Parthenon Perspectives
Viewpoints on Business Strategy
Pricing: The Neglected Orphan
Pricing is the grossly
neglected orphan of profit
management. Most
companies leave list prices
unchanged year after year
or simply modestly
increase list prices in an
unchallenged annual ritual.
Other companies perform
strategic analyses,
producing the facts and
generating the confidence
to change prices
aggressively and to raise
profits dramatically.
by Roger E. Brinner, Partner and Chief Economist
The Parthenon Group
$
1.0% Price Increase
5.3% Profit Increase
Profit Potential of Price Increases for an
Average S&P 500 Corporation
Parthenon Perspectives
Viewpoints on Business Strategy
Pricing: The Neglected Orphan
Executive Summary
Pricing is the grossly neglected orphan of
profit management. Despite its enormous
potential for boosting margins and
revenue, many companies leave list prices
unchanged year after year or simply
increase them by the prevailing national
inflation rate in an unchallenged annual
ritual. Why don’t more executives
capitalize on the opportunity every
company has to manage prices?
From working closely with many
companies selling everything from
industrial components and textbooks to
legal information and theatre tickets, we
find that bad pricing practices stem from
unexamined and often erroneous beliefs.
Some managers think “the market” sets
the price and their company must simply
take it. Others believe that discounts
from list prices should be left to the sales
force to negotiate. Still others are simply
afraid to test the status quo.
Reversing such practices can improve
profits substantially because a percentage
point of price increase is worth 5 or more
points of profit growth. For example,
after a thorough pricing study, an
information services company raised its
rates an average 8%, with a strategic mix
of adjustments, and doubled annual
profits.
by Roger E. Brinner, Partner and Chief Economist
The Parthenon Group
Generating results like those requires a
whole different set of pricing philosophies
and practices. Five stand out:
• Shifting top management thinking to
the notion that leading companies and
their competitors -- not an “invisible
hand“ -- set prices and other firms
follow.
• There are optimum times to raise
industry prices. 2004 is one of them.
• Strategic price discrimination across
customer niches is the profit-maximizing
focus of realistic, value-based pricing.
This is far superior to standardized list
pricing coupled with official volume
discounts.
• Price-getting must be as disciplined as
price-setting. Companies that optimize
pricing know that salespeople who
poorly manage discounts, terms and
conditions with their accounts give up
many margin points.
• For newer generations of products,
prices must be set within a global
corporate view, not from the perspective
of an isolated product or marketing
manager. Unsynchronized pricing pits
new and existing offerings against one
another thus irrationally draining profit.
The plural of “anecdote” is not “data”. A
foundation of facts should supplant the
anecdotes and conventional thinking that
guide your pricing. Companies must
gather and then analyze strategic facts and
patterns about past pricing, customer and
competitor responses, the value of
products and services to customers, and
macro-economic trends to obtain the full
potential price in each niche. Companies
that have adopted these disciplines have
been surprised and gratified by their
previously untapped pricing power and
profits.
A Rising Wave of Pricing and Profits in 2004
Companies Raising Prices
25
20
15
10
5
0
-5
JAN‘03
NET PERCENT
MAY ‘04
Data: National Federation of Independent Business
Roger Brinner is a Partner and Chief Economist of The Parthenon Group. Dr. Brinner is well
known as an expert economist and articulate analyst of the United States and international
economies. He can be reached at [email protected]
3
© 2004 The Parthenon Group, USA May not be reproduced by any means without express permission. All rights reserved.
Parthenon Perspectives
Viewpoints on Business Strategy
Pricing: The Neglected Orphan
by Roger E. Brinner, Partner and Chief
Economist, The Parthenon Group
In August 2001, the outlook for an
information business looked grim. Pushed
by the 1990s dot-com explosion to an
unsustainable peak, the volume of services
sold then plunged after the dot-com
demise. To the senior managers of this
business unit, it appeared impossible to
quickly recover and meet corporate profit
targets. Moreover, with customer demand
apparently so weak, price increases seemed
out of the question.
Or were they? When managers took a
much more microscopic view of prior
pricing structures, customer and
competitor responses, and the value of their
products to customers, they saw a much
different picture. They realized their
products were significantly under-priced
relative to value. They responded with a
multi-year program of substantial list price
increases and strategic control of discounts.
In the first year they strategically raised list
prices 20% for the lowest priced and 3%
for the highest: their cheap products were
competing too well with their expensive
options! The 8 percentage points average
increase was 5 percentage points above the
company’s typical 3 percent “normal
inflation” increase. A premium-priced
express service was added, and discounting
was strategically restricted. The moves
doubled profits and increased revenue 15%
in 2002. Corporate managers were
surprised and very satisfied.
So are many other managers who learn the
new rules of pricing. One industrial
components company we worked with
expects to boost permanently profits by
$30 million per year after a 5-month
pricing study.
