demand was more robust, prices will most likely have to decrease to reach economic equilibrium.  However, market supply is a broad concept, and there are often many micro markets within the broad market.  If some of the micro markets have a more balanced supply/ demand equation, it would be unnecessarily costly to reduce prices in those balanced micro markets.

4.    Can you help balance the supply/ demand equation by reducing supply?  This is obviously more relevant to firms that make up a larger part of the market, but it is exactly what OPEC does.  When demand falls, oil prices come down, but the OPEC members try to offset that by restricting output.

5.    Are your competitors lowering their prices?  Are they winning more market share?  Clearly if your competitors are taking market share from you with lower prices, you will have to react.  But if competitors are not lowering their prices, do you really want to lead the market down?  You will only be able to take market share if you have a cost advantage and the competitors can’t match your price moves.  If you have cost parity, and everyone lowers prices but volumes don’t increase, the result will be lower profits for all.

6.    If competitors are lowering prices, are they doing it for all customers and all geographies?  Are they lowering prices on all products?  Is the product a stripped-down or generic version?  Are you competitors changing product availability or service levels to partly offset the lower prices?  Be careful that you don’t misinterpret competitor actions and react broadly to some moves that were targeted or inadvertent.

7.    Are the lower prices you are contemplating or seeing from your competitors greater than your incremental variable cost?  That means you have a cost to acquire a product or make it, plus handling, shipping, selling, invoicing and other indirect costs that you will only incur if you make or sell a product.  If the prices you are contemplating are not even that high, don’t do it.  Each sale would further detract from your profitability, rather than add to it.  These are just some of the questions that should be asked if you are thinking of lowering prices because of the recession.

Beyond those questions, don’t forget the sound pricing principles that apply in boom and bust times.  Not all customers are equally price sensitive and you should not treat them as if they are.  Odds are you already have the data to let you determine which customers are price sensitive versus service oriented, versus relationship driven.  Make sure you understand who is who.  Similarly, customers are not equally price sensitive on all products.  Make sure you understand which is which.

Maintain discipline in your process.  It is common and easy for your sales team to be fearful of losing volume and give out discounts freely.  Even if your overall price levels come down, it is important to be disciplined and monitor which customers are getting which discounts and why.  Offering discounts in situations that do not warrant them is wasteful.

Service the heck out of your customers that value service.  The more your customers feel like you serve all their needs and they like doing business with you, the less anxious they will be to look for lower prices or to switch suppliers.

If you have to make price concessions, ask for something in return.  Each time you grant a price concession to a customer, you are reinforcing the statement “Ask and ye shall receive”.  So get something in a trade-off for the concession, such as a larger order, incremental volume, product extensions, quicker payments, etc.  Make it a two-sided bargain.

Ok. It has been awhile since my last blog entry. I guess I don’t find interesting articles about pricing all that often. But I think this one, although not overtly about pricing, is terrific. The article, “Claiming a Large Slice of a Small Pie: Asymmetric Disconfirmation in Negotiation” was written by George Wu and Richard Larrick and a summary was published by Capital Ideas, Selected Papers on Decision Research by the University of Chicago Graduate School of Business. In short, Wu and Larrick show that in negotiations between two people, both sides consistently underestimate the amount of bargaining room that exists (small pie bias), and as a result, they overestimate how much of it they captured (large slice bias). The reasons for these errors, they argue, are: (1) it is difficult to accurately determine how far a counterpart will move and negotiators use flawed hypotheses to estimate that range; and (2) negotiators want to believe they have done a good job. A negotiation that looks like it resulted in the individual capturing most of the negotiating zone confirms to that individual that he/ she has done a good job, because he/ she doesn’t realize or have the incentive to realize that the negotiating zone was much larger.

According to Wu and Larrick, if we overestimate what we can get in a negotiation, our counter party has a strong interest in correcting our mistake. In fact, the counter parties often object rather aggressively to estimates of negotiating room that are too high. Those aggressive objections can lead us to over-compensate, and end up underestimating going forward. Conversely, if we underestimate that negotiating range, the other side has no incentive to correct our estimate. If our estimate is already acceptable, their incentive is to make a good deal relatively quickly and claim victory for themselves.

