Chapter 6
Price Level

Setting the Right Price for Sustainable Profit

Price setting is challenging, requiring the collection and analysis of information about the company’s business goals and cost structure, the customer’s preferences and needs, and the competition’s pricing and strategic intent. Even the best marketers struggle to synthesize these data into coherent, profit-maximizing prices. The price setting task is all the more challenging because of its importance to the organization—there are few decisions that have greater impact on financial performance. Whereas a good pricing decision can improve profits dramatically, a poor one can invoke a competitive response that quickly devolves into a price war that destroys profits for all.

Given the importance and complexity of pricing decisions, one might expect firms to invest heavily in the pricing function to ensure that managers have the right data and effective decision-support tools. Yet our research has found this is often not the case. In a benchmarking survey, 74 percent of managers indicated they often make pricing decisions with insufficient data; another 65 percent cite a lack of decision-support tools. Given this lack of data and tools, it’s not surprising that managers often take shortcuts that undercut their profits and increase their customers’ ability to negotiate lower prices.

For example, a biomedical device manufacturer we know has focused primarily on costs and to a lesser degree, value, when setting prices. The company knows that many of its products are differentiated, but it has not invested enough time and effort in value estimation to know how much that differentiation is worth to customers. As a result, its published prices tend to be quite high relative to the competition and the customer’s willingness-to-pay. On the surface, theirs might seem like a prudent approach because it ensures the company never “leaves money on the table” when negotiating final prices. Over time, however, the differentiation value of many of its products has eroded as competitors introduced new, higher-performing products. The resulting price pressure led to ad hoc discounting, which undercut the company’s reputation for price integrity. Customers have learned that published prices are only a starting point for negotiation and that the way to get better prices is to negotiate harder. Now, after several years of reduced price realization and lower profits, the company has correctly concluded that it must add discipline to its pricing process to set prices that are defensible to customers.

In this chapter, we present a three-stage price setting process that integrates the relevant customer, competitor, and cost data in a way that enables marketers to set more profitable price levels. The process is designed to be efficient and adaptable to most products, services, and market contexts. It integrates data on value estimation and segmentation, non-value price sensitivity drivers, costs, strategic objectives, and market response analysis in a way that can be supported by the organization and understood by customers.

The Price-Setting Process

The goal of the price-setting process shown in Exhibit 6-1 is to set profit-maximizing prices by capturing the appropriate amount of differential value in each of the served segments. In following the process, we advise managers to evaluate the return on their time invested at each stage to ensure each analysis provides enough actionable information to materially affect the final price decision. For example, a key question when establishing the price window is the amount of effort to invest in assessing the value of a product or service. For mature products with little differentiation and whose benefits are well understood by the customer, marketers would not learn enough actionable information to justify a full value assessment using the monetary estimation process or a conjoint study described in Chapter 2. They would be better served by relying on past experience and readily available data to form a rough estimate of customer value as a means of setting a price ceiling. When pricing a more differentiated product, however, the insight gained from thorough value estimation can substantially improve the price setting choice.

The process is grounded in the premise that prices should be set at the segment level to reflect value differences and to maximize profitability as described in Chapter 3. For companies that have historically used a “one size fits all” approach to pricing, this segmented approach can be a significant change. It requires managers to think less about what price will sell the most products and more about how to use price to capture the different values they create. The first step in the process is to set an initial price window defined by a price ceiling and floor for each segment. This band provides the “guardrails” for the organization to ensure that no matter what kind of price pressures are confronting managers, the final price will not inadvertently trigger unexpected reactions from competitors and customers.

The second step in the process involves determining the amount of differential value to be captured with price. A common mistake made by novice

EXHIBIT 6-1 Overview of the Price Setting Process

pricing strategists is to always seek to capture the maximum amount of differential value possible. For these managers, strategic pricing becomes a mechanism for raising prices and little else. But true strategic pricing requires a more insightful approach to price setting that discerns when it is more profitable to allow the customer to keep more value as a purchase incentive. Small companies vying for sales volume to bring their costs down, for example, might appropriately price their offerings to capture less value so they can increase market share. Similarly, first-time customers may feel that a purchase is more risky than long-time buyers and, hence, may be legitimately more price sensitive and merit a lower price. The price-setting process outlined in Exhibit 6-1 accounts for these factors as well as others to ensure that the price maximizes profitability.

