Pragmatic Pricing

Like most marketing mix variables, pricing is different in small and large companies.  Some of these differences give small companies a clear advantage.

I work as a Director of Pricing at a multi-billion dollar corporation, yet I’ve run a start-up and spend a lot of time coaching small businesses. I’ve experienced the differences and they are stark. The two key advantages for small businesses are setting and executing pricing strategy.

Setting Pricing Strategy

Large corporations are like a boulder rolling downhill.  It’s almost impossible to change direction.  When a company has a pricing strategy in place it is very difficult to change it.  Nobody in a large corporation really owns pricing strategy, except maybe the CEO and he’s too busy with much more important issues (ahem). Besides, everyone in a corporation already implemented their role around the existing pricing strategy.

Small companies don’t have this problem.  Pricing strategy is almost always determined by the executives, and the executives are more closely involved in the business.  They are more likely to see the new strategies that will work.

Take Blockbuster and Netflix.  Someone inside Blockbuster must have come up with the idea to rent DVD’s on a monthly subscription before Netflix, but who would they tell?  How do you get an audience with the CEO to tell him your great idea?  How do you sell your boss so well that he sells his boss as convincingly who then sells his boss as convincingly who then …  You get the picture.  The idea must have been inside Blockbuster’s walls, but couldn’t percolate to the top in a persuasive enough manner.

Executing Pricing Strategy

Once a new pricing strategy is set, small businesses can just go execute.  A few people do most of the work, and they can be redirected.  In a large corporation, policies and procedures dictate how one department interacts with another.  IT systems must be built or modified.  Big change, like a change in pricing strategy, is a herculean task that requires huge change management efforts.

Even if the CEO of Blockbuster liked the idea of renting DVD’s using a monthly fee, it would take at least year to organize the company and get the processes in place to execute this.  Pricing strategies are so intimately tied to so many pieces of the business it’s impossible for a large corporation to change quickly.

As a small business owner, you have the ability to quickly make and execute pricing strategies.  Of course you don’t want to do this often, but you do want to think hard about how you could gain an advantage over your much larger competition.  After all, your competitor will not move quickly.  Use your advantage.

Mark Stiving, Ph.D. – Small business pricing expert

Picture by More Good Foundation

Think about your customers.  What is different about the ones who are willing to pay more vs the ones who need a low price to buy?  How can you charge one group more than another?  Keep thinking.  There are more ideas you haven’t thought of yet.

Here is a brilliant example.  Customers who are price sensitive probably comparison shop.  Customers who are not price sensitive probably just decide what they want and buy it.  In the world of Internet retail, you can tell these customers apart (at least statistically).

This became clear after reading this blog from Upstream Commerce. In it, Gilon Miller points out that you can tell how your website visitors arrived at your store.  If they came from a price comparison site, then they are probably very price sensitive so we want to price more aggressively.  If they came from a product review site, then they probably already know they want our product and are much less price sensitive.  Let’s charge them full price.

This is a wonderful example of price segmentation based on transaction characteristics.

You probably didn’t think up this one on your own (I know I didn’t).  There must be thousands more opportunities for price segmentation out there.  Keep thinking.

Mark Stiving, Ph.D. – Small Business Pricing Expert

Photo by Brian Watkins

Here’s an interesting article titled “Pricing in Reverse” on how to “price” a product based on costs.

The article looked at the cost of an eBook.  Obviously, the variable costs are zero.  However, the article looked closely at the amount of spending required on Google Adwords in order to sell books.  Simplifying the math, here are the conclusions:

Google charges $1.53 per click on the keywords selected.  If we assume a 1.5% purchase rate on people who click through, then we pay $1.53/.015=$102.

That’s right, our advertising costs would come out to $102 per book.  Obviously we can’t sell our book for that much (unless it’s a college text book) so we would end up losing money.  Hence, don’t even bother writing the book.

Yes, it’s not a perfect analysis.  However, it is a great example of estimating all of our costs before we even begin the project. Then we can decide if the project is worth doing.

Most costs don’t drive pricing, but rather they help determine whether or not to even get into the business. How are you using costs?

Mark Stiving, Ph.D. – Small Business Pricing Expert

Photo by Mike Licht

The other day I was talking with someone about price segmentation and he asked me about the Bausch & Lomb situation.  I didn’t know anything about it, so I looked it up.  Here is a detailed description. 

From a pricing perspective, it was brilliant.  B&L took the exact same contact lens, packaged it differently with three different brand names, and had different instructions for how often to replace them: daily, every couple weeks or extended.  The wholesale prices were $5, $8, and $46 (for the exact same lens).

Why was this smart?  They had a market for long life lenses and realized they could make more money by dramatically lowering the price and getting customers to buy more often.  By creating a new version, they didn’t have to lower their prices on the existing business.

If you already know this story though, you know that B&L was sued for this in 1994 and eventually settled.  They weren’t sued for breaking any pricing laws.  Rather, they were sued for fraudulent marketing.  They were misleading their customers into thinking the lenses were different, that they needed to throw away the disposables every day.  (I used to wear disposables and was too cheap to throw them away daily so I’d usually keep them for several weeks.  Now I know I could have kept them even longer.)

