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The Pricing Journey
The Organizational Transformation Toward Pricing Excellence
By Stephan M. Liozu STANFORD UNIVERSITY PRESS
Copyright © 2015 Board of Trustees of the Leland Stanford Junior University
All rights reserved.
ISBN: 978-0-8047-8874-8
CHAPTER 1
What Is Pricing Excellence?
Renowned investor Warren Buffett once said, "The single most important decision in evaluating a business is pricing power. If you've got the power to raise prices without losing business to a competitor, you've got a very good business. And if you have to have a prayer session before raising the price by 10%, then you've got a terrible business" (Frye and Campbell 2011).
Although the Oracle of Omaha is far from alone in seeing pricing strength as closely linked to the health of a business, the actual practice of pricing receives scant attention in most companies. McKinsey & Company estimates that fewer than 15 percent of companies conduct any systematic research before they set their prices (Mitchell 2011). One reason for the lack of interest may be that nearly two thirds of companies lack pricing power. In their 2011 study of global pricing practices, Simon-Kucher & Partners found that 65 percent of companies had low pricing power and only 35 percent had high pricing power, which Simon-Kucher defines as the ability of a company to get all or nearly all "the money it deserves for the value it delivers."
Most companies with low pricing power blame a cutthroat environment of competitive pricing (71 percent) and customers with strong buying power (36 percent). But at least one statistic suggests that many companies are overly pessimistic: Simon-Kucher found that nearly half (46 percent) of those surveyed believe their company is fighting a price war, and most of the besieged (83 percent) blame their competitors for starting it—a combination that doesn't quite make sense: how could a price war always be the other company's fault? By contrast, companies with high pricing power tend to believe they deserve it, thanks to a stronger brand (75 percent) and a premium product (49 percent), according to Simon-Kucher's survey (2012).
End of story? Not quite. In fact, neither the winners nor the losers are right about how they got to where they are. As you will learn in the next section, pricing power does not automatically correlate with value. Instead, pricing power correlates much more closely with pricing skills. My research suggests that price setting and price getting require discipline, not luck. A survey of 748 members of the Professional Pricing Society, conducted in April 2011, found that although external factors such as competitive intensity affect pricing power, companies have much more control than they think they do over the prices they charge. Even controlling for firm size, nature, main activity, and function of respondents, pricing capabilities had a positive and significant correlation with firm performance (pricing performance, sales performance, and financial performance). The evidence suggests that almost any business can improve its pricing performance, provided it approaches pricing in a structured way.
More specifically, the survey found the following:
• The behavior of an internal champion for pricing had a positive and significant impact on relative firm performance, pricing capabilities, and organizational confidence for pricing.
• Center-led pricing management had a significant impact on the design and development of pricing capabilities.
• The capacity of an organization to change its prices relates positively and significantly to the level of pricing capabilities, to the level of organizational confidence in pricing, and to relative firm performance.
• Pricing capabilities had a positive and significant influence on organizational confidence in pricing.
• And this confidence is a good thing: as with pricing capabilities, organizational confidence itself has a positive and significant influence on relative firm performance.
Most significantly, the analysis showed that pricing capabilities are the most important survey factor in a firm's relative overall pricing performance—accounting for over 34 percent of the variance—more than any other factor, including organizational confidence (22 percent), change capacity (11 percent), and championing behaviors (10 percent). Several other studies have likewise confirmed that pricing has a substantial impact on company profitability. Simon-Kucher & Partners estimates that two thirds of all companies give up as much as 25 percent of their profits through weak pricing practices (2011). Even small variations in price can raise or lower profitability by as much as 20 to 50 percent (Hinterhuber 2004).
But firms that decide they would like to achieve pricing excellence face two problems. First, no one can quite agree about how to define pricing excellence; ask 100 pricing practitioners what pricing excellence means and you'll get 100 different answers. Second, nobody can fully agree on a road map or process on how to achieve it. You can learn a lot from the great pricing thinkers—Tom Nagle, John Hogan, Ken Monroe, Hermann Simon, Gerald Smith, and Robert Dolan, just to mention a few—but no one in the profession, not even the profession itself, has really developed a standard road map that shows how you make the long journey from pricing weakness to pricing strength. Until now.