Having arrived at a preliminary price point through the analytics in steps one and two, the final step is to communicate new prices to the market. This requires careful consideration to ensure the prices are perceived to be fair even when they represent a premium to past prices or prices offered by less differentiated competitors.

Defining the Price Window

The price window is set for each segment and is defined by the ceiling, the highest allowable price point, and the floor, the lowest allowable price point. We begin the price setting process by establishing the price window for each segment and then, in step two, narrow that window based on strategic objectives for the segment and potential customer responses to the new prices. The price points for the price ceiling and floor will differ depending on whether the product is positively or negatively differentiated as shown in Exhibit 6-2.

In both cases, the price ceiling is determined by the economic value created for customers. If the price were set higher than the economic value, then customers would be better off buying the competitor’s product even though they might very much want (or need) some of the differentiated value of your offering. Suppose you were pricing a product with a total economic value of $140 comprised of a $100 reference price and $40 of net differential value as shown below. A customer buying your product at a price of $150 would find themselves with a net benefit loss of $10. The same customer would have a net gain of $10 if they purchased from your competitor, even though they would have to forgo some of the differential value offered by your product.

EXHIBIT 6-2 Defining Price Windows

The price floor for a positively differentiated product is determined by the competitor’s reference price because it represents an important tipping point for competitive response. Suppose that we chose to set our price for the product in the previous example at $90, which is $10 below the reference value. We can see the implications for such a move by calculating the economic value of the competitor’s product, as illustrated below. By pricing below the competitive reference price, we have placed the competitor in an untenable position in which their product creates negative economic benefit for customers—a situation they can reverse in the short term only by cutting the price. Indeed, if their price ceiling is their total economic value, then you could expect a cut in excess of 50 percent as your competitor tries to stave off significant volume loss.

As this example illustrates, the price floor for a negatively differentiated product cannot be the competitive reference value because that would place the floor above the price ceiling defined by the economic value (see graphic illustration on right side of Exhibit 6-2). The limiting factor for a negatively differentiated product is the relevant costs of the offering that are defined as those that determine the profit impact of prices. We define these costs and discuss their role in pricing in depth in Chapter 9 and, thus, will not repeat that discussion here. Instead, it is sufficient to point out that the price window for negatively differentiated products is lower than those that are positively differentiated, and it is important to allow those offerings to maintain lower prices in order to maintain stable market prices.

Establishing an Initial Price Point

Once the price window has been defined for different customer segments, the next step is to determine where, within that window, the initial price should be set. The decision should not be driven by altruism but rather by judgment about what will yield long-term, sustainable profits. Leaving more of the economic value “on the table” can, other things equal, induce customers to migrate to a new product or service more quickly. They will not first need to fully understand the value if they can see that it is much greater but the price is only a little more. Moreover, the seller saves the cost of having to educate customers and the low price, and quick market uptake discourages competitive entry. On the other hand, if the product’s differentiation is likely to be sustainable for a long time, setting price significantly below value to drive sales may require forgoing a lot of potential margin over the long term. Unless value is initially established and paid by the early adopters, it can be difficult if not impossible to raise prices to value-based levels later on.

There are three considerations when determining where in the price window to set the initial price:

1. Alignment with Overall Business Strategy: Pricing is but one element of the firms marketing and sales strategy and it is important that price levels reinforce the overall business strategy. When Jeff Bezos founded Amazon.com in 1995, his goal was to grow market share quickly in the retailing sector before any competitor could enter and duplicate the company's business model. His pricing strategy was to undercut traditional retailers so much that customers would be willing to switch their purchases to the new Internet channel. Although Amazon.com creates significant differential value through quicker search, greater selection, and customer reviews, a premium pricing strategy intended to capture that value would not have advanced the company's mission.
2. Price-Volume Trade-offs: The inability to establish fences between different segments will force a seller to make trade-offs between price and volume. The financial impact of these trade-offs is determined primarily by a firm’s cost structure. If a firm’s costs are primarily variable (as in grocery retailing and personal service businesses), its percent contribution margin (the amount of each sale that contributes to fixed costs and profit), will tend to be low as well. As a result, small decreases in price require large increases in volume to be profitable. In contrast, if costs are primarily fixed (as in software, pharmaceuticals, and publishing), the percent contribution margin will tend to be high. As a result, small decreases in price will require much smaller increases in volume to improve profits because each additional sale adds significant contribution to profit. These concepts, and the calculations to support them, are developed further in Chapters 9 and 10. However, it is essential that the underlying economics of the price volume trade-off be understood at this stage of the price setting process.
3. Customer Response: Perhaps the most challenging question when setting prices is “how will customers respond to the new prices?” There are many non-value related factors that can affect the degree to which price influences a customer’s purchase decision. If the expenditure is small for the segment of customers, or if someone else is paying the bill, then a seller can win sales even while pricing to capture a high share of the economic value to that segment. This is why small impulse purchases such as candy bars and gum are rarely, if ever, discounted. On the other hand, if customers feel the price is unfair, even when justified by value, they will tend to be highly price sensitive and less likely to buy. The amount of differential value that can be captured depends upon how successful marketers are identifying and mitigating those non-value factors that drive price sensitivity.