Virtually every company, market share
leader or not, can raise effective prices and
thus dramatically lift profits. The impact
can be profound considering that a one
percentage-point boost in pricing goes
right to the bottom line. Given that the
average pre-tax profit margin for a
Standard and Poors 500 company was 8.6
percent over the past decade, a company
would have to increase revenues sold at
this margin by 12% to generate the same
amount of profit as an extra 1% price
boost (boosting the margin to 9.6%).
Price optimization is also a quicker and
less expensive solution than cost
reduction: compared to the moderate time
and dollars required to analyze pricing
strategies, cost-cutting campaigns can be
far more expensive, especially if layoffs
and severances ensue.
Even if a fraction of customers will defect
in response to broad-scale price increases,
profits usually will increase. The keys are
to understand are, first, how much
volume will you lose if you raise prices
(the “price elasticity of demand,” as
economists like to say) and, second, what
proportion of your costs is variable. A
drop in volume will be less damaging to
revenue and profits the greater the
variability of your costs, as the exhibit on
page 1 demonstrates.
The fear of losing a customer can be
paralyzing, until you remember profit
maximization is not identical to client or
even revenue maximization. Some
customers are not worth having if they
can only be kept with a price that is well
below what most others are willing to pay.
Setting the wrong goals -- based on
customer-retention or simple revenue -will drain profits. One client measured
and paid managers based on the percent
of inquiries that were closed as business.
This was shown to encourage grossly low
list prices and excessive discounting.
Figure 1:
Economic Recovery offers Huge Profit Potential from Pricing
Price Increases Typically Produce Profit Benefits 5x the Price Increase
Measured Price Elasticity
The % Change in Units Sold
per % Increase in Price Relative to Competitor’s Price
Impact of a 1% Price
Increase on:
0
-.5
-1.0
-1.5
-2.0
Revenue
+1%
+0.5%
unchanged
-0.5%
-0.9%
Units Sold and Variable
Costs
0%
-0.5%
-0.9%
-1.3%
-1.7%
11.6%
8.4%
5.3%
2.3%
-0.5%
Profits*
Base Case: variable costs = 50%
The Profit Benefits of Price Increases Are Greater
the More Variable Are a Firm’s Costs
Alternative Cases with Lesser or
Greated Variable Costs
Profits* if variable costs = 30%
11.6%
7.3%
3.2%
-0.8%
-4.5%
Profits* if variable costs = 70%
11.6%
9.4%
7.4%
5.4%
3.5%
* Base Case before price increase assumes typical US values: Variable Costs are 50% of revenues,
Fixed Costs are 41%, Implying Margins Pre-tax of 8.6% and Post-tax of 5.6%.
Alternative cases adjust fixed costs in line with variable cost changes to maintain same initial margin.
4
© 2004 The Parthenon Group, USA May not be reproduced by any means without express permission. All rights reserved.
Parthenon Perspectives
Viewpoints on Business Strategy
A useful metaphor to help overcome the
mental hurdle comes from baseball. Runs,
not hits, win games. Profits, not revenues,
satisfy shareholders. Paying players based
on “batting average” will lead to excessive
singles and too few extra-base hits. A
batting average is simply the number of
hits of any type divided by the number of
official plate appearances. But this doesn’t
discriminate at all between a single and a
home-run, and what really matters for
winning are the runs scored by the team;
batting average maximization will not
maximize runs. Astute fans and managers
look to “slugging percentages” (total bases
divided by at-bats) and more sophisticated
assessments of run impacts, not just the
number of hits and recognize the added
value of a double, triple, or home-run. A
slugger should be allowed more strike-outs
and a lower batting average given that his
hits have a greater impact. In the same
vein, a manager or sales professional who
closes fewer deals but at higher prices is
better for profits than the peer who has
the highest closing percentage or even the
highest revenues.
Figure 2:
Maximize Profits, Not Deals Closed:
A Baseball Metaphor to Overcome Bad Strategy
In Baseball, Runs, Not Hits, Win Games
125
Runs
Hits
R 2 = .65
R 2 = .33
AL Team Wins
100
75
50
25
500
1000
1500
2000
To be certain, price will always be
mentioned as a factor in purchasing
decisions. However, its importance varies
by product and customer segments. In
fact, our experience shows that customers
will accept your price increases if any of
the following conditions are in play:
Total AL Team Runs and Hits
Runs have twice as much success as hits in explaining games won
R2 = 65% vs R2 = 33%
Runs Created per 100 At-Bats
0.300
2003 AL Leaders
0.250
0.211
0.185
0.200
0.150
0.100
0.050
Sluggers
Slugging Percentage
Batting Average
Strikeout/Plate
Appearance
.569
.306
.211
Hitters
Slugging Percentage
Batting Average
Strikeout/Plate
Appearance
.514
.316
.185
0.000
AL Sluggers
Purging the ”Invisible Hand“ Theory
and Other Pricing Myths
Fact: Leaders, not “the Market”, Set
Prices. A number of erroneous beliefs
prevent managers from pricing their
offerings optimally. The most significant
myth is that the “invisible hand” of the
market determines prices. This image
assumes perfect competition has
established an equilibrium price. In this
equilibrium, fully-informed buyers force
competing suppliers to offer their
commodity at a standard, transparent
price. This price offers efficient producers
a moderate return on capital. Raise prices
in opposition to such market forces and
demand will drop precipitously, the
thinking goes. “If competitors do not
follow with price increases, unilateral price
hikes will result in a quick exodus of
customers.” But the real world rarely
matches many elements of this perfect
competition model. Markets are dynamic,
and rarely reach a clear equilibrium.
