Last week Andy Kessler wrote an article in the Wall Street Journal, The High Cost of Raising Prices, which might scare you into thinking you will ruin your business by raising prices. While I usually enjoy reading his articles and I found a few valid points, I mostly disagree with this article. Don’t fall for the scary stories and false correlations that could make you afraid to raise your prices. When the value you provide to your customers is greater than the price you are charging them, you can and should increase your prices to match the value.
One of the more common things we see is pricing strategies and tactics succumbing to fear, uncertainty and d-doubt (FUDD). When that happens, companies frequently begin a cycle of value-destroying pricing decisions. You can prevent those decisions by recognizing the symptoms and stopping Elmer Fudd from leading your pricing strategies.
When you are entering negotiations, is it better to offer a number first, or wait for the other side to do it? Although many books and seminars on negotiations suggest you should wait for the other side to offer a number, I disagree. I have been asked that question a few times, and my answer is put your number out first and take advantage of the anchoring effect.
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.
The availability of data and tools to analyze them have increased significantly over the past few years. Many companies have added pricing analytics capabilities and have purchased new data visualization tools. Those are steps that can improve profitability, if they are focused on the right pricing analyses. Unfortunately, too many companies spend their time creating cool new visualizations of basic metrics that are of limited use. To capture greater margins, it is important to focus on more granular indicators of price effectiveness that can enhance decision making.
The year 2016 is almost over. All businesses should reflect on what has worked, and what has not worked; and they should be prepared to adjust in 2017. That evaluation should include reviewing the results of decisions made regarding pricing strategies and tactics. Equally important, the evaluation should be rigorous and thorough, and there should be no sacred cows. Regardless of who made the decision(s) or which customers were affected, the choices should be evaluated with a goal of making continuous improvements.
As you start your review of 2016 pricing decisions, consider these four main themes, and analyze them in detail:
- Did you grow where you expected to grow?
- Did you expand margins in the expected areas?
- Did you capture the price increases you intended?
- How have your prices affected your customer/prospect buying choices?
It is important to get the facts, even if they are inconsistent with company messages and plans. At many firms, growth is celebrated regardless of how and why it occurred. We have talked with companies who have set goals at the beginning of the year to price to value provided, and to correct underpriced products and accounts. Then when measuring results, those companies ignore the fact that prices were lowered at some large customers. It is considered irrelevant if the volume with those customers grew. But how do the companies know that volume would not have grown without lower prices?
If the decision to lower prices at specific accounts is not evaluated just as critically as other pricing choices, the organization will interpret that to mean prices don’t matter. To make real pricing progress, messages and actions must be consistent, even if it is uncomfortable.
Similarly, we frequently see companies realize much lower price increases than planned, but do nothing about it. They just accept the aggregate results as being due to strategic accounts. Unfortunately, simply accepting lower-than-expected results likely means the company is earning less profit than they could.
We are not advocating a rigid approach that does not allow any deviation from planned price increases. Certainly in B2B environments, some customers can get away with smaller price increases than others due to longer-term contracts, poor competitive positioning by the selling firm, or clear tradeoffs that were made resulting in higher overall profit. However, it is very important to ensure that the lower price performance is a result of conscious decision making rather than poor pricing discipline. Only by analyzing actual price realization account by account compared to the planned price realization, is it possible to determine where shortcuts are being taken and profit is given away.
All accounts must be put under this microscope, including large accounts and strategic accounts. The fact that the accounts are large or strategic, does not necessarily mean there will be pricing discipline.
One of the more difficult things to measure in a B2B environment is the affect your pricing decisions have had on sales volume. Customers decide what to buy and from whom based on many factors, only one of which is price. That makes elasticity measurements more complicated than simply the change in unit volume divided by the change in price. However, it is still important to make your best determination of how your customers have reacted to your pricing actions rather than just listening to anecdotes. You can evaluate:
- Did customers with the smallest price increases or largest price decreases grow faster than the median customers?
- Did the customers with the lowest aggregate prices grow faster than customers with the highest aggregate prices?
- Are you gaining market share faster in segments with lower prices or lower price increases?
If the answers are no, then it is unlikely prices are driving your volumes. Conversely, if the answers to those questions are consistently yes, then your pricing actions might be affecting volumes and you should dig deeper to find out which specific actions need to change.
It can be difficult for pricing teams who have recommended higher price increases, to shine a spotlight on any results that might indicate the company raised prices too much. Nobody wants to be wrong, especially when they were advocating an aggressive approach. In addition to wanting to be correct, people naturally fear that if they are wrong, the organization will no longer listen to their recommendations. However, we believe that if you never fail, you are not trying hard enough. Learning from failures is one of the most durable ways to grow, and hiding failures is a way to ensure the loss of trust from the rest of the organization. So, pricing teams must be willing to call out the situations where prices were too high and customers left because of them.
