Last week I read an article in the Wall Street Journal, The Dubious Management Fad Sweeping Corporate America, which said that American companies were irrationally obsessed with their net promoter scores, NPS. Last year 155 S&P 500 companies cited their NPS during earnings conference calls, none of whom said their score was declining. All of the companies believed their scores were predictors of growth ahead. The WSJ article was skeptical, and I am too. In my opinion, NPS is like Average Selling Price (ASP) and Gross Margin – interesting, but insufficient as stand-alone metrics. The devil is in the details.
After Amazon bought Whole Foods in 2017 I wrote a post, Amazon Unlikely to Start Grocery Price War. This past week, Amazon announced some price reductions, Amazon Cuts More Prices at Whole Foods. So, was I wrong in my original post? No, but market competition has increased, and the company is adjusting accordingly. I still expect them to maintain a premium pricing strategy.
Apple recently lowered their estimates of Q1 2019 Sales, citing slower iPhone sales among other factors. Since then I heard from several people that Apple’s pricing strategy was wrong, and they had misjudged price elasticity. My response is to quote Aaron Rodgers, QB of the Green Bay Packers, “Relax.” While Apple clearly overshot with pricing in China and India, they must tweak some prices; but they do not have the wrong iPhone pricing strategy.
We often tell our clients they should pay more attention to how their customers behave rather than what the customers say. We don’t mean to imply that clients should ignore customer feedback; but customers do not always act the way they say they will. For example, they will often say price is the most important thing, and then decide what to purchase and where to purchase it based on other criteria. One helpful technique for understanding real customer behavior is conjoint analysis, which is a market research tool that measures customer trade-offs.
All companies want to grow. The tough question is how to do it profitably and sustainably. A common approach for many manufacturers is to expand the number of channels through which their products are available to reach customers who otherwise might not try them. However, if that is not done with a proper understanding of segmentation (which customer segments buy in which channels), growth can be fleeting and potentially profit-killing in the long term.
Trade promotion spending is an important part of most companies’ annual budget. Although not always thought of as a component of pricing, a trade promotion is like a discount. It is another mechanism for transferring money from the seller’s pocket to the buyer’s pocket. On the other hand, a trade promotion can be superior to a discount if it results in increased sales without damaging your long-term price levels or pricing structure. Unfortunately, according to Nielsen 67% of trade promotions do not break even. It is therefore critical to measure the ROI of trade spending, and ensure there is a process for managing trade promotion decisions.
After getting raked over the coals by Congress earlier this year, Mylan is preparing to release a generic version of their EpiPen, Mylan To Start Selling $300 Generic EpiPen Pack Next Month. The price of the generic will be roughly half the price of the brand name EpiPen. That raises obvious questions like, “How will the generic impact the sale of the EpiPen?” and “What will happen to Mylan’s profitability?” Although the Mylan issue is a bit extreme, these are similar questions to those that must be answered by any company whose pricing strategy includes offering a generic version of their product or an introductory level version of another product. All of the strategic aspects of introducing a low-priced offering must be explicitly considered and planned.
Customers are not all the same. They have different levels of price sensitivity and often experience different levels of value from a given product. The whole point of segmentation is to identify which customers fit into logical groups with common levels of value and common levels of price sensitivity, and then create offers that fit each segment. We see it with automobiles, such as Mercedes which offers an entry level, middle tier, and premium tier of their 4-door sedan. We also see it in HP laptops with devices aimed at basic users, gamers, power users, and multiple steps in between. The products in the lineups of Mercedes and HP have a range of prices and a range of features to address multiple customer segments.
An important point is companies introduce 2nd, 3rd, and 4th versions of products to capture additional customers. If a company’s first version of a product starts at the premium end, future versions are likely to be descoped versions to appeal to customers who are currently not buying. The purpose of the reduced-price version is to capture more price-sensitive customers, or those who do not need all the features of the original, not just to lower the price for existing customers. Conversely a company who starts at the lower end of the spectrum would offer a premium version to meet more advanced customer needs and capture premium prices.
The next important point in these lineups is the products are not simply the same thing with different names. There must be differences. The highest end products have features that add more value compared to the lower level products. The manufacturers communicate those extra features and the additional value to customers and prospects, along with communicating the higher prices.
Generic items market themselves as products that provide the same value as the brand-name products, but at a lower price; and brand names compete by touting their quality, reliability, safety, and special features. In other words, not the same thing. Mylan appears to be trying to market their generic EpiPen by saying it is the same thing as their own brand name drug. If customers perceive a Mylan’s generic product is identical to the brand-name product, a large percentage of those customers will simply switch to the generic version. That will significantly reduce Mylan’s revenue.
For any company looking to expand their customer base by offering a generic or entry-level product, they need to address:
- How large is the market for a generic version of the product?
- How many existing customers are likely to switch to the lower-priced version?
