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 the results achieved by a business are poor or less than expected, should the strategy be changed? It is a question every entity wrestles with at some time, and typically the worse the results, the more there is a demand to change the business strategy or the pricing strategy. Sometimes changing the strategy is the right answer, but very often poor results are a result of poor execution. In those cases, the business should stick with their well-thought-out strategy, but focus their efforts on improving the implementation.
Last month I attended two Major League Baseball spring training games with some long-time friends. Of course, our experience included beer, because ball parks and beer go together so well. Buying the beers also reminded me that in pricing strategy, how you structure your prices is just as important as the prices you set.
While there are surely more important things than crowd size for our politicians and news media to worry about, both groups have participated in a flurry of recent discussions of the expression “alternative facts”. While that is not a term often heard in negotiations, other erroneous statements are. You can improve your profitability by using the right tactics in responding to these alternative facts.
Remember that everyone, including your customer, operates in their own self interest. Often that means stretching the truth a bit. As evidence, consider how you behave as a buyer. Have you ever told a car salesman that another dealer offered the same car for a lower price, when it was not the exact same car? It happens all the time. That is why car sellers ask for documentation. Not all buyers are liars, but they are all looking out for themselves or their companies. Be ready to counter some of their claims during negotiations.
“Your products are exactly like your competitor’s “
First, don’t accept commoditization of your product. Your customer bought your product initially based on its value. Remind them of that. What are the differences in performance and durability? If your product lasts longer or performs better for the customer, they will realize cost reductions or revenue improvements from them. Even if you are selling the identical brand as your competitor, there are probably differences in service, delivery, reliability and availability. Make sure you identify these and sell the value of them. Make sure all your sales people understand these differences and are not trapped by the commodity mindset.
I seem to have received an extraordinary number of requests lately to complete customer satisfaction surveys. Some have been only one question and some have been 10-minute surveys. The goals of the companies requesting my survey participation are generally to improve their service delivery and build customer loyalty. Both are good goals. Unfortunately, if the surveys are not crafted and interpreted properly, they can kill the companies’ chances of achieving their goals.
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.
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.
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.
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.