The Strategy and Tactics of Pricing

1. Strategic pricing is about value creation, not just cost recovery

The purpose of strategic pricing is to price more profitably by capturing more value, not necessarily by making more sales.

Value-based pricing focuses on understanding and capturing the economic value created for customers, rather than just covering costs. This approach enables companies to set prices that reflect the true worth of their offerings. Unlike cost-plus pricing, which can lead to overpricing in weak markets and underpricing in strong ones, value-based pricing aligns prices with market conditions.

Key principles of strategic pricing:

• Proactive - Anticipate events and develop strategies in advance
• Value-based - Reflect differences in value across customers
• Profit-driven - Evaluate success by profitability, not just revenue

The strategic pricing pyramid provides a framework with five levels:

1. Value creation
2. Price structure
3. Price and value communication
4. Pricing policy
5. Price level

2. Understand and quantify economic value to set optimal prices

Economic value accounts for the fact that the value one can capture for commodity attributes of an offer is limited to whatever competitors charge.

Economic value estimation involves determining the total economic value of an offering, which consists of:

• Reference value - Price of the customer's best alternative
• Differentiation value - Worth of what distinguishes the offering from alternatives

Approaches to estimating value:

• Monetary value - Quantify financial impact through in-depth customer interviews
• Psychological value - Use techniques like conjoint analysis to estimate subjective worth

Understanding economic value enables companies to:

• Set prices that reflect true worth to customers
• Identify opportunities to create and capture more value
• Make informed decisions about product development and positioning

3. Segment prices to capture different values across customers

The goal of that structure is to mitigate the tradeoff between winning high prices for low volume and high volume for low prices.

Price segmentation involves creating a structure of prices that aligns with differences in economic value and cost-to-serve across customer segments. This approach allows companies to capture more revenue from high-value segments while still serving price-sensitive segments profitably.

Key mechanisms for maintaining segmented pricing:

• Price-offer configuration - Tailor product/service bundles for different segments
• Price metrics - Use different units of pricing (e.g. per use, per outcome)
• Price fences - Create criteria customers must meet to qualify for lower prices

Effective segmentation enables companies to:

• Maximize profitability across diverse customer groups
• Serve a broader market without sacrificing margins
• Align prices more closely with perceived value

4. Craft value messages tailored to product type and buying stage

The role of value and price communications, therefore, is to protect your value proposition from competitive encroachment, improve willingness-to-pay, and increase the likelihood of purchase as customers move through their buying process.

Value communication should be adapted based on:
Product characteristics:

• Search vs. experience goods
• Monetary vs. psychological benefits
  Customer's stage in buying process:

1. Origination
2. Information gathering
3. Selection
4. Fulfillment

Key principles for effective value communication:

• For search goods, explicitly link features to benefits
• For experience goods, focus on broader assurances of value
• Tailor messages to different participants in B2B buying processes
• Frame price relative to value at the fulfillment stage

Effective communication can significantly impact purchase intent and willingness-to-pay by helping customers recognize the full value of an offering.

5. Develop pricing policies to manage expectations and negotiations

Pricing policies are rules or habits, either explicit or cultural, that determine how a company varies its prices when faced with factors other than value and cost that threaten its ability to achieve its objectives.

Well-designed pricing policies help companies:

• Maintain price integrity and avoid rewarding aggressive negotiation
• Proactively address common pricing challenges
• Create expectations that drive better customer behavior

Key areas for policy development:

• Responding to price objections
• Managing price increases
• Dealing with economic downturns
• Promotional pricing

Effective policies should be:

• Transparent - Clearly communicated to customers
• Consistent - Applied uniformly across similar situations
• Proactive - Anticipate and address potential issues in advance

By establishing and enforcing clear policies, companies can reduce the need for ad hoc discounting and improve long-term profitability.

6. Set prices strategically based on objectives and market response

The goal of pricing should be to find the combination of margin and market share that maximizes profitability over the long term.

The price-setting process involves:

1. Defining the price window (ceiling and floor)
2. Establishing an initial price point based on:
   • Alignment with overall business strategy
   • Price-volume trade-offs
   • Estimated customer response
3. Communicating new prices to the market

Strategic considerations for price setting:

• Skim pricing - High prices for unique, high-value offerings
• Penetration pricing - Low prices to rapidly gain market share
• Neutral pricing - Balancing price with other marketing tools

Tools for estimating market response:

• Controlled price experiments
• Purchase intention surveys
• Structured inferences from historical data
• Incremental implementation and adjustment

The key is to balance internal financial constraints with external market conditions to maximize long-term profitability.

