Chapter 10
The Hinge of Fate: Pricing Strategy
History will be kind to me, for I intend to write it.
—WINSTON S. CHURCHILL
Many writings on price strategy focus exclusively on relative market power among competitors. While immediate market power is indeed very important, there are a few other factors that can strongly influence results. One of them is time: if you lack market power, you are likely to need some time to accomplish your goals. Time and power are the primary commodities required to construct a pricing strategy.
Why time? The primary reason is that market power changes over time, and the strategy rule is to take price at a time and in a market when and where your customer or competitor is least ready to fight you on it. When we say market power changes, we are not talking about glacial erosion of entrenched competitors but rather rapid changes in customer needs and how you can take advantage of those changes.
For instance, in the college textbook market, major textbook adoptions in higher education last for a period of two to three years and are often decided by committees of relevant faculty. Apparently, these meetings are not much fun: various champions endorsing their particular favorite book or educational materials. Often, few people have read or studied all the alternatives, so the discussion is impressionistic, heated, and endless. Because there is no consistent decision criteria and little systematic comparison, often price is one of the few objective comparisons. As a result, books priced significantly above average will be eliminated from consideration—regardless of their merits.
The price strategy best suited to win such an adoption is to set the price close to average for year one. Then, to achieve superior returns in years two and three, prices should be raised sharply. These raises can be made secure in the knowledge that no one wants to reconvene the adoption committee and reconsider the adoption. Of course the students won’t like the price rises, but the decision makers—the professors—don’t have to pay for the books themselves. Not until the next adoption cycle must prices come down again.
The same sort of decision-cycle-based pricing applies in countless industries. For instance, when selling a computer cluster, hardware manufacturers know that the initial bid is very price-sensitive, but a year later additional memory or power supplies can be sold at a premium. Leveraging changes in time is central to pricing strategy. That is not to say that the sequence is always identical. For instance, when selling some categories of services, such as entertainment, the time pattern of value capture works in reverse order. Let’s take a closer look.
A major entertainment park located in Atlanta had spent tens of millions of dollars on a new exhibit. The new exhibit initially had the excitement and value of novelty. Therefore, the optimal strategy was to charge a premium until the local visitor pool was exhausted. After the local customer segment was exhausted, the second-stage strategy was to merge the exhibit into the entrance fee, except for special occasions and events with a high proportion of out-of-town visitors. Then it was optimal to continue to charge extra. The idea is that while the Atlanta pool of visitors is finite, the pool of out-of-town visitors is virtually infinite.
This example illustrates the need for time-based contextual pricing strategy. In some cases, sellers will even create a time-based context such as a “limited time offer,” for example, selling fashion items for a short time only. Many fashion items are deliberately rationed so as to create scarcity and so a lack of price resistance. A more subtle version of this use of context is expansion, for example, taking products from a micro-brewery with a reputation for superior beer to national distribution. The previous scarcity can translate to a bounce in current price.1
Take price when and where your customer and competitor is least ready to fight you on it.
Strategy Homework
Successful strategy requires some homework before beginning. One task is to define where you hold a stronger position and where you hold a weaker one. If you know that, then the actions and price structures supporting strategy will flow quite logically. To know weakness or strength, context is key.2
Determining Strengths and Weaknesses
While management will generally have some intuition on this, there are often material rewards for doing a better job in evaluating and quantifying differences in strengths and weaknesses. For instance, in 2008 the Food Network felt it was time to dramatically increase the prices paid by cable television companies to broadcast its content. The Food Network CFO announced that the company was seeking a big jump in rates based on its audience ratings success. This helped set the contextual basis for pricing—showing that price should relate to ratings.
To achieve the increase, the Food Network had to negotiate with a half dozen cable and satellite operators. The key negotiation context was that while each negotiation was separate, results from one influenced others.3
The Food Network’s first step was to quantify exactly what the financial pain would be of losing different cable companies carrying the Food Network if they refused the new rates. Because of its small size, and smaller footprint, Cablevision was the obvious weak point. When Cablevision rejected the Food Network’s demands, it dropped the channel at the end of the contract term while other cable companies continued on a provisional basis.
But three weeks later Cablevision recanted and accepted the Food Network’s new rates. As one blogger commented, “Sounds like Cablevision needs Scripps [Food Network] more than Scripps needs Cablevision. I wonder how many subscribers Cablevision lost?”4 Apparently a material number, since eventually Cablevision agreed to the new, higher, rates. More important, after this precedent, the other cable companies then fell into line and accepted the new rates.
As another example of identifying strengths, in the search engine market there are several hundred players, plus many metasearch engines that aggregate other search engines’ results. Search engines are specialized in many ways (e.g., medical, legal, semantic, social, visual, etc.). These differences matter depending on the context. For instance, having intraenterprise search abilities (i.e., a search scans your company’s databases as well as outside ones) is important for research departments at larger pharmaceutical companies, but less important to smaller ones. Visual capabilities are important for trademarks, motion pictures, and engineering, but less important for blog search engines such as Technorati.