B&L had FDA approval every step of the way, but in the end misleading customers is what caught them.  Here is what B&L could have done.  They could have tested their long life lenses with an additional QA check and then guarantee a level of performance to those customers.  This would have added very little additional cost, the products perform the same in the short term but only one is guaranteed for the long term.

What can you learn from this?  Don’t use fraudulent marketing to support your price segmentation.  Price segmentation is used all the time and is not the culprit here.  Continue to pursue means to segment your customers based on Willingness To Pay.  However, don’t intentionally mislead them.

Mark Stiving, Ph.D. – Pricing Expert, Speaker, Author

Photo by maikel_nai

Pricing captures value. Although true, it doesn’t tell the whole story.  Realized profit is a great indicator of how much value was captured.

A recent article estimated that Google makes $1.70 per Android device.  At the same time, Apple makes $576.30 per iOS device.  WOW!

To consumers, Android devices and Apple devices are priced similarly, but the profit difference to the two creators is HUGE.  Why is this?  There are many reasons, but the lesson to take away from this blog is that Apple created a ton of value and figured out how to capture a lot of it.  Google created a lot of value with Android as well, but they share most of that value with other companies.

Apple makes and sells their own hardware, Google licenses Android. Apple sells apps and makes a large percentage, Google doesn’t.  Apple licenses the right to sell accessories, Google doesn’t have control over them.

When Disney first created Disneyland, they bought 510 acres and built the park.  The city of Anaheim grew around the location, with hotels and restaurants popping up and capturing a lot of the value that Disney created.  When Disney created DisneyWorld in Orlando, they bought 25,000 acres and have built 23 of their own hotels.  They knew they created the value and they were able to capture more of it the second time around.

Google is like Disneyland, Apple like Disney World. Both create a lot of value, but Google shares that value with other market players. Apple is able to create value AND capture it.

Here’s your challenge.  What value are you creating?  How much of it are you capturing?  Look around your market and see who else is making money.  Are they capturing value that you create?  Is there a way for you to capture more of that value?

This doesn’t mean you MUST expand your reach, but this does identify areas where you may be able to capture more value.

What Apple has done isn’t easy.  They have built a fantastic brand and a relatively closed ecosystem where they can make money from almost everyone who participates in their success.  This has taken years, sharp vision, and big risks.  But success is sweet.

Can you be a little more like Apple?  Can you capture more value?  Think about it.

Mark Stiving, Ph.D. – Pricing expert, speaker, author

Photo by missha

The difference between 90% gross margin and 50% gross margin is not what you think.  Be careful.

Let’s assume your company finds 50% gross margin “acceptable” but you have some products with 90% gross margin.  First, congratulations!  This demonstrates you are pricing to what the market is willing to pay, not just cost plus.  Now assume your sales or marketing or pricing team wants to bring the price of the high margin product down to 50% margin to rapidly increase sales.

Here’s an example.  You have a product that sells for $10 at 90% margin.  Your sales team says “Margins are too high.  We need to bring the price down.”  What is the new price if you bring it down to the acceptable level of 50%?

It seems like you have drop your price almost in half to get there.  If you believe that, you’d be wrong.  You have to drop your price 80% to get there.  The new price would be $2.  You have to give up $8 of profit to get to 50% margin.   Ouch!

Here is a quick chart of prices and margins for a product with a $1 cost.
Price    Margin
$1.00    0%
$1.50    33%
$2.00    50%
$3.00    66%
$4.00    75%
$5.00    80%
$10.00    90%
$20.00    95%
$100.00    99%

Margin math is counter intuitive.  It’s confusing because margins can never go over 100%. However, our brains aren’t wired to think this way.  We think in straight lines.  My suggestion is to monitor your margins with an eye toward increasing the average margin for a product, product line, or company; but when it comes to pricing and especially discounting, think in dollars or percentage discounts, not in gross margin.

Dollar discounts and percentage discounts are straight line concepts that are easily interpreted by our brains.  Use them when evaluating transactions or price changes.  Don’t be tricked by using margins.

Mark Stiving, Ph.D. – Pricing expert, speaker, author

Photo by xcode

Pricing is the most powerful marketing mix variable. A small improvement in pricing will have a huge impact in profitability. It is relatively easy to see how.

Take a company that drops 10% of its revenue to its bottom line. In other words, after all fixed and variable costs are taken into account, after all salaries are paid, the company’s profit is 10% of its total sales. For example, a company with $1M in sales has profits of $100,000.

If this company increases pricing an average of 1% without changing anything else, their revenue would be up 1% to $1,010,000, an increase of $10,000. This $10,000 is all profit so their profit increases from $100,000 to $110,000 -  a 10% increase in profit. In other words, a 1% improvement in pricing can yield a 10% increase in profit.

What percentage of your company’s revenue is profit? If your profit margin is normally 20% of revenue (very rare) then a 1% price improvement increases profit by 5%. If your profit margin is normally only 5%, then this same price improvement can yield a whopping 20% improvement in profit. Wow!

