Using Pricing As A Strategic Tool

ABSTRACT

Do you base product prices on the cost of production or the market’s perception of value? This article looks at ways to make pricing a strategic rather than a purely financial decision and to break out of conventional paradigms and explore possible new revenue models.

STRATEGIC PRICING

Pricing your product is often seen first and foremost as a financial decision, where you calculate a price that ensures you make an adequate profit after deducting the cost of development, marketing, fulfillment, support, and other expenses. Many business people make the mistake of basing their pricing strategy primarily on this calculation, with little concern for other crucial business factors that could or should be considered.

Once you know the “adequate profit” number, put on your marketing hat and think about what effect the selected price will have on market success. Marketing will never look at pricing as a function of the cost of production but rather in terms of perception of value. Marketers know (or should know!) that customers will pay any amount regardless of how much it costs to produce the product or service, as long as the customer believes the price represents good value for their investment.

I once consulted for an agricultural chemical company which sold a tiny bottle of herbicide for $750. The marketing manager in charge of this product kept saying that “there were really good margins” behind the product, which was a coy way of saying that they produced the fluid in giant vats and a tiny bottle cost next to nothing to produce (not counting the cost of the original research). But farmers would pay the price without hesitation because this herbicide used a revolutionary new chemistry which, when mixed with a tank of water, swept their fields clean of weeds far better than anything else available on the market. Because the customers wanted this product and almost nothing else (the herbicide grabbed 85% of the market in less than three years), the manufacturer had tremendous latitude in pricing and could get away with charging a relatively high price, even though each bottle was so cheap to produce.

What are some of the other factors to consider when setting a price for your product or service?

USE PRICING TO POSITION YOUR PRODUCT

Do you want to position your product as the premium item available in your market space? Charging a higher price tells your customers that you believe your product is better than all the rest. Haagen Daaz positions itself as super premium ice cream by charging a super premium price. I have never seen them use taste tests in their marketing to compare themselves to other top ice creams. Why not? Doesn’t their ice cream taste better? They know that because of the brand image they project and the price they charge, consumers perceive of them as the best possible brand, the one you buy when you want to spoil yourself or make the best possible impression on your guests, so it would be foolhardy to take the risk of actually doing a taste comparison.

A software client I worked with had a robust little media manipulation toolset which they first priced in the $450 range. Their logic was that they were just as a good as the high-end competitors in that space, which were priced in the $750-$1,000 range, so by undercutting the price they would force their target market to make the only logical choice possible and select their product. Problem was that consumers didn’t agree with their logic. The product was priced halfway between the high-end and the low-end competitors (which charged around $200 a package). When consumers went to buy media manipulation software in this category, they would gravitate towards the low-end price if they were entry-level media producers, and they would gravitate towards the high-end price if they were professional media producers. For the most part, these latter customers didn’t know what to make of my client’s product and didn’t look at it as a serious contender in that market space because of its middleweight price. The manufacturer was about to drop the product altogether due to low sales, but first they agreed to do a pricing test and bumped the price up to $800 without changing anything else about the product. The result was a substantial increase in actual unit sales (not to mention revenues)! Suddenly, professional media producers took them seriously and would do a proper feature comparison with the other professional-level software packages, so they could see for themselves that this product was in many ways better than the other products out there.

AVOID THE COMMODITY TRAP

When a product becomes a commodity, the only way to differentiate your product is to charge a lower price. A barrel of oil is a barrel of oil is a barrel of oil, so customers will only pay the going market rate, depending on the grade. If customers come to view your product or service in the same light and see no difference between the offerings of various vendors, then you can only ever charge the going market rate, and the only way to advance your business is to find ways to lower your cost of production. Dell Computers wins in the PC commodity market because they have engineered the most efficient manufacturing process (supported by great marketing and branding campaigns), so they can charge lower prices and still make money. One of their tricks is to stock most inventory for less than two hours, with no parts ever stocked for more than three days. They know that the price of PC components drops an average of 1% per month, so they can beat smaller competitors who must warehouse components if they want to get volume discounts. If you are unwilling or unable to compete on this footing, then you need to find ways to differentiate your product on more than just price.

FIND NEW MARKET SEGMENTS

One way is to find new market segments where price is not the primary consideration. One of my clients has found that they can charge double to triple their normal rate by adapting their service to the needs of customers in offshore markets, where the competitive environment is less developed. In mature markets such as the US and UK, they are forced to compete against deeply entrenched competitors, which tends to commoditize the service and trend prices down. But in carefully chosen emerging markets such as several third-world countries, they are the only or leading game in town and can therefore get away with jacking up the price. Their small investment in localizing their service to the needs of adolescent markets results in the kind of profit margins that haven’t been seen in this industry for decades.