Interestingly, in many markets, differences in capabilities are not clear to many of the users. Yet they do exist upon close inspection. Further, the differences matter to users once they are made aware of the differences. For instance, search tracking matters to medical researchers who are required to show their due diligence in examining the existing literature. This matters less to financial search-engine users, but they in turn care more about differences in security and privacy capabilities.
As with any sophisticated set of products, the list of differences among search engines is long—yet sometimes the lists do not make it out of R&D into marketing or sales. Further, the right message may not make it to buyers and influencers. This failure to leverage differences represents a failure to set the basis for, or engage in, contextual pricing. With a blank slate, pricing cannot be contextual and so cannot really capture the pricing it might with better-defined context.
Often there is the delusion that sales staff will have the time to figure out the differences and will point out the advantages of a product, or the unreliable hope that a buyer (such as an information professional, like a librarian) will understand those differences and then be able to support a higher price. That is very optimistic; make up the list or there can be no effective pricing!
Often imprecise and sloppy pricing is the result of a failure to carefully distinguish market factors such as product differences. Developing a list of differences is the prerequisite, and communicating that list downstream is essential.
Strategic Pricing by Category
Once you have the list, the next step is to build a map of where your offer is strong, average, or weak. We tend to call these Homeland, Battleground, and Entrants/Opportunistic Raiding market sectors.
Note that there should be a lot more than mere product focus on this map. Limits to channel reach and other offers within the portfolio and customer decision-making process will have an impact on the map. For instance, if your features are not immediately obvious to casual users, the existence of expert buyers such as librarians or in-house experts may shape the classification. Where it takes time to learn of your offer’s differential benefits, the map must show where buyers will invest that time and where they will not. This is the contextual dimension to strategy.
Homeland. These secure customers are where you should be extracting value. Usually such a customer believes your product to be very valuable to them, and in B2B situations these customers may have made your product or service integral to their work flow.
The value capture strategy for Homeland customers is to create price structures that are better at extracting value (e.g., employing two-part charging schemes, as described in Chapter 6). For instance, warehouse clubs such as Sam’s charge membership fees in addition to the item price. And, of course, in some cases simply raising price is an option.
The more important question is how to do this without exposing your Homeland customers to raids from competitors. Remember that the high margins of this customer category will make them subject to competitor attention.5 There are three pricing strategies that can help defend these customers:
Neutralize the attacker’s strong points. This means to rebalance pricing so that the likely points of attack are priced competitively. For instance, if a competitor offers a low flat rate on some part of the service bundle, you must meet that price. Any value-added features or higher tiers of service can still command a premium, but your company must make it easy for loyal buyers to say to their bosses, “We did not take the new entrant’s low-priced offer. Both our incumbent supplier and the challenger offered the same basic price. But because on closer inspection we needed additional functionality, we stayed with the incumbent and his higher tier offer.”
Message and signal that any competitor price attack will provoke price or nonprice retaliation. There must always be some retaliation, and the retaliation must have an impact on the same chain of command at the competitor as those who are launching the attacks. Counterattacks need not involve lower prices, for instance: making known to the competitor’s best customers that any low prices offered by them to your customers can be a form of retaliation. Sponsoring a study that examines shortcomings in the attacking products (like the floating decimal research used by IBM against Intel) is another potential response; again, it was not linked to a price level.
Employ retention tactics. These may include price opacity (keeping discounts separate, perhaps in the form of rebates to different influencers), increasing administrative burden of departure (separate renewal cycles for different component parts, making notice of cancellation difficult or limit opportunity) and, finally, offering cumulative discounts over time lost if the customer leaves—similar to the loss of American Express reward points if the customer closes his or her account.
Battleground. For the Battleground sector, the full capabilities of the organization come into play. That means highlighting your product differences (such as the speed, durability, ease of maintenance or reliability of product, timeliness of delivery, scope of reach, unique content, and lowest price) and what it means in different buyer or user contexts.
For instance, in the data processing market there are dozens of buyer segments. One server manufacturer has split its marketing efforts by vertical industry segments. This certainly has some validity: needs differed materially among customer segments. Most important, these segments paid up to 20 percent more or less for the same product.
But on closer inspection, the industry segment price varied more because of differences in user missions than anything intrinsic to the industry vertical. In some cases, their mission was to reduce costs, so they were very sensitive to price tags. In other cases, their mission was to improve computer support to business units, so they were less focused on the price and more on the operational capabilities being created.
Each mission represents a context. The best pricing strategy was to address pricing structure (e.g., timing and apportioning of component costs) differently for these segments. This produces a coherent price approach much more prone to success than simple industry segmentation.
Table 10-1 Differences in Evaluation by Objectives
Comparison of devices under two different criteria, linked to organization
Notice how in Table 10-1 below, the front-loaded pricing and back-loaded pricing won in different contexts. In this case, if your company product offered more MIPs but would be junked with little resale valuedue to a lack of standards compatibility, you would certainly target the departmental user buyers looking to maximize immediate performance.