Continuous improvement in pricing can only be delivered when results are measured critically, and in detail (not with anecdotes). It is important that all pricing decisions be measured – both for building the mutual trust of all parts of the organization and for identifying all the improvement opportunities. Regardless of who made the decision or took the action, there should be no sacred cows.
Today is Halloween, but it is no time to be spooked by the challenge of increasing prices to fully capture the value of your products or services. In nearly every company, opportunities exist to capture more value from select customers or products. However, those opportunities are often not where you think they are, so do your due diligence. Avoid chasing the ghosts of phantom opportunities.
In many companies, pricing attention is driven by the 80/20 rule. That is, roughly 80% of the volume comes from 20% of the customers. Companies look at those large customers that deliver a disproportionate amount of sales to determine if there are opportunities to raise prices. It certainly seems easier to manage fewer customers and prices, and they can get more leverage out of small price increases. However, the companies then conclude they can’t raise prices because “We are locked into contracts”, or “We don’t want to cause the customers to put everything out for bid.” Unfortunately, that is not a good application of the 80/20 rule. Very often there is more money to be made in managing the long tail of prices to smaller customers and low-volume products.
When you look deeply into your transaction history, you will frequently find small customers receiving low, big-customer prices. Similarly, you will probably find low-volume products being priced as if they are fast movers. Correcting these underpriced items can improve your profitability. Although each transaction may be small, the improvements spread over all those products add up to real money. After all, a 5% increase on 20% of the volume results in an overall 1% increase.
Another tactic we often see is targeting customers with below-average gross margins for price increases. It seems simple and logical, but it is often wrong for two reasons:
- It does not consider the segment or the size of the customer
- It does not consider the inherent margin of the products that customer is purchasing
More specifically, in the B2B world, not all customers should get the same price. There is greater value for some segments than others, and often differences in the willingness to pay. When you look at the prices paid by segment, you will often find certain segments consistently paying lower prices. Similarly, the typical margins earned on sales are not the same across all products. For a variety of reasons, some products consistently deliver lower margins than others.
Your average gross margin is derived from sales to customers in all segments and sizes, and sales of all types of products. If you target price increases to customers who happen to be in low-value segments or customers who buy primarily lower margin products, you may be targeting customers who actually are already paying relatively high prices for the products they buy (high relative to the prices paid by similar customers you serve). If they are already paying high prices and you increase them further, you increase the risk of losing the customer completely. And although the gross margins may be below average, losing them would also mean losing whatever contribution margin they are delivering (gross margin less incremental variable costs), and lowering your overall profitability.
The final area that sometimes becomes a phantom opportunity is managing the pricing waterfall. The concept is simple – when you give away things you sometimes charge for, such as free freight, customization, extended payment terms, etc., your profit is leaking out like going over a waterfall. To manage it, you can calculate and evaluate Pocket Margin (Gross Margin less the value of all the free or enhanced services) for each customer. By looking at Pocket Margin, you are comparing customers based on what you actually keep.
Unfortunately, many companies target the waterfall as “low-hanging fruit” when looking to improve profitability, and they mismanage it. Because it can be difficult to manage exceptions, we commonly hear broad statements like “Effective January 1st, all customers need to pay for shipping,” or “No customers can receive 60-day payment terms without VP approval.” In the case of each statement, there is no connection to the Pocket Margin. It is simply cutting off the enhanced value items without examining what prices the customers are paying. If those customers are paying high nominal prices and provide acceptable Pocket Margins, these types of drastic actions can seriously disrupt the customer relationship. And if the customers leave, you will really be seeing ghosts.
To find real price and profit improvement opportunities, it is imperative to avoid broad approaches like the 80/20 rule, below-average-margin customers, and edicts in managing the waterfall. By doing detailed analyses to identify customers paying less than appropriate for their segment and size, or customers getting high-volume pricing on low-volume purchases, you can find real opportunities. And even though those opportunities may be individually small, they will add up to real value. Only by doing that detailed work can you avoid chasing phantoms. And the return for your efforts will be the real treat.
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.
Lou Gerstner recently wrote an op-ed for the Wall Street Journal, The Culture Ate Our Corporate Reputation, in which he discussed corporate leaders blaming their culture for poor performance. In the article, Gerstner wrote that leaders were missing the critical component of culture that people do what you inspect, not what you expect. The corporate processes, not just words, need to reflect the corporate priorities; and compensation is a big part of those processes. In other words, you get what you pay for.
In many companies, pricing is a microcosm of processes not matching the words. Over the years, I have talked with many companies who state that they want to improve profitability by being more strategic in their pricing. Their strategic plans and business plan refer to competing with differentiated products and services, and pricing to customer value. Those principles and goals are communicated to all employees, and sometimes the companies invest in new analytics or build new tools to help. But they experience limited to no success in improving profitability. One of the reasons for this lack of success is the companies never adjust their compensation schemes to reflect these priorities.