This is not saying you should raise all of your prices 1%. It is very likely you can raise some prices to some customers 5%, 10%, 20% or even more with minimal impact. You only need an average price improvement of 1% to see these effects. Yes, pricing is hard, but it is so powerful. It is worth investing resources to improve it.

Mark Stiving, Ph.D. – Pricing Expert, Speaker, Author

Photo by Photo-Fenix

Markup vs. margin:  what’s the difference?  For you math whizzes, it’s all in the denominator.  For everyone else, it’s all in your perspective.

The Math (feel free to skip this part)

Start with price minus cost and call that margin dollars (per unit).  Markup is margin dollars divided by cost.  Margin is margin dollars divided by price.

Markup = (price – cost)/cost

Margin = (price – cost)/price

As an example, if you purchase something for $1.00 and sell it for $1.50, you have a 50% markup and a 33% margin.

The Perspective

Markups are commonly used in retail.  They buy something for a price and apply a standard markup to get to the price.  Since retailers buy thousands of items at different prices this seems to make sense.  BE AWARE – This is cost plus pricing.  Starting with a cost and adding a markup is the definition of cost plus pricing.  Hopefully by now you realize that cost plus pricing is not optimal.  It leaves money on the table.

Margins are what are reported on companies’ annual reports.  Margins represent what you actually realized from a price and cost perspective.  The implication is that margins are what materialized, not how to set the price.  If you use Value Based Pricing (as you should) then you are closely monitoring your margins, looking for areas of improvement, watching for indicators of decline.  Margins are a KPI (key performance indicator), not a means to drive pricing.

What are you using?  If your company commonly uses markup, you are almost certainly in the cost plus pricing mentality.  Throw that concept away and focus instead on margins.  If your company uses margins, it is not a guarantee that you use value based pricing, but at least it’s an enabler.

Use margin.

Mark Stiving, Ph.D. – Pricing expert, speaker, author

Photo by The Consumerist

I ordered the New iPad on the day it was released.  I never do this, but after watching Apple’s pricing over the years I’m confident they won’t be lowering their price for a year or so when they release the next version.  Why not buy immediately?  Apple has trained me what to expect.

An attendee in a presentation last night described her experience with Banana Republic.  She said, “I used to shop at Banana Republic and sometimes buy at full price.  However I signed up for their email list and I get coupons in the mail every few days.  Now I don’t buy anything there unless I get a discount.”  Banana Republic trained her to only buy with coupons.

JCPenney is trying very hard to retrain their customers.  Customers used to wait for sales.  JC Penney wants to give them good pricing every day and make their customers confident in these prices.

Here’s the point.  You are training your customers with your pricing behaviors.  Whatever you do frequently, your customers will come to expect.  Do you have frequent sales?  Do you hold price?  Your customers learn your behaviors and use that to help them make their best decisions.

This is not a bad thing.  It’s a fact.  You are training your customers.  The question is are you training them to behave in the manner you’d like?

Mark Stiving, Ph.D. – Pricing expert, speaker, author

Photo by skycaptaintwo

It’s no secret, pricing can signal quality. But why, and more importantly when, does it work? 

Think about the last time you went to your wine retailer, stood in front of the seemingly infinite choices of wines, and had to decide which one to purchase.  If you’re like me, you were probably thinking something like this:  “I’m going to a good friend’s house and they are making dinner.  The least I could do is bring a nice bottle.  I’ll spend about $40.”

We are all relatively clueless about how the wines taste, so we choose some price point and buy a wine at that price.  Here’s why it makes sense.  We are trusting that the manufacturer and the retailer both know how good this wine tastes, and they’ve decided that it’s worth $40.  We’re also hoping (or believing) many other consumers also know something about wine and if it wasn’t worth $40, they wouldn’t pay it, so the retailer wouldn’t charge it.

If only this were all true.

Let’s use something other than wine, something where we can determine quality if we try hard enough.  How about a new LCD TV?  If you are so inclined you could study all the features of a TV, figure out which ones you really need and then buy the one that just meets your requirements, without going overboard.  Another option is to look at the price range, and then buy one toward the middle of that range.  By doing this you are believing that other consumers, the manufacturers and the retailers all know what range is needed, and you are probably average so you get one in the middle.

These were two examples where we surely use price as an indicator of the quality of the choices.  But it doesn’t always work.  As consumers we use as many cues as possible to infer quality, and if some cues are off then a high price is not enough to make us believe the product is high quality.  Imagine a real estate agent pulling up to your house in an old beat up Chevy saying “I’m the most expensive because I’m worth it.”  You wouldn’t believe him.  Imagine your neighbor shows up at your door pulling a red wagon that holds several cases of unlabeled wine.  He tells you “This wine is a great bargain at only $50 per bottle.”  Do you believe him?  Of course not.

You see, price is one of many indicators of quality.  A high price alone will not make you look like high quality.  If you want to be seen as high quality, all indicators must point in that direction.

Mark Stiving, Ph.D. – Pricing expert, speaker, author

Picture by Sassoles