To defend customers in the Battleground, timing is key because customer understanding of the product changes over time. Here is an illustration of how price plus the right information helped turn a loss to a win back: a leading software provider for small business was facing a slew of low-priced competitors offering subscriptions to back-office applications at prices that were half the levels of the leading vendor. Attrition of small firm customers was material. The market leader had a superior product; competitive research had shown that there were many operational issues with the competitors’ applications, but this did not seem to matter to customers.
Looking closely at the decision process at the small firms showed a typical pattern: within a three- to five-person management team, one manager was typically responsible for back-office applications, such as billing or payroll. Other members of the management team were more focused on sales, operations, and other functions. The management team member responsible for back-office applications was usually quite loyal to the market leader and its products. Major expenditures such as a billing system upgrade and other big-ticket items, however, were decided jointly by the entire team.
The result was that when approached with a supposedly equivalent product offered at half the price, the majority of the management team would vote to switch to a low-priced alternative, and the back-office head would be outvoted. After the switch, the defeated back-office head would unhappily adjust to the new provider and gradually drift out of touch with the market leader—losing sight of its advantages and product improvements.
A pricing strategy to retain the firm prevented this drift out of touch. Instead of stopping service upon cancellation notice, the market leader would continue it free for one year. In the course of that year, the loyal manager would check both services against each other and often find fault in the new service. In some cases the fault was major: the billing results were wrong or accounts receivable failed to point out issues. This armed that manager with specific examples where serious harm could have resulted from the use of the new supplier. Against a specific example, often the nonloyal managers would agree to return to the market leader since getting customer invoices wrong can be a big problem.
So, as often happens, the situation changed with time. The power shifted among the sides, and what appeared to be a lost cause was won.
Time is critical to pricing strategy. Take price at a time when your customers and competitors are not ready to fight you on it.
Entrants/Opportunistic Raiding. In addition to entrants, companies raiding competitor’s Homeland markets face the problem of changing customer buying habits. Entrants typically will set a superior price/ performance offer before potential customers (depending on the quality of the product or service, this price may be above or below that of the incumbent). The idea is to make it worthwhile for customers to change. With multiple competitors in a market, companies are likely to resort repeatedly to lowering pricing as a way of gaining market share. This is why, to no one’s surprise, more competitors generally means lower prices.
To send the message of lower price, entrants tend to favor a relatively simple “transparent” price. Underpricing the incumbent works best when customers can compare product or service prices easily; it becomes less effective as the purchase grows more complex. Complexity and hidden price elements are usually not the best tactics for an entrant, because they force customers to work to understand the entrant’s price advantage—something customers may not be willing to do.6
Understanding underdog strategies is important because every company sometimes plays the role of underdog or challenger or entrant somewhere in its markets. That role applies to start-ups, such as mail-order florist Calyx & Corolla entering the retail flower market. It applies to large established firms in new areas, for example, P&G’s entry into the premium pet food market. It can apply to overseas expansion, such as major automobile manufacturers muscling their way into the Chinese market.
An example of “Simpler is better for entrants” is the long-distance telephone service market. Large corporate users’ contracts run hundreds of pages and depend on dozens of elements such as usage, geography, installations, and features. Consequently, direct “apples to apples” price comparison is difficult. This is one reason why price is a less effective tool for capturing large business customers than for winning smaller business and consumer accounts. That is why voice over Internet Protocol (VoIP) entrants such as Skype and Pioneer offer simple tariffs to new accounts, either flat rate or a penny or two per minute.
In contrast, customer inertia and conservatism help incumbents. To avoid the effort and perceived risk in changing suppliers, customers will often allow incumbent suppliers a material price premium. For example, as part of its quality programs at one point, Xerox had a policy that allowed incumbent suppliers up to a 15 percent price premium over potential suppliers before it would switch providers.
When customers are not willing to grant incumbent vendors a price premium explicitly, the real price level can often be masked through a complex price structure. Unless they have a monopoly, incumbents have a strong incentive to make it difficult for customers to compare prices directly. For instance, consumer electronics manufacturers such as Sony vary their model numbers among retailers so that consumers cannot be sure they are comparing the same model. Similarly, in the commodity chemicals business, buyers are highly sensitive to price. As a result, sellers make sure that actual prices can be pieced together only from many contracts and deals throughout the distribution chain (e.g., some at the factory, some deals by warehouse, etc.).
The less market power a company has, the less it can obstruct the process of price comparisons—and so must typically offer simpler pricing. That is why new-entrant stockbrokers such as Scottrade offer simple $7-per-trade pricing, while incumbents such as Merrill Lynch, Schwab, and others have more complicated structures linked to volumes, stock prices, and annual fees.
Differences in market power and context mean a uniform price is frequently not feasible. Even the strongest companies are weak in some contexts and in some markets. No company is uniformly strong in all regions in which it operates. Differences in market share and power across geographics is an obstacle to a uniform global pricing strategy. Additionally, there are other contexts that favor or disfavor an incumbent even in its core markets. Therefore, the price structure should vary to reflect these differences: in some cases, an incumbent strategy is appropriate; in other cases, the context favors weaker competitors or entrants, even against strong incumbents.