Understanding each of these three factors in detail enables a manager to determine the extent to which price should be used to capture value or to drive volume in each segment. We discuss each of these factors in more detail below.

Pricing Objectives

Few decisions that marketers make influence customer behaviors as much as pricing. That is why it is essential that price levels be set in a way that supports and advances the broader marketing objectives of the firm. When Microsoft dropped prices on its Windows operating system by as much as 40 percent in 2009, the move was consistent with the company’s long-held goal of maintaining and growing market share. The critical question for Microsoft managers was whether the price cuts would result in higher profits over the long-term. It is easy to envision scenarios in which competitor response limits any volume gains from the price cuts, thereby reducing profitability. If Microsoft’s primary business objective was to increase profitability and market share, it might have been better served by maintaining a premium pricing strategy, even at the expense of some lost volume.

To be useful, pricing objectives must be set relative to some reference point. Given the strategic importance of customer value to the overall pricing strategy, we define pricing objectives in terms of the percentage of value captured with price. This decision should be driven by judgments about what will yield long-term, sustainable profitability. As noted earlier, a low price will, other things equal, induce customers to migrate to a new product or service more quickly. On the other hand, if the product’s differentiation is likely to be sustained, a low price established to drive sales means foregoing considerable margin over the long run because it is difficult, if not impossible, to raise prices later. There are three options for setting prices: skimming the market, penetrating the market, and neutral market pricing. Let’s examine the conditions under which each option is appropriate.

OPTION 1: SKIM THE MARKET Skim pricing (or skimming) is designed to capture high margins at the expense of large sales volume. By definition, skim prices are high in relation to what most buyers in a segment can be convinced to pay. Consequently, this strategy optimizes immediate profitability only when the profit from selling to relatively price-insensitive customers exceeds that from selling to a larger market at a lower price. In some instances, products might reap more profit in the long run by setting initial prices high and reducing them over time—the “sequential skimming” strategy we discuss below—even if those high initial prices reduce immediate profitability.

Buyers are often price insensitive because they belong to a market segment that places exceptionally high value on a product’s differentiating attributes. For example, in many sports a segment of enthusiasts will often pay astronomical prices for the bike, club, or racquet that they think will give them an edge. You can buy a plain aluminum canoe paddle for $35. You can buy a Bending Branches Double Bent paddle (wood laminate, 44 ounces) for $149. Or you can buy the Werner Camano paddle (graphite, 26 ounces) for $249. The Werner Camano not only makes canoeing long distances easier but also signals that one belongs to a select group that has a very serious commitment to the sport.

Of course, simply targeting a segment of customers who are relatively price insensitive does not mean that they are fools who will buy at any price. It means that they can and will pay fully for the exceptionally high value they place on perceived differentiating benefits. Thus skim pricing generally requires a substantial commitment to communicate the benefits that justify a high price. If effective value communications are neither practical nor cost-effective, then the firm must limit its pricing to reflect what it can communicate or to what potential customers are likely to believe from what they can observe.

The competitive environment must be right for skimming. A firm must have some source of competitive protection to ensure long-term profitability by precluding competitors from providing lower-priced alternatives. Patents or copyrights are one source of protection against competitive threats. Pharmaceutical companies cite their huge expenditures on research to justify the skim prices they command until a drug’s patent expires. Even then, they enjoy some premium because of the name recognition. Other forms of protection include a brand’s reputation for quality, access to a scarce resource, and preemption of the best distribution channels.

skim price isn’t necessarily a poor strategy even when a firm lacks the ability to prevent competition in the future. If a company introduces a new product at a high price relative to manufacturing cost, competitors will be attracted by the high margin even if the product is priced low relative to its economic value. Pricing low in the face of competition makes sense only when it serves to deter competitors or to establish a competitive advantage. If a low price cannot do either, the best rule for pricing is to earn what you can while you can. If and when competitors enter by duplicating the product’s differentiating attributes and, thus, undermine its competitive advantage, the firm can then reevaluate its strategy.

