The 1% Windfall

Rafi Mohammed

• Publisher: HarperCollins e-books
• Year: 2010
• ISBN:
  9780061985270
• Topic: Economía
• Subtopic: Política comercial

Leading pricing expert Rafi Mohammed shows businesses how to reap a financial windfall and foster growth using the underutilized and often overlooked strategy of setting prices.

The 1% Windfall reveals how modest incremental changes to an everyday business practice—pricing—can yield significant rewards. Illustrating the power of pricing, a study of the Global 1200 found that if companies raised prices by just 1%, their average operating profits would increase by 11%. Using a 1% increase in price, some companies would see even more growth in percentage of profit: Sears, 155%; McKesson, 100%; Tyson, 81%; Land O'Lakes, 58%; and Whirlpool, 35%.

The good news is that better pricing is more than simply raising prices. Instead, the key is to offer customers a variety of pricing options. This strategy is win-win: profits to companies and choices for consumers.

But how do executives and managers set the right price? Underpinned by sound empirical research and real-life anecdotes, The 1% Windfall addresses this fundamental question. This book offers guidelines that any company—whether a multinational conglomerate, a small business, or even a nonprofit—can follow to create a comprehensive pricing strategy for any product or service. In addition, these versatile techniques and tools provide solutions to avert a slump in a recession, offset the impact of inflation, or battle a new competitor.

The result is a mind-opening, clear blueprint for com-panies to price for profit and growth.

PART ONE

The Foundation of Pricing: Value-Based Pricing

The first part of this book is composed of Chapter 1 only. This is a critical chapter that introduces value-based pricing, which is the foundation of pricing for profits and growth.

Thinking about and setting prices based on a product’s value is a new concept for most companies. And while change is often a challenge, the commonsense reasoning in this chapter demonstrates why value-based pricing should be adopted for all products.

One of the most important takeaway messages of this book is: set prices to capture a product’s value.

1

Capture Value by Thinking Like a Customer

By setting prices to capture the value that a product provides relative to the next-best alternatives, Olivier Biebuyck and his colleagues took a waste product that many considered to be valueless and earned millions of dollars of new profits for Lafarge North America, the Fortune Global 500 building materials company.

Olivier is a driven executive who is always focused on profit: if there is money to be made, he will find it. Booking new profits is exactly what he started searching for on his first day as vice president of cementitious materials at Lafarge’s corporate headquarters in Herndon, Virginia. This new job was politically tricky. In the past, most key operating decisions involving cementitious materials were made at one of Lafarge’s twenty district outposts, which oversee more than a thousand locations in the United States and Canada. But now many of these decisions were being recentralized to Olivier. “I needed to build credibility quickly,” he shared with me.¹ As he reviewed stacks of status reports, he honed in on pricing. In particular, he couldn’t understand why the fly ash prices were all over the map.

Fly ash is the residue generated from coal-fired power plants. It is usually dumped in landfills as waste. As it turns out, fly ash can be used as an ingredient to make concrete.² Replacing some cement (which is an expensive component of concrete) with fly ash can result in stronger concrete with a smoother finish. Fly ash can replace 15–20% of cement in a concrete mixture depending on the type of application, such as pavement, walls, and patios. Lafarge’s role as a middleman between power plants and concrete manufacturers involves the company in distribution, quality control, marketing, and technical research about fly ash’s benefits.

A key issue for fly ash is its poor image: concrete manufacturers viewed it as a waste product…which it is. Some even suggested that they should be paid to take fly ash, since it saves on landfill disposal costs for utility companies. With little being done to battle this perception, prices were at rock bottom, barely covering distribution and storage costs.

With no clear story about how prices were being set, Olivier started inviting himself to meetings. “Let’s discuss pricing,” he’d suggest. Up to this point, the sales force had had wide discretion in setting fly ash prices. With little guidance on setting prices from headquarters and a limited understanding of the potential upside from better pricing, fly ash prices weren’t a pressing issue for the organization. Undeterred, Olivier focused on setting prices by thinking from his customers’ point of view: “What’s the next-best alternative that concrete producers have to fly ash? Buying expensive cement that produces lower-quality concrete. Let’s educate our customers about the benefits of fly ash,” he encouraged at meetings. “It’s lower-cost, it produces quality results, and it’s ecologically green.”

The renewed sales efforts from district managers and the focus on the benefits of fly ash particularly helped Lafarge’s customers during the high-demand summer months, when cement was in short supply. Instead of facing costly construction delays while they wait for cement, concrete customers now mix in fly ash instead.

While some concrete producers balked, even with the price hike, fly ash was a great deal compared to its next-best alternative. Two-and a half years later, in great part due to his team’s focus on setting prices that capture value, Olivier’s division’s operating profits have doubled.

What’s your company’s fly ash?

VALUE-BASED PRICE: THE FOUNDATION OF BETTER PRICING

For many companies, thinking like their customers and setting prices that capture value are fundamental shifts in the way they create their pricing strategy. Most don’t focus on capturing value today. Instead, they mark up their cost (“I set prices by doubling costs”) or focus on margins (“I need a 30% margin over costs”). While it’s easy to set prices this way (just a few calculator keystrokes), money is left on the table. A price that’s based on cost bears no relation to what customers might pay. When you are shopping, do you deem a price acceptable if it is double the cost to produce the item or is 30% higher than the item’s cost? Instead we consider several alternatives presented to us on a store shelf or in a showroom and choose the one that’s best for us.