As an example, in commercial jet engine procurements there is a need for multiple sourcing on spare parts and supplies—a requirement driven by the fear of an airline being held hostage over the price of replacement parts.7 This sort of requirement can be a nice entrée for a weaker player.
While both primary supplier and second-source suppliers must of course show that their products and service are reliable, many of the other success factors are different for the second-source player than for primary provider. The incumbent will be looking to make up the low initial bid price through sales of higher margin spare parts. The second sourcer is often looking to show its attractiveness through low spare parts costs and compatibility with the primary provider. Hence the context and the messaging can be exact opposites: one is “We are best, we are unique,” which suits the contenders for the primary position; the other is “We are just the same and a cheap second-source candidate.”
Third Parties, Alliances, and Eco Systems
Leveraging additional parties, beyond your company and your customers, can add pricing strength. In the same way that “third parties” called competitors can destroy value, third parties called coventurers can help create value. They do this by joining with you to create bundles consisting of their products and your products (or services). For instance, Smartphone manufacturers and software developers offer just such a bundle, sometimes purchased together (preloaded) or sometimes a soft bundle, whereby both can be purchased via the same channel. Third parties can also help your company legitimize and monetize the value of your offers.
This role, when applied to multiple linked parties, can be very powerful both in adjusting the context but also in helping with reach. Here are a few examples:
Entertainment. Management at some amusement parks has been gratified that they have many admirers in their communities. These supporters, or “ambassadors,” are a major source of visitors and income, and an important context. When out-of-town relatives and friends show up, the ambassadors are likely to urge the visitors to go to the amusement park. In many cases, however, the frequency of visitors is greater than the desire or budget of the ambassador to see the park again.
The answer in one case was to create a membership program that allowed unlimited visits and even to give the out-of-town guest visitors a 10 percent discount by virtue of association with the ambassador. Given the leverage, a huge return followed. For the sake of heavy discounts for a small number of ambassadors, there was a large uptick in related visitors at close-to-full prices. In many markets, the context includes advocates—such as enthusiastic users or influential observers, bloggers, or family members.
Construction. In the construction industry, there is a flow of influence and money beginning with the master developer or owner, going to the architect or the development company, then to the general contractor, then to the subcontractors, and so on. Some vendors have linked up with the next level in the chain, and this has helped everyone’s pricing to have that link. For instance, developers such as Trump have a core group of contractors that they use repeatedly, and so they do not have to be educated about the Trump organization’s preferences and standards.
Similarly, general contractors have set up links with skilled subcontractors, such as roofers or concrete formulators for foundations. This helps reduce general contractor uncertainty as to quality and has helped higher skilled but higher hourly cost subcontractors benefit from repeat work because both general and subcontractors know what to expect from each other—it takes the uncertainty out. Also, the relationship gives both sides more opportunity to discuss requirements and costs, which can prevent problems. This can mean higher hourly rates, but, more important, overall lower costs due to fewer problems and less risks as the buying unit is redefined. For instance, not all building foundations are equally easy to pour. A dialogue between foundation subcontractors and general contractors can be very productive, and this is more likely as part of an ongoing relationship.
Financing. A lucrative example of an “ecosystem” operates on Wall Street. The start-up financing to IPO lifecycle relies heavily on context to set value. For instance in the case of Facebook, Goldman Sachs played a major role in lining up investors in the start-up. These investors did well. Microsoft invested $240 million in 2007, which by 2011 grew to be valued at $15 billion. Goldman Sachs also created a special vehicle that allowed some of its best clients to invest in Facebook: the vehicle combined hundreds of investors so they were treated as one investor, thus skirting the SEC rule that firms with more than 499 shareholders must report quarterly earnings and audited financial information to the public.
In return for legitimizing the prepublic value of Facebook, Goldman Sachs collects stiff fees: 4 percent placement amounts and a 5 percent share of the investment’s profits. It is also likely to handle the Facebook IPO. So far its “friend” investors have enjoyed more than 60 times return on investment, if you believe the valuations. Goldman Sachs may pocket over $2 billion as Facebook and its investor friends cross the IPO finish line. Overall, this arrangement represents a very successful ecosystem context.8
The lesson from these examples is that your company can bundle resources or capture legitimizing context from outside of your company. In many cases, such third-party allies are more effective because they help complete a broad picture context, which your company cannot do by itself. For instance, for educational products, marshaling a panel of Ph.D.s is more effective than doing your own product evaluations.
Another nice feature of third parties is that frequently they can ally themselves with you for their own purposes, so they require no support—just an invitation. For instance when Cablevision went dark on Food Network in 2009, vocal critics of Cablevision’s decision included foodstuff advertisers like Pillsbury and their agencies, who were deprived of an effective advertising vehicle. No money flows from the Food Network to these ad hoc allies, actually the opposite: these allies actually buy from the network, so the third party actually paid for being a supporter.
Third parties can influence context, and since context influences price, this can be a useful tool in price negotiations.