Sequential skimming can be a more appropriate strategy for products and services with low repurchase rates. The market for long-lived durable goods that a customer purchases infrequently, or products that most buyers would purchase only once, such as a ticket to a stage play, can be skimmed for only a limited time at each price. Skimming, in such cases, cannot be maintained indefinitely, but its dynamic variant, sequential skimming, may remain profitable for some time.

Sequential skimming, like the more sustainable variety of skimming, begins with a price that attracts the least price-sensitive buyers first. After the firm has “skimmed the cream” of buyers, however, that market is gone. Consequently, to maintain its sales, the firm must reduce its price enough to sell to the next most lucrative segment. The firm continues this process until it has exhausted all segments with profitable volume potential. In theory, a firm could sequentially skim the market for a durable good or a one-time purchase by lowering its price in hundreds of small steps, thus charging every segment the maximum it would pay for the product. In practice, however, potential buyers catch on rather quickly and begin delaying their purchases, anticipating further price reductions. To minimize this problem, the firm can cut price less frequently, thus forcing potential buyers to bear a significant cost of waiting. It can also launch less attractive models as it cuts the price. This is the strategy Apple followed when it introduced the iPod. The fist iPod was priced at $399. Rather than follow a traditional sequential pricing strategy and cut the price some time after launch, Apple introduced the iPod mini and the iPod shuffle with more limited functionality and lower price points. Over time, Apple has increased the functionality and value for each of its products while generally maintaining the price points. This variant to sequential skimming has been described as “pushing down the stack” and is used frequently in other technology markets such as semiconductors and cellular phones.

OPTION 2: PENETRATE THE MARKET Penetration pricing involves setting a price low enough to attract and hold a large base of customers. Penetration prices are not necessarily cheap, but they are low relative to perceived value in the target segment. Hyundai, for example, used a sustained penetration pricing strategy to enter the U.S. market in which the company offered high value in the form of reliability, 10-year warranties, and well-appointed interiors at prices far below those of Japanese makers such as Toyota or Honda. Similarly, Target and Trader Joe’s stores have positioned themselves as offering the same or better value as their competitors at lower prices.

Penetration pricing will work only if a large share of the market is willing to change brands or suppliers in response to lower prices. A common misconception is that every market will respond to lower prices, which is one reason why unsuccessful penetration pricing schemes are so common. In some cases, penetration pricing can actually undermine a brand’s long-term appeal. When Lacoste allowed its “alligator” shirts to be discounted by lower-priced mass merchants, high-image retailers refused to carry the product and longer and traditional Lacoste customers migrated to more exclusive brands.

Of course, not all buyers need to be price sensitive for penetration pricing to succeed, but enough of the market must be adequately price sensitive to justify low pricing. Warehouse clubs such as Sam’s, Costco, and B.J.’s Wholesale Club have used penetration pricing to target only buyers willing to purchase in large quantities. Charter vacation operators sell heavily discounted travel to people who do not mind inflexible scheduling. Discount retail stores such as T.J. Maxx, Marshall’s, and Trader Joe’s target those price-sensitive customers willing to shop frequently through limited and rapidly changing stocks to find a bargain. Some wholesalers of sheet steel use penetration prices to attract the high-volume buyers, who require no selling or service and who buy truckload quantities.

To determine how much volume one must gain to justify penetration pricing, a manager must also consider costs. Conditions are more favorable for penetration pricing when incremental costs (variable and incremental fixed) represent a small share of the price, so that each additional sale provides a large contribution to profit. Because the contribution per sale is already high, a lower price does not represent a large cut in the contribution from each sale. For example, even if a company had to cut its prices 10 percent to attract a large segment of buyers, penetration pricing could still be profitable if the product had a high contribution margin. In order for the strategy to pay with a 90 percent contribution margin, the sales gain would need to exceed only 12.5 percent. The lower the contribution per sale, the larger the volume gain required before penetration pricing is profitable.

