Six Steps to Strategic Pricing
By: Mark Bremer and Rafi Musher

For many companies, pricing is more art than science. A lack of precise data about customer preferences leads many pricing managers to make decisions based on "feel" rather than facts. Lately, sluggish demand, overcapacity, and Web-enabled comparison shoppers all seem destined to drive prices down to their lowest common denominator: what the competition charges, or what the best customers get.

 

Yet pricing need not be an economic endgame. In fact, pricing should be a powerful lever for achieving specific business goals. Analytic frameworks supported by new technologies are enabling some companies to develop pricing strategies based on reliable predictors of customer behavior. Some are maximizing margins by eliminating unwanted features. Others are increasing penetration by tailoring products for more precisely defined segments or expanding the market by adding new features. Taking a focused and disciplined approach, managers can put strategy back into pricing by following six basic steps.

 

1.  Know your strategic business objectives: Developing your pricing strategy begins by asking: “What are we trying to achieve?” Organizations need to be very specific about this, because broad generalities such as “being the market leader” will not provide the direction needed to make tough decisions. The pricing strategy required to drive penetration often differs from the one needed to gain market share, which in turn differs from the pricing strategy that will grow revenues or maximize margins. Starting with a clear set of strategic objectives will make pricing strategy decisions much easier once you develop a good understanding of how customers respond to different offerings.

 

2.  Embrace the science of pricing: Too many pricing and product feature decisions are made using inconclusive or anecdotal evidence. Lacking concrete information, managers are forced to make pricing decisions based on anecdotal experience or personal hunches. This also exposes pricing strategy to the influence of organizational politics, where value-destroying habits can become entrenched as misaligned sales incentives or cost-focused thinking rules pricing decisions.

 

Thinking strategically about pricing begins with the willingness to adopt a disciplined, data-driven approach to pricing strategy. This means using information to discover how price and other product attributes affect customer behaviors, and applying this knowledge to develop a pricing strategy that supports specific strategic objectives.

 

3.  Think in terms of value, not cost: Business strategy is about creating and capturing value. What your organization does—the goods or services it provides, and the activities it performs to provide them—largely determine how your organization creates value. But capturing value is an entirely different discipline, and pricing is the primary mechanism by which any organization realizes its own share of the value it creates.

 

Too many organizations that take a “cost plus” view of pricing with little consideration of business strategy and customer perception of value. Because cost data is often the most readily available information to pricing managers, the “default” approach is often to set prices according to cost.

 

Price and cost together dictate profitability, and profitability is a good indicator of whether or not your organization should be involved in a particular business. But your own cost structure tells you nothing about your customers’ perception of value. Effective pricing strategy is about understanding what the customer is willing to pay—not how much margin the organization is hoping to earn, or willing to sacrifice to boost revenue.

 

4.  Look for patterns of customer behavior: Modeling customer preferences and predicting their willingness to pay has challenged marketers for decades. While many segmentation techniques have attempted to simplify patterns of customer preferences, evidence suggests that the most reliable segmentation models are based on purchase behaviors. Traditional psychographic and demographic data can be very useful in targeting, but modeling customer preferences is often best done through analyzing buying behaviors.

 

Behavior-based modeling is effective because it has proven to be a good predictor of customer response. The best pricing strategists are learning to use more sophisticated research and analysis techniques to identify behavior patterns that are likely to repeat themselves. These are quantitative models that predict what happens at the margin: how incremental changes in the offering—including price and non-price attributes—affect purchase behavior.

 

It is equally important to understand how customers make trade-offs among product features. Many managers overlook product configuration when assessing their pricing strategy options. For example, a price drop on a competing product tends to provoke a natural reaction to match the price decrease. Yet it is not unusual to find untapped sources of value in new product features that can provide the differentiation needed to sustain or even increase prices. Or, there is opportunity to lower prices and drop unwanted features that contribute unnecessarily to product costs.

 

5.  Test your hypotheses: Predictive models can give a sense of how customers will behave given specific choices, but these models are only as good as the data used to build them. The exploratory survey methods often used in new product development or enhancements rely on customer responses to hypothetical situations, not their actual behaviors. No technique can fully predict what will happen in the real world, nor can any amount of modeling overcome the absence of “real world” data.

 

Some organizations are in the enviable position to use powerful software tools to test pricing and identify relevant patterns using live data. Zilliant, a software company, has received complimentary press coverage lately for its exciting work in testing prices in “live” settings. Zilliant’s software enabled DHL to experiment with different price points for phone-in customers to determine revenue-maximizing prices in over 40 markets. Business Week recently described how large retailers analyze millions of sales transactions to alter the timing and extent of product markdowns to improve revenues and margins.

 

Most organizations are not in the position to develop and test pricing strategies using real-time data. Configuring highly analytical software tools to analyze purchasing patterns for hundreds of items across dozens of markets can take months of effort. Thus, the ability to quickly develop hypotheses and rapidly test them in controlled environments is a critical capability for fine-tuning pricing strategy. This is especially important for consumer good companies that use highly targeted promotions and other direct marketing tactics. The best consumer marketing organizations have well-defined processes for quickly developing and testing pricing strategies.

 

6.  Take Action. New analytic frameworks and software tools have made pricing a more scientific discipline. More information has meant more opportunity to study the effects of pricing changes, and some organizations now employ small armies of analysts devoted to price modeling. However, it is critical to maintain an organizational bias toward action, rather than study.

 

Strategic pricing is as much about timely execution as it is about the right information. Some organizations can develop, test, and execute a promotion in as little as four weeks. In general, organizations should be able to research, test, and implement pricing strategy within 2 months. Organizations can shorten their pricing strategy cycle times by taking a more proactive approach to learning from customer behaviors. This starts with accumulating relevant customer transaction data and frequently analyzing it for relevant patterns.

 

Finally, organizations need to be pragmatic about pricing power. This is especially true in multi-level relationships. One client, a small supplier of a highly commoditized consumer good was thrilled to learn that their product was priced in a high-volume retail channel at a lower point on the inelastic part of the demand curve. They could raise the supplier price a few cents, the retailer could pass it on to the consumer, and everyone would be happy. The only catch was that the retailer was Wal-Mart. Any pricing strategy needs to take into account the reality of the company’s position within the value chain.