Costs
Costs, often maligned as the basis for pricing, can also be inspirational in suggesting a price strategy. While costs have an impact on pricing only indirectly, they do highlight opportunities for better pricing. For instance, the U.S. Postal Service offers its popular flat-rate box service, which has pricing independent of weight (some restrictions, but not material in most cases) because it found that its airfreight charters filled up the airplane in volume before it ever reached the airplane’s weight limit. Hence, because the weight was not a constraining factor, the postal tariff could ignore it.
A smaller-scale example comes from a car wash named Car Spa, in New Canaan, Connecticut, where all cleaning is guaranteed for three days following the service. The benefit advertised is that if it rains, owners can come back with their cars and get a free wash. The logic of this offer is powerful: induce car drivers to have their cars washed even if bad weather threatens. Since car washes have very low variable cost (some soap, some power), the incremental revenues are not offset by material costs.
How costs are treated managerially can make a material difference in outcomes and how competitors price. Often the attention to such differences seems to focus on accounting differences (e.g., differences between GAAP accounting and non-GAAP accounting such as between U.S. and overseas firms). Yet that is not the largest difference we have seen. The managerial cost approach can make a much bigger difference in pricing outcomes and the competitive context.
For instance, in the early 1980s Mobil Oil Europe enjoyed considerably better management than most of its competitors and did very well employing marginal costing to its markets. The idea, simply, is that the company applied the highest cost fuel source to the lowest price (marginal) market. This is in contrast to mechanically applying the actual cost of whatever fuel happened to be closest to a particular market. The results, in the illustration here, were material (30 percent difference in total margins), as shown in Table 10-2.
Table 10-2 Marginalist Costing and Profit
In the table, the marginalist costing, by applying marginal (highest cost) supply against marginal distribution (lowest price) regions, obtains a higher total margin and on lower assets. This worked out even after adjusting for the transport cost differences, although it was “incredibly complex” to do, according to management.
The benefits of marginalist costing go beyond short-term profits. This approach allowed Mobil to buy assets from Texaco and BP to consolidate its position in profitable market regions. Although not needed in that case, it might also have given Mobil more pricing options in matching price competition.
Risk as Part of Strategy
Interestingly, in the same way that courage plays a role in military strategy, it also appears to play a major role in pricing strategy. Fear is a common reaction by managers not familiar with pricing. At one level, who can blame them?
Bold strategy does require courage. Don Regan, CEO of Merrill Lynch when they invented the CMA Account (integrated money management account), bet his job on what was then a huge investment in systems to support the product. In that case it was a huge success. Similarly, Dell Computer repeatedly bet on volume price economies to aggressively price its personal computers. Likewise, winemaker Jess Jackson bet on marketing a new type of semisweet wine called Vintner’s Reserve at a new price point of $4.50 per bottle. The first year sales volume of 20,000 bottles fell well below the breakeven of 50,000, but Jackson persevered. Eventually sales grew to five million cases annually. This established Kendall-Jackson as a major winery, despite fierce competition from E&J Gallo, the world’s largest winemaker.9
So why is courage important? Courage appears to be important to pricing success because it takes courage to accept the facts. For instance, in 1991 IBM, which invented the router, was the dominant vendor. A small competitor, called Cisco Systems, had however been effective in integrating more data protocols into its router, so a clear value gap had emerged.
In retrospect it is clear that IBM should have done all it could to regain the protocol lead from Cisco. Failing that, it should have used pricing and bundling to blunt Cisco’s inroads. True, offering a lower price would have been dissonant with the concept of the famous “IBM premium,” but it would have given IBM time to catch up. Sadly for IBM Communications, its then-chief Ellen Hancock refused to consider the option, so IBM ceded the router market to Cisco. Her refusal to look at reality cost IBM billions.
There is, to be fair, great pressure to go with “normal” pricing in most companies. A similar refusal to accept abnormal numbers was experienced by one of the authors of this book while in finance at Bell Atlantic. Strong advocates urged the purchase of paging companies, which were hot in the 1980s. Application of the capital asset pricing model (CAPM), however, suggested a more than 80 percent hurdle rate was applicable. This killed the deal, but only because finance stood united in the correctness of this analysis. To the nonfinancial mind, an 80 percent discount rate was clearly to be ignored even if correct.10
Successful strategy probably requires courage—in most cases, at least courage in sticking with the numbers.
The Impact of Price Variation
Similarly, in many pricing decisions, there are numbers that do not have the benefit of hard bases and so tend to be replaced with innocuous numbers that result in mistaken pricing. Repeatedly the most difficult number to assess is what a change in price for one customer will do to the prices for other customers. If you hold firm with one customer, will that improve your company’s pricing with another customer? If you drop a price, how does that affect your ability to hold price with another customer or customer segment?
A normal practice is for companies to assume zero impact. This can be correct, or it can be quite mistaken. However, solid strategy requires more than a default answer or ignoring the issue. As Warren Buffett commented: “Risk comes from not knowing what you are doing.”
The right approach is to assess the interaction of different pricing decisions on one another. This would include understanding if and how customers communicate with one another on purchase prices. It should also include an assessment of how your own sales force or market management will react to a low-priced sale. One study of the consumer cellular market found that the vast majority of subscriber down-tiers to less expensive plans were the result of unintentional communication by their own wireless provider. In B2B markets, often company’s own sales force is a primary driver of destructive interaccount communication about price.
