- Developing a pricing strategy
- Implementing a pricing strategy
- Reviewing a pricing strategy
- Conclusions and the future of pricing
Your customer value proposition (CVP) is a critical element of your pricing strategy. Although pricing is an innately cross-disciplinary function, your value proposition will inevitably be the crux of your pricing. Throughout this piece, I will outline some recurring topics around pricing, and approach them through a value based lens that looks at your key value propositions and those of your competitors' as the basis to develop your pricing strategy. Pricing is highly dependent on the specifics of the business that you are dealing with. This piece will address some of the more common topics that need to be looked at, without aiming to be prescriptive but aiming to put forward a general view of pricing across different types of businesses and industries. The topics in this piece could also be dealt with in a different order. For example, one could start from review financial results and then exploring the market segments as a consequence. This piece consists of three broad sections: developing, implementing and reviewing a pricing strategy.
How to develop a pricing strategy
One of the first issues to address in an organisation that wants to adopt a good pricing strategy and practice is to understand which company function is supposed to carry such activity. As a discipline, pricing is part of marketing, but it's often done by either finance, strategy or sales, sometimes with a bit of friction between them. If the founders are still involved in running the business, they may be the ones making price decisions. Alternatively, an organisation could engage an external pricing consultant. The legacy talent management model inherited from the past, involves staffing numerically skilled people in finance and corporate strategy, and creatively skilled people in marketing. Maybe that's one of the reasons why in the past, pricing evolved a bit separately from the other components of a traditional marketing mix (4Ps: Product, Pricing, Place, Promotion). One other reason is related to the ICT revolution. In the next sections, I'll go through the main topics that may be considered when planning and developing a pricing strategy.
Mapping markets, customers and value propositions
The exercise of understanding markets, segments, customers and value propositions is crucial to pricing. Pricing models have a strong dependency on the customer value proposition (CVP). A simple image I keep in mind while going through such an exercise is fishing. Mapping markets, customers and value propositions are like understanding in what lake the company is fishing, in which of its area, with what rod & bait, and what are the commercial results.
Since the choice of markets and segments is part of a broader marketing strategy, in this paper I consider them an input to design pricing options. Note that the CVP - Pricing relationship can also work in the opposite direction: a CVP or product can be designed around given pricing, especially if the price point chosen is a high one. If well done, this can impose a disruption or a new category to the market. Designing a CVP around a low price point usually works well for temporary initiatives such as discounts and offers. If not, a new CVP around a constantly low price is riskier and must be planned carefully. If the new CVP turns out to be undifferentiated in the customers' perception, it may lead to unhealthy price wars. The approach of designing pricing around a CVP should be the preferred one. Hence the importance of understanding what exactly is the CVP in the customers' perception.
The importance of competitor and market pricing
One of the key aspects in devising a pricing strategy is to compare our CVP with other alternatives that the targeted customers can obtain. This means looking at:
- Substitute products and services
- Their characteristics
- Their purchase process
It is important, in this exercise, not to limit our view to direct competitors, but to think about any other alternative that customers may have. This is moreover important in a general environment with lots of disruption, as has been the case in recent years. My advice would be to complete such a comparison regardless of prices and then to look at prices in a second step. It just helps in concentrating on the CVP and customer experience or journey. Such work should be done in conjunction with marketing and sales. This may sound like a strategic marketing exercise rather strategic pricing, but again, pricing is most closely linked with marketing. Once customer options have been listed, analysed and compared, then prices should be compared. The goal is to dig out which sensitivity factors are likely to play in customer's purchase decisions (switching costs, difficult comparison, expenditure, price-quality, end-benefit, etc.) and their price sensitivity or elasticity.
The outcome of this activity should be more insight into how customers decide to buy and perceive value propositions with their price.
The difficulty here is to be as objective as possible and to really reflect the customers' mindset. The more objective the information, the better. I won't get into market research and survey techniques, but the main risk here is to follow what management thinks is happening in the marketplace, instead of what's really happening out there.
Generating pricing options
What I refer here as a pricing option, is, in fact, a possible pricing strategy. There are lots of possibilities: versioning, bundling, variable, dynamic, premium, penetration, skimming, freemium, etc., the list is long and it is not possible to conclude that any of them are generally better or worse. Each of them has been historically devised to take the opportunity of a specific price insensitivity in targeted customers. The most typical examples are when alternatives are hard to compare for customers, either because the product/service is complex or because of a lack of information at points of sale. Other examples come from perishable products/services such as food or tickets. It really depends on the specific business at hand. The good news is that pricing options can be combined and added up to create new strategies. They don't necessarily exclude each other. Versioning, penetration, premium and dynamic pricing can be done at once. To generate possible options, we should look at:
- Customer needs
- Key sensitivity factors and then associate pricing strategies that may work with them.