The Pricing Capability Grid
The Pricing Capability Grid changes that. It defines pricing excellence and suggests the best paths you can take to get there. It frames the concept of pricing excellence into a grid on two axes: pricing orientation and pricing realization.
The grid is the outcome of our own experience as pricing practitioners and extensive research. In 2011, I interviewed 44 executives to learn more about the nature of pricing capabilities. Their companies varied in size from about 50 to more than 2,000 employees and differed dramatically in their pricing capabilities. I spoke to CEOs and CFOs, heads of business units and professionals in marketing, and heads of pricing and finance functions in fifteen U.S.-based industrial companies about their pricing practices and capabilities, and tried to find out why pricing skills tended to be so undervalued (Liozu et al. 2011).
To capture contrasting perspectives on pricing within companies, I narrowed my search down to businesses with at least three respondents, each at a different management level, including at least one respondent from top management (either a CEO, a managing director, or a member of the board of management), one respondent from middle management (either a business unit manager or a head of a functional unit), and one respondent from lower management (a functional manager). Of the 36 companies meeting these criteria, 15 agreed to participate in this research project. At least three interviews were conducted at each company. Respondents included 15 CEOs or top executives, 18 sales and marketing managers with full or partial responsibility for pricing, and 11 finance and accounting managers with decision-making authority.
In the course of this research, I concluded that pricing power is not a destiny that depends on your market position, but a learned behavior. While competition, costs, and price sensitivity within a market affect the parameters within which companies set prices, superior pricing is almost always based on skills. The companies in my survey that had achieved better pricing all had high-level managers who championed the development of skills in price setting (price orientation) and price getting (price realization). Regardless of their industry, the degree to which managers focused on developing these two capabilities correlated with their success in getting a better price for their product than their competitors (Liozu and Hinterhuber 2012b). Without managerial engagement, companies typically fall back on historical heuristics, such as cost information, to set prices, and yield too much pricing authority to the sales force.
To rank the relative development of the company's pricing function, we created and operationalized the Pricing Capability Grid (Figure 1.1). We categorized pricing abilities into five major categories: the Pricing Power Zone, the Value Surrender Zone, the Price Capture Zone, the Zone of Good Intentions, and the White Flag Zone. Companies in the Pricing Power Zone command significantly higher prices and profitability levels than companies in the White Flag Zone. Most of these companies had undergone a long and difficult transformation that enabled them to evolve from traditional, cost-based pricing toward higher-margin pricing with more disciplined pricing execution. But when they finished, they had achieved something impossible according to traditional pricing theory: they had essentially learned their way to better prices.
Pricing capabilities have two dimensions: price setting and price getting, and all companies fit into one of five squares it creates.
Price Setting
Price setting (price orientation) is how a company determines its final selling prices. Companies differ wildly in their approach to price setting. However, although companies that sell services to individual consumers, for example, may price differently than companies that sell jet engines to sophisticated purchasing centers, and pricing approaches in India may differ considerably from pricing approaches in France, my own experience—and most academic research supports this—suggests that pricing methods across industries, countries, and companies usually fall into one of three buckets: cost-based pricing, competition-based pricing, or customer value-based pricing (Liozu and Hinterhuber 2013; Hinterhuber 2008b).
• Cost-based pricing decisions are influenced primarily by accounting data, with the objective of reaching a certain return on investment or markup on costs. Typical examples of cost-based pricing approaches are cost-plus pricing, target return pricing, markup pricing, and break-even pricing. The main advantage of this approach is for the price setter: the data you need to set the prices are usually easy to find. The main weakness of cost-based pricing is that aspects related to demand (willingness to pay, price elasticity) and competition (competitive price levels) are ignored.
• Competition-based pricing uses data on competitive price levels or on anticipated or observed actions of actual or potential competitors as a primary source to determine appropriate price levels. The main advantage of this approach is that it incorporates a view of the competition. The main disadvantage is that it again ignores demand. In addition, an aggressive response to a competitor's price can raise the risk of a price war, which at extremes may not only hurt the profitability of one company but destroy the profitability of an entire industry. The kinds of scorched-earth wars that hit the U.S. domestic car market between 2005 and 2009 and the U.S. airline industry around the same time are good examples of the damage an all-out price war can inflict. Competition-based pricing approaches are frequently justified on the grounds that price is one of the customer's most important purchase criteria, but if it triggers a war that leads to widespread bankruptcies, it's hard to see how those unsustainable bargains benefit the consumer in the long run.