Penetration pricing can succeed without a high contribution margin if the strategy creates sufficient variable cost economies, enabling the seller to offer penetration prices without suffering lower margins. The price sensitivity of target customers enables penetration-priced retailers to vary the brands they offer depending on who gives them the best deal, thus increasing their leverage with suppliers. The penetration prices of Save-A-Lot grocers (a division of Supervalu Inc.) enables them to maintain such high turnover, high sales per square foot, and high sales per employee that they can offer rock-bottom prices and still earn higher profits than traditional grocers do.¹ To cite a manufacturing example, as personal computer users became more knowledgeable buyers, manufacturers such as Dell and Gateway leveraged the economies of mail-order distribution to sell high-quality products to knowledgeable buyers using penetration pricing. Competitors who distributed through retail stores could not match their prices.

For penetration pricing to succeed, competitors must allow a company to set a price that is attractive to a large segment of the market. Competitors always have the option of undercutting a penetration strategy by cutting their own prices, preventing the penetration pricer from offering a better value. Only when competitors lack the ability or incentive to do so is penetration pricing a practical strategy for gaining and holding market share. There are three common situations in which this is likely to occur:

1. When the firm has a significant cost advantage and/or a resource advantage so that its competitors believe they would lose if they began a price war
2. When the firm has a broader line of complementary products, enabling it to use one as a penetration-priced “loss leader” in order to drive sales of others
3. When the firm is currently so small that it can significantly increase its sales without affecting the sales of its competitors enough to prompt a response

As telecom markets have opened to competition in most developed countries, new suppliers have successfully used penetration pricing to capture market share. The low variable costs of carrying a call or message make such a strategy desirable. Regulatory constraints and the unwillingness of large, established competitors to match the lower prices of new entrants on their large installed base of customers has made the strategy successful in many markets. Many telecom managers would question whether the heavy reliance on penetration strategies was a wise choice over the long term because it conditioned consumers to seek deals and may have accelerated the decline in prices for the entire market.

OPTION 3: NEUTRAL MARKET PRICING Neutral pricing involves a strategic decision not to use price to gain market share, while not allowing price alone to restrict it. Neutral pricing minimizes the role of price as a marketing tool in favor of other tactics that management believes are more powerful or cost-effective for a product’s market. This does not mean that neutral pricing is easier. On the contrary, it is less difficult to choose a price that is sufficiently high to skim or sufficiently low to penetrate than to choose one that strikes a near perfect balance.

A firm generally adopts a neutral pricing strategy by default because market conditions are not sufficient to support either a skim or penetration strategy. For example, a marketer may be unable to adopt skim pricing when buyers consider the products in a particular market to be so substitutable that no significant segment will pay a premium. That same firm may be unable to adopt a penetration pricing strategy because, particularly if it’s a newcomer to the market, customers would be unable to judge its quality before purchase and would infer low quality from low prices (the price–quality effect) or because competitors would respond vigorously to any price that undercut the established price structure. Neutral pricing is especially common in industries where customers are quite value sensitive, precluding skimming, but competitors are quite volume sensitive, precluding successful penetration.

Although neutral pricing is less proactive than skimming or penetration pricing, its proper execution is no less difficult or important to profitability. Neutral prices are not necessarily equal to those of competitors or near the middle of the range. A neutral price can, in principle, be the highest or lowest price in the market and still be neutral. Sony TVs are consistently priced above competitors, yet they capture large market shares because of the high perceived value associated with their clear screens and reliable performance. Like a skim or penetration price, a neutral price is defined relative to the perceived economic value of the product.

Defining the Price-Volume Trade-Off

The second factor that must be understood when determining where to set price levels is the relationship between changes in price and volume. Economic theory indicates that profit-maximizing prices are found at the point on the demand curve where marginal revenue is equal to marginal cost. While this price-setting theory is elegant and clear, setting prices in practice is considerably more difficult. Identifying marginal revenues is challenging because revenues are dependant on multiple factors such as the relative size of the increase (for example, is it a significant portion of the customers’ expenditure?), the visibility of the price increase in the market, and competitor response, to name a few. Although marketers have many techniques available to them for estimating customer response (which we discuss later in this chapter), all of them have some uncertainty associated with their estimates.

Just as estimating customer response is challenging, many marketers struggle to determine the relevant costs for a pricing decision. One might think that determining the relevant costs for pricing would be straightforward given the ubiquity of sophisticated enterprise software systems and data warehouses in use today. As we explain in more detail in Chapter 9, relevant costs are those that are incremental (not average) and avoidable (not sunk). In practice, identifying relevant costs can be challenging because much of the data available to marketers is averaged (for example, the average labor rate) or loaded with non-avoidable costs such as corporate overhead.

