Profits are not Growing

[kaemon salvate]

10 of the most common mistakes companies make when pricing:

Mistake No. 1: Basing prices on costs

Prices based on costs invariably lead to one of the following two scenarios: (1) if the price is higher than the customers’ perceived value, the cost of sales goes up, discounting increases, sales cycles are prolonged, and profits suffer; (2) if the price is lower than the customers’ perceived value, sales are brisk, but companies are leaving money on the table and are not maximising their profits.

Costs are only relevant in the pricing process because they establish a lower boundary for the price. In certain circumstances, there are strategic reasons a company may decide to sell a product below its cost for a period of time or to a certain market segment as a 'loss leader', a product sold at a low price (at cost or below cost) to stimulate more profitable sales. However, when a price is set according to the perceived value of the product or service, sales are brisk and profits are maximised.

No. 2: Basing prices on the marketplace

The marketplace is often cited as the 'wisdom of the crowds', the collective judgment of the value of a product. But by resorting to marketplace pricing, companies accept the commoditisation of their product or service. Marketplace pricing is a resting place for companies that have given up, and their profits invariably end up being thin. Instead, these management teams must find ways to differentiate their products or services so as to create additional value for specific market segments. The marketplace is full of companies that have managed to drag themselves out of commoditisation and establish a unique value proposition. They have then gone on to capture that unique value at prices higher than those of the marketplace.

No. 3: Attempting to get the same profits from different lines

Some financial strategies support a drive for uniformity, and companies try to achieve identical profit margins for disparate product lines. The iron law of pricing is that different customers will assign different values to identical products. For any single product, profit is optimised when the price reflects the customer’s willingness to pay. This willingness to pay is a reflection of his or her perception of value of that product. The profit margin of another product line is completely irrelevant.

No. 4: Failing to segment customers

Customer segments are differentiated by customers’ requirements for your product. The value proposition for any product or service is different in each market segment, and the price strategy must reflect that difference. Your price-realisation strategy should include options that tailor your product, packaging, delivery options, marketing message and your pricing structure to particular customer segments to capture the additional value created for these segments.

No. 5: Holding prices at the same level for too long

While we don’t advocate changing prices every day, the fact is that most companies fear the uproar of a price change and put it off as long as possible. Savvy companies accustom their customers and their sales forces to frequent price changes. The process of keeping customers informed of price changes can be a component of good customer service. Marketplaces change radically in a short period of time. It is important to recognise that the value proposition of your products changes along with the marketplace, and you must adjust your pricing to reflect these changes.

No. 6: Incentivising salespeople on units sold or revenue generated

Volume-based sales incentives create a drain on profits when salespeople are compensated to push volume, even at the lowest possible price. This mistake is especially costly when salespeople have the authority to negotiate discounts. They will almost always leave money on the table by 1) selling lower priced products and 2) dropping prices to clinch the deal. When their job is to get the deal, regardless of profitability, salespeople will do exactly that. As a result, your profitability will diminish.

Companies need to redefine the salesperson’s job as maximising profitability while providing the salespeople the necessary tools to do so. These tools include information on profitability on each of the products your company sells, strict control of the awarding of discounts, and alternative choices and configurations to enable the salesperson to manage the inevitable negotiation about price.

Savvy companies understand that any significant lowering of your price—which may drive increases in volume—will provoke a reaction from your competitors. Knowing enough about your competitors to forecast their reactions could avoid a costly price war that can destroy the profitability of an entire industry.

No. 7: Spending insufficient resources managing pricing practices

There are three basic variables in a company’s profit calculation: cost, sales volume, and price. Most management teams are comfortable working on cost reduction initiatives, and they have some level of confidence in growing their sales volume. But good price-setting practices is seen as a 'black art'. Some companies use highly sophisticated procedures and technologies to track and control their costs while resorting to simplistic price procedures. Likewise, companies may confidently forecast the effect that marketing campaigns and the number of 'feet on the street' have on sales volume.

Managers usually feel comfortable with these two hard-data sets. Therefore, they spend nearly all their time on the issues of sales-volume growth and cost control, overlooking the vital role of pricing strategy. They erroneously believe that pricing is not important or hard data and rigorous methods are not available to enable them to control pricing.

In fact, there are accurate pricing strategies—such as value-attribute positioning, conjoint analysis, or Van Westendorp’s price sensitivity meter—that generate accurate hard data on the perceived value of a product or service, thereby enabling mangers to maximise their profits by optimising their prices.

No. 8: Failing to establish internal procedures to optimize prices

In some companies, the hastily called price meeting has become a regular occurrence—a last-minute meeting to set the final price for a new product or service or a semi-regular review of the company’s price list. The attendees are often unprepared, and research is limited to a few salespeople’s anecdotes, perhaps a competitor’s last year’s price list, and a financial officer’s careful calculation of the product’s cost structure across a variety of assumptions.

A more productive approach to price optimisation requires data, analysis, and discipline. These are the same ingredients that drove the cost-cutting success of the 1980s and 1990s when companies systematically studied, reviewed and re-engineered their processes to eliminate redundancy and reduce costs and cycle times. Price optimisation deserves the same level of attention and support.

Price-optimisation data comes from focused research. The research comes from surveys conducted by professionals who know how to extract the information that is important to the pricing project. They have experience structuring the questions, questionnaires and data to uncover the most important points, inconsistencies, and above all, the values perceived by the interviewees.

No. 9: Spending too much time serving the least profitable customers

Most companies do not even know who their most profitable customers are. While 80% of a company’s profits generally come from 20% of its customers, a careful review of the data often shows surprises, since a company’s largest customers often are only marginally profitable. Failure to identify and focus on their most profitable customers leaves companies undefended against competitors.

Such failure also deprives the company of the loyalty that more attention and better service would provide. These companies base their decisions on anecdotes, stories, whispers and hearsay, rather than hard data about customers and competitors.

No. 10 Relying on salespeople for customer data

Such people are an uncertain source because their information-gathering methodology is often haphazard and the information obtained can be purely anecdotal. Such information is neither precise nor quantifiable. A customer will rarely tell the complete truth to a salesperson, so any information the customer volunteers may be biased.

Salespeople can readily identify those anecdotes that advance their interests (e.g., lower prices means higher revenues, regardless of profitability) and those that operate against them.

Savvy companies employ trained professionals to collect and analyse the data to identify and evaluate the value perceptions of their marketplace. Large companies have entire departments doing this full time; smaller companies may outsource it to a specialist.

Conclusion

The optimisation of pricing strategy is as important as the management of costs and the growth of sales volume.

Rigorous price optimisation has emerged as an important source of competitive advantage and increased profitability. The iron law of pricing states that different customers will ascribe different values to your products and services.

Savvy companies do the research to identify the various market segments they serve and they re-engineer their marketing, packaging and service operations to excel at meeting their needs. They use that research to align their prices with the value perceptions of their customers. In this way they win customer loyalty, lower costs of sales, and above all, enhanced profits.