• Customer value-based pricing, often called "value-based pricing," uses analytics about the customer's perceived value of the product or service as the main factor for determining the final selling price. Instead of asking, "How can we realize higher prices despite intense competition?" customer value-based pricing asks, "How can we create additional customer value and increase customer willingness to pay, despite intense competition?" The subjective value of a purchase offering to actual and potential customers is the primary driver in setting prices. Customer value-based pricing approaches require a deep understanding of customer needs, customer perceptions of value, price elasticity, and customers' willingness to pay. Or as one executive explained to me:
Value-based pricing I think is, in my mind, simple. It's what the customer is prepared to pay based on what the product does for the customer, and that they perceive it will do for them.
The advantage of customer value-driven pricing approaches is their direct link to the customer. Their big disadvantage is that data on customer preferences, willingness to pay, price elasticity, and size of different market segments are usually hard to find and interpret. Customer value-based pricing approaches may also lead to relatively high prices, especially for unique products. That may sound good, but if your prices are too high you can encourage new entrants to join the market or create a huge opportunity for competitors to sell comparable products at slightly lower prices. Finally, customers must first recognize value before they are willing to pay for it, which can be a problem if you have just introduced a genuinely superior product. Often, marketers must educate prospective customers to recognize the product's superiority before linking price to value.
Despite these shortcomings, many pricing scholars consider customer value-based pricing to be the best way to set new-product prices or to adjust prices for existing products (Anderson and Narus 1998; Anderson, Wouters, and van Rossum 2010). Some businesspeople have also found that customer value-based pricing can have important benefits, especially in highly competitive industries (Ingenbleek et al. 2003). This may seem counterintuitive, but it's not. Many managers mistakenly assume they are stuck in a "commodity" business. They overlook possibilities for differentiation and customer value creation and resign themselves to competing solely on price. While some segments in an industry may become severely price competitive, most of us give up the fight too easily. In fact, thinking of your product as a commodity is a good way to make it a commodity. Through deeper research into customer needs, almost any product or service can be differentiated. Such research can also be a powerful weapon to overcome price pressure by retailers. Armed with data on customer willingness to pay, price elasticities, and perceptions of value and price, manufacturers can demonstrate to retailers the total value jointly created through their value-based pricing strategy.
Price Getting
Companies also differ in their abilities to realize the prices they set. Price getting (or more formally, price realization) refers to the capabilities and processes that ensure that the price the company gets is as close as possible to the price the company sets. Why would those two numbers differ? One reason is inconsistent discount systems (Sodhi and Sodhi 2005). The abilities of sales reps to negotiate and levels of authority among sales managers vary widely, enabling some customers to obtain much more favorable conditions than others. Also, in order to reach their sales quota, IT-savvy sales associates sometimes override the discount control systems, even as colleagues try to protect prices and margins, preferring to walk away from deals below well-defined target prices. Price-getting capabilities are thus fundamentally related to a company's ability to translate goals into results; they reflect the capacity and will of a company to enforce—both internally through sales personnel and externally through customers and trade partners—its list prices and to translate these list prices into the prices the company actually gets (Nagle and Holden 2002; Dutta et al. 2002).
Our research indicates that differences in price-getting capabilities reflect a slew of factors:
• The existence of pricing rules specifying maximum discount levels for any given order size
• The extent to which these rules and guidelines are followed
• The individual and organizational consequences for not following these guidelines
• The extent to which sales personnel have to justify and ask for approval for deviating from list prices
• The negotiation skills of sales personnel
• The degree to which sales associates understand a customer's best available alternative
• The customer's maximum willingness to pay and the differential value to customers of the company's product and service offering
• The existence of clear target prices before sales personnel enter into negotiations with customers
• The amount of pressure (self-imposed or organizational) that pushes sales personnel to conclude unprofitable deals
• The confidence to walk away from unprofitable deals
• The extent of free services offered to customers to close a deal
• The systems in place to monitor and communicate price deviations to sales personnel, marketing managers, and other decision makers
(Continues...)
Excerpted from The Pricing Journey by Stephan M. Liozu. Copyright © 2015 Board of Trustees of the Leland Stanford Junior University. Excerpted by permission of STANFORD UNIVERSITY PRESS.
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