One of the many things I love about the holidays is attending parties. Joining family, friends, neighbors and colleagues in celebration of the season offers us all a chance to solidify long-term relationships and get to know people better. This year during some of the many casual conversations, I was struck by the number of statements made by my friends and neighbors that were based on opinions and beliefs they had heard from others, rather than being based on facts. I realized that pricing strategies are often based on the same types of un-tested opinions and beliefs; and while that is relatively harmless socially, it can be an expensive profit killer in any business.
At one of the first parties of the season, I was talking with a new neighbor. She had recently moved to our neighborhood from California, and she considered herself environmentally sensitive. Pennsylvania has seen explosive growth in drilling for natural gas via “fracking”, and that has generated strong emotions. She told me “The frackers are polluting the water.” When I asked how she knew that, she said “They are shooting chemicals into the ground. The chemicals have nowhere to go but into the water.” Since drilling is regulated by the EPA, I said there must be studies that can determine the impact on the water. My neighbor’s reply was “People are getting sick in Washington County. They are getting lesions and sores on their skin from drinking the water.” My neighbor had not actually seen these people with lesions; she had heard about them from a friend. And she had not actually seen any data on the quantity of chemicals in the water, but “It is common sense those chemicals are bad for the water.”
The next data-free opinion came from a good friend. During the holidays, kids are home from college and my friend and I got on the subject of universities. “Penn State is harder to get into than any private school in the state”, he said. “Where did you get that?” I asked. “I don’t remember where I read it, but it’s true.” Well that statement was easy to refute. When I got home, I looked up the average test scores and GPAs of incoming students at College Prowler and sent some links to my friend. University of Pennsylvania, Carnegie Mellon, Bucknell University, Lehigh University, and Dickinson College all had higher test scores of admitted students and lower acceptance rates than Penn State. I stopped looking after those few schools. I still think Penn State is an excellent school, and my friend’s statement was harmless, but it was also free of the facts.
The tendency of people to latch onto opinions in the absence of facts is well documented. The Myth of the Rational Voter, by Bryan Caplan, points out there is a cost to individuals (time and energy) to get facts about these kinds of subjects. Since it is very unlikely that actually knowing the facts will result in any benefit to an individual, that individual is highly unlikely get the facts. It is easier and less costly to just go with what sounds right or what someone tells us. (If it is on the internet, it must be true!)
Following that same approach in business could be disastrous. When it comes to pricing, businesses have the incentive to get it right, but do not always do so. As an example, last year one of our clients had raised prices on a group of accounts. In the subsequent two months, their overall margin stayed flat compared to the prior year, but their total revenue decreased slightly. The client’s conclusion was price increases were costing them volume. However, we dug into the data and found a different answer. On the accounts where they had increased prices, some accounts increased unit volumes and some decreased. Digging further, we found the vast majority of the accounts with decreased volume had stopped purchasing product from our client more than 6 months earlier. So the customers had left our client well before the price increases, not because of them. Had they followed their initial instincts rather than getting the facts, our client could have removed the price increases and suffered a loss in margin. Instead, they developed the confidence to slightly increase other customers whose prices had not changed and were well below their targets; and the client increased their margin in the process. They also began an effort to win back those customers they had lost due to inattention or other issues.
A different client of ours was in a relatively flat market. Their margins were steady, but they were not hitting their targets, so they decided to raise prices on the smallest customers. However, when we reviewed the data, we found the business was already shrinking with these small customers. Compounding the problem, the sales decline was greatest with the customers currently paying the highest prices. Pushing those prices higher would likely accelerate the sales decline. The company scrapped their initial decision, and they launched an effort to win back the lost business with a more dedicated small-customer sales team and incentives that would lower the prices for that group at certain volume levels. The client also found some medium-sized customers whose prices were very low relative to similar accounts, and they successfully implemented modest price increases to those accounts.
In our personal lives, Caplan may be right that it is not worth our time individually to figure out what the right answers are. However as the two previous examples show, it absolutely is worth spending time to understand the data when it comes to setting prices. As Sergeant Joe Friday said, “Just the facts ma’am.”
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