Buyers are not fully informed about prices
and competing options. Suppliers offer
differentiated goods and services, not
totally substitutable commodities. And,
most importantly, competitors will often
match your price increases.
AL Hitters
• They have limited ability or desire to
substitute another product
• Your product’s value is high relative to
its price
• Your price is not their principal purchasing criterion
Despite lower batting averages and more strikeouts “sluggers” create 15% more runs than “hitters”
5
© 2004 The Parthenon Group, USA May not be reproduced by any means without express permission. All rights reserved.
Parthenon Perspectives
Viewpoints on Business Strategy
• Your competitors also need higher
prices and profits
marketing if they try to buy market share
by failing to follow price leadership.
Customer sensitivity to price changes
should be understood and quantified
through sales analysis, surveys, and
reviewing a company’s past pricing and
sales trends.
Of course, there may be legal limitations
on the amount to which you may reduce
your prices or on your ability to offer different prices to similarly situated resellers.
You should consult with counsel to be
certain your proposed pricing plan is
lawful.
What about the fear of competitors using
your price increase to undercut you and
siphon away your customers? Of course,
this could happen if you are not the scale
leader in the marketplace. However, in
many industries, small and mid-size competitors follow the leader’s suit. After
watching an industry leader raise prices,
such price followers consider the
additional profits they can enjoy. They
also know from experience the leader will
punish them with discounts and scale
Price following is especially the case for
competitors suffering from low profitability. As shown below, smaller competitors—and by small we mean those who
have not carved out a unique defensible
niche in which they are a leader—are necessarily less profitable. They cannot
spread the costs of research, product development, marketing, or administration
across a broad base, hence income margins
are predictable much lower.
Figure 3:
Benefits of Market Leadership
40%
$100M
Revenue
30%
Operating Profit
Company
A
Co.
C
Co.
B
20%
Co.
F
Co.
G
10%
Company
D
Co.
E
0%
0.1
0.2
0.5
1
2
5
10
Such participants are eager to have
industry prices set higher. Moreover, they
will particularly be discouraged from
under-cutting if the leader’s sales force is
known to have the discretion to counter
such moves with strategic discounting.
Fact: Inflation, not Deflation, is Still the
Norm. Another myth that prevents
companies from optimizing pricing is
more macroeconomic. “Inflation is dead
in the US, killed by high productivity
growth and outsourcing to China,” goes
this line of thought.
Fortunately, these views don’t hold up to
economic reality. A close look at
aggregate and industry-specific price data
shows otherwise. Deflation is not here
today and is not likely to be tomorrow. In
the U.S., aggregate price indexes are not
falling. Last year, the consumer price
index rose 2.3%, the GDP deflator (the
price of all goods and services produced
here) rose 1.7%, and wages and benefits
per hour rose 4.0%. As always, these
aggregates are the result of a broad range
of microeconomic experiences, but official
government statistics confirm the average
business raised prices by about 2%. From
our economic perch, the outlook on
inflation is favorable. We see it increasing
because of a weaker dollar, higher capacity
utilization, and stronger demands for
wage increases as employment strengthens.
All of this is to say that when it comes to
pricing, no company is at the complete
mercy of competitors, customers and a
deflating economy. The real determinants
of pricing are far different, and much
more within management’s control.
Relative Market Share (segment-weighted)
Smaller competitors are generally less profitable than market leaders and will welcome
the additional margin afforded by a price increase
6
© 2004 The Parthenon Group, USA May not be reproduced by any means without express permission. All rights reserved.
Parthenon Perspectives
Viewpoints on Business Strategy
The Four Fact-Bases on Which to
Build Pricing Strategy
After abandoning the myths that wrongly
place the power of pricing into the hands
of outsiders, managers should feel they
have more control over pricing than they
suspected. However, they must not follow
this new-found confidence with instinct –
that is, acting on hunches about how much
of a price increase their customers will
swallow. Determining where and how
much to change prices requires a
compelling fact base and careful statistical
analysis. The result invariably will be
pricing strategies that discriminate by
customer segment, whose prices will
depend on the value of the product
perceived by customers, offset by their
bargaining leverage.