- Can we articulate the differences between the premium product and the generic product in a way that demonstrates value?
- How many new customers are likely to be captured with the new product?
- Does the profit increase from new customers offset the profit decrease from customers who simply switch to the lower-price version?
- How are competitors likely to react?
In Mylan’s case, there were already many complaints that potential customers had been priced out of the market and could not buy EpiPens. In addition, a new competitor will be entering the market, and the new competitor will likely capture some existing Mylan customers and compete for the more price-sensitive customers. So, Mylan needed to act.
For most of Mylan’s existence, they have manufactured generic drugs and sold them as equivalent to the branded versions. With the very large price increases they implemented, they should also have been planning for a path to address the more price-sensitive segments. Without some identifiable differentiation, customers will know that their new generic EpiPen is the same as the branded product. I expect the revenue and profit from EpiPens will fall dramatically. More modest price hikes and better planning could have avoided the coming profit decrease.
Last month I read an article, How Amazon’s Pricing Algorithm is Designed to Hurt Consumers, that implied Amazon is not as customer focused as they claim. The article said that the online retailer does not always have the lowest-priced item first in their results list, and therefore is trying to take advantage of their customers. I disagree. What Amazon is doing is aligning their merchandising and pricing strategies. They are trying to sell more products by delighting their customers, and they are trying to make more money in the process. Isn’t that the point of retail?
When you shop in any physical retail store, you can see the merchandising choices the retailer has made. The products that have the most prominent placement, which makes them most likely to be seen, are seldom the least expensive products. In simple terms, they are usually products that either drive more traffic or generate more gross margin per foot of space. The store layout is also designed to encourage customers to spend more. In some cases, that means moving high-demand items to the rear of the store so that customers flow through the aisles and are tempted by other items on the way. It can also mean spreading the most recognized brands widely within a section to encourage more browsing. Rarely does it mean putting the lowest-priced items closest to the doors.
In grocery stores, customers usually pass the produce and prepared foods first, engaging positive feelings from visually appealing displays and pleasant aromas. Research has shown customers spend more when they are hungry (which can be triggered from the nice smells) or enticed by the fresh vibrant colors of fresh produce. The stores do not start customers there because the lowest-priced items are there! In addition, within any aisle in a grocery store, the low-priced and generic brands are not often at eye level. That premium space is usually reserved for the premium brands.
Retail is an inherently low-margin business. (If you doubt it, just look at Amazon’s return on sales.) To survive, retailers use many tools to determine how they can sell more to customers and at higher prices. In recent years, data science has become a much more important part of the retail toolkit. By analyzing how customers make purchase decisions, which factors affect those decisions, and how customer selections affect profitability, retailers can make much more informed and effective merchandising choices. Those choices include having an array of products to serve multiple segments, including the more price-sensitive buyers, and providing a simple path for each segment to find the products they want. Those merchandising choices also mean presenting higher priced, higher value alternatives to customers.
When online retailing started, low prices were one of the primary competitive strategies of online retailers. However, Amazon and other online retailers have learned that customers care about more than just low prices. They value a broad portfolio of products, service, ease of use, and the ability to find what they are looking for. The retailers also understand that product placement in their search results is similar to product placement on physical store shelves. They can and should use a more scientific approach to making those merchandising decisions. The fact that Amazon is using their considerable data science capability to improve their profitability should be expected. After all, they are in business to serve customers and to make money.
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:
- Take the time to determine the real value of your product up front and get pricing right the first time
- Communicate your complete value proposition to your customers
- Make corrections in logical increments over time
Too often companies have a ready, fire, aim approach to pricing new products. They may take a cost-plus approach which has nothing to do with value, or perhaps shoot for quick market share with low prices, or respond to external pressures to provide more benefits for less. When one of these approaches is taken, the company invariably makes less money than expected or fails to sell as many units as their market research would have predicted; and they disappoint their shareholders. Worse yet, they have to try to adjust having set an inappropriate reference point.
Sovaldi is an example of a drug launch where the company took the time to determine the real value. Although the price for Sovaldi was high, the Gilead team did the work to understand how their drug helped patients and what the economic impact would be. Then they priced it so both the customers and shareholders benefitted. In a similar example many years earlier, Amgen introduced Neupogen (a drug that reduces infection in patients undergoing chemotherapy) at an apparently high price, which reflected its life-extending value. In both cases, the companies sold large amounts of the drugs at high prices and were not forced to make significant adjustments later.
Unfortunately, customers will not automatically figure out what a product is worth. They will attempt to do so by comparing the product to whatever frame of reference comes to mind. The company’s job is to identify for potential customers what the appropriate benchmark is, and identify all the aspects of additional value provided by the new product vis -a-vis the benchmark. Gilead was quite effective in this for Sovaldi. They made clear that their new drug was not just an evolutionary advancement of existing hepatitis drugs, but could actually cure the disease. So the real value included avoiding the long-term use of maintenance drugs, significant reduction of additional future conditions which are by-products of having hepatitis, and significantly improving the quality of life. Although insurance complained about the price, they have continued to pay for it, because Gilead has clearly demonstrated that the benefits exceed the price of the drug.
