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Last week a friend told me that her sister’s business had overpaid their taxes and without justification the government would not refund the overpayment. I was skeptical of the story and responded that there is a very clear process for requesting refunds of overpaid taxes or applying them to the subsequent year, and the IRS would not just ignore that. My friend was adamant that her sister would not make something up and she believed her. Not long after that conversation, I read an an article Misleading Statistics, by Thomas Sowell. In the post, Sowell focused primarliy on statistics that might be accurate in and of themselves, but are then used incorrectly to support something that is not true. Although these situations are very different, they are good reminders that people will believe statements, anecdotes, and plausible-sounding statistics that support their ingrained beliefs. It is therefore important to be skeptical of sound bite statistics, and require your team to provide the whole truth and nothing but the truth.
Pricing strategies and individual pricing decisions are areas where incomplete or misleading data are often presented. There is a general perception that higher prices will reduce sales, and management teams will often hear that a firm’s prices are an obstacle to greater success. While in a macro sense, there is some truth that prices will affect volume, prices are usually not the number one factor in a customer’s decision of whether and where to buy something. So simple statements that pricing was the reason business was either won or lost is usually not the whole truth.
Real monopolies are rare. There is competition for everything. That does not mean most products or services are commodities. I have often heard executives say, “We sell commodities, and price is what matters.” They then set their pricing strategy around winning with low prices, but in reality anything can be made special. Is there anything more basic than water? It covers nearly 3/4 of the earth and the average person uses between 40 and 200 gallons each day, at a price of a fraction of a penny per gallon. However, water has become highly differentiated and the prices we pay for it vary widely. For example, I looked at some bottled water prices at Amazon.com (24 packs unless otherwise noted):
Member’s Mark – $.05 per ounce when bought in bottles of 8 ounces
Nestle Pure Life – $.012 per ounce
Dasani – $.044 per ounce
Poland Spring – $.032 per ounce by the liter
Smart Water – $.035 per ounce in 6-packs of 1 liter each
Fiji – $.053 per ounce
Evian – $.062 per ounce
The most expensive brand is 5 times the price of the cheapest. And the 2nd most expensive is more than 4 times the price of the 2nd cheapest. Isn’t water a commodity? In some respects, water is a commodity, but these well-known brands have widely different prices. How can they succeed like that? Each brand communicates to their customers how their products are different. They sell the experience, cache and unique features of their water; and they sell at these prices at Amazon shoppers who are among the most price sensitive anywhere.
I recently spoke with the head of pricing for a multi-billion dollar, multi-division company about their goals for price improvement. His team leads the development of pricing strategy and management of the pricing process; and they provide analytics, and pricing targets for the divisions. Final pricing decisions are somewhat decentralized. He described the challenge he had been given to generate a 100-basis point margin improvement from better pricing. The challenge would be part of the goals he and his small team had to meet in 2017, but it would not be part of any other group’s goals. Unfortunately, it will be very difficult to reach their goals if no other group has skin in the game. Real pricing improvement requires the involvement of all those who make pricing decisions.
Last month I wrote a post, When to Use Low Prices to Grab Market Share, in which I described situations where that pricing strategy worked and where it didn’t. Recent earnings releases have provided new clarity about the perils of discounting as certain restaurant chains, retailers and manufacturers have suffered stock declines primarily because of margin squeezes. Price wars are inevitably painful for everyone.
Whole Foods reported decreased earnings for their 2nd quarter although sales for the quarter had increased. The cause was continued price reductions resulting in same-store-sales declining 2.6%. Whole Foods’ stock price decreased by 8% following their earnings announcement. (See Whole Foods stock sinks after key metric disappoints Street)
Over the past several months, pricing strategies and practices of the pharmaceutical industry have been a subject of discussion, many times for the wrong reasons. In particular, Valeant has come under extreme criticism for raising the prices of its drugs. Another company, Turing Pharmaceuticals raised the price of Daraprim from $13.50 to $750.00, an increase of more than 5000%. Last year Gilead set the price of its Hepatitis C drug, Sovaldi, at $84,000 for a 12-week treatment. All of these cases resulted in politicians calling for more regulation of drug pricing. However when we look back at them, Gilead’s pricing of Sovaldi looks smart, whereas Valeant’s and Turing’s actions look regrettable. So let’s try to learn from their pricing successes and failures.
There are many things to be learned from studying the pricing actions of others, but there are three critical take-aways from these:
1. Take the time to determine the real value of your product up front and get pricing right the first time
2. Communicate your value proposition to you customers
3. Make corrections in logical increments over time
I don’t use Uber often, but our family recently used it to take us to the airport. When we returned, we just walked outside the airport and hopped in a taxi. The price of the Uber ride ended up about 35% lower than the price of the taxi. That is not news. It has been widely discussed that Uber generally offers lower non-surge prices than taxis, and the service has grown very rapidly, in part at the expense of taxi companies. So is that a model that other companies can follow – offer lower prices than the market leaders to take share and grow quickly? The answer is sometimes, but not often.
Let’s think about some examples. In the early 80’s People Express launched one of the first budget airlines. Prices were low and service was poor. They grew for a while, but on common routes full-scale airlines lowered prices to match People’s and People Express eventually died. Other budget carriers tried similar tactics over the years, like Jet America, Air Florida, PSA, etc. and all went out of business. Not learning much from that, the major airlines occasionally launched price reductions to capture more share, but their prices were quickly matched by competitors and everybody lost in the price wars. Southwest was really the only US-based discount airline that thrived. They succeeded because they had a much lower cost structure than the major carriers and could make money at lower fares, they offered a very efficient service, and they did not compete head to head on the major carrier’s busiest lanes. And today, Southwest is no longer the lowest priced airline.