The institution of new pricing strategies
can be organized in four parts:
• Understanding the overall macroeconomic climate
• Determining industry dynamics to
anticipate competitors’ reactions
• Assessing customer behavior to potential
pricing changes
• Creating internal processes to ensure
price-getting (the terms and conditions
that the sales force negotiates with customers) is optimized along with pricesetting (the standard prices)
I. Understanding the Economic Climate
All companies’ pricing actions are to some
extent subject to the macroeconomic
trends affecting their industry. In pricing,
the primary trends to investigate are
market growth, foreign exchange rates,
and cost inflation rates. The case of an
industrial components manufacturer sheds
light on these factors. In 2002, the
company’s revenue was flat. Initially,
management believed niche price increases
were possible, but thought broad-based
increases would be out of step with their
competitors and would be fighting an
economic tide. A closer look at historic
patterns of relevant industry inflation
rates, exchange rates, and economic trends
revealed a different picture.
In the long run, pricing trends in their
industrial equipment market generally
tracked those of overall economy’s GDP
price increases. Machinery prices rose
8.1% versus 6.7% for all US output in the
1970s, 4.6% versus 4.5% in the 1980s,
and 2.0% versus 2.2% in the 1990s. For
this industry, the GDP price index is a
reasonable gauge of long-term cost
increases, and thus a reasonable guide to
average price long-term inflation in a
competitive industry. But there were also
some major discrepancies between the two
price indices in key periods. For example,
industrial equipment price inflation fell to
just 1-2% in 1983-4 and then shot back
up to 5% in the 1986-1987, these
contrasted sharply with a fairly stable 34% aggregate GDP price inflation.
Similar contrasts existed in key periods of
the 1998-2002 era.
The company clearly needed to look
beyond GDP prices for overall guidance.
Analysis convincingly determined that the
foreign exchange value of the dollar was a
critical determinant of the industry’s
pricing power both abroad and at home in
the US. Every 10% decline in the dollar
correlated with a 2% increase in industrial
equipment prices within a year. For this
company, a 2% price increase would mean
Figure 4:
The Four Fact-Bases of Pricing Strategy
Full PotentialTM Price Optimization
Macro-Economic
Factors
Objective:
7
• Understand the Market
Dynamics
Company/Industry
Dynamics
• Determine Where You Are Best
Positioned for Price Actions
Customer
Behavior
• Set the Optimal Structure and
Level of Pricing
Internal
Processes
• Maximize Price Realization
© 2004 The Parthenon Group, USA May not be reproduced by any means without express permission. All rights reserved.
Parthenon Perspectives
Viewpoints on Business Strategy
Figure 5:
The Economic Climate Drives Factory Equipment Inflation
The Pricing Opportunities Offered by a Weak Dollar
10%
0%
0%
-2%
-10%
Equipment Inflation
(Relative price to GDP)
Dollar Depreciation
vs Major Trading Partner Currencies
2%
2002 Q1
2000 Q1
1998 Q1
1996 Q1
1994 Q1
1992 Q1
1990 Q1
1988 Q1
1986 Q1
1984 Q1
1982 Q1
-20%
Each 10% Depreciation of the Dollar Typically Produces a 2% Boost to
Equipment Inflation Beyond US Inflation
The Tempering Influence of a Strong or Weak Economy
93%
6%
Factory Capacity
Utilization Rate
(US Average,
1 Year Earlier)
88%
84%
2%
80%
0%
76%
-2%
Equipment Inflation
(Relative price to GDP)
72%
68%
2004 Q1
2002 Q1
2000 Q1
1998 Q1
1996 Q1
1992 Q1
1990 Q1
1982 Q1
1988 Q1
-4%
• How will exchange rates impact sector
pricing?
Capacity Utilization Rate
4%
• How prosperous are my customers and
what is their likely demand growth?
As the economy recovers and factories get busier, the need for extra capacity rises and
equipment makers can boost prices more aggressively
Combined Normal Price Increase Opportunity Offered by the Macroeconomic Setting
6%
Equipment Price Inflation
The same approach works well for service
businesses. Knowing cost inflation facing
your peers, understanding the financial
health of customers, and isolating critical
special external factors sets the economic
climate for aggressive or restrained pricing
tactics. This can often be forecast with
statistical model
20%
Depreciation
1986 Q1
• Where are costs moving for my peers
and myself?
4%
1984 Q1
The work in this step of the price optimization process boils down to answering
three questions:
30%
Actual Industrial Equipment
Price Inflation
-4%
Equipment Price Inflation,
Relative to GDP Price Index
Delays in recognizing these opportunities
would be a major current strategic error.
The dollar has fallen 20% over the past
two years against its major trading
partners’ currencies, and the evidence
listed above indicates that list prices can
be promptly raised by about 4% across
the board. The economic tide is rising
and shouldn’t be resisted.
Equipment Price Inflation,
Actual and Relative to GDP Price Index
6%
A second major “climate” factor was
found to be the utilization rate of manufacturing capacity as reported by the
Federal Reserve. As utilization rises, the
need for new equipment surges, and a
“buyers” market moves toward becoming
a “seller’s” market. Key inflection points
were identified and opportunities sized
and timed.