There are some obvious connections in the Wu, Larrick article and how I think about pricing. B2B pricing involves a bunch of negotiations. Sales people who face the challenges described by Wu and Larrick conduct those negotiations every day. Most sales reps have many (hundreds) of customers who buy hundreds or thousands of products. The amount each customer is willing to pay for a given product varies from customer to customer, which makes it nearly impossible for a single sales person to accurately assess how much each customer is willing to pay for a given product. In addition, most sales reps receive at least part of their compensation based on how much they sell. From a sales rep’s perspective, the risk of getting no sale (and therefore less commission) increases as the rep’s estimate of willingness to pay increases. So even though a sales rep probably would make more money by selling at a higher price, the difficulty of figuring out what a customer will pay and the risk of losing the entire sale offset that incentive to price higher. That means sales reps will tend to be more conservative in estimating how much negotiating room they have.

The other connection between my view of pricing and the Wu, Larrick article is a syndrome I refer to as “We can afford it”. In the article, the authors demonstrated that the amount by which individuals underestimate the negotiating range is greater for large zones than it is for small ones. What that means is it is more likely a sales rep will underestimate a customer’s willingness to pay if the product they are selling has an inherently high margin. If a sales rep is selling something that has an average margin of 60%, they are much more likely to think the price is high and at the outer edge of what a customer will pay than when the margin on the product is 10%. So many times in my career I have heard a sales person say they can’t possibly raise the price because “we are getting a 40% margin!” The corollary to that is when a customer asks for a lower price on a high margin product, and the sales rep agrees, because “We can afford it.” I don’t see that on products whose list price provides a low margin. The sales reps know they don’t have much room to move, so they assume the customer is not going to demand as big a bargain.

Perhaps none of this is news to you. Sales people have limited information to figure out how much a customer is willing to pay, they perceive greater risk in asking for too much than in asking for too little, and they underestimate even more when “we can afford it.” There is money to be made in helping sales people get past that and better estimate what customers are really willing to pay. It requires a combination of better processes and tools for reps to understand the ranges of prices available to them, a better understanding of the real risk/reward trade-offs, ( and perhaps better incentives), and better tools and processes to manage exceptions, so we don’t give away discounts just because we can afford it. And in a shameless plug, Strategic Pricing Solutions can show you how to do that.

Bob Smizik, a columnist for the Pittsburgh Post-Gazette thinks sports teams, their stadiums, and their contract concession providers are perpetrators of “world class price gouging”.  He thinks they have no conscience because they charge $6 or $7 for a beer and $3 or $4 for a soda. http://www.post-gazette.com/pg/08011/848397-194.stm.  I don’t agree, for several reasons.

I often cite sports teams as good examples of businesses who use two-part pricing, or three-part pricing.  Hotels, movie theaters, live theaters, concerts, and nearly all entertainment venues are also good practitioners of two-part pricing.  The simple concept is to attract customers with a price for that item or service they are seeking, and then sell ancillary products at healthy markups when the customer is much less sensitive to the price.  Parking and food/drink are the 2^nd and 3^rd parts of the pricing.

Parking is never included in the price of a ticket to a sporting event, concert, play, etc. Concert tickets for some of the major shows have been $200 to $300 per seat lately.  Do they really need to charge another $25 for parking? Perhaps not, but people will gladly pay it. One can park near the Mellon Arena in Pittsburgh for $12 to $15 per day.  At concert time, though, the cost of parking can go up to $25 depending on how close to the arena the lot is.  Now the parking lot earned fees all day, and at night there is not a city full of workers trying to find a place to park, so why charge so much?  Because you and I and many other people bought tickets to the event, we have to park somewhere, and we are willing to pay.  I know I don’t factor in the cost of parking when deciding to buy tickets to a concert – do you?

Some would argue that parking is different.  Land is very expensive and limited and the parking lot owner has to earn a return on their investment in the land.  But, if beer companies can earn a return on beer by selling it for $14 per case, why do they have to charge $7 for a single beer at the baseball game?  Answer- because 40,000 people are happy to pay it.

Sometimes I watch baseball on TV, and I watch at least one football game nearly every weekend.  I don’t have a beer or a hot dog each time I watch a game on TV, and if my kids watch with me, they don’t eat ice cream while doing so.  But it’s different when we go to a live game.  My family and I go to baseball games every summer.  I don’t remember exactly, but I guess we have paid about $27 per ticket on average.  I am quite certain we have also purchased beers (for my wife and I) priced at $6 or $7 each, sodas for $3.50, hamburgers or hot dogs for $5 to $7, peanuts for $3.50, and Dippin Dots for $4.50.  Why? Because we enjoy it as part of the whole experience.  We are cognizant that the prices seem high, but we accept that and pay them.