All companies want to improve their profitability and deliver more value to their shareholders, but the best ways to do that are often debated. Pricing is the most powerful lever available to companies striving to improve profitability, but how to effectively use that lever may be unclear. Over the years we have talked with many firms who have read about others extolling the virtues of using revenue management, revenue and profit optimization, big data analytics, dynamic pricing, and price optimization. However, those firms did not understand what the terms really meant, and they did not want to spend millions of dollars betting on something confusing. Our advice – start small and build your capabilities and returns from pricing incrementally.
We have no doubt that pricing is the best profit-improvement weapon available, and we regularly demonstrate the reason for that to clients and potential clients. But that is a little like demonstrating that investments in equities are required to build long-term wealth. You still have to know how to do it, and the road is littered with people and companies who swung for the fences with poorly understood investments that were supposed to yield big profits but failed. To improve profits through better pricing, we recommend companies start with smaller investments that identify where prices can be improved without sacrificing volume, and build organizational confidence in a more strategic pricing approach.
For simplicity, we think of four levels of pricing improvement:
Baby steps
Low-cost optimization
Enterprise tools
Enhanced enterprise tools
I have been watching the Game of Thrones the past several seasons. I love the rich scenery, the diverse range of characters, and the intriguing, suspenseful drama. A recent episode about the Many Faced God got me thinking about customer types. In particular, it got me thinking about customers with multiple faces or personalities. Some customers are like Dr. Jekyll and Mr. Hyde with two personalities, while others are like Sybil or the Many Faced God with several personalities.
Consider my wife. She occasionally shops at Costco. Does that make her a price-sensitive shopper? Maybe, but not necessarily. She will not travel to Costco unless we need a large quantity of something, such as paper towels, napkins, or bottles of water, or because she wants something specific, like a laptop or a printer. The first items she buys in bulk, because prices are lower in large quantities and we are able to store them. In addition, while my wife is at Costco, she will usually pick up a 4 lb. pack of bacon, not because we need it, but because I like it. And if it is in the house, I will eat it. This bulk buying process definitely indicates a level of price sensitivity, and she is willing to use our storage space in exchange for lower prices. But that is not the whole story.
We have written many times before in our blogs and newsletters that customers are not all equal. They have different needs, they value product attributes differently, and they have varying levels of price sensitivity. In order to address these multiple customer segments, it is common to have multiple variations of a product or service offering – a Good, Better, Best product lineup. Beyond just creating multiple offerings, your pricing strategy needs to include getting the relative positioning right. Your profitability depends on it.
There is no perfect number of alternatives or options to offer customers, but how many you will offer is an important question to answer. If you do not offer enough options, you run the risk of missing some customer segments by not specifically addressing them. Conversely, if you offer too many options, it is easy for customers to be overwhelmed with the complexity and not make any choice. To determine your best number of offers in your product lineup, consider the ease with which customers can assess the differences, the number of competitive offerings that exist, the range of values perceived by customers, and your capability in managing the range of products or services.
In addition to determining how many products to offer within a lineup, it is also important to determine how the price of each product or service will relate to the others. Multiple studies have shown that when faced with three or more options, customers tend to choose the middle option more frequently than the highest or lowest priced offer. Customers often avoid picking the least expensive offer because they don’t want to feel like a cheapskate. And they often avoid the most expensive option, because they really aren’t extravagant and do not need whatever additional benefits the highest options offer. So they go with the middle.
Thinking about this behavioral tendency can help you execute a stronger pricing strategy. If your goal is to maximize your profitability over time, you will need price points that attract customers at multiple levels of value. But what if you find that your results are skewed in that a large percentage of customers are picking either the most expensive or least expensive option? In that case, the prices of your product offerings are probably not aligned with their relative levels of value.
If you’ve ever tried to take an Uber during a rainstorm or on a holiday, you know why surge pricing can be unpopular. Then again, if you’ve been picked up by that Uber while other people were still waiting for cabs, you know why it also makes sense and provides benefit to customers. Surge pricing which is another name for dynamic pricing, isn’t just for ride sharing; and it is an excellent way to balance supply and demand for your company’s products or services.
Dynamic pricing is a relatively simple concept. It is the principle that the price for a given item or service should vary with customer demand. This means that you can charge more for your product sometimes, but you should charge less other times. It also means that if you have the ability to increase capacity, you will probably provide more of that service when customers really want it, and take advantage of those higher prices. This helps to ensure that the customers who really want what you are selling can find it. It creates equilibrium.
Imagine looking for a cab on New Year’s Eve. If you can find one, you’ll wait a long time for it. Why is that? For cab drivers, the calculus is simple. They charge the same on New Year’s Eve as on any other day and can’t enjoy the holiday with family and friends. So why work harder? They don’t, so it is harder for you to find a cab.
If you hail an Uber, you’ll probably pay a lot more than you would for a cab, but you almost certainly won’t wait as long. Uber drivers know if they work that night, they will not only stay busy, but also get to charge a lot more for their services, so more people work. That’s the power of dynamic pricing, which because of Uber is often called surge pricing.