Sales people are critical pieces of the relationships between suppliers and their customers. We have found the stronger those relationships are, the more hesitant companies are to adjust their compensation plans. This fear is most acute when the compensation plan is based solely on sales volume. The fear is – if salesperson X does not like the new compensation plan, or makes less money because they don’t capture any higher prices, X will leave for a competitor. And if X leaves, many of X’s customers will switch to the competitor. So the compensation plan remains the same. In these situations, the result is the sales team hears the words of the company strategy, but they are not paid to execute it.
From a sales person’s perspective, trying to capture higher prices often means increasing their risk of not getting sales. Basic economics says higher prices reduce demand. If there is no upside to the sales person from raising prices, why take the risk?
Year-end sales awards are similar to the compensation plans. Sales people are like all of us. We like to be recognized for a job well done, and we like to receive awards. So if the year-end sales awards are all based on sales volume and hitting sales targets, but do not recognize pricing, what do you think the sales team will focus on? Sales volume of course.
If you, or any company, are serious about capturing the value of your products and services, and you are serious about improving profitability through more strategic pricing, your compensation plans need to reflect it. That does not necessarily mean you need to drastically change everything in the comp plan, but it does mean you need to make incremental changes that create a risk/reward opportunity for your team to sell at higher prices. Your compensation plans need to reflect your priorities.
One word of caution – your plans should not encourage destructive behavior. Earlier this year Turing Pharma raised the price of Daraprim more than 5000%. Doctors, insurers, and patients were furious. Then the CEO appeared before Congress to try to defend the company. In the end, they reversed course. More recently, Mylan had a similar reaction to a 5X increase in the price of an EpiPen. They have also back pedaled, creating a new lower priced offer and agreeing to pay $465 million to the government.
Your compensation system needs to balance your desire for your prices to capture the value you deliver to customers with the need to remain a value to your customers. It should balance the need for rewards that encourage taking appropriate risks with constraints that prevent excessive risks that could damage your brand. When you do that, you get what you pay for.
September is nearly ended and we are preparing to start the 4th quarter of the calendar year. For many companies, it is also the final quarter of the fiscal year. Similar to sports teams, whether you have a lead or are trying to catch up, winning in the 4th quarter often determines whether you win or not for the full year. That often means a big push to meet or exceed targets by finishing the year strong. Focus and effort are critical, and strategic pricing concepts can help you determine which customers to target. More specifically, you can use the insight from your pricing analytics to help you be more efficient and productive. That insight can also help you make decisions that won’t come back to haunt you next year.
A fairly simple way to identify higher value targets is to think about your customers in terms of how many products they need or could buy, and how price sensitive their behavior tends to be. You can plot your customers and prospects on a simple grid like Figure 1, and prioritize according to the grid. The quadrants can be categorized as High Priority; Good, Not Great; Caution; and Avoid.
On the horizontal axis, the breadth of product assortment the customer needs will give you indications of how many purchase decisions will be made in the 4th quarter, and the likelihood of customer needs for non-core products that you are not already discussing. Customers who purchase a large assortment give you more chances to win. These customers also are more likely to purchase products that are less critical and don’t get as much price scrutiny.
On the vertical axis, the level of a customer’s price sensitivity gives you indications of how likely they are to switch to your competitor for a lower price next year, and how high the margins are likely to be. Go after the customers with lower price sensitivity where you can get better margin efficiency and they are more likely to stay with you. If your pricing analytics don’t show price sensitivity, think about evidence of price sensitivity such as how often they switch suppliers, how often they call for support, whether they order electronically or by phone, how often they ask for a price before ordering, and how often they request rush orders. You can probably think of your own questions too.
Your highest priority targets should be the customers who use a large assortment of products and who have tended to be less price sensitive. With these customers, you will have more opportunities to win, and the pricing is likely to be better, so your time will be more efficient and effective.
Don’t waste your time on the customers in the upper left quadrant. Since they will make very few purchase decisions you will have to work very hard to get any sales, and those sales would be at low prices. The efficiency of the margin you earn compared to the effort required will be very low. Also remember if you take this business from someone else with a low price, the odds are high that the customer would switch back next year if your competitor lowers the price again. You may think that is a trade-off worth making, but you would regret it next year.
There are opportunities in the other two quadrants, but they are unlikely to be as productive as the High Priority targets. The smaller assortment but less price-sensitive group gives you fewer chances to win, but the prices should be good and they will not drop you next year for small price decreases. Conversely, the high sensitivity customers with a large assortment give you more chances to win, but margins may not be as great. For this group, look for opportunities on non-core products that the customers are buying elsewhere and perhaps are not even considering you. Make your pitch with a focus on the particular value your company brings and the outstanding service you provide them.
Good luck in the fourth quarter. Use your pricing analytics to set your priorities and you should be more successful.