The key to better pricing is to set value-based prices. As New York City street vendors Parker Hannifin and Olivier Biebuyck have demonstrated, this simple change in how a company thinks about pricing alone can reap a windfall.

There are two primary approaches to setting value-based prices. A one-on-one price is used when setting (or negotiating) a price to sell one unit of a product to a single customer. A multicustomer price is used when setting a unit price to sell many units of a product to more than one customer.

Why two pricing methodologies? Setting a price to sell multiple products to different customers requires more analysis (which involves constructing a demand curve) compared to calculating a price meant for a single consumer. We’ll start off with the basics of one-on-one pricing, and then build on those principles to create a multicustomer demand curve.

---

Figure 1-1 What Pricing Methodology Should Be Used?

Pricing Methodology: One-on-one

Applicability: Selling one product (or service) to one customer (home, used car, negotiating a custom service).

Pricing Methodology: Multicustomer

Applicability: Selling many units of a product to a variety of customers. Most products and services are in this category.

---

METHODOLOGY 1: ONE-ON-ONE PRICING

Here’s a simple example that illustrates the key principles of setting a value-based price. Suppose you own a beach house that you rent to vacationers by the week. The house next door is also available for rent. The only difference: yours has a swimming pool. Everything else is identical. A potential renter is deciding which house to use for summer vacation. What is the highest weekly rental price at which you can close the deal right now?

Step 1: Identify target customers. Vacationers looking to rent a beach house for a week.

Step 2: Identify their next-best alternative. The beach house next door. Use this product’s price as a starting point.

Step 3: Determine your product’s difference. In this case, your house has a pool.

Step 4: Calculate your product’s value based on its differentiation. Suppose from your experienced judgment you’ve determined the average vacationer will pay a 20% premium over their next-best alternative for a pool.

Step 5: Do a reality check. Before basing your price on your customer’s next-best alternative, you have to undertake two analyses. First, determine if the base price is realistic. If the price of the next-best alternative is too high (customers aren’t willing to pay it), it’s not a valid price to use as a starting point. Second, ask yourself, “Can I make money at this price? Does the price at least cover variable costs?”

Suppose your neighbor sets an unrealistically high price of $2,000 per week (when, according to online classified ads for similar houses, the price should be $1,000 per week). If you simply add a 20% pool premium to calculate your price ($2,400 per week), both houses will sit vacant.

There are three potential outcomes of this reality check:

Your neighbor’s $1,000 price is reasonable. Set your price at $1,200 ($1,000 + 20%).

Your neighbor’s $2,000 price is too high. Use experienced judgment and/or ancillary data to determine a reasonable base price ($1,000). Thus, your price should be $1,200 ($1,000 + 20%).

Your neighbor’s $500 price is too low. As many e-tailers learned during the Internet boom, this low price has to be used as the base because this highly discounted price is a viable option for consumers. One point to keep in mind: when customers get a good deal, they may be willing to pay a more generous premium for higher-quality attributes (called an income effect): “Since I can get a great deal on a house without a pool, I’m now willing to pay 30% more for a pool.”³ If this is the case, your price should be $650 ($500 + 30%).

Step 4 in this process is critical. Why is the pool premium 20%? How about 15% or 25%? To determine the value of a pool, you have to think like your customers. After all, it’s their personal judgment that determines the price they will pay. Because of this, there’s no simple formula that can calculate a value-based price. Consumer insights on value can be gleaned through two primary methods: experienced judgment or market research methods. Companies often rely on experienced judgment supported by insights from existing market research. In this case, the 20% premium could have been derived from years of beach house rental experience or a recent conversation with a local realtor.

Figure 1-2 FIVE STEPS TO A ONE-ON-ONE VALUE-BASED PRICE

STEP 1: Identify target customers

STEP 2: Determine their next best alternative

STEP 3: Understand how the product differs

STEP 4: Calculate value based on differentiation

STEP 5: Do a reality check

What role, if any, do costs play in setting a value-based price? They set boundaries. Of course, to make a profit, on average prices have to be greater than total costs. While prime holiday weeks will garner top dollar, at other times prices need to be discounted to accommodate reduced customer value. What’s the lowest price you can set during off-peak periods, such as those first two weeks of August, when jellyfish invade the beach? Suppose your mortgage (divided by fifty-two weeks) is $450 a week and the additional cost of renting is $300 per week (commission to agent, cleaning fees). In other words, you have $450 of fixed costs (incurred regardless of whether the house is rented or not) and $300 of variable costs (incurred only if the house is rented) per week. During low customer valuation weeks, any price above variable costs ($300) is acceptable because it contributes to fixed overhead that will be incurred anyway.

Admittedly, there are a limited number of one-on-one pricing situations. Examples include selling a house, selling a used car, or setting a custom job price for one customer. This methodology can also be used for business-to-business transactions, such as a faucet manufacturer, to highlight their product’s value. When pitching a majo...