The Strategy and Tactics of Pricing

A Guide to Growing More Profitably

Thomas T. Nagle, Georg Müller

• Publisher: Routledge
• Year: 2017
• ISBN:
  9781351733717
• Edition: 6
• Topic: Business
• Subtopic: Operations
• Index: Business

The Strategy and Tactics of Pricing explains how to manage markets strategically and how to grow more profitably. Rather than calculating prices to cover costs or achieve sales goals, students will learn to make strategic pricing decisions that proactively manage customer perceptions of value, motivate purchasing decisions, and shift demand curves.

This edition features a new discussion on harnessing concepts from behavioral economics as well as a more streamlined "value cascade" structure to the topics. Readers will also benefit from:

• Major revisions to almost half of the chapters, including an expanded discussion of big data analytics and a revised chapter on "Specialized Strategies", which addresses timely technical issues like foreign exchange risks, reactions to market slumps, and managing transfer prices between independent profit centers.

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• A completely rewritten chapter on "Creating a Strategic Pricing Capability", which shows readers how to implement the principles of value-based, strategic pricing successfully in their organizations.

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• In-chapter textboxes, updated to provide walk-through examples of current pricing challenges, revenue models enabled by an increasingly digital economy, and advances in buyer decision-making, explained through classic principles that still apply today.

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• Chapter summaries and visual aids, which help readers grasp the theoretical frameworks and actionable principles of pricing analysis.

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This comprehensive, managerially-focused text is a must-read for students and professionals with an interest in strategic marketing and pricing. A companion website features PowerPoint slides and an instructor's manual, including exercises, mini-cases, and examination questions.

Chapter 1
Strategic Pricing

Coordinating the Drivers of Profitability

If you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.

Warren Buffet¹

Marketing consists of four key elements: The product, its promotion, its placement or distribution, and its price. The first three elements—product, promotion, and placement—comprise a firm’s effort to create value in the marketplace. The last element—pricing—differs essentially from the other three: It represents the firm’s attempt to capture some of the value in the profit it earns. If effective product development, promotion, and placement sow the seeds of business success, effective pricing is the harvest. Although effective pricing can never compensate for poor execution of the first three elements, ineffective pricing can surely prevent those efforts from resulting in financial success. Regrettably, this is a common occurrence.

Complicating matters, the ability to harvest potential profits is in a continuous state of flux as technology, regulation, market information, consumer preferences, or relative costs change. Consequently, companies that expect to grow profitably in changing markets often need to break old rules, including those that govern how they will set prices to earn revenues. Our interest in strategic pricing dates back to when the telecommunications industry was deregulated in most developed countries and new suppliers recognized that they could gain both market share and profitability by replacing the then prevailing price-per-minute revenue models with more innovative models—first including a price per month for a bundle of “peak” minutes plus “free” off-peak time. Later, they introduced “family plans” involving the sharing of minutes across numbers. Similarly, Apple quickly went from nothing to market leadership in music sales, in large part because, after the internet slashed the cost of distribution, it was the first to recognize that it was better to price music by the song than by the album. And at the time of writing this edition, the predominant revenue model for music is shifting yet again, with subscription-based streaming services such as Spotify and Apple Music^® overtaking digital music store sales.² Producers of new online media created a new metric for pricing ads—cost per click—that aligned the cost of an ad more closely to its value than was possible in traditional print media. Even governments have begun to use prices, often called “user fees,” instead of taxes to raise revenues and better allocate scarce resources. Congested cities, such as London and Singapore, charge to drive a car into congested areas during peak times and highways in major U.S. cities such as Atlanta and Minneapolis increasingly have express lanes that are kept moving even during rush hours by adjusting a wirelessly collected price to access them.³

Unfortunately, few managers, even those in marketing, have been trained in how to develop innovative pricing strategies such as these. Most companies still make pricing decisions in reaction to change rather than in anticipation of it. This is unfortunate, given that the need for rapid and thoughtful adaptations to changing markets has never been greater. The information revolution has made prices everywhere more transparent and customers more price aware.⁴ The globalization of markets, even for services, has increased the number of competitors and often lowered their cost of sales. The high rate of technological change in many industries has created new sources of value for customers, but not necessarily led to increases in profit for the producers.