This point is illustrated by the experience of one of this book’s authors when he was starting his first job as a pricing analyst for a global manufacturing firm. On his first big pricing project, he went to the director of corporate pricing to ask where he could find the cost data for the product. The director showed him where to find the data and then told him “. . . you need to understand that our system will spit out a cost number for any product you are interested in . . . but that number is created for accounting purposes and has almost no relationship to the relevant cost of the product because it is fully loaded with overheads.” Needless to say, it was a rude awakening for an idealistic analyst well versed in theory but inexperienced in the workings of the real world.

Rather than attempting to determine marginal revenues and costs, we advocate that marketers follow a sequence of steps to first understand the financial trade-offs between price and volume and then analyze the market to estimate consumer response. Rather than attempt to answer the impossible question of “How will sales change following this price change,” we suggest that managers focus on a more useful pair of questions to guide their pricing choice:

• How much volume could I afford to lose before a particular price increase would be unprofitable?
• How much volume would I have to gain in order for a particular price decrease to improve my profitability?

These are more useful questions because they provide directionally sound guidance about profit-maximizing prices without a detailed volume estimate. Instead of developing future volume and profit estimates with a false sense of precision, it is better to gain a definitive understanding of the price-volume trade-offs using a simple, yet powerful, break-even analysis.

Incremental break-even analysis can be implemented on a spreadsheet and easily combined with both data and managerial judgment to make price adjustments that improve profitability. Although similar in form to the break-even analyses commonly used to evaluate investments, incremental break-even analysis for pricing is quite different in practice. Rather than evaluating the price and volume required for the product to achieve overall profitability, incremental break-even analysis focuses on the change in volume required for a price change to improve profitability. Using only the size of the price change and the contribution margin of the product as inputs, the break-even % sales change demonstrates the degree to which volume is required to make the price change profitable, as illustrated in Exhibit 6-3. This exhibit shows how much unit volume must change for a given price change to produce an equivalent profit, depending on the product’s contribution margin before the price change. (We will describe incremental break-even analysis in more detail in Chapter 10.)

EXHIBIT 6-3 Incremental Percent Break-Even Sales Changes

One of the benefits of the break-even sales change approach is practicality. Very few pricing decisions are made with the luxury of knowing in advance how competitors and customers will respond to them. Even the most statistically rigorous research techniques (discussed in Chapter 12) rely either on making inferences from past data or rely on customer responses to surveys of their intentions, neither of which is highly reliable. Most managers must make decisions with less quantitative information than that. Incremental break-even analysis enables managers to deal with the judgments they must make despite that uncertainty. In our experience, managers who report that they have no idea what their customers’ demand curve looks like, or even how much more customers would buy if prices were 10 percent lower, can and will estimate comfortably the probability that sales will change by more than the break-even number. Fortunately, that is all the information they need to conclude whether or not the decision is directionally correct.

Estimating Consumer Response

Once the price-volume trade-offs are understood, the next consideration is to estimate how consumers are likely to respond to a potential price change in order to balance the potential profit impact against the risks. One of the major drivers of how consumers respond to new prices is the degree to which factors other than value influence willingness-to-pay. People casually call this “price” sensitivity, but it is really sensitivity to the price-value trade-off. If the expenditure is small or if someone else is paying the bill (for example, expenses for business travelers), then a new competitor or established player can win sales even while capturing a high percentage of the value provided. Conversely, if customers believe prices to be unfair, even when justified by value, they will be highly sensitive to the price-value trade-off. Researchers have identified a wide variety of factors influencing price-value sensitivity, which we have summarized in Exhibit 6-4.

Marketers must understand which of these price sensitivity drivers are relevant for their particular products in order to influence them favorably through price and value communications. One of the major differences between tactical and strategic pricing is that tactical pricing assumes that price sensitivity is a constant that cannot be influenced. That assumption, which often is made implicitly, simplifies price setting by reducing it to a measurement task. But experienced marketers understand that this simplification comes at a cost, because thoughtful price and value communications can decrease price sensitivity and support higher prices with less adverse volume impact than would have been expected.

In some instances, it is beneficial to perform research to estimate which of the sensitivity drivers are most important for a particular product and purchase context. In other cases, it is sufficient to estimate customer response at a more aggregate level and use managerial judgment to identify which factors can be influenced through communications. These aggregate approaches, ranging from the most sophisticated and costly to the least effective but easy to implement are: controlled price experiments, purchase intention surveys, structured inferences, and incremental implementation. A thoughtful choice from among these options involves trade-offs between the cost to implement and the quality of data gained to aid in making the pricing decision.