- CVPs offered
In the example below I omitted the value propositions and listed very brief needs for the sake of synthesis. I then listed sensitivity factors in decreasing order: first the most likely to play a role in the purchase decision, then the second most likely,... and so on. The key here is to be as specific as possible. The better purchase processes and decisions are understood, the more specific and tailored the pricing can be, and the more the opportunity to increase revenues.
Example of possible pricing options associated with customer value propositions. Illustrative only, not to be taken as readily available advice or insight.
Choosing how to structure markets, segments and channels is marketing strategy or corporate strategy. I won't discuss that in this article. What I'm highlighting here, is the work of associating pricing ideas or options with each CVP. A sophisticated tool to analyse pricing / CVP options is Conjoint Analysis. This is a statistical method used to analyse and model customer preferences for various product/service versions at various price points. It works well with versioning and static pricing. Unfortunately, it also requires a large customer base (i.e. B2C or B2B with lots of customers), tends to be prone to customer bias, complex, expensive and requires a specialised dedicated project. Conjoint Analysis can also be used to design a CVP around a price. Keep in mind what I mentioned previously about the CVP - Pricing relationship.
Analysing costs, cost attributions and unit margins
No one wants to end up with negative margins. Checking costs and margins is very important, but it must not become the pricing strategy alone. I cannot put enough emphasis on the importance of avoiding a blind “cost plus” practice. Looking at costs must be done only to verify prospective margins. It's not the basis of our pricing and not its starting point. Another issue that may come across in looking at costs is what to do with fixed costs or sunk costs. In Pricing, fixed costs and sunk costs should be ignored. Those are related to the very fact of being in that business, market or segment. It's about investment. There is no logical connection between a sales decision and a cost that does not depend on sales volumes, such as salaries or rents. Trying to include fixed costs in pricing means we're dealing with a strategic decision on whether to be in that business or a related calculation such as an ROI, NPV, IRR, payback or break-even. This can be done, obviously. But it's not pricing, it's corporate strategy or finance. Pricing is about optimising revenues once there's a decision to compete in a given market or segment.
The next obvious thing to do is to analyse variable costs to arrive at unit costs. This has to be done with finance and it's essentially a management accounting topic. It's worth keeping in mind that the more industrial the business, the more variable costs there should be. Service businesses tend to have very few variable costs:
How a P/L should look like, depending on the business being in services or industrial.
To arrive at unit costs, dollar costs may be divided into volumes. Depending on the company's financial reporting, discounts may also be reported in the PL. In that case, care must be taken in differentiating the types of effective revenue and pocket prices from nominal items. Identifying price components and market data to track.
There are usually two types of information to track:
- Unit costs.
- Exchange rates.
Every single item in any of these sets may be worth to track depending on its likely impact on the final price. Capturing competitors' prices can be a delicate issue. Getting such information through non-public sources may be considered collusive behaviour. The general rule is to use market data from publicly available sources or publicly listed prices accessible to anyone. If not, my advice is to check with the legal counsel whether data about competitors' prices can be used for pricing purposes. Historical data should be analysed to understand each component's movements in time. The greater or the more unpredictable the movements, the more is going to be worth tracking that component. An example below:
The example above shows that cost 4 changes less over time.
How to implement a pricing strategy
The topics that may recur in making a pricing strategy operational are:
- Analysing feasibility.
- Choosing a pricing option or strategy.
- Controlling the pricing.
In order to estimate the success of a pricing strategy, comparable data about price-volume relationships (i.e. elasticity) should be considered. The more innovative the CVP, the less it will be comparable to past or present products, and the less we will be able to rely or even find relevant information on elasticity. In such cases, information has to come from market surveys or other comparable information that the organisation has obtained before deciding to launch a new product. If not, experiments and building knowledge with a trial and error approach remain the only options. For established products with variable costs - typical in commodity businesses - margins and prices are also strongly dependent on input costs. In such cases, past data on prices and volumes may not be relevant because of different types of price levels that were observed in the market at that time. One way to work around this issue is to take unit margins as a proxy of prices and to look at the unit margin to volume relationships instead of price-volume. Assuming that the market is competitive, volumes obtained against given unit margin levels should give insight into elasticity.
In terms of feasibility, commercial and legal risks, as well as technical feasibility and cost of implementation, need all to be verified and confirmed by working with subject matter experts. Chances are that the commercial risks would already be discussed with marketing or sales functions while generating the pricing idea. Legal risks should be assessed with the legal counsel: pricing can be a delicate area in terms of law and regulations.