1994 Q1
an overall 20% boost in profits, (given
their margin and variable cost structure).
Actual Industrial Equipment
Price Inflation
4%
Estimated Normal Combined
Impacts of Depreciation,
Factory Operating Rates and
US GDP Inflation
2%
0%
2002 Q1
2000 Q1
1998 Q1
1996 Q1
1994 Q1
1992 Q1
1990 Q1
1988 Q1
1986 Q1
1984 Q1
1982 Q1
-2%
Statistical Modeling Can Identify the Simultaneous Impacts of the Key Factors to Set Realistic Plans
8
© 2004 The Parthenon Group, USA May not be reproduced by any means without express permission. All rights reserved.
Parthenon Perspectives
Viewpoints on Business Strategy
II. Gauging Competitor Dynamics
The second step of the process involves
determining if a company can be
confident competitors will be wellbehaved or if they are likely to misbehave
in response to a price increase.
• Where are we already seeing “price
leakage” – i.e., transaction prices that
are far from list in specific customer
segments of product lines?
• What is our market share, properly
defined?
• What is our cost position relative to
competitors? Who has the ability to be
the price-setter/price leader?
• How will competitors react to prices
changes? Who has led or followed well
in the past?
Figure 6:
Both of the previously mentioned
companies started their pricing initiatives
in the market segments in which they had
the largest market share. The reason:
relative market share is a key indicator of
profitability and thus establishes a natural
leadership position. For example, it is
quite typical for a company with the
leading market share to have a profit
margin 2 times that of a competitor onethird its size. Intermediate-scale competitors will have proportionately better
margins as they approach the scale of the
largest firm. The greater the gap, the
more likely is it that the competitor will
not be earning a satisfactory return on
invested capital and will welcome an
opportunity for a rising price tide to lift
all boats.
But how can you be sure your competitors
will follow suit and hike prices? While
direct contact with competitors with
respect to price is, of course, off-limits,
Measure Competitor Price Response
Key
Client Prices
Competitors
conducting a historical analysis of competitors’ pricing behavior becomes
extremely valuable to build the necessary
managerial and sales force confidence.
The information firm looked back at five
years of price increases – its own and those
of its primary competitor’s. In three out
of four product categories, the competitor
matched its yearly price increases, its
actions trailing typically by a couple of
months. In the fourth product category,
the competitor’s pricing was higher for the
first three years, before retracting to
matching in the fourth. In the fifth year,
the competitor followed the leader’s price
increase. That gave all “stakeholders” at
our client the confidence that future price
increases would be followed and eased
fears that price hikes would shed market
share.
By identifying areas of significant price
leakage, bench-marking pricing history
against competitors, and combing through
financial records, managers can rely on
facts instead of intuition in deciding
where to look for price increases and
assessing how competitors are likely to
respond.
Service Offering A
United Prices in Dollars
(disguised)
III. Anticipating Customer Reactions
Service Offering B
Service Offering C
Service Offering D
1997
1998
1999
2000
2001
The competitor clearly followed the leader’s pricing moves within 2-3 months. Understanding such
historical management’s tendencies greatly lessens management’s perceived risk of a price increase
9
Possibly the most critical step is assessing
how customers themselves will react to
price changes. Here it is important to
understand their perceptions of your value
and to review their prior behavior toward
price changes. Key questions are:
• How different are your products from
those of the competition?
• What is the market perception of your
value to price? How high are customers’ switching costs?
© 2004 The Parthenon Group, USA May not be reproduced by any means without express permission. All rights reserved.
Parthenon Perspectives
Viewpoints on Business Strategy
• What product attributes do customers
value, segment by segment?
• How important is price in their purchasing decision, absolutely and relative to these other values?
• What price-sensitivities have customers
historically displayed?
• Finally, do you compete against yourself in unsuspected ways in your pricing of alternative packages and similar
products? What structural changes in
pricing offer profit improvement
potential?
The more differentiated a product, and
the more that customers value this differentiation, the higher your value-to-price
ratio, the less willing they will be to jump
to a competitor following your price
increase. This is the issue of product substitution: customers who can easily
substitute one product for another will be
more resistant to price increases.
The plural of “anecdote” is not “data”. Is
your sales force or your gut the likely
current basis of your price-setting? We
incorporate these inputs, but complement
them and then educate them with datadriven insights. We apply, as required by
the specific case, choices from an array of
analytical tools to collect facts on which to
base confident pricing decisions.
Option 1: Conduct customer surveys to
compare price to other attributes (service,
Figure 7:
Understanding Your Customers’ Values
Price Segment
(36%)
Brand
Choices
Pricing
Alternatives
Distribution
Options
Performance
Levels
Feature
Choices
Value Segment
(24%)
Performance Segment
(21%)
Feature Segment
(19%)
{
{
{
{
{
Customer Utility Scores
Surveys, using statistical techniques such as Conjoint analysis, allow a
company to understand the role price plays in the customer decision process
10
reputation, convenience, installed base,
custom features, integration in valued
package). Ask questions directly, and
indirectly, to reveal the magnitude of the
price difference it would take to get a
customer to switch vendors. The analysis
reveals both the customers’ buying
decision priorities and client satisfaction
rates compared to key competitors.