Improvements in technology have driven an explosion of data that some suppliers are using to target customers they can serve more profitably: Either because those customers are more willing to pay for the differentiation the company can offer or because the company can meet their needs more cost-effectively than competitors. This is especially true of consumer goods, where manufacturers used to operate with only minimal and long-delayed data on where and how well their products were selling in retail stores, and pricing involved negotiating “trade promotions” with channel intermediaries that may or may not have passed the savings on to end consumers. Now, with the ability to buy almost “real time” data on how individual package sizes are selling in types of outlets and in specific geographies, manufacturers are able to develop more sophisticated pricing strategies to target specific types of customers and competitors. At the extreme, many retailers charge online shoppers different prices or offer them different product assortments based on the type of device they are using to access the site, with the theory that the type of device can signal a systematic difference in willingness-to-pay.⁵

Leveraging Profit Into Sustainable Growth

Learning to make sales more profitably is the key to achieving sustainable growth in revenue, market share, and company value over the long haul. When the first edition of this book was published more than three decades ago, the idea that profit margins should be prioritized over growth was seen as short-sighted. A 1975 study conducted at the Harvard Business School using the PIMS (which originally stood for Profit Impact of Market Share) database of historical market performance of leading global companies reported a strong, consistently positive, correlation between a company’s market share and its relative profitability within an industry.⁶ In the Harvard Business Review article discussing this study, the authors proposed multiple plausible reasons why a larger market share could enable a company to operate more profitably. That led to an explosion of literature by marketing theorists and leading consultancies advocating aggressively low pricing as an “investment” in growth that would eventually create “cash cows”—exceptionally profitable revenue streams requiring little investment to maintain them.

Unfortunately, companies that adopted this approach to pricing, more often than not, found the theory and the eventual profitability it promised lacking. As the PIMS database grew to cover multiple years, more nuanced relationships were revealed. Although a cross-sectional correlation between market share and profitability proved durable, how a company invested to grow was shown to be a better predictor of financial success. Consequently, the PIMS organization cleverly redefined their acronym to stand for Profit Impact of Marketing Strategy.

More recent research by Deloitte Consulting LLP has brought further clarity to the relationship between growth and profitability. Deloitte compiled a time-series dataset of 394 companies, covering the period from 1970 to 2013 with exceptional, mediocre and poor performers matched by industry. The researchers defined “exceptional performance” as a company achieving superior profitability (return on assets), stock value, and revenue growth for more than a decade and sought to understand how a small minority of firms manage to achieve it. Their conclusion:

a [near term] focus on profitability, rather than revenue growth or [stock] value creation, offers a surer path to enduring exceptional performance.⁷

So how do marketing and financial managers at exceptional companies achieve sustainable exceptional profitability? It is not the result of slashing overheads more ruthlessly than their competitors. In fact, Deloitte’s data indicates that exceptional performers tend to spend a bit more than competitors (as a percent of sales) on R&D and SG&A. Their exceptional profitability and, eventually, exceptional stock valuations are built on higher margins per sale that fund initiatives to grow revenues without compromising those margins.⁸

Unfortunately, many companies fail to understand that making sales profitably should be the first priority—not an afterthought—of a strategy for driving growth. Creating and communicating superior value propositions or finding a way to deliver superior value at lower cost is a precondition to sustainable revenue growth. Many years of experience have taught us that applying the principles explained in these pages is necessary to make sales more profitable and at least equal with the best in the industry.

The difference between successful and unsuccessful pricers lies in how they approach the process. To achieve superior, sustainable profitability, pricing must become an integral part of strategy. Strategic pricers do not ask, “What prices do we need to cover our costs and earn a profit?” Rather, they ask, “What costs can we afford to incur, given the prices achievable in the market, and still earn a profit?” Strategic pricers do not ask, “What price is this customer willing to pay?” but “What is our product worth to this customer and how can we better communicate that value, thus justifying the price?” When value doesn’t justify price to some customers, strategic pricers do not surreptitiously discount. Instead, they consider how they can segment the market with different products or distribution channels to serve these customers without undermining the perceived value to other customers. And strategic pricers never ask, “What prices do we need to meet our sales or market share objectives?” Instead they ask, “What level of sales or market share can we most profitably achieve?”

Strategic pricing often requires more than just a change in attitude; it requires a change in when, how, and who makes pricing decisions. For example, strategic pricing requires anticipating price levels before beginning product development. It requires determining the economic value of a product or service, which depends on the alternatives customers have available to satisfy the same need. We go into much more depth on the concept of Economic Value Estimation (EVE^®) in Chapter 2. The only way to ensure profitable pricing is to reject early those ideas for which adequate value cannot be captured to justify the cost.

