For small companies in particular, few decisions are as important -- and as neglected -- as price setting. Here's how to create a pricing strategy that does what you need it to
Vermont grocery-store owner once shared his pricing philosophy with a sales rep: "What you charge tells me how low I can go. What my competitor sets prices at is how high I can go. I just pick a place in between, and that's my price."
That Vermont grocer is not alone. Many companies approach pricing in much the same unimaginative way. Most managers simply don't think about pricing as a marketing tool that can be used creatively to build their businesses. And yet for many companies (particularly start-ups or small, growing businesses) there is no other marketing or sales decision that more immediately affects customer acceptance or rejection of what you sell, your cash flow, and perhaps even your overall success or failure. What's more, even if your company has been around for a while, chances are, you're using the same approach to pricing you developed 5 or 10 years ago.
The goal here, then, is not to tell you how to price your products or services. Instead, it's to help you step back and take a fresh look at your company's pricing policies so you can compete better and, ultimately, make more money.
In the Beginning
Before you can figure out how to make pricing really work for you, you have to know what it is specifically you want pricing to do for your business. In other words, what are your company's goals? To increase sales? To increase market share? To maximize cash flow or profit? To deter competition from entering your company's niche? To lower demand so you can stay within your current production capacity? To get more people to try your product or service? To establish a particular image? Some combination of those objectives? Once you've given serious thought to what you want to accomplish, write it down. That may sound trivial, but I can't emphasize it enough. Those written goals will be what keeps you on track when you begin to try out different pricing ideas. They'll be the measure you'll use to judge what is or isn't appropriate so your pricing decisions will be in line with your company's objectives.
What You Need to Know
Is pricing a marketing decision? A sales decision? A financial decision? Highly effective pricing decisions are all of those. If you have separate managers for those functional areas of the business, each should play a role in building your pricing strategy. If you serve in all those roles, then be sure to wear all the hats as you think about pricing. Otherwise, your pricing decisions will not take into account everything necessary to make them highly effective. By approaching pricing from a multifunctional view, you'll be sure to include each of the "Five Cs of Pricing." (A college professor once taught me that there are three Cs; experience has added two more!)
1. Cost. This is the most obvious component of pricing decisions (the "what you charge me" in our Vermont grocer's strategy). You obviously cannot begin to price effectively until you know your cost structure inside out, and that includes both direct costs and fully loaded costs (in other words, anything beyond product costs) such as overhead, trade discounts, and so on. And it means knowing those cost structures for each item or service you sell, not just on an average companywide or product-line basis. Too often managers make pricing decisions based on average cost of goods when, in fact, huge margin variations exist from item to item.
2. Customer. Ah, the customer, the ultimate judge of whether your price, in combination with quality of service or product, delivers a superior value. How exactly do your customers or potential customers view price? You can bet they do not see it as a single number, but instead, view it in a wide variety of ways. So when you consider your pricing strategy, ask your customers for their input. You may be surprised at the answers you get. For instance, when a colleague and I were designing a mortgage-evaluation service, we called recent home buyers, described the idea to them, and asked two simple questions: What do you think this service would cost? Would you have bought the service when you were shopping for a mortgage? Their answers astonished us. Customers expected and were willing to pay two to three times what we were planning to charge.
Here's the information you'll want to know: What is the customer's expected range -- the highest and lowest price points available -- for your product or service? Within that range, what is your specific target customer's acceptable range, the highest and lowest he or she will pay? Both the high and the low points in those ranges affect how your customers view price, and it is important to realize that the ranges have not just a top end but a bottom end as well.
Which prices do customers look at? Soda prices provide a good, simple example. There's the absolute price ($1.29 for a two-liter bottle of Coke); the relative price (compared with a two-liter bottle of Pepsi, or even with other Coke products, such as a six-pack of cans at $2.29); the standard price (per ounce at about 6¢); and, of course, the regular versus sale price (99¢ "on special," almost every other week). Which ways do your customers look at the price of what you sell?