Option 2: Conduct sales force
interviews and/or surveys on the same
topics. This is valuable for the client
insight it might collect. It is equally
valuable to contrast or reinforce the conventional wisdom of the field with the
direct voice of the customer. This option
is almost always necessary so that the field
feels it is truly represented and heard in
the strategic process that will critically
affect their livelihoods. They are the
“soldiers” who must project the new,
higher pricing to the market with
confidence.
Option 3: Perform conjoint analysis, a
sophisticated statistical analysis of custom
survey results designed to clarify the
clusters of most important characteristics
to specific customer segments. This
extends the earlier analysis by defining
customer sets that must be served differently in terms of both product content
and pricing.
Option 4: Execute statistical (regression)
analysis of historic buying patterns. The
sales data each client has – somewhere in
the organization -- of sales and prices
charged by territory, year, and customer
class lends itself well to regression analysis.
Through this, we can measure the price
elasticity while simultaneously identifying
and quantifying the roles of market
growth, demographics, penetration curve
phase, and other key factors.
© 2004 The Parthenon Group, USA May not be reproduced by any means without express permission. All rights reserved.
Parthenon Perspectives
Viewpoints on Business Strategy
Figure 8:
Using ‘Voice of the Customer’ to Validate Statistical Analysis
Customer Conversion Rate Program Price
(Survey Responses)
80%
67%
58%
59%
60%
59%
54%
44%
42%
40%
20%
0%
<$2K
$2-4K
$4-6K
$6-8K
$8-10K
$10-12K
>$12K
Elasticity ~ -0.2
Moving from the average price of $5K to $10K (a 100% price increase) ...
Reduces the conversion rate from 58% to 50% (a 14% reduction)
Raising prices is never comfortable until
the facts are convincingly assembled. For
this reason, it is best practice to combine
the surveys with the statistical tools. The
surveys help the statistician define the
hypotheses to be tested and thus make for
better models. Equally important,
managers are human beings and like to
hear from other people through the
surveys, rather than simply accepting the
verdict of a statistical analysis.
The statistical analyses are capable of
doing what the surveys cannot: isolating
and measuring the impacts of pricing
when many market fundamentals have
been simultaneously changing through the
history of the product line. Statistical
models, executed well, answer such basic
questions as, “Did my sales fall because I
raised prices last year, or was the decline
purely the result of a recession, a competitors’ product introduction, or my
reduced marketing budget?”
11
One business service client feared their
product was quite similar to the competition and hence that any price increase
beyond national inflation (2% or 3%)
would send customers flocking to the
competition. We conducted a survey of
customers –its own and competitors’—
asking directly and indirectly: “Weighing
the cost of learning a new provider’s
process, what is the minimum price
reduction they would demand to switch
their current provider to another? ” The
answer: about a 30% reduction, on
average. More important, we obtained
good information on the percentage distribution of customers who would likely
switch at higher and lower points, and the
characteristics of these segments. We also
learned that: 1) reputation for best quality
and thoroughness was the key purchase
criterion, 2) this service was actually a
small cost component of the customer’s
budget, 3) our client was ranked highest
on quality and service.
We triangulated with two of the other
options to test the conclusions, refine the
segmentation, and build confidence in the
outcomes of pricing action. The data
allowed us to calculate that a 10% acrossthe-board price increase would result in a
loss of only 3% (+/- 1%) of the business
Service Offering
volume,
whileC raising revenue 7% and
nearly doubling profits. Targeted
adjustments by segment offered even
better gains. After due consideration, the
qualitative insights on client values and
firm reputation resonated with both
management and the sales force, adjusting
their product perspective from that of a
somewhat undifferentiated commodity to
a strong value, branded service.
They executed a strong price increase,
tilting to even larger increases in the
highest value segments, and gave the field
permission to rescind the increase
selectively if the competition tried to buy
share through lower price campaign. The
three-pronged strategy worked well: do
the multi-facet analysis, communicate it
well throughout the organization by
making all parties part of the process, and
provide the comfort of a safety-valve
rescission if the competition misbehaves.
The competitor, responding as expected to
the opportunity to improve its own subpar profits given its smaller scale, matched
the price increases. The following year,
our client was able to once again raise
prices by more than twice the national
inflation rate.
A high-end manufacturer of recreational
equipment also put price into proper perspective after surveying customers. While
price turned out to be a factor in every
buying decision, customers mentioned
quality, reputation of the manufacturer,
customer service, and product features far
more frequently. The clients needed this
information as they re-launched a brand
© 2004
2003 The Parthenon Group, USA May not be reproduced by any means without express permission. All rights reserved.
Parthenon Perspectives
Viewpoints on Business Strategy
that had been dormant; they needed to set
the initial price point for their product in
its luxury and performance niche. Setting
too low a starting price point would
cripple the business forever; too high a
price would doom it to launch failure.