The most important price estimate is also the toughest: estimating what moving one customer’s price will do to other customers’ prices. The default assumption of no impact can be dangerous.
In addition to assessing the impact of price variation, there are a number of things companies can do to reduce the impact of customer communication on pricing. The first is to adopt the contextual pricing approach advocated in this book. When sales and markets are presented with the right price to begin with, there is less need for damage control afterwards. The perpetual battle over discounts loses much of its meaning.
Another means for controlling interaccount communication is to use price structure. As described earlier, each pricing context often should get its own price structure, partly because the customers probably want it, but also to reduce interaccount communication. Ask yourself: will the customer who gets capped variable pricing easily compare prices with the customer who gets a flat price with rollover pricing? Structure differences render different price points far less comparable, or at least require some math before customers can decide if someone else got a bargain.
Estimating the Risk of Loss
A common problem among market leaders is the desire to never lose a competitor. This policy effectively strips the market leader of much of its negotiation power—and courage. While there are many negotiation tactics you might employ, broadly “If you have no choice, you cannot negotiate.”11 Over time this tends to lead to the reduction of any value premium your company enjoys.
The financial math required to disentangle this situation is not obvious, and it’s even tougher without some courageous estimates. In a nutshell, the question is: which is greater? The risk-adjusted expected lifetime value of the account being priced or the reduction in lifetime value of the other accounts potentially affected by this price outcome?
The same question can also apply to consumer markets, with the calculation being performed at a segment level. For example, if we lower our price to supermarkets in suburbia, will we have to give that same reduction to Sam’s Club?
In both cases the core calculation rests on the signaling impact of holding firm to a price. Since nothing is certain, this is a probabilistic (expected value) number. Through customer interviews and modeling, however, the risk of loss or gain can be quantified. For instance, one group health insurance company found that if it increased its prices to midsized companies with high levels of stress-related illness, their initial share loss was made up in the longer term by other midsized companies, because other group insurers followed suit and employers in this segment had no cheaper options.
Estimating risk of loss is tougher the smaller your number of customers. For relatively numerous customers (e.g., BlackBerry users), a set of statistical tests, perhaps combined with some models of customer utility and alternatives, will provide a clear answer. In the case of monopsony or very concentrated buyers, it requires extensive research into the buyer decision process and some subtle probing and dialogue with decision makers. The good news is also that with few buyers, communication can be much more direct, and there is often a highly compensated account team who should be able to influence outcomes.
Reducing Risk
A final point on risk: it can be reduced. One way to reduce risk is to offer customers a choice—perhaps not the choices they would want ideally, nor the status quo, but a choice. This way if you turn out to be wrong on your price (or other) changes, they can choose the least-offensive option. For instance, if you need to cap data use to preserve network economics, don’t just legislate a cap—offer a range of alternatives that amounts to a very large surcharge on usage that causes network congestion.12
Another way to reduce risk is to offer “insurance” to buyers who are wary of a price structure change. That insurance can be as simple as a price-paid guarantee: that next year the customer’s price-paid total will not go up. We have found that such a guarantee can defer any problems with conversion, yet lays the groundwork for later revenue gains.
Another form of insurance is for your company to guarantee the value of its product or service. For instance, in 2008 a major cable network was raising its licensing fees to affiliates such as cable companies. Since the overall economy was slipping into deep recession at the time, many of the network affiliates (buyers) worried about paying for an increase in a faltering economy. They worried viewership would shrink, and with a slip in viewership, advertising would suffer; the affiliates worried that they risked over-paying.
To address this concern, the network offered to compensate affiliates in the event that viewership fell. Pricing this guarantee similarly to selling a put option (according to the well-known Black-Scholes option-pricing model), the network established the price for a guarantee on viewership and offered it to the buyers. The offer silenced the buyers’ negotiation lever, even though none of the buyers took up the option.
Most businesses should consider offering a similar guarantee of value, if needed. We find that often the calculated value is quite reasonable, and adding it to the negotiation context usually takes away the opponent’s bargaining lever. One reason such a tool is effective is that studies repeatedly show that fear of loss is valued higher by buyers than the benefits of gain—even if the two are objectively equal. Thus, a standard strategic move should be to reduce or eliminate fears of potential loss.
Give customers options, guarantees, or insurance to reduce your market risk from price changes.
Executional Capabilities
Managers with pricing responsibility in increasingly competitive markets need to consider whether they have in place the analysis and the corporate capabilities required to price effectively in the face of new competition. If not, now is the time to develop a pricing strategy and hone your pricing weapons.
Of course, some elements of pricing strategy must be unique to each company and its capabilities, but there are some fairly typical pricing behaviors. Incumbents and entrants classically choose different pricing levels and structures.
Figure 10-1 Competitor levers on reference point: differences between incumbent (defender) strategies and entrant (attacker) strategies.