USE AN ENTIRELY NEW APPROACH

Another winning approach is to challenge conventional wisdom when planning your pricing strategy. Auto dealerships make less than 15% of their total revenue on new car sales while over 65% comes from back end financing, insurance, and service packages, so the car is almost a loss leader to bring in aftermarket customers. They very deliberately plan their revenue model around the “business office”, which is where the aftermarket sales are closed, rather than the car lot, where most people would assume they make the bulk of their money. For years, Sears made virtually no profits from retail sales but had a gold mine in their credit card division, so they used low in-store prices to bring in credit card customers. Costco located a source of revenue when they realized that they could get ninety day credit terms from suppliers while turning their inventory every twenty-two days on average. They therefore structured their pricing to simply cover overhead, and then they set up a sophisticated investment department to invest their billions in annual sales for the short periods before they were required to pay their suppliers. These short-term investments became the source of all their profits, so Costco was in fact using their retail operation to provide funds for their pseudo investment banking arm.

Many professionals such as lawyers and consultants charge by the hour for their time, which limits their possible annual revenue because they can only work a limited number of hours per year. To earn more money, professional firms must resort to hiring more staff so the partners can take a percentage of the billings of junior staff. But again, the constraint is the number of hours multiplied by the number of people multiplied by the billable rate. To break out of this paradigm, some consultants have adopted a “flat fee” approach. The customer agrees to pay a set fee for a project of defined scope. As long as the client is satisfied that they are getting a valuable service or solution for their investment, they don’t care how many (or few) hours or sub-contractors the consultant needs to implement the solution. Another pricing approach is to partner with the client and share both risks and rewards. The service provider or supplier would charge a small monthly retainer to cover basic costs and would then get a percentage of the money saved or additional revenues earned as a result of his or her engagement. You can break out of limiting paradigms when you challenge the established “way” things have traditionally been done and look for new ways to generate revenue for your business.

DON’T OBSESS ABOUT MAKING MONEY

Wait a minute, isn’t making money what business is all about? In the long term, of course it is, but you can make short-term pricing decisions to help you accomplish other strategic goals beyond immediate profitability. For example, you can lower your price to “buy” market share from an entrenched competitor. When Microsoft launched Access in 1992, they introduced the product for an unheard of price of $99, which was less than 10% of the price of the entrenched database program, dBASE. Observers thought Microsoft was making a huge blunder. dBASE was so dominant in the business world that it was believed nobody could ever take their market share, so people felt Microsoft was just giving their software away for no reason and would never recoup their development and marketing costs. But the low price prompted many database managers to buy Access just to check it out for themselves, and they found that it was actually a robust database that could be used in a corporate IT environment. So began the decline and fall of the dBASE empire.

Note that IBM failed with this exact same strategy when they introduced OS/2 as a replacement for the burgeoning Windows operating system. The introductory price was around $59, which at the time was less than the value of the twenty or so HD floppy disks that were shipped with the package (people were actually buying the package and reformatting the floppy disks and not using the software), so IBM was in effect giving the system away to try to win market share. So there are no guarantees this approach will work, but it should certainly be considered if you want to disrupt the current market and create an opening for your new product.

URL stands for “unique resource locator” and is the unique address used on the Internet for each website. During the dot-com craze of the late 1990’s, established pricing models went out the window as companies competed to become the leading player in the emerging Internet market spaces. People therefore joked that URL stood for “ubiquity now, revenues later” as companies spent billions in attempts to become ubiquitous, with the hope that this approach would somehow lead to revenues down the road when the market settled down. History was not kind to many of these businesses, but to this day, it is still a valid approach in the right context. Overstock.com is a good example, as they focus on building market share and don’t worry about quarter-to-quarter profitability (much to the dismay of market analysts). Their expectation is that by becoming the number one Internet destination for discounted products, they will reap the lion’s share of profits in the future.

FINE TUNE YOUR APPROACH

Develop metrics and research techniques so you can evaluate the on-going success or problems with your strategy. How have competitors responded to your pricing moves? What are customers saying? What are salespeople experiencing in the field? What is happening to your sales funnel? Do you have financing in place to support your chosen strategy? Can you meet the demand that might be generated by this strategy? Make sure you understand what is happening in the market and keep a very close eye on changes and reactions.

Pricing, which is one of the four P’s of marketing, is one of the most important parts of your overall marketing strategy. Too many businesses make ad hoc pricing decisions or don’t take important factors into consideration when setting the price. Use pricing as a strategic weapon in your marketing arsenal and this will help you differentiate your offering, win market share, build stronger customer relationships, and reap larger profits.