Strategic pricing also requires that management take responsibility for establishing a coherent set of pricing policies and procedures, consistent with the company’s strategic goals. Abdicating responsibility for pricing to the sales force or to the distribution channel is abdicating responsibility for the strategic direction of the business.

Perhaps most important, strategic pricing requires a new relationship between marketing and finance because pricing involves finding a balance between the customer’s desire to obtain good value and the firm’s need to cover costs and earn profits. Unfortunately, pricing at most companies is characterized more by conflict than by balance between these objectives. If pricing is to reflect the value to the customer, specific prices must be set by those best able to anticipate that value—presumably marketing and sales managers. The problem is that their efforts will not generate substantial profits unless constrained by appropriate financial objectives. Rather than attempting to “cover costs,” finance must learn how costs change with shifts in sales volume and use that knowledge to develop appropriate incentives for marketing and sales to achieve their objectives.

With their respective roles appropriately defined, marketing and finance can work together toward a common goal—to achieve profitability through strategic pricing.

Before marketing and sales can attain this goal, however, managers in all functional areas must discard the flawed thinking about pricing that frequently leads them into conflict and that drives them to make unprofitable decisions. Let’s look at these flawed paradigms so that you can recognize them and understand why you need to let them go.

Cost-Plus Pricing

Cost-plus pricing is, historically, the most common pricing procedure because it carries an aura of financial prudence. Financial prudence, according to this view, is achieved by pricing every product or service to yield a fair return over all costs, fully and fairly allocated. In theory, it is a simple guide to profitability; in practice, it is a blueprint for mediocre financial performance.

The problem with cost-driven pricing is fundamental: In most industries, it is impossible to determine a product’s unit cost before determining its price. Why? Because unit costs change with volume. This cost change occurs because a significant portion of costs are “fixed” and must somehow be “allocated” to determine the full unit cost. Unfortunately, because these allocations depend on volume, and volume changes as prices change, unit cost is a moving target.

To solve the problem of determining unit cost before determining price, cost-based pricers are forced to assume a level of sales volume and then to make the absurd assumption that they can set price without affecting that volume. The failure to account for the effects of price on volume, and of volume on costs, leads managers directly into pricing decisions that undermine profits. A price increase to cover higher fixed costs can start a death spiral in which higher prices reduce sales and raise average unit costs further, indicating (according to cost-plus theory) that prices should be raised even higher. On the other hand, if sales are higher than expected, fixed costs are spread over more units, allowing average unit costs to decline a lot. According to cost-plus theory, that would call for lower prices. Cost-plus pricing leads to overpricing in weak markets and underpricing in strong ones—exactly the opposite direction of a prudent strategy.

How, then, should managers deal with the problem of pricing to cover fixed costs? They shouldn’t. The question itself reflects an erroneous perception of the role of pricing, a perception based on the belief that one can first determine sales levels, then calculate unit cost and profit objectives, and then set a price. Once managers realize that sales volume (the beginning assumption) depends on price (the end of the process), the flawed circularity of cost-based pricing is obvious. The only way to ensure profitable pricing is to let anticipated pricing determine the costs incurred rather that the other way around. Value-based pricing must begin before investments are made using a process that we will describe later in this chapter.

Customer-Driven Pricing

Many companies now recognize the fallacy of cost-based pricing and its adverse effect on profit. They realize the need for pricing to reflect market conditions. As a result, some firms have taken pricing authority away from financial managers and given it to sales or product managers. In theory, this trend is consistent with value-based pricing, since marketing and sales are that part of the organization best positioned to understand value to the customer. In practice, however, their misuse of pricing to achieve short-term sales objectives often undermines perceived value and depresses future profitability.

The purpose of strategic pricing is not simply to create satisfied customers. Customer satisfaction can usually be bought by a combination of overdelivering on value and underpricing products. But marketers delude themselves if they believe that the resulting increases in sales represent marketing successes. The purpose of strategic pricing is to price more profitably by capturing more value, not necessarily by making more sales. When marketers confuse the first objective with the second, they fall into the trap of pricing at whatever buyers are willing to pay, rather than at what the product is really worth. Although that decision may enable marketing and sales managers to meet their sales objectives, it invariably undermines long-term profitability.

Two problems arise when prices reflect the amount buyers seem willing to pay. First, sophisticated buyers are rarely honest about how much they are actually willing to pay for a product. Professional purchasing agents are adept at concealing the true value of a product to their organizations. Once buyers learn that sellers’ prices are reactively flexible, they have a financial incentive to conceal information from, and even mislead, sellers. Obviously, this undermines the salesperson’s ability to establish close...