Managers with pricing responsibility in competitive markets need to consider whether they have in place the wide analytical and corporate capabilities required to face new competition and preserve shareholder value. Additionally, managers must understand the operational risks of various pricing tools. For instance, discounts can carry operational risks. A few years ago, a major cigarette manufacturer offered a significant price break to its wholesalers. But it failed to structure the new price to pass savings to end users. As a result, the wholesalers got a one-time windfall, end users saw no change in price, and the manufacturer failed to win any new market share.
Information technology capabilities are crucial in some markets. The right IT capabilities can not only help improve the quality of customer service that supports premium pricing but also help support segmentation and price changes. For a company to push its pricing strategy beyond its IT limits, however, can be counterproductive. For instance, a leading telco unintentionally sent almost one million checks, designed to induce users to change vendors, to its own customers—needlessly costing it $30 million. We happened to arrive at the client’s office that day, and by the look in peoples’ eyes you might have thought a bomb had gone off. But the real lesson is that this telecom company had pushed its ancient systems beyond what they could do safely.13
Strategizing for Duopolies and Oligopolies
Two major industry players engaged in duopolistic pricing represent a special case of price competition. Often the word comfortable appears in front of the word duopoly. This phrase nicely describes the optimal pricing strategy for duopolies and oligopolies. No party will benefit from a price war, but incremental gains are acceptable. As an illustration, United Airlines fought ferociously and successfully to keep Frontier and other airlines out of its O’Hare Chicago fortress hub, but it had to allow American Airlines to expand its existing operations since it had operated there since the 1930s. That is a fairly neat example of the tiered rules of duopoly competition.
So what does this mean? It suggests that competition needs to take the form of improvements in pricing capabilities and changes in price levels that cannot be construed as directed at the competition. As long as there is credible denial that no direct price attack is intended, the duopoly equilibrium tends to survive. Continuing with airline examples, when in 1982 Continental Airlines was struck by unions and 12,000 employees walked off the job, management rolled out a low $49 fare for any direct route flown by the airline. This price had the ostensible purpose of breaking the strike and retaining customers. While many new passengers flocked to this price, because it was not aimed at any competitor, this low fare did not provoke a price war.
So what are the tactics that allow duopolists and oligopolists to compete on price? There are three common practices:
1. Improved pricing sophistication. More sophisticated pricing tools have included better demand-management systems like Sabre for airlines, better cost-based pricing by integrated oil companies that have concentrated their service stations around refineries, better bundling of improved product features (which can backfire if done badly), and price signaling among leading players.
2. Improved price-related terms. These are especially terms that secure customer loyalty. An example includes the AT&T cellular rollover minutes plan and other retention tactics described in the Structure chapter.
3. Product innovation. While not strictly a price strategy, the nice thing about new products is that there is no direct comparison to the duopolist competitor, plus often the product innovation is a way to undercut existing competitor products. For instance, many “digital” products are actually little different in functionality to preexisting products; however, the changes in underlying technology, cost basis, and (some) differences in functionality have made these effective tools for attack.14
The end of the duopoly dance comes either when new entrants succeed in establishing themselves in the market of one of the duopolists or one of the duopolists falls behind in market power. An example of a new entrant succeeding in establishing itself—through clever pricing—happened in 1973 when top-12 airline Braniff International began facing competition from start-up Southwest Airlines on the Houston–Dallas route. To kill the upstart, Braniff attacked with a $13 fare, half of the previous $26 fare. Southwest Airlines, financially stretched, offered passengers a choice of the $13 fare or the $26 fare plus a bottle of Chivas Regal. Some 75 percent of travelers chose the higher fare and bottle. Southwest had survived.
Then it was time for Braniff to be eaten by its fellow sharks. By 1975 Braniff withdrew from the Houston–Dallas route, and in a few more years it went out of business because of very smart competition from American Airlines. Other examples of sharks circling a wounded prey include the dismemberment of publisher Harcourt in the 2000s and veteran financial player Lehman Brothers being gobbled up in the 2008 financial crisis.
The nature of competition between duopolists varies with the level of responsibility inside each company. Outside top management, competition is fierce and lethal, and encouraged. Given sales compensation plans or division management objectives, a win or a loss means a lot to an account manager, a product manager, or a divisional VP.
At the top, however, another game is being played. This could be called Grand Strategy. The difference between battlefield strategy and Grand Strategy is that the former is focused on winning and killing enemies. Not so with Grand Strategy, which is focused on using “war to achieve a better peace—if only from one point of view.” 15 This means that top management focus includes how to avoid ruinous price war and to ensure ongoing corporate well-being. Unless presented with an absolutely certain kill of a competitor, top management will avoid risk of mutual destruction. As former Coke Chairman Neville Isdell once told his senior managers, “Be mindful of the consequences of the consequences.”
Summary
In summary, when handled correctly, price strategy will help to combat new competitors and preserve margins, or to invade new markets. But price strategy must reflect the relative position of the product or service being priced—a key distinction being that between new entrants and incumbents. Prices will vary dramatically by context and segment; if not, you will work harder than you need to accomplish your company’s objectives. Price structure must reflect your objectives and capability to execute a price strategy. Most important, price strategy is the integrated set of management actions over time, designed to create lasting price advantage.