For companies who have not done the appropriate value-identification work up front, or those who tried but missed the mark, price adjustments are needed. In our experience, changes in prices are best done gradually. Customers generally accept modest price increases, but get very upset with large increases. As Reed Hastings recently said in the wake of Netflix price increases, “People don’t like price increases. We know that.” Nonetheless, Netflix raised their price and expect only modest customer defection. Conversely, when Valeant and Turing significantly increased their prices, some more than 100%, their customers complained so loudly that company management was called before Congress to explain themselves. The politicians are now looking at increasing regulation of drug prices, and the stock prices of the drug companies have tanked.
Instead of large changes, the smarter pharmaceutical companies have been instituting more moderate price increases. Eli Lilly, Merck, and Bristol Meyers Squibb have hiked prices 2 – 3% in the past year (see Drug price increases lower so far in 2016) and still others have implemented 7 – 9% increases. The drugs and circumstances for each are different, but the price increases do not seem egregious and customers are generally accepting them.
Over the past year or two, we have seen examples of smart and not-so-wise pricing decisions from the pharma industry. Let’s try to learn from them. Do the work to get it right up front, communicate all the elements of value to your customers, and make adjustments gradually. You will avoid much of the drama and enjoy greater long-term success.
If customers complain about your pricing, should you do something? A few things have occurred recently that have prompted me to write this post. In early March a bill was introduced in the Senate, Forbidding Airlines from Imposing Ridiculous Fees (FAIR) Act. A few days later I overheard two guys in the gym complaining about being charged for paper statements on their brokerage accounts. And a week after that, my personal dealings with Verizon for TV and internet felt like playing a game of Hunt the Wumpus. (Due to space, I will write more about this in a future post.) The issues are slightly different, but all are related to customers complaining about pricing strategies. Complaints about differentiated prices for differentiated service are natural and should not cause changes in your pricing structures. On the other hand, if your pricing is deceptive rather than aligned with different value profiles, you should fix it.
Senators Ed Markey (Dem., MA) and Richard Blumenthal (Ind., CT) have decided that separate fees for checking bags, changing or canceling a flight, and selecting better seats are somehow unfair and should be limited or prohibited; and that led them to introduce the FAIR Act. Certainly some customers have complained about those fees, which lends support to the senators’ view. However neither the complaining customers nor the senators are recognizing the benefit of those add-on fees. Customers are not all the same. They have different budgets, different needs on planes, and different abilities to plan their schedules. The airlines have appropriately recognized these different customer segments and created offers that can appeal to each. By differentiating prices, the airlines can offer the lowest fares to those who:
- Can plan their trips in advance (which enables the airlines to schedule flights more efficiently)
- Don’t need to check a bag (which saves space and bag handling labor)
- Are willing to accept less spacious seats
- Are willing to board the flight later than others
Remarkably, the price of a cross-country flight is similar today to prices 20 or 30 years ago. Those low fares are possible in part because of these structural price changes. And those low fares enable many people to fly who otherwise would choose not to. The airlines are able to make money by selling premium services like early check-in, exit-row seats and blankets to only those travelers who want them and are willing to pay for them.
On a political note, our politicians do not seem to mind tacking on separate fees for excise taxes, tourist taxes, airport usage fees, and drink taxes to all customers. It is pretty inconsistent to believe add-ons to fund government spending habits are acceptable, but add-ons for extra services are not.
Moving on to the guys in the gym, I understand why they might complain. They always got paper statements in the past and they do not understand why they wouldn’t today. Well the main reason is technology has enabled the world to do things electronically at a lower cost than mailing paper. That technology has enabled many new options for brokerage and other financial services over the years, and the prices for buying and selling securities have dropped dramatically. The financial services firms have passed their technology-related savings on to customers. Since it costs the firms money to print and mail paper statements, and many customers are happy to keep electronic records, it makes sense to offer the paper service for a separate fee. The separate fees also encourage customers to migrate away from paper records which is good for the environment.
Since customers have different needs and desires, pricing strategies should include identifying the different segments and creating offers for them. Restaurant customers do not all want cocktails, appetizers, and desserts, so prices for those items are usually separate. In some restaurants, even side dishes have separate prices, so the most price-sensitive or least-hungry customers can get what they want without subsidizing others. On the other hand, it is inappropriate to deceive customers about your prices, and doing so will ultimately cause customers to defect. A restaurant would not stay in business by posting a price for a meal, and then charging an extra fee to cook it.
It has often been said that if your customers do not complain about your prices, they are too low. Pricing to resistance is an acceptable part of any pricing strategy. More important is pricing to the value desired by different segments of customers.