Technical and operational feasibility is about the organisational assets, resources and competencies available in a company. These aspects must be assessed with Operations and IT functions. At this point, the pricing options must be very well described in terms of what information would be needed, with what frequency, and how prices would be updated. This is increasingly important if the pricing option under consideration is different than what the organisation has done so far. The outcome should look like an attractiveness/cost table:
Choosing an option. Planning customer feedback
The choice of a pricing option as a pricing strategy should be a cross-functional effort with contribution from marketing, sales, IT, operations, finance and legal. Marketing and sales should be the main stakeholders that bring expert judgement and commercial advice on how attractive or viable a pricing model is likely to be. The others should provide advice on feasibility and costs. In case there's a matrix similar to the one described previously, my advice is to keep on working with that table until a consensus or decision is reached on the pricing option(s) to go ahead with.
Generally having more options under discussion is better: it avoids choosing a poor option just because it happens to be the easiest or the only thing to do. For example, the last row in the previous table is not a good candidate to go ahead with. In such a case we should come up with better ideas than a very unattractive option, even if it's easy to do. Below, I summarised how ideas should be managed depending on where they fall in an attractiveness-feasibility space:
Only the options that are judged attractive and feasible should go ahead for project initiation. Pricing is too delicate to have a “so and so” idea realised. On the other hand, highly attractive but too expensive options should be retained, kept in a strategic plan and be periodically reviewed or reassessed. At this point, there's a decision to propose a new CVP and/or pricing to our customers. Changing the pricing or introducing a new one is always going to carry some risk. That's why a preliminary experiment may be designed and implemented, similar to a marketing campaign, in order to confirm the assumptions made so far. Such an initiative wouldn't differ much from a marketing campaign and related feedback with the tools and methods used to measure its success. When implementing or changing a pricing strategy, it's useful to have a customer feedback process. Such a feedback loop will allow the business to continuously adjust, react and, in the worst case, learn from failures and avoid the same mistakes in the future. The difference is that this time we're not dealing with a temporary experiment such as a campaign, so the feedback is not one-off but a continuous and permanent process that brings richer information than just a volume increase or decrease. The way of achieving this depends a lot on how customers interact with the company and/or product:
- In B2B, there's usually a Sales / Account Management team or Customer Support.
- In B2C, getting customer feedback is usually harder, but probably the organisation has staff monitoring the activity at retailers.
- In unattended or digital B2C businesses, having a customer relationship is still hard, but the product or service may lend itself well to interactions with customers.
No matter the context, establishing a feedback channel that includes pricing in the information fed back, can go a long way.
Initiating, executing, monitoring and controlling a pricing strategy
There's a bit of PMP® conditioning in me. I tend to think of change initiatives as projects. Clarifying goals and expected benefits in changing a pricing strategy is usually well spent time and should always be done. In doing this:
- Subject matters experts and stakeholders should be identified and involved.
- A charter containing the necessary internal information should be written, as well as the external marketing message, information or banner to inform customers. The range and possibilities in crafting these pieces is very wide and heavily depends on the specific business, management style and expected size or impact of the change. The owner of the initiative must be directly involved in preparing such information with marketing for the external information, and with the assigned project/implementation manager for the internal charter.
I didn't mention planning in the titles, but planning a new pricing model is essentially what's discussed in the previous sections. In terms of the work required to change the internal organisation and resources to accommodate a chosen strategy, the planning of that work must be done after a project or implementation manager has been assigned. It's always better to assign a project manager before starting to plan activities and intermediate milestones.
The more complex the change initiative looks like, the more important it is to plan with the project or implementation manager.
Enough said about project management. Let's go back to pricing.
Summary of stages, what functions should be involved and for what purpose. These stages are not meant to be in a strict sequence. If a pricing strategy requires a significant project effort, its execution will wait for that project's delivery.
The execution of a pricing strategy can be a delicate activity where the success of a pricing strategy is made, especially with a variable or dynamic pricing where prices are frequently reviewed and changed. A company probably won't spend most of the time constantly rethinking strategies, but will probably spend more time in executing and making successful a chosen pricing strategy. The execution must always consider the most updated market information and unit costs, in order to review and update prices according to new information. A reminder of key market data usually worth tracking:
- Customer feedbacks
- Market prices
- Exchange rates if the business is international.
Sometimes other indices or rates such as CPI/inflation rate, labour or material cost indices or interest rates may be involved in the pricing strategy. In my opinion, considering such rates in a non-financial business is more of a “cost plus” mindset, rather than value-based pricing. Still, many businesses, especially in B2B, review prices according to indices. Often because they find themselves mandated to do so by contractual terms.
Generally, executing a pricing strategy is about finding the right balance between flexibility to adjust prices that prove not to be working, and a certain discipline to keep the chosen strategy without getting lost in details of customer complaints or problematic areas. Monitoring and controlling the pricing strategy is the way to understand how the strategy is performing and how it is executed.
