Moving from cost- to value-based pricing

Throughout my travels, I have heard business describe their grandiose plans for moving towards "value-based pricing".  Great... this sounds wonderful... value is a good thing, you base your price off of this value... recipe for success!  Right? ... right?

Not exactly.  There are many questions you have to answer when talking about the "value" in "value-based pricing".  First and foremost, this is not your perceived value; it is your customers' perceived value.  But I will get to that in a second.  First, I want to address what is specifically NOT "value-based pricing": when determining if a price offered to us by your customers meets some pre-determined margin minimum, this is decidedly NOT "value-based pricing".  In fact, this is (everyone say it with me now): cost-based pricing (the clue are the words "margin" and "minimum").

Anytime you take a price based on margin (revenue less cost), you are taking a priced based on the one aspect you control... cost.  Cost-based pricing is good for two things: determining a floor price (which has its place in pricing strategies) and relying entirely upon your procurement department to drive your profitability.  After all, if they do their job better, profits increase!  Wait... you mean that is not the message you are sending to the Street?  Then you need to stop cost-based pricing methods from impacting the price delivered to customers.  Cost-based pricing is a disaster waiting to happen, just ask anyone who tried to compete with Walmart on price (oh, forgot, those places are not in business anymore).

When you price based on cost, you are not taking advantage of what the market has to offer.  You are looking at your own internal metrics and hoping for the best.  This will never move the needle of profitability.  In order to transform your profits, you must transform the ONLY element of the marketing mix that brings in revenue and profit - price!

So, back to my comment about how your customers perceive your products' value…  You have to get over your own egos and start thinking like your customers.  And this is not easy, because last time I checked, you are not your own customers.  So how do you get in their heads and start to think like your customers?  Unless sci-fi becomes a reality, this simply will not happen (and besides, all the sci-fi movies about miniaturization and being implanted in someone’s head never ends up pretty).  But you can forecast how customers might behave, given certain market characteristics.

To better forecast, you need to better segment your customers and products.  I'm not asking for a revolution for any current practices, I'm simply suggesting to break out of your current segments and start treating profitable customers like profitable customers and non-profitable customers like non-profitable customers, regardless if they are in the same country or not.  I cannot tell you how many times I have heard, "well, customer A and customer B are both in France; therefore, they should purchase the same".  OK, you are right, I have not heard that explicitly, but I see it all the time because many companies I have worked with price the same to all customers in France!  You have the data necessary to identify these segments, but you need to take the time to build these segments properly.  And this is a topic for another day.

Once you have those segments, you can begin to appreciate how those segments behave.  For example, a scatter plot of revenue and volume should look similar for all those customer/product combinations in one segment.  But there will still be variation.  Now, you can take this smaller amount of variation and quantify the gains made by forcing higher prices to the lower performers.  Will you achieve 100% of this improvement?  No, but 50% is reasonable.  One company I worked with simply stopped selling below market average for a week for specific product lines in specific areas.  The results?  15% improvement in profits against the baseline forecast for that week.  Imagine what you could achieve by implementing pricing strategies at this level?  The possibilities are almost endless.

I'll leave you today with the reiteration of one of my statements above and encourage you to comment: price is the ONLY element of the marketing mix that brings in revenue, hence profits.  All others only bring costs to the table.  Why then is SO much time devoted to the other elements, with so little attention being paid to price?

Price Strategy Proliferation

Many companies recognize the importance of having multiple business strategies in place for how they will approach the market.  Do they want market share, or do they want to be the prestige brand?  Are they trying to launch new products and/or sunset others?  Each business strategy requires the tactical plans in place to execute, and therein lies the need for mixing up your pricing strategies.

Why is it that many companies recognize the need for multiple business strategies, but then execute through one or two “tried and true” pricing strategies?  Each different market approach can be achieved through different pricing strategies, but with vastly different results.  If your brand is positioned as the “prestige” brand in the market, don’t expect the same pricing policies that keep that image in place to work for market penetration.  The same can be said for the typical commodity markets – applying value based pricing to those products in those markets simply will not produce similar results to value based pricing for specialty products.  Yet company after company will re-apply “proven” pricing strategies in new markets for new products, without fully analyzing all alternatives.  And why is that?  It’s not because they don’t want to; typically, it’s related to a company’s inability to project and forecast multiple strategies and manage them once they are in place.

This is where a robust pricing execution tool shines.  The ability to forecast properly price changes using a library (meaning more than two or three) of B2B price strategies is invaluable.  In addition, companies need to realize that since business is dynamic, so too must be your pricing libraries.  A true price execution tool will allow for price change modeling using proven price strategies, but with the necessary tweaks to meet changing market conditions.  And so, a new price strategy may be added to the ever-growing library for use elsewhere.  The value of such a price execution tool is the reusability of what works, the elimination of what does not, and the proliferation of pricing success throughout the entire organization.

Pricing Best Practices – How Do I Get There?

As more and more businesses are looking at pricing, they are asking themselves, “what can we do to jump start the process?”  Ultimately, it’s understanding how you price.  The process must, at some level, be understood, before you can begin to enhance and evolve.

Pricing process improvements would not be complete without what I'll term a “Day in the Life” of users.  I used to call this “riding in the truck” as a reminder – because I have actually ridden in the sales truck to a job site!  This is the only true way to fully understand the pricing practices of, empathize with, and appreciate the pains of potential users.  If pricing is such a strategic lever that can make a significant difference in profitability, you should be willing to invest the time to understand all the corners of your organization’s pricing practices in order to squeeze out as much ROI as possible.  And what better place to start than with the front line of price communication?

The question is: how do you conduct these Day in the Life sessions?  I can start by stating what not to do… don’t just ask questions!  You must put yourselves in your employees’ shoes… if they are called into a room and must answer a bunch of questions about how they do their job, what do you think they are imagining?  No matter how well you prep them, how you preface your message, or how you triage any malcontent, they will be nervous.  Unfortunately, that feeling will result in them answering the questions they way they “think” you want them to answer.  Anyone can put concepts on paper, which is what their answers will no doubt provide; you are trying to get at the dark and ugly truth about price and profit leakage.  Therefore, take the “interview” to the next level… go ride in the truck.

But don’t just observe in the “white lab coat, clipboard, and one-way mirror” sort of way… observe AND interact.  You should ask “why did you [insert activity here]” until you fully understand – don’t assume anything.  Then go beyond observation and interaction: solicit their feedback for how they would improve their processes.  What else do they need?  What could they do without?  What typically causes them to sit around and wait for three days while competitors steal your business?  Get them to believe they will have an impact on the outcome, the new process that they will be asked to follow… BECAUSE THEY DO!  Once you have this buy-in and belief instilled in your employees (that you want them to do better and are willing to give your time and efforts to help them), the truth comes out.  It’s only then you can work with your cross-functional team to improve your pricing processes in a way beneficial to all… because you know how your organization really prices.