We are often asked by clients and prospective clients whether it is better to have a centralized or decentralized pricing function. Of course, without much more information the only answer to that question is, “It depends.” That said, we almost never recommend completely centralizing or decentralizing pricing. We generally believe a hybrid solution works best, with some level of centralization and some degree of local autonomy. The degree of centralization is dependent on the types of customers, capabilities, and competitors in the company’s business units, product lines, and geographies, and their respective pricing strategies.
We use multiple online tools at SPS, and last month I called one of the providers with the intention of upgrading to a higher tier. I asked a few questions to clarify the differences between the tiers of service; and, unprompted by me, the customer service rep said, “I see you have been a customer for a long time, I can upgrade your account for free.” Of course, I was pleased, and I readily accepted; however, after the call I thought about whether the company was smart to give us the free upgrade. My conclusion is probably not. There are times when free upgrades make sense and other times when they just destroy margins.
Customers, and people in general, will generally say that prices are very important to their choices. They say if the price is too high, they will buy from someone else or just not buy at all. While there is always some truth in that, customers don’t always behave the way they say they will. So, build your pricing strategy around what customers do, not just what they tell you.
I have said it and written it repeatedly – customers don’t care about your costs. They care about the value of your price compared to their next best alternative. You can’t set high prices just because your costs are high. That said, if your costs decrease and your customers know it, they will often view the decrease as leverage to request lower prices. Don’t assume you need to grant their wish.
Pricing power is a simple concept. It really reflects the ability of the selling entity to set or raise prices to the point where they capture the value provided to the buyer. I have written about the USWNT players’ personal pricing power and pricing power in healthcare, however, occasionally there are external factors that seem to limit a company’s ability to use their pricing power. When that situation occurs, remember there are multiple components of price – the value you capture is not limited to the price of your product or service.
I have had several conversations recently with potential clients who want help in setting their pricing strategies. When asked what their current pricing strategies are, the most common answers have been, “We do it by gut feel” or “We take last year’s price and adjust it for our cost changes.” My second question is always, “What is your business strategy?” The answers to that question vary more widely. Although I ask that question second, it is more important and must be answered before setting pricing strategies.
The women’s World Cup Soccer tournament has started, and the US women have won their first two games. At the same time, the subject of pay for the United States Women’s National Team (USWNT) has received more attention. In 2016, five of the more prominent members of the team filed a complaint with the EEOC, alleging that discrimination is limiting their salaries compared to US men. Personally, I believe the players could solve this problem by recognizing and exercising the considerable pricing power they have.
Two weeks ago I wrote a post Dynamic Pricing Made Simple, in which I explained the concepts underlying dynamic pricing. Stated simply, the demand for a product or service can vary depending on the situation, and the amount customers will pay in those situations also varies. Significant profit improvement is available for the companies that can identify those different situations, quantify the potential change in customer value, and set prices accordingly. Conversely, companies that are not prepared to manage a more complex pricing structure can cause long-term damage by implementing it poorly. I recommend taking a logical incremental approach to pricing improvement (do it in steps over time).
I am often asked about dynamic pricing – what it means and how it is implemented. The short answer is dynamic pricing is a process of maximizing profit by adjusting prices based on demand. Earlier this month it was reported that New York City is considering congestion pricing to ease traffic gridlock. Congestion pricing is just a variation of dynamic pricing, in which the city is attempting to increase revenue and reduce demand. Uber does something similar but calls it surge pricing. Some utilities call it peak-load pricing. The concepts in all these uses of dynamic pricing are similar and simple. The critical part is determining how to apply those concepts to the specific industry.
The most important concept in dynamic pricing is demand for a product or service can vary depending on the situation, and the amount customers will pay in those situations also varies. The challenge for any business to set prices dynamically is to determine:
- What are the situations that can cause demand to vary?
- Is the supply of the product or service limited, or can the supply easily be increased or decreased as needed?
- How much more can we charge in high-demand situations to increase overall profit?
- Recognizing that some high-demand customers will no longer buy at higher prices
- How much do we need to lower prices in low-demand situations to stimulate sales without lowering the total profit of those situations?
Let’s consider some possible situations and the demand implications:
- Seasonality – Some things are in higher demand during the summer, such as swimsuits, lodging at national parks, rides at theme parks, tee-times at golf courses, etc.
- There is also a sub-seasonality measure – Some of those same attractions have even higher demand on holidays within a specific season
- Demand for costumes and candy increases near Halloween
- Ski resorts are more popular on holiday weekends, and spring break
- Day of the week – Theaters, aquariums, museums, and sports venues are usually less popular during the week with greater demand on weekends
- Hotels in business districts have greater demand Monday through Thursday nights, while hotels in tourist areas have greater weekend demand
- Time of day – more people go to movie theaters between 6 and 10 pm; the most popular dinner reservation times are 6:30 to 9, depending on the city; fitness classes have more participants before and after work hours, and businesses use more electricity during the peak daytime hours
- Theaters, restaurants, gyms, and utilities are under-utilized at other times
- Weather – pools, theme parks, and outdoor sporting events are more popular when it is dry and warm
- Ancillary attractions – attendance at Pittsburgh Pirate baseball games always increases on Fireworks Night
- Some promotional give-away items are more attractive than others and increase demand for the corresponding events
- Amount of time between purchase and use – often customer price sensitivity is related to how far in advance he or she purchases a ticket for an event
- Customers who are price sensitive will shop early for deals
- Customers who decide to do something without much lead time often are less sensitive to the price
- With a large enough discount, price-sensitive customers can often be persuaded to buy unused capacity that would otherwise go to waste
- Market availability – when the supply of a commodity tightens, customers who need that commodity will pay more.
You get the idea, and no doubt you can come up with more examples. Once the situations that impact demand have been identified, the next step is to determine if capacity is limited or can easily be ramped up. Each restaurant, sporting event, hotel, etc. has a fixed capacity, which cannot be easily increased. When demand is greater than capacity, raising the price will capture more income and allocate the fixed capacity. Conversely, more candy can be made around Halloween, so raising the price might just drive customers to a different brand.
In a somewhat similar comparison, high demand for concerts would have different capacity ramifications than high demand for a specific movie. The number of customers who would like to see Beyonce and Jay-Z, or Taylor Swift or Elton John, is much higher than many other acts. Concert promoters should set the prices for those events high. However, although demand for A Star is Born, Bohemian Rhapsody, and Aquaman was high relative to other films in 2018, a theater would capture more revenue by allocating additional screens to those films on Friday and Saturday night instead of increasing the prices of those specific movies.
After determining when prices should be adjusted due to demand, the next questions are how much to increase them for high-demand periods and how much to decrease them for low-demand periods. There is no simple answer, but it is always important to do the math. By that I mean, if prices are increased 10%, what percent of current buyers could switch to a low-demand period without lowering profit? Similarly, if low-demand prices are decreased by 10%, how many additional buyers are needed to break even?
There will always be uncertainty in adjusting prices to match changes in demand. My advice is to start small and prove the concepts. For a multi-location entity, you could try dynamic pricing in some, but not all, locations. If that is not feasible, start with modest differences in peak-period prices versus off-peak, and adjust as you learn from your results.
Nothing in this blog post is complicated. The concepts of dynamic pricing are pretty simple. It is true that companies like Disney and the airlines have sophisticated computer models to calculate the optimal amounts to adjust prices for different demand situations, but they all started with simple adjustments. By starting with smaller price differences and learning from their results over time, they have been able to identify more granular situations with varying demand characteristics; and they have been able to fine-tune their pricing. If you start with the basics, your dynamic pricing capabilities will also improve over time.
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.