To achieve good quality, the pricing should be controlled inside the execution process rather than trying to intervene from outside the process. Quality is achieved inside the process while doing the pricing. Additionally, the overall target or goal that was originally intended to achieve in the development phase should be broken down into intermediate goals. The variance of selected KPI compared to intermediate goals should be periodically assessed, and appropriate corrective actions are taken. Such corrective actions may go from minor changes in price levels up to a complete review of the pricing strategy.
Do's & Don’ts
In this sub-section, I share some advice related to good and bad practices. Problems mostly show themselves at the execution stage. Sometimes they're just related to commercial practices:
- If revenues do not respond as fast as expected to a pricing change, it's better to be patient and wait for more data before concluding that the whole strategy isn't working. Sometimes customers do not react as fast as expected. Additionally, changing the pricing too frequently makes it harder to associate market responses with a change in prices.
- If there is a goal to increase revenues by increasing pocket prices, then change the current value proposition. Don't ask for more if you don't provide more, or different.
- Just increasing prices may work well to temporarily boost revenues in inelastic products or services. Customers' loyalty level and longer-term impacts should also be considered.
- Before dropping a price, always consider the best alternative that a customer has. Do not drop prices unless there is convincing proof that volumes are going (or will go) elsewhere.
- Don't expose or discuss details of unit costs externally as a justification of your price, or price movements. Costs are to be treated confidentially and it's your organisation's business, not your customers'. This kind of situation may happen in B2B, especially in tenders or similar procurement processes. Sell value, not costs.
- Be flexible enough to change or challenge plans and assumptions. If the KPI chosen has not gone in the right direction for a few periods, do question the strategy and/or the KPI themselves. Sometimes all is going well but the KPI may be the wrong one.
- The ability to charge prices and obtain revenues is always a result of customer satisfaction and how the market evaluates the value proposition, company, brand, service and relationship. If that market consensus lacks, there's no pricing alone that will save the boat.
- Mind the communication on new prices. Disclosing new prices externally in advance can be anti-competitive behaviour. My advice is to minimise communication on this topic and stick to the essential, even internally. Safer.
How to review a pricing strategy
If the previous sections sound familiar, then reviewing a pricing strategy should come naturally too. We already mentioned that:
- A continuous customer feedback processor channel is important for market sensing.
- Market price data is a piece of key information to execute and control a pricing strategy.
- Defining KPIs, intermediate goals and monitoring variances between KPI and goals is how to keep track of execution.
These are all enablers that may trigger a review. Reviewing a pricing strategy is done outside of execution and should look at how the results obtained by pursuing the pricing strategy compared to the original intent and to the broader performance of the company. In order to achieve this, there are two main approaches that do not exclude each other:
- Starting from financials.
- Going through the assessment work described in this article.
When starting from financials to compare performances, meaningful comparisons should consider and adjust the performance obtained in a period, with an event that was not originally predicted and that was unrelated to just pricing. Examples may include variations in the product portfolio, in the points of sale, merger & acquisitions, partnerships, and so on. Another good practice is to compare performances with the overall company, area or market trend. In other words: if revenues declined but the market declined more than us, then maybe the pricing strategy achieved something. An additional review should be done by ignoring the financial results and going through the assessment work described in this article. A pricing strategy may look just fine in the financials and still be improved. Worst case, by leaving no stone unturned the organisation will have more confidence in the pricing strategy.
Conclusions and the future of pricing
I hope you enjoyed the article. Rather than explaining the various pricing strategies, I focused on the “how to” and tried to be practical yet not specific about a given type of product or business. The key is to always start from the value for customers, to be considerate in moving a price, and to think ahead of possible responses from competitors. I think pricing has a great future as a discipline. The ICT revolution is still running fast. Artificial intelligence & machine learning techniques are no longer pure research topics. Currently, most companies are able to assist pricing decisions with lots of data and insight on margins and market prices. Some companies let algorithms decide their pricing. The world's biggest e-retailers and technology juggernauts are pricing automatically through algorithms. Airlines have been early adopters of algorithmic pricing and how they handle their pricing masterfully. As these technologies become more accessible, the pricing skills demanded will become more about planning, monitoring and reviewing pricing strategies, instead of deciding the prices.
How human and machine pricing activities are (or will be) split by company innovation levels. [/caption] The next innovation step is to let the algorithms (i.e. machines) implicitly learn the business rules for pricing decisions, by feeding them with the market and financial data. I suspect these technologies will also present new challenges to regulators: how are they going to monitor and intervene in a marketplace where prices, and ultimately our economic activity are decided by machines? What if machines learn to collude tacitly?
“Anybody can cut prices, but it takes the brain to produce a better article.”
– Phillip D. Armour