Facts had to replace introspection.
An industrial components manufacturer
was somewhat sophisticated in pricing.
Distributors were given an array of
standard discounts from published list
prices. Segments were identified by both
type and size of customer. Beyond this,
distributors could work with the manufacturer when additional (and deeper)
discounts were needed to close isolated,
strategically valuable deals. Unfortunately,
the outcome of this decades-old structure
had not been seriously analyzed.
Management correctly did not believe they
had fortuitously evolved to an optimal
price structure. They knew their
marketing specialists were working on
instinct rather than a systematic fact base
in responding to deal requests.
To optimize pricing strategy, we compiled
the facts of transactions for each of a set of
representative, major products: list price,
standard discount, transaction price, units
sold, customer industry and type of
customer (e.g., original equipment manufacturer, contractor). We complemented
this with macroeconomic and microeconomic data defining the markets at
points in time. We coded in the sales
districts. Then, through regression
analysis, we were able to measure the price
elasticities of demand for each segment,
while simultaneously evaluating district
performance (in the context of who they
served and what was happening to their
market). We complemented this statistical
analysis with interviews of management,
marketing, and sales personnel. They gave
us the right structure for the econometric
12
regression models, telling us the
hypotheses that needed to be tested to get
to answers that would be executed with
confidence. Every affected party’s right to
be heard and to offer insight was
respected.
The analysis revealed wide variations in
price elasticity across the customer
segments – from strong to minimal. In
general, the smaller the customer, the less
sensitive it was to price increases. The
firm decided to raise prices for small
customers and lower prices for large
OEMs; within each OEM class, industry
differentials were established to reflect
volume and other elements of bargaining
leverage or attitudes. Within the analysis
at hand, each product manager came back
with different price recommendations for
their customer segments. The advice
ranged from raising prices for some by
20% to lowering prices for others by 10%.
IV. Setting and Getting the Optimal
Prices
The final stage of price optimization is
ensuring the pricing terms and conditions
salespeople negotiate with customers are
close to optimal. Creating new sales and
marketing guidelines and processes will
make price-getting as sharp as price-setting.
Price-setting is structuring your list prices
as the starting point of negotiations. List
prices are the place to raise your prices. If
you cut your list prices for all customers,
you give margin away to those willing to
pay list. You also frustrate aggressive
purchasing managers who must
demonstrate achieved discounts to justify
their jobs since their bonuses are
sometimes explicitly tied to discounts
achieved. Standard discounts for very
specific customer segments or volumes are
often appropriate for different customer
segments.
Beyond this lies the game of price-getting.
Price getting has to do with the terms and
conditions the sales force strikes and
enforces with specific customers, and the
rules for exceptions beyond standard
discounts.
Optimal price-getting will require ending
a number of traditional practices.
Generous discounts for payment in 30 days
are profit-hemorrhaging artifacts from earlier
decades when interest rates were high and
accounting systems were not as technologically efficient. The cost of short-term
funds today is less than a 0.3% per
month. If you want to motivate prompt
payment, it is far more logical to add a
surcharge of 1.5% per month for
payments over 30 days—or 60 days if you
want to be generous--reflecting both your
cost of money and the cost of follow-up
billing.
The profit potential is striking. Consider
a hypothetical case where half your
customers now pay in 30 days and take a
1.5% discount and the other half pay in
90 days (probably after you have sent out
past-due reminders).
Switching to a 0.5% credit for the good
payers adds a half percentage point to your
margin; switching to a 1.5% surcharge for
the late payers adds 0.75%. Together, this
boosts the margin by 1.25%, which
translates into a 14% increase in profits for
the average American business (with a
8.6% pre-tax margin).
Poorly managed terms and conditions also
cost many margin points. The industrial
components company was losing $19
million a year from rebates and poor
negotiation of pricing terms. Price
© 2004 The Parthenon Group, USA May not be reproduced by any means without express permission. All rights reserved.
Parthenon Perspectives
Viewpoints on Business Strategy
Figure 9:
The Facts: Discounts are Out of Control
Effective Discount
(percent of list price)
Transaction Discipline and Exceptions
Official
Volume
Discount
Schedule
Actual
Negotiated
Discounts
$
$10,000
$20,000
$30,000
$10,000
$50,000
$60,000
$70,000
$80,000
$90,000
$100,000
Customer Spending
Minimizing revenue impact of exceptions can be a large fast source
of revenue improvements
leakage, indeed, can lead to a torrent of
red ink.
If terms, conditions, and discounts are left
solely to the discretion of the sales force,
great pricing strategies will be wasted.