7. Adapt pricing approach throughout the product life cycle

Pricing decisions affect whether a company will sell less of the product at a higher price or more of the product at a lower price.

The product life cycle stages require different pricing approaches:

1. Introduction:

   • Focus on educating buyers about value
   • Use price to signal product worth
   • Consider promotional pricing to drive adoption

2. Growth:

   • Adjust prices as competition emerges
   • Balance margin and volume to maximize growth
   • Consider sequential skimming or penetration strategies

3. Maturity:

   • Defend against increased price competition
   • Explore opportunities for price segmentation
   • Optimize pricing of complementary products/services

4. Decline:

   • Choose between retrenchment, harvesting, or consolidation
   • Adjust pricing to support chosen strategy

Adapting pricing strategies throughout the life cycle helps maximize profitability at each stage and extend the product's profitable lifespan.

8. Implement pricing strategy through organizational alignment

Implementing pricing strategy decisions requires properly addressing organizational issues related to how decisions are made and enforced as well as motivational issues that encourage managers to engage in more profitable behaviors.

Key elements for effective implementation:

1. Organizational structure:

   • Define roles and responsibilities for pricing
   • Determine level of centralization vs. decentralization
   • Establish clear decision rights

2. Pricing processes:

   • Map and optimize key pricing activities
   • Identify and address profit leaks

3. Information and tools:

   • Provide managers with relevant data and analytics
   • Implement price management systems where appropriate

4. Performance measures and incentives:

   • Align metrics with pricing strategy objectives
   • Design compensation to reward profitable pricing decisions

5. Change management:

   • Secure senior leadership support
   • Use demonstration projects to build momentum
   • Provide training and ongoing support

Successful implementation requires a holistic approach addressing structure, processes, tools, and motivation to drive consistent execution of pricing strategy.

9. Use relevant costs, not accounting costs, for pricing decisions

Costs should never determine price, but costs do play a critical role in formulating a pricing strategy.

Relevant costs for pricing decisions are those that are:

• Incremental - Change as a result of the pricing decision
• Avoidable - Can be eliminated if the sale is not made

Key principles for identifying relevant costs:

• Focus on future costs, not historical or sunk costs
• Consider opportunity costs of resources used
• Analyze cost changes at the margin, not average costs

Common pitfalls to avoid:

• Using fully allocated costs that include fixed overheads
• Relying on depreciation schedules that don't reflect true economic costs
• Ignoring capacity utilization effects on incremental costs

Understanding relevant costs enables more accurate profitability analysis and better pricing decisions, especially in competitive markets or for short-term opportunities.

10. Analyze price changes using break-even and financial tools

To calculate the break-even sales changes for a reactive price change, we need to address the following key questions: (1) What is the minimum potential sales loss that justifies meeting a lower competitive price? (2) What is the minimum potential sales gain that justifies not following a competitive price increase?

Key financial analysis tools for pricing decisions:

1. Break-even analysis:

   • Calculate minimum sales change needed to justify a price change
   • Consider both price effects and volume effects

2. Contribution margin analysis:

   • Focus on incremental profit per unit sold
   • Use to evaluate price-volume trade-offs

3. Incremental profit analysis:

   • Compare change in total contribution to change in fixed costs
   • Useful for evaluating pricing strategies with capacity changes

4. Break-even sales curves:

   • Visualize price-volume relationships
   • Identify profitable pricing zones

These tools help managers quantify the potential impact of pricing decisions and make more informed choices in the face of uncertainty about market response.

11. Compete on price thoughtfully, considering long-term impacts

The key to surviving a negative-sum pricing game is to avoid confrontation unless you can structure it in a way that you can win and the likely benefit from winning exceeds the likely cost.

Guidelines for price competition:

1. Analyze the situation:

   • Is there a cost-effective response?
   • Can the competitor sustain the price difference?
   • Are other markets threatened?

2. Choose an appropriate strategy:

   • Ignore - For weak threats with low sales at risk
   • Accommodate - Adjust strategy to minimize impact of strong threats
   • Attack - When justified against weaker competitors
   • Defend - Convince strong competitors to back off

3. Manage competitive information:

   • Collect and evaluate competitor pricing data
   • Selectively communicate intentions and capabilities

4. Consider long-term impacts:

   • Avoid undermining industry profitability
   • Focus on building sustainable competitive advantages

Thoughtful price competition requires balancing short-term gains against long-term strategic positioning and industry health. The goal is to achieve competitive objectives while minimizing destructive price wars.

Last updated: July 25, 2024