The Price Advantage

Nov 17 2010

“There is no victory at bargain basement prices.”  - Dwight D. Eisenhower

The price is right?

I have spent a lot of time over the last week in discussions with clients over the pricing of work, and it’s something that I believe the market research industry does very badly (even though we sell pricing research).  So I am very glad to have also been reading The Price Advantage at the same time, which contains some great advice in thinking strategically and long term about the business impact of pricing decisions.

In many ways the whole book follows from the opening chapter which explains in clear and simple terms how pricing decisions have more impact on profitability and business sustainability than any other levers. They look at the income statements of an aggregation of 1,200 large publically held companies from around the world and show the relationship between their price, fixed costs, variable costs and operating profit.  If price is indexed to 100, then fixed costs are around 20.5% of this (on average), variable costs 68% and operating profit 11.5%.  This will of course will vary depending on the kind of business you run, but serves as a good benchmark for assessing price changes.

Show me the money

Based on these relationships, what is the impact of changing price?  A one percent increase in price, to 101, assuming volume remains constant along with fixed costs, leads profit to increase from 11.5 to 12.5 (a 9% rise).  That’s quite a bang for your buck, and shows that very small improvements in price translate into huge increases in operating profit.

Too often we focus on changes in revenue and costs rather than changes in price, but if we were to increase the 1% price rise to 3% (which is not outrageous, if done after careful consideration), then the profit jump is 25%!  Pricing is by far and away the most powerful lever any company has in their toolbox.

Securing the future

Using the same figures from the global 1,200 average, then every 1% increase in price yields 9% more profit, 1% reduction in variable costs yields 6% more profit, 1% increase in volume yields only 3% more profit and a 1% reduction in fixed costs yields only 2% increase in profits.  So big programs of reducing headcount just don’t have the same bottom line impact as initiatives which can support even small increases in price. It’s also helpful to look at things from the opposite perspective, as no lever can drop profits through the floor as quickly as pricing.  If the average price slips 1% to 99 in the same example, then operating profits decrease to 10.5 (a reduction of 9%).

So what does that really mean for my pricing conundrums and what is the best strategy when trading off price against volume?  Essentially this is not a trade off at all, but a one horse race.  If a business reduces prices by 5%, then it needs an almost 20% volume increase to sustain the same level of profitability.  This is a huge, and highly unlikely, increase in volume which would be equivalent to a price elasticity of -4 (I’ve never seen it that high in any business I’ve researched!).  That’s twice the elasticity of even the most impulsive markets.

These trade offs are not symmetrical. A 5% price increase would maintain or increase profits at the same level even if volume declined up to 14%!

Trading up

Market research as an industry has all too often resorted to the most unhelpful of pricing tactics in order to maintain or grow share, but this comes at a huge long term cost.  Cost pressures if reacted to ultimately depress market prices and erode everyone’s profits.

Elasticity is a straightforward concept showing how price changes impact volume sold and hence revenue and profit.  However, although conceptually easy, elasticity is complex in practice as it should never be used as a single number to describe a brand or category.  In practice, elasticity is complicated by many factors:

  • elasticity is non-linear, and changes as pricing moves away from the average
  • elasticity varies by segment, as different customers have different needs and seek different benefits, so some segments may even be inelastic to pricing
  • elasticity varies by occasion, and the context in which a product is bought will influence elasticity dramatically (and is often linked to segments) – an impulse purchase may show very different price elasticity to a pre-planned purchase
  • elasticity changes over time
  • elasticity depends on the method of communication (eg daily rate vs hourly rate vs total cost)

Jaw jaw not war war

Low price advantages over competitors are almost always short lived.  Attempting to increase your share by dropping prices more often leads to retaining your original share at lower prices – not a smart business move.  When prices drop, customers’ expectations change and their perception of price reference points becomes distorted, remaining so long after a price war ends and often re-setting the category pricing for the long term.  Research shows that the lowest price someone has paid for a product is the one that they often remember best, and therefore acts as an anchor or reference point for their future purchases.

More importantly, and worryingly, customers become sensitised to price at the expense of product benefits when price is the focus of market activity.  So even if you sell a superior product, and charge more than your competitors, then taking customer attention away from these benefits can upset the balance of price vs benefits makingyour customers less benefit sensitive.  Price wars change perceptions of your products, usually adversely and very often for a long time. Price wars are to be avoided at all costs (no pun intended).

The research advantage?

This is a great book, and contains further advice on how to price for markets, individual products and also at a transactional level as well as examples and case studies of pricing in different categories and contexts.  I would recommend it to anyway making price decisions (or conducting price research).

Market research has done itself some great disservice in the past, and especially over the past two years, in focusing attention on pricing as a lever to drive share (often with client collaboration).  In most cases, the share has not been sustained, and all that has happened is that prices and margins have dropped for everyone.

A recent thread on LinkedIn, has discussed the challenges and barriers for market research to be accepted by senior management in client companies. Although I am only a small operator trying to negotiate with the big boys, I believe one of my key challenges is to sell the value of what I do, and charge appropriately.  If I sell myself short on price, then I will always struggle to have my value appreciated. Small and big alike, the market research industry has to face up to the same challenge.

REFERENCE

The Price Advantage by Baker, Marn & Zawada

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