Price experimentation involves testing new prices on a controlled sample of customers before rolling the price change out to the entire market. After we helped a large business-to-business distributor restructure its pricing into three different service options, it had to reset price points for various products in its line. The distributor did so by experimentally rolling out the new price structure to approximately 180 of its more than 1,000 value-added resellers (VARs). The rest of its value-added resellers served as a control group. After three weeks, a second round of price adjustments, some up and some down, were made based on the degree to which sales exceeded or fell short of the break-even sales changes for each product category. After a final iteration a few weeks later, the profit improvement from the new structure and levels was clear and the new pricing was rolled out to the entire market.

Price experimentation is most useful when the cost of implementing the change is low and useful comparisons can be made between the experimental and control groups. The online environment is ideally suited to price experiments because the cost to implement new prices is minimal and it is difficult for some customer to realize they are seeing different prices than others. This ability to customize prices at the individual customer level is invaluable to the ability to conduct price experiments. However, it carries the risk of customer backlash if customers discover they are not being treated the same as others. Amazon.com found this out when customers discovered that the price they were charged to purchase a DVD varied depending on the data stored in a cookie on the customer’s computer. Although Amazon was simply trying to discover the profit maximizing price points for various types of DVDs, customers viewed the practice as exploitive and put enough pressure on the company so that it chose to discontinue the experiment.

Purchase intention surveys can be used when price experimentation is impractical, as is the case for many large, infrequently purchased products (such as automobiles and enterprise software) that don’t lend themselves to experimentation. In those cases, surveys of various types and sophistication can be used to uncover customer product preferences at various price points. By comparing differences in responses at different price points, and by adjusting for historical biases in responses, researchers can infer how customers would respond if faced with those price differences in actual purchase situations. Chapter 12 describes the benefits and costs of alternative survey techniques.

Structured inference by managers is an approach that leverages managerial market knowledge combined with appropriate analysis to arrive at a sound price point. Structured inferences can range from the highly formal and statistical to the purely judgmental. In all cases, the idea is to use results that managers have seen in the past to estimate the likelihood that they will achieve the necessary break-even sales changes under new conditions. For example, in one case we built a model for a chain of newspapers that in the past

had initiated multiple price changes at different locations. By pooling data and controlling statistically for differences in demographics and market conditions across geographies and time, we were able to create rough models that predicted the impact of future price changes accurately enough to justify additional profitable price changes. After each change, the publisher added the new data generated to the database, which management could use to make inferences about the effect of future price changes.

When companies lack historical data on their own products, as is common for new product launches, they often look for surrogate information about the impact of price differences in other geographic markets, or on similar products in the same market. For example, pharmaceuticals companies look for “analogs” when launching a new product to get some idea of how much of the value they might successfully capture. They look at what happened, both in their same category and ones they deem similar, when earlier drugs were launched with price premiums reflecting their value, and compare that to the market penetration gained by drugs priced closer to parity. Such analysis reveals that the ability to capture value varies widely depending on the category of disease being treated and the type of differentiation offered.

Incremental implementation can work when none of the other methods for estimating customer response are practical or reliable enough to produce confident inferences. This approach often works well for products for which price changes are not very costly to make or reverse. In this approach, managers simply test customer response by making limited price changes in a series of small steps. The goal is to gradually arrive at a profit-maximizing price point while minimizing the risk of a pricing blunder that could have long-term negative effects. For example, a maker of distinctive pre-manufactured homes slowly repositioned its brand from being a cheaper alternative to being a premium-priced product with distinctive value in design and reliability. During that period, it raised prices a few percentage points more each year than the prices of similar traditional homes and tracked the effect on its sales relative to the industry. When the changes no longer improved profits, the manufacturer stopped making them.

Simulations provide a means to explore systematically the effects of competitor reactions to customer responses to a price change. Simulations combined with an appropriate decision framework provide a deeper understanding of the upside potential of a price change as well the potential downside risks. They also provide a powerful tool to compare different pricing strategies and develop action plans to manage identifiable risks. By performing thousands of simulated “runs” of the strategy, it is possible to estimate the distribution of potential outcomes for each strategy. To illustrate, Exhibit 6-5 shows a risk profile for a skim pricing strategy. Using this analysis, managers can make informed, thoughtful decisions about the trade-offs between the risk and the potential gain of alternative strategies. Instead of assuming away uncertainty, the analytic approach accounts for risk in a way that facilitates more effective decision making.