Beyond what you charge, what are the other costs customers think about as they consider your product or service? Are there any search costs (such as costs in time and money to shop around for a sales-meeting site)? Are there transaction costs (such as the shipping and taxes and the cost of borrowing money to buy a boat)? Are there switching costs customers must pay to change from the product or service they are now using (such as fees to switch phone services, or the aggravation and paperwork involved in switching checking accounts)? Are there costs of related purchases (such as a customer's having to pay someone else to put up the wallpaper he or she buys from you)? All of those factors may enter into the customer's thinking about price in your business, even though they have nothing to do with what you charge. So to be smart about your pricing choices, you have to think about those unseen elements. Sometimes they represent limitations. Other times they provide great opportunities. For example, gambling casinos often structure their prices to eliminate the other costs involved in the purchase by providing free travel to their location. Essentially, they've turned costs of related purchases into part of the deal.
3. Channels of Distribution If you sell through any middlemen to get to the end-users of your product or service, then those intermediaries affect your pricing in two ways. First, you have to price so their margins will be large enough to motivate them to do what you need them to do. Second, you must consider the margins they add that affect the price your end-users ultimately pay.
4. Competition. This is where managers often make their fatal pricing decisions. First of all, don't kid yourself. Every company and every product has competition. Even if your product or service is unique (whatever that really means), your potential customer has been getting by without it until now, so there must be alternatives, however remote they may seem to you. Make sure, as you consider pricing approaches, that you think very carefully about whom you compete with from the buyer's point of view (the only point of view that matters). If you don't know all the alternatives buyers evaluate you against, pick up the phone and ask a few of them.
5. Compatibility. Pricing is not a stand-alone decision. It must work in concert with everything else you're trying to achieve as a company. Is your pricing approach compatible with your marketing objectives? With your sales goals? With the image you want to project? Again, those objectives have to be explicitly stated and written down. If your production goals, for instance, are to even out the process so you can better control inventory, the last thing you want is a pricing strategy that forces seasonal spikes in demand.
How to Break the Mold
OK, you've figured out what you want your pricing to achieve (you wrote it down, remember?), and you and your managers have thoroughly examined the Five Cs of Pricing as they apply to your business. Now you're ready to start thinking creatively and proactively about pricing. To do that, you have to follow one simple rule: Forget absolutely everything you know about "how it's done in my business," and start looking at how it's done in other businesses. Then think about how other companies' and industries' pricing approaches might be applied (either directly or indirectly) to pricing your company's products or services. One more rule: Never look at a pricing approach from other companies or industries and think, Well, that would never work in my business. That sort of thinking is the kiss of death. Instead, always ask, How could that kind of pricing -- or some variation -- possibly be applied to my business?
To help you get started, you'll find 19 pricing approaches outlined in the Creative Pricing Primer. (See page 3.) These examples come from consumer products and services and business-to-business situations. The approaches presented are not mutually exclusive, and they are certainly not all-inclusive. They are offered as a way to stimulate ideas that will work for your company. Here's your assignment (after all, this is a mini-M.B.A. course): go through the primer, and for every approach presented, jot down in the space provided some way your company might be able to use that type of pricing.
As you challenge yourself and your people to approach pricing with imagination and an open mind, here are several other considerations that can make you more effective:
1. Do not limit new pricing strategies to new products. Challenge the pricing on your existing products or services. How can you price differently to achieve your objectives?
2. Do not sell yourself short. The most common mistake in pricing is to assume you must price low. Find creative ways to figure out how high you can go. Can you test it somehow? Talk to potential customers about pricing. An old proverb says, "There are two fools in every market. One charges too much, the other not enough." Don't be a fool -- either way.
3. When making a price increase, try to time it with other changes in your product or service that add value. The car companies, for instance, raise their prices when the new models come out.
4. If you're thinking about lowering price, make sure you crunch the numbers to see how big an increase in sales you'll need just to get back to the levels of cash flow and profit you have now. An obvious point, maybe, but it's often overlooked.
5. Never stop looking for new pricing ideas. When you're shopping for anything as a consumer or a professional, think about how products or services are priced. Then try to apply the thinking to your business. Ask your managers and employees to do the same and report back to you.
Whoever first said "A penny for your thoughts" obviously assumed the seller would take a rather straightforward and unimaginative pricing approach. I'll bet the seller would improve profit margins by charging a nickel for the first thought and then using a stair-stepping approach for every thought after that, up to a limit of . . . well, you get the picture.
