Value has to be the primary driver in setting a pricing strategy. This can then deliver both higher profits and improved customer satisfaction. Andreas Hinterhuber’s extensive research shows that business efforts to increase prices result in higher profitability than those to reduce costs. He sets out below the key components to increased business profitability.
Andreas will be joined by Paul Chadwick, CFO of B&Q, at Chartered Accountants’ Hall in April to discuss pricing in a competitive market and the difficulties faced by those seeking to increase prices without alienating customers.
No business can afford to ignore the importance of pricing. Ensuring you are competitive as well as profitable is a central element of the FD role in any industry. For many FDs, though, pricing strategies are often left to out-of-date formulae and allowed to stagnate. Perhaps a new approach is needed.
Pricing has a dramatic but frequently underappreciated effect on profits. A study of a sample of Fortune 500 companies showed the impact of pricing exceeded the impact of other elements of the marketing mix on profitability (Hinterhuber, 2004). An increase in average selling prices of 5% increases EBIT by an average of 22%, while other activities, such as revenue growth or cost reduction tend to have a much smaller impact. So why does pricing have a bigger impact on profitability than other tactical measures, such as growth or cost reductions? The answer lies in understanding and analysing customer value.
Pricing is clearly a key profit driver; however most companies get it wrong. They base prices on costs or on competitor benchmarks. Of course both of these should influence the pricing decision, but they should never be top of the list.
Conversely, only a minority of companies – between 15% and 20% – based their prices primarily on customer value (Hinterhuber, 2008). Substantial empirical research over the last few years has confirmed that value-based pricing is the only pricing approach that leads to higher profits (Liozu and Hinterhuber, 2013). By contrast, cost-based and competition-based pricing are likely to be detrimental to company profitability.
So what do we mean by ‘customer value’? It is the willingness of the customer to pay and is the sum of the combined benefits that accrue to the customer as a result of purchasing a given offering. It can be calculated and quantified as “the price of the customer’s best alternative – reference value – plus the value of whatever differentiates the offering from the alternative – differentiation value” (Nagle & Holden, 2002).
Value-based pricing is especially appropriate for highly differentiated products. But it would be a mistake to assume it is only appropriate for products with a clear competitive advantage, such as branded tablet PCs or life-saving pharmaceuticals. Value-based pricing should guide pricing decisions for apparent commodity products as well.
Consider a recent case study in the highly-competitive global chemical industry. Executives at this company assume themselves to be operating in a commodities industry, and are convinced that – in order to achieve meaningful sales – prices for the chemical in question need to be set at parity to price levels of the industry leader.
Workshops with executives and focus groups with core customers and distributors led to the discovery of a number of differentiating factors between the company’s main competitor and its own offering.
While there was not a dramatic difference between the two products, we found a number of small but meaningful distinguishing characteristics between the two products. Using internal evaluation and field-value-in-use assessments, we tentatively quantified the additional customer value for these differentiating features.
We found small differences in logistical know-how, in product quality, in ordering costs and complexity, in vendor competence and in customer knowledge added up to a positive differentiation value of 8%, allowing the product price to be up to 8% higher than the customer’s best alternative. The highest possible price is, of course, not necessarily the best price. But after applying a series of price optimisations, competitive simulations and estimates of customer reactions, we calculated the most profitable price point to be 5% above the best available alternative. The final price of 105 will – although higher than competitive prices by 5% – still be convenient for customers, since this price is below the maximum value of 108.
When basing price on customer value remember that:
The first step in the successful implementation of value-based pricing is to define the objective of the company. As much as improving profitability seems a straightforward objective, different companies may pursue different objectives during different stages of their own life cycle.
Growth in absolute revenues (as opposed to growth in profits) is frequently an important goal – especially for products with network externalities. Finally, the growth for ancillary products (e.g., razors versus blades) may be the main consideration behind the overall pricing strategy in case of interdependencies between products.
Mutually incompatible goals of profit maximisation, revenue maximisation, and the maximisation of sales of ancillary products require substantially different pricing strategies.
Customers have a subjective measure when deciding to buy or not – value. The value a customer assigns to the product and which determines the price a company should charge can be assessed by asking a few questions:
Each company is different and different cost structures will allow different degrees of leeway for implementing short-term, impactful pricing strategies. A simple issue arising is the effect that an increase in price might have on demand. Since even small price changes have a substantial effect on profitability, we need a structured approach to understand how price and volume affect profits.
A structured way to calculate this is through CVP (cost-volume profit) analysis. It allows us to calculate the required volume increase to compensate for price reductions, and the maximum affordable volume loss associated with price increases, if the overall goal is to maintain profits.
For example, a product or service has a 30% contribution margin. A 10% price reduction – e.g. a special one-off discount granted to a customer – requires an increase of 50% in sales to keep overall profits constant. The implied price elasticity of demand is unlikely in practice. Conversely, a 10% price increase for the same product maintains its profitability even if volumes decline by up to 14%. The implied price elasticity of demand for price increases is considerably lower.
Competitive analysis is an important aspect to take into account when deciding what strategy to implement. A thoughtful look at competition may show unexplored markets, or better segmentations by others, as well as unserved niches or needs that the firm can tackle.
It can also be important to assess the effectiveness the strategy is going to have in the arena. Price wars often come from overlooking the power of pricing, such as when companies with new superior products charge the market average without considering the value they create; this forces competition to respond fiercely.
In other situations, and against common sense, companies may charge a premium to gain market share by eliciting exclusiveness and high quality in the mind of customers, as well as distinguishing their offering from the competition. In some situations, the pricing strategy adopted by some players may influence and actually determine the competitive structure.
The final step on the road to successful pricing is to implement and follow up the pricing decision. It all comes down to setting price and leveraging the newly discovered value of the company’s product or service.
The decision to change price in itself is not enough – a correct implementation is key. A few guidelines can ensure that the price orientation (the ability to set prices based on value), matches the price realisation (the ability to enforce the prices):
In conclusion, pricing is one area where small changes can set a company apart from competition. Value-based pricing is a road that secures results in the short run; it also sets the direction for a path toward serving customers better, in light of the understanding of what value really means to them.
The original version of this article, written by Andreas Hinterhuber, partner and Evandro Pollono, senior consultant at Hinterhuber and Partners, Innsbruck, Austria appeared in the May 2014 edition of the ICAEW Finance and Management Faculty magazine.
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