EXHIBIT 6-5 Risk Analytic Output from Profitability Analysis

Communicate New Prices to the Market

The final task in setting the price level is to ensure that new prices are communicated to the market. The most important consideration when communicating price changes to customers is that they understand the rationale for the change and believe it to be fair. Perceived fairness is one of the most powerful factors driving price sensitivity. Done correctly, communicating fairness can have dramatic effects. For example, a well-known medical device manufacturer successfully implemented a 40 percent price increase for one of its key products by carefully communicating why such a large increase was fair. The company recognized that it had made a tactical mistake by not raising prices annually along with industry practice, so it notified customers three months in advance of the increase to allow them to plan for the new prices. Not surprisingly, some customers “bought forward” at the lower prices, loading up before the price increase. But, giving them an option for dealing with the change made the company’s decision seem fair and reasonable.

To further communicate fairness, the company’s letter to customers noted it had not taken an increase in eight years and the new price was still less than what it would have been had they increased prices in line with the medical device price index. Finally, the sales force met with each major account to explain that, prior to the price increase, the product was not generating sufficient returns to fund continued research and development (R&D). This was important to hospitals and doctors who relied on the company, a technology leader, to bring innovative solutions to market. Moreover, it communicated the inherent fairness of the price change by explaining that much of the additional profit would be invested in R&D and returned to customers in the form of new products rather than end up in executive and shareholder pockets.

Just as there are different reasons for price changes, there are different approaches to communicating fairness. In some instances, rising raw material costs requires a price increase. In such situations, customers are concerned about whether the vendor is being opportunistic by raising prices more than is justified and whether all customers are being treated equally. To communicate fairness in these situations, first send a letter, e-mail, or press release to all customers simultaneously that explains why across-the-board price increases are necessary. Tie the increase clearly to the cost increase (for instance, “Energy prices have increased 24 percent; energy accounts for 10 percent of the price you pay, so prices must increase by 2.4 percent”) and be prepared to provide documented evidence. Where possible, index your prices to an objective measure of raw material costs such as a published commodity price index. Customers, and competitors, too, are more likely to accept a price increase if they know that prices will come back down when costs are lower. Indexed pricing is especially useful in times of significant price spikes because indices can be adjusted monthly or weekly depending on the frequency of raw material price changes.

Second, avoid being opportunistic by attempting to gain share by compromising on the increase. It can be tempting to waive a 5 percent increase for customers willing to give you 20 percent more volume, particularly in industries with excess capacity. But such an action is shortsighted because your competitors cannot afford to lose volume any more than you can. Although being opportunistic may lead to a short-term volume increase, it will surely invoke a competitive response and send a clear message to customers that the rationale for the price increase was not legitimate.

Finally, be prepared to play hardball with competitors who are opportunistic about the increase and cut deals like the one just described. Your ability to pass along cost increases will be undercut if even one credible supplier does not go along with it. Combined, these tactics send a clear message to customers that the price increase is fair and will be evenly enforced.

Another situation that requires communicating fairness occurs when a company increases prices after underpricing its products relative to the value delivered. This occurs frequently when companies begin to assess the economic value of their products for the first time and discover that they have an opportunity to increase price if they communicate value more effectively. The fairness issue stems from the fact that the company wasn’t charging for value in the first place, so why start charging for it now? This is a legitimate question, the answer to which should be that over time, all prices will be adjusted to align with value. In some cases, this will mean lower prices and in others, higher prices.

To ensure that customers do not think that price increases are being forced on them, offer them options on how they can adjust to the new prices. For example, when large customers resist the price change, offer them the ability to “earn” lower prices by increasing the share of their total spend that they spend with you. Alternatively, be prepared to unbundle the core offering from services and other value-adds in order to provide a lower-value option at the old price. Whichever approach the company adopts, it is critical that customers pay for the value received. By providing choices for how that happens, you increase the perception of fairness and improve the odds that the price change will be successful.

Summary

Despite the sophisticated tools and analytics available to marketers, price setting ultimately comes down to using informed judgment to find a price that balances costs, customer value, and competitor responses. The process we have described in this chapter when followed by managers well informed about their markets and basic pricing knowledge, will lead to sustainable and profitable prices.