Michael D. Mondello has looked at pricing from an academic point of view while majoring in finance and marketing at Northwestern University's Kellogg School of Management; from a sales perspective when he served as a sales rep and zone manager at Procter & Gamble; as a consultant with the Delta Consulting Group, in Trumbull, Conn.; and as a marketing manager, formerly at Procter & Gamble and currently at Celestial Seasonings, in Boulder, Colo., where he is vice-president of marketing.
CREATIVE PRICING PRIMER
HOW IT WORKS
HOW MIGHT IT APPLY TO YOUR BUSINESS?
1. Bundling or unbundling
Sell products or services together as packages or break them apart and price accordingly.
Season tickets; stereo equipment; car rentals charging for air-conditioning.
2. Time-period pricing
Adjust price, up or down, during specific times to spur or acknowledge changes in demand.
Off-season travel fares (to build demand); peak-period fees on bank ATMs (to shift demand).
3. Trial pricing
Make it easy and lower the risk for a customer to try out what you sell.
Three-month health-club starter memberships; low, nonrefundable "preview fees" on training videos.
4. Image pricing
Sometimes the customer wants to pay more, so you price accordingly.
Most expensive hotel room in a city; a private-label vitamin's raising price to increase unit sales by signaling quality to shoppers.
5. Accounting-system pricing
Structure price to make it more salable within a business's buying systems.
Bill in phases so no single invoice exceeds an authorization threshold; classify elements so pieces get charged to other line items.
6. Value-added price packages
Include free "value-added" services to appeal to bargain shoppers, without lowering price.
A magazine's offering advertisers free merchandising tie-ins when they buy ad space at rate-card prices.
HOW IT WORKS
HOW MIGHT IT APPLY TO YOUR BUSINESS?
Unlimited use or unlimited amount of a service or product, for one set fee.
Amusement parks; office-copier contracts; salad bars.
8. Constant promotional pricing
Although a "regular" price exists, no one ever pays it.
Consumer-electronics retailers' always matching "lowest price" in town; always offering one pizza free when customer buys one at regular price.
9. Price performance
Amount customers pay is determined by the performance or value they receive.
Money managers' being paid profits; offering a career-transition guide for $80 and allowing buyers to ask for any amount refunded after use.
10. Change thestandard
Rather than adjust price, adjust the standard to make your price seem different (and better).
A magazine clearinghouse's selling a $20 subscription for "four payments of only $4.99."
11. Shift costs to your customer
Pass on ancillary costs directly to your customer, and do not include those costs in your price.
A consulting firm's charging a fee and then rebilling all mail, phone, and travel costs directly to client.
12. Variable pricing tied to a creative variable
Set up a "price per" pricing schedule tied to a related variable.
Children's haircuts at 10¢ per inch of the child's height; marina space billed at $25 per foot for a boat.
13. Different names for different price segments
Sell essentially the same product, under different names, to appeal to different price segments.
Separate model numbers or variations of the same TV for discounters, department stores, and electronics stores.
14. Captive pricing
Lock in your customer by selling the system cheap, and then profit by selling high-margin consumables.
The classic example: selling razors at cost, with all the margin made on razor-blade sales.
15. Product-line pricing
Establish a range of price points within your line. Structure the prices to encourage customers to buy your highest-profit product or service.
Luxury-car lines (high-end models enhance prestige of entire line but are priced to encourage sale of more profitable low end).
16. Differential pricing
Charge each customer or each customer segment what each will pay.
In new-car sales, a deal for every buyer; Colorado lift tickets sold locally at a discount, at full price for fly-ins.
17. Quality discount
Set up a standard pricing practice, which can be done several ways.
Per-unit discount on all units, as with article reprints; discounts only on the units above a certain level, as with record clubs.
18. Fixed, thenvariable
Institute a "just-to-get-started" charge, followed by a variable charge.
Taxi fares; phone services tied to usage.
19. "Don't break that price point!"
Price just below important thresholds for the buyer, to give a perception of lower price.
Charging $499 for a suit; $195,000 instead of $200,000 for a design project.
NOTE: Once you've been creative, make sure you're covered. The most important aspect of any pricing approach is that it is legal and ethical. Check with counsel.