How to develop a pricing strategy that reflects the true value of your products.
Pricing is so tricky that it's the subject of a popular game show called The Price Is Right previously hosted by Bob Barker.
Setting the right price for products and services is often one of the more challenging decisions any business faces. Price too low and you can leave significant profits on the table. Price too high and you may see declining sales as your most price-sensitive customers desert you. There are pitfalls on either side of the narrow line on pricing.
One of our clients, a specialty plastics manufacturer, recently faced this pricing dilemma. Their plastics, used in automotive and aerospace applications as a replacement for steel, were superior to their competitors, which offered a range of imperfect substitutes, all at different price/performance points.
The challenge: How to develop a pricing strategy that reflects the fact that your products run the gamut from essential in some applications to the lowest-performance competitor in other applications?
Step 1: Agree on Your Pricing Philosophy
We quickly rejected any pricing strategy built around the cost to produce the plastics. The specialty plastics were baked in an expensive process from a set of expensive ingredients. All of the parts were molded (like a cake in a pan); some were then milled, and others were fastened into assemblies.
Our client had gone into great detail building a per-part costing model that reflected these differences in production. We could have leveraged that model and simply set pricing as some markup of our cost to produce. Why did we choose not to? Because customers don’t care about your cost to produce a product. They make buying decisions based on the value they gain from your products, not your cost to deliver that value.
We also chose not to price at a fixed premium above alternative technologies (e.g., steel). The client’s value proposition vs. steel varied greatly from one application to the next. A fixed premium would have priced them out of some applications entirely and wildly underpriced what their customers were willing to pay in others.
Instead, we chose to price for Value-In-Use (VIU), a philosophy by which pricing decisions are guided by the value the customer would lose if they used the next best alternative to your product. Generally, VIU or value-based pricing works best when there are no direct, perfect substitutes for a product.
Step 2: Determine Your Value-In-Use
Before we could set VIU pricing, we needed to understand how valuable the client’s products were relative to the nearest competitive products. This varied greatly by industry and application.
We built an extensive scoring system for each of 30 different applications. These were high-volume applications representing more than 50 percent of the client’s revenue, so it was a good starting point.
For each application we determined the most important attributes to the customer based on conversations with the product development teams (who often worked closely with customers to create new parts) and the sales force. Time constraints prevented us from directly querying customers about value in use, so we tabled that as a follow-on for the management team.
We assigned each attribute a weight for relative importance and then scored the client and key competitors in each application. We also gathered or estimated competitors’ pricing in those applications based on competitive bidding situations where we had gained insight into our relative pricing.
We then compared relative performance scores to relative prices and looked for significant discrepancies. We drew three main conclusions:
Although the client had the premium-priced product in the market, it was actually underpriced relative to its VIU advantage over competitors
The biggest gaps between current prices and VIU-suggested prices were in the applications where the client’s superior performance was most critical and irreplaceable
There were a few applications where the client’s product had little or no VIU advantage, calling into question whether they should even compete in those applications
These conclusions gave the management team confidence to push through price increases of 15 percent across the board, and up to 30 percent in the most critical applications. We also clarified where the client’s products had the greatest advantages, and thus were able to guide future application development to exploit those advantages.
We knew that raising prices all at once would pose too high a risk. So we focused initially on the highest-VIU areas of the business, re-pricing 10 percent of the “worst offender” parts to breakeven or better in each of the next three years. In some cases this meant an additional 10-30 percent price hike. We knew the increases would risk volumes, but the estimated rewards–an incremental 10 percent increase in annual revenues–made the risk worth taking.
The client was able to re-invest these incremental sales into new growth opportunities, including new product development. The result: greatly accelerated growth and improved profitability.
KARL STARK AND BILL STEWART are managing directors and co-founders of Avondale, a strategic advisory firm focused on growing companies. Avondale, based in Chicago, is a high-growth company itself and is a two-time Inc. 500 honoree. @karlstark