Notes
1. Some of the best contextual pricing lies in happenstance. “After 181 Years, Local Beer Stops Playing Hard to Get,” The Wall Street Journal, October 21, 2010, p. B1. Note how the volume multiplier makes later price level improvement desirable.
2. Just as military strategists have found strategy requires taking advantage of the unique features of a battlefield (e.g., the “topology”), pricers should take advantage of the unusual aspects of the market—what we are calling context. General Carl von Clausewitz also commented that “No topology is ever the same,” and his book On War (1873) has chapters discussing defense and offense in relation to mountains, forests, rivers, swamps, and other factors that frame how armies should attack and defend. More recently B. H. Liddell Hart pointed out the importance of factors that may obscure the other side’s vision during the “fog of war.” That is highly applicable to pricing, except that instead of mountains and swamps we face customer preferences and budget limits. Liddell Hart, incidentally, is the inventor of modern tank warfare and his admirers included General George Patton, Field Marshall Rommel, and others. B. H. Liddell Hart, Strategy (Second Edition), Praeger, N.Y., 1967, pp. 335–346.
3. Mike Farrell, Multichannel News, December 9, 2009, 5:00:51 p.m. The jump in rates was large: from 8 cents per subscriber to 25 cents per subscriber, according to the New York Times, January 21, 2010, p. B3.
4. Thread on foodnetworkfans.com.
5. In one professional services market, a smart incumbent had figured out what was the pricing threshold for competitive inroads. A strong CEO kept prices just below that level. After that company was acquired, the new corporate owner wanted to improve returns and therefore raised prices. Within three years the company had lost enough market share that it showed a negative revenue trend.
6. See Chapter 6 for a longer discussion of structure. Besides avoiding price transparency, market leaders have strong economic incentives to favor more complex, two-part pricing. The economist Walter Oi pointed this out in his classic analysis of pricing at Disneyland, which charges both a significant entrance fee and a small charge for rides once inside. Oi demonstrated that by charging marginal costs for rides and a material entrance fee, Disney (or any entity with substantial market share) ends up with greater profitability than charging only the usage fees for rides.
7. A legitimate concern beyond jet engines. Henry Ford once commented, “I would give away my cars for free, if I could be guaranteed the sale of their replacement parts.” A recognition of context, perhaps.
8. “Goldman’s Buddy System,” The New York Times, January 4, 2011, p. B1 and p. B6. This ecosystem reflects the dictum by Phebe Prescott, a senior transportation strategist, who noted that in noncommodity purchasing “relationships only work if both sides are getting something from the relationship.”
9. E&J Gallo employed the right tactics: it developed duplicate products and sold them for competitive prices, but Kendall-Jackson apparently just out-innovated them. “Jess Jackson Dies at 81,” The New York Times, April 22, 2011, p. B11.
10. Subsequent performance of paging companies fell into line with this hurdle estimate. Often analysts have also been cast out for correct analysis. “The Loneliest Analyst,” The New York Times, Sunday Business, September 12, 2011, p. 1, tells the story of a Wall Street analyst who was right but paid a high price for speaking the truth.
11. Former President of Mobil Oil Corporation William Tavoulareas. With products of any sophistication, there are components of the offer that can be withheld. For instance, your company can substitute a lower-tier service for higher levels of service.
12. See H. Raiffa, The Art and Science of Negotiation, Harvard University Press (1982). Also “FCC Chief Backs Metered Broadband,” Wall Street Journal, December 2, 2010, p. B3. Another important concept is avoiding overreaching and being rebuffed by buyers, as this destroys what master negotiator Barbara Meili calls “negotiation capital.” Just this happened in 2008 to a large chemical company that broke off negotiations with a supplier, only to discover that supplier was its best choice. That chemical company is now paying 40 percent more for the supplier product—substantially more than the 15 percent increase initially on the table.
13. We understand the idea that with urgency, and competitive pressure, you must push elements beyond what they are capable of. Just not too far. To return to military analogies, for the famous World War II battle in the Denmark Strait between the Schlachtschiffes Bismarck and the British ships HMS Hood and HMS Prince of Wales. The Prince of Wales was put to sea while it was still under construction: there were technicians and carpenters still onboard working as she sailed to intercept the German squadron. While it was a risky decision by the admiralty, it was necessary. The Prince of Wales scored some hits on Bismarck, which forced the German ship to curtail its proposed cruise.
14. Price wars can result from accidents and confused signals, but more systematically they can result when one competitor dramatically improves the price/value ratio of its offers. This forces competitors that cannot increase the value of their offers to drop their prices in order to remain competitive—and ironically results in a decrease in industry pricing. An example of a gradual end to duopoly is the entrance into the 100-seat passenger jet market by Brazil, China, Canada, and Russia. See “Airbus and Boeing Call End to Duopoly,” Financial Times, June 21, 2011, p. 14.
15. Liddell Hart, supra, pp. 366–372. This is why we have found that often when top management does a negotiation, the immediate price outcomes tend to be less favorable.