In his article, Mr. Smizik seems indignant at how high the prices are compared to the grocery store.  Look around, though, and I think you will find they are not that much higher than other places.  Sodas sold at the movie theater cost as much as those at a stadium.  Hamburgers in restaurants are nearly all $8 or $9.  Beers in a restaurant are $5. Have you been to a private golf club or tennis club lately?  The prices there rival those at the stadium, and in some clubs exceed stadium prices.  None of these establishments charge what grocery stores do, and they shouldn’t.  Customers decide which grocery store to go to based on a number of factors, including the prices of hot dogs, hamburgers, and sodas.  Once they are there, customers buy what they need and want, including light bulbs and batteries that are priced higher than at Home Depot.  Customers decide which events to attend based on many other factors long before price becomes a factor.  Once they are at the stadium, they buy what they want and are less concerned about the prices.

My last observation is the laws of supply and demand work. If the customers were really that sensitive to the prices and did not get sufficient value out of their purchases, they would stop making those purchases and ultimately those prices would come down.  If that happens, Bob Smizik will have been right.  I would not bet on it, though.

We all know more than a few people who bought Apple iPhones the first day they were available, June 29th.  Some people feverishly called around their city to find stores that had them.  Others stood in line at AT&T stores.  But all of those people paid premium prices for the phones, which have a cool, user-friendly interface.  Those people, our friends and colleagues, are early adopters.  Anyone who has taken a marketing course knows - early adopters frequently pay a premium price compared to others who buy a product after it has been around awhile.  The question in this case is whether that premium, which now appears to be $200, was too much.

Each individual purchaser can decide that answer on his or her own, but from my perspective Apple was smart to charge such a high initial price.  Here’s why.

Each prospective purchaser of a phone forms an opinion of the value of the phone to him or her.  That value depends on many things including, the specific functions available in the phone and how easy it is to use them, the frequency with which specific features would be used, the quality of the phone signal, and the data transmission speeds versus the need for fast transmission.  The value perception of each person also depends on the prices of alternatives in the market, the personal value of having a new toy to play with, and the value of being perceived as hip.  With all those variables, each person is likely to come up with a unique perception of value.  If we could learn all of those individual value perceptions, we could actually draw a value curve. 

Apple’s shareholders would want the management to capture as much of that value curve as possible.  That is something the airlines have been doing for quite some time, using statistical models to predict where those different value points are, then setting prices targeted at the individuals who fit various points on the curve.  Unfortunately the retail environment cannot easily tailor each price to each buyer.  The value curve is really a demand curve, and sellers select price points on the demand curve and offer their products to all buyers at a single price (at least for awhile).  One way sellers maximize their take from the demand curve is by setting higher prices initially to capture the demand at the higher prices, then lowering prices over time to capture incremental demand.  That is exactly what Apple has done. 

We see this behavior all the time in consumer electronic products.  It is generally written that the reason prices on electronics drop over time, is the manufacturers are spreading their fixed costs over higher volumes, additional capacity is coming into the market, and new products are available with more features.  All of those statements may be true, but they don’t fully explain why manufacturers don’t try to capture more volume earlier by setting lower prices that will attract more buyers earlier.  Well, the reason they don’t do that is because there are plenty of early adopters out there who are willing to pay more to get the newest product.  If Apple and other manufacturers don’t price their products high initially, they leave all that money on the table.

I suppose the danger in this type of situation is that of angering the early adopters with too high a price premium.  In this case, it appears that Apple has run the risk of that by dropping the iPhone price by 33% after only 6 weeks.  That strikes me as pretty aggressive, and I have seen a few customer quotes venting their anger.  I would bet any anger will all blow over, though.  Apple has been very good at understanding their customer base and has consistently offered premium-priced products.  My guess is they understand them well this time too, and the $100 credit they are offering will mollify the vast majority of the early adopters.  It will also entice them to spend some more money on other Apple products and services.  Use your iPhone, and send a response if you don’t agree.