Why? Because the goals of the sales force
are not in line with the goals of the
company. A sales person who cuts prices
10% on a product with a 50% variable
cost suffers only a 10% drop in
commission. But he reduces the operating
contribution by 20%. If he cuts the price
by 50%, he still keeps half his commission
but wipes out the company’s operating
margin on that customer altogether. So,
sales force compensation is also critical to
maximizing pricing.
13
The Pricing Imperative
As dozens of companies have
demonstrated, overhauling pricing in the
strategic, programmatic and data-driven
way described here can generate major
increases in profitability. But determining
the right pricing and who gets what
discounts, segment by segment, is only
half the endeavor. The other half is
ensuring that people who ultimately set
prices with customers -- the sales force –
exercise price discrimination lawfully and
with discipline.
Only when the lessons of pricing are
taught convincingly and extensively across
an organization can its profit-boosting
potential be realized. When that happens,
managers at all levels will no longer
wonder why pricing requires the disciplined approach that marks so many
other significant business decisions.
© 2004 The Parthenon Group, USA May not be reproduced by any means without express permission. All rights reserved.
Parthenon Perspectives
Viewpoints on Business Strategy
About The Author
About The Parthenon Group
Roger E. Brinner, Ph.D.
Roger is the Chief Economist and a Partner
of The Parthenon Group. Dr. Brinner is well
known as an expert economist and
articulate analyst of the United States and
international economies.
Dr. Brinner counsels corporate and
government clients on economic issues
specifically relating to their strategies,
market growth, pricing, and equity valuation.
Corporations with long-term advisory
relationships with Dr. Brinner have included
Anheuser-Busch, Catterton Partners, Cooper
Industries, Dow Chemical, Emerson Electric,
Exxon, General Electric, J.M. Huber,
McGraw-Hill, Microsoft, Textron, and
Thomson Corporation. Government advisory
relationships have included the Federal
Reserve Board of Governors and the US
Cabinet Departments of Treasury, Energy,
Commerce, and Defense. He has testified
frequently before Congress on budget policy,
inflation, and growth issues, and he is often
quoted in the media.
His career includes senior positions at
respected business, academic, and
government institutions. During his recent
years with Parthenon, Dr. Brinner was
simultaneously a Visiting Professor at the
Massachusetts Institute of Technology;
earlier he was an economics professor at
Harvard University. He served at the White
House as Senior Staff Economist in the
Council of Economic Advisers, and has
been a Visiting Scholar at the Federal
Reserve Bank of Boston. For over two
decades, Dr. Brinner led the pre-eminent
economic research organization, Data
Resources (DRI), as a senior operating
executive and chief economist.
Dr. Brinner received a Bachelors degree
from Kalamazoo College and a M.A. and
Ph.D. in economics from Harvard
University. Board memberships have
included Paul Revere Insurance, The
Concord Coalition, the National Association
of Business Economists, Kalamazoo
College, and several charitable organizations.
14
Founded in 1991 as a strategic consulting and
principal investment firm, the Parthenon
Group today has 150 professionals across
offices in Boston, San Francisco and London.
The firm serves Global 1000, emerging/high
growth, and leading private equity companies
across a range of critical business issues that
include corporate and business unit strategy,
profit improvement, innovation and growth,
mergers and acquisitions, and private equity
strategy and evaluation.
The hallmarks for which Parthenon has
become recognized in the industry are a
unique boutique approach to client service,
long-term relationships, and performance
based fees. Over the past decade, the firm
has become the strategic consulting firm of
choice for several Fortune 1000 and
emerging/high growth companies.
Representative clients include: AnheuserBusch, Bausch & Lomb, Brown Brothers
Harriman, Catterton Partners, Corning, Cort
Furniture, Crane Stationery, eBay, Freeman
Spogli, Friedman, Fleischer & Lowe, Houghton
Mifflin, Invensys, McGraw-Hill, Ocean Spray,
Starwood, Textron, The Thomson Corporation,
and Young and Rubicam. Parthenon’s mission
is to become the strategic advisor of choice
for CEOs and business leaders worldwide.
Through careful growth and the highest
recruitment standards, Parthenon is
committed to preserving its boutique
philosophy and entrepreneurial distinctiveness. The firm today remains recognized
as the leading consulting firm to consider
ways to share client risk through direct
investment, consulting-for-equity and performance-based fees. As an extension of its
commitment to investment and risk sharing,
the firm launched Parthenon Capital in 1995, a
private equity firm which today has over one
billion dollars under management.
200 State Street, Boston, MA 02109
617.478.2550
39 Sloane Street, London, SW1X 9LP, UK
555 California Street, San Francisco, CA 94104
www.parthenon.com
This article does not purport to provide legal advice. You should consult your counsel in connection with
any modification of your pricing policies, particularly if you enjoy a large share of sales in the market in
which you operate. You should be aware that coordinated pricing activity among competitors may carry
both civil and criminal penalties under the antitrust laws. In addition, certain unilateral conduct with
respect to discount pricing may also have antitrust implications.
© 2004 The Parthenon Group, USA May not be reproduced by any means without express permission. All rights reserved.