[Originally published in June] 

I recently read the paper “An Economist Sells Bagels: A Case Study in Profit Maximization” by Steven D. Levitt, author of Freakonomics and economics professor at the University of Chicago. (Pardon me for not typing the full text of his title). The link to the article is attached. http://www.chicagogsb.edu/capideas/may07/5.aspx

As usual for Dr. Levitt, the paper is very well written in a way most people can understand. The paper’s most important point was the necessity of feedback on prices. In his paper, Dr. Levitt describes how an economist turned bagel salesman captured and evaluated significant details regarding the volumes and types of bagels and donuts that were sold. He was getting daily feedback on volumes. An opportunity to evaluate the effect of pricing decisions (by looking at the impact of price changes) appears to have been ignored, resulting in missed opportunities to maximize profits by raising prices.

It seems to me that the bagel economist’s allocation of effort, lots of analysis on volume and much less on pricing effectiveness, occurs at other companies all the time. Because it is difficult, too often companies avoid capturing and analyzing the important feedback on their prices. Instead they rely on anecdotes, gut feel, and rules of thumb for margins to set their prices.

So if it is hard, how should companies get the feedback on their prices? This is a very simplistic response, but:
1. First they need to make sure someone’s job responsibilities include measuring pricing effectiveness.
2. Next that person(s) needs to appropriately segment their customer base. It is important to have peer groups (segments) to look at, because when individual product volumes change, they will want to see if the volume changes are common within a peer group or not.
3. Third, they need to measure as much as they can at the most granular levels they can handle. So that means the companies must build analyses to isolate price as a variable impacting volumes, as opposed to lumping it in with all other variables. Transaction-level details in appropriate segments will help get there.
4. Last (in this simplistic answer), companies need to experiment. Make small price changes in certain customer groups or products or customer/products and evaluate the impact. Try to determine how elastic or inelastic those customers or products are in the tests, and build confidence for broader price moves.

Obviously the world is complicated and those four points are fairly simple. But companies can and should take some steps to get and evaluate feedback on their pricing. If a firm finds that on average 20% of its products are under-priced by 5% because they relied on anecdotes rather than getting empirical feedback, there is a 100 basis point improvement in margin just waiting to be earned. Perhaps that is worth considering over a bagel.

[Originally published in April]

On March 27th an article in the Wall Street Journal highlighted the moves by Parker Hannifin over the past few years to improve the strategic dimension of their pricing practices.

The transformation at Parker during the past 5 years has been outstanding, and has improved operating income by $200 million. The company segmented their customers better, focused on identifying who was most price sensitive and on which products, better identified the values of their products, and eliminated much of the previous cost-plus mentality. The question is - should the CEO, Donald Washkewicz, have given a much detail as he did?

From my perspective, Parker disclosed too much. It seems perfectly fine to tell your shareholders, customers, and competitors that you view pricing as a critical competency and that you intend to move to pricing based on value. It also seems acceptable to tell those same parties that you expect your margins to increase as a result of eliminating wasteful practices. Shareholders and competitors will applaud those moves, and most customers will probably perceive that the comments apply to other customers. (”We do a very good job of benchmarking prices and getting the lowest price”). That is as far as I would go, though. Once a customer is told exactly how prices have been changed, the risk is that they will look much more closely at how their purchases line up against your specific price moves and get angry.

Now, it is likely that most of the moves Parker made were justified. They undoubtedly found products whose prices were too low compared to the alternatives their customers had. They were simply correcting those wastefully low prices. But, part of the pricing equation is the emotion of it all - how the customer perceives your company and your price. Parker seems to have recognized that their customers do business with them because they like the company, the products, the people, etc, but not simply because they like the prices. Parker also recognized that most customers don’t have the time or inclination to check prices on every item. If the customer is paying a little more for some lower volume items, it is not a big deal.

That emotion can work both ways, though. When the customer sees that you are raising prices on specialty items more than 25%, just because it is a specialty item, how likely are they to get angry? What if the customer thought he was paying a fair price or a high price already? The customer may very well still be paying a fair price, but the risk is that now conversations with the customer center much more on price and on whether he/she has been screwed, whereas before publishing the article the conversations were around the value delivered to the customer.

Don’t misinterpret me. I applaud the pricing moves by Parker and would hold them up as good examples of strategic pricing. I just worry that they may have kicked some sleeping dogs.