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What Is Value-Based Pricing?

Value-Based Pricing (VBP) means to charge what your customers are willing to pay (WTP). This is a simple concept to understand and probably impossible to implement. Every buyer has a different WTP. Perfect VBP implies we can read each buyer’s mind and charge them that one price exactly equal to their WTP. Using today’s technology, this is still impossible.

A better meaning of VBP is implementing strategies and tactics to price closer to your buyer’s WTP than you are today.

Cost-plus pricing is as far away from VBP as possible. In cost-plus pricing, we set a price based on our costs and our desired margin. This has absolutely nothing to do with WTP.

Many companies are at least a few steps beyond cost-plus pricing. For example, they may capture higher margins on some products than others because that is what the “market will bear.” This is a step toward VBP. What the market will bear is a rough estimate of WTP, and it is usually determined using trial and error. We price too high and people stop buying. Hence, we reduce margin to what the market will bear.

Different margins for different products is a good first step toward VBP. The big disadvantage is everyone who buys any given product pays the same price, yet buyers for that product have very different WTPs. The second, and very powerful step, toward VBP is price segmentation. Figure out how to charge different customers different prices.

Many B2B companies do price segmentation simply by having salespeople negotiate deals. Each deal is at a different price. Ideally though, salespeople have been trained to determine each buyer’s WTP and hold firm on negotiations at that point. Determining and capturing WTP for a buyer is not easy. Salespeople need to be trained on techniques like value conversations and negotiations.

There are many other price segmentation techniques companies can implement to capture more of their buyers’ WTP. One technique is building a product portfolio that allows buyers to self-select to higher or lower priced products. Another is understanding the characteristics of customers and transactions that typically demonstrate a higher WTP, and not discounting as much in those situations.

Don’t panic, you will never implement VBP perfectly. Just take a step closer.

Hardware Companies “Selling” Software

Hey hardware companies, WAKE UP!!!!

Software companies have much better margins and are a zillion times more profitable. Why is that?

If you’re trying to defend hardware companies, you would say, “that’s because software companies have much lower costs.”  That’s a true statement.  But still …

Hardware companies have been absolutely brainwashed into always thinking about costs when they price.  They are addicted to cost plus pricing.  They constantly focus on margin.

Then they decide to innovate.  They decide to create a software product that adds additional value to their hardware.  Sometimes significantly more value.  And you know what they do?  They give it away!  Oh, they put a price on it, but the salespeople throw it in to close the deal. Why not?  There wasn’t any cost associated with it.

This makes me want to pull out what little hair I have left.

If software companies gave away their software because there wasn’t any cost, they wouldn’t make any money.  They don’t, and they make a lot of money.  Hmmmm.

There is an accounting practice used by software companies that is completely wrong for pricing, but maybe hardware companies should adopt this.  Software companies take their total development budget and use that as their cost.  They divide this by the number of units they expect to sell to calculate a cost of goods sold.  Then they price above that so they make a profit.  This is horrendous pricing practice, but I think hardware companies should adopt it.

Here’s the difference.  Hardware companies have hard costs.  Speaking financially, they can correctly and accurately calculate COGS.  They don’t allocate their engineering overhead to costs.  Hence, when they add a software product, where there are very little hard costs, they don’t add anything to the COGS.  Salespeople have always known they can convince management to accept a deal as long as it’s slightly above COGS, so they give away the software.

What if hardware companies implemented accounting like software companies?  Their calculated COGS would be higher for their hardware and more importantly for their software.  Sales wouldn’t be able to easily throw in the software for free.  It comes right out of the margin.

To be fair, software accounting for pricing is so wrong in so many ways, but when it comes to sharing COGS with sales, maybe they are on the right track.  It may make sense for hardware companies to adopt the same (wrong) accounting practice.

A Pricing Skills Gap?

Here is a question from a reader:

I have a skills gap that I need to close. I earned my Certified Pricing Professional (CPP) designation last year through the Professional Pricing Society. At work, we have engaged a pricing optimization firm to apply science to our pricing process. I’ve found myself taking a backseat to a more technical coworker that has more experience in the quantitative aspects of pricing. Any advice? I really need to develop a plan for bridging this gap.

Many things come to mind while reading this:

First, huge kudos to you for taking responsibility for your own career and learning. That’s a lesson I learned much too late in life.

Second, maybe you don’t really need to fill that skills gap the way you think. Becoming a pricing champion requires three crucial skills: pricing expertise, understanding data and leadership. You probably already have a lot of pricing expertise based on your CPP.

Notice I didn’t say you needed to be a data expert or statistician. The better you understand data, the more you can contribute with knowing what data to collect and what information you might be able to dig out of the data. However, as you move up in your career you will want to know how to work well with statisticians, not be one.

The leadership portion is the biggest downfall of most pricing experts. With what I know about your situation and most pricing experts, this is the area I’d advise you to work on. This is about listening to other departments, gaining a deep understanding of their goals, and then figuring out how to help them achieve those goals. This is the art of influence. Not easy, but this skill will take you much further than the ability to analyze data.

Combining the last two paragraphs, you will want to support your colleague as much as possible. Don’t worry about how they find the answers. Instead worry about how to implement those results. Like a leader though, don’t forget to give your colleague a ton of credit for his or her achievements.

Third, start studying data analytics. Specifically, you are interested in understanding more about “big data.” Every statistics class I ever took was about deriving the formulas. Maybe that gives some people a more nuanced understanding, but it’s totally useless in the real world. Look for an applied statistics course. If you find a couple you’re considering, feel free to send the info to me and I’d be happy to share my opinion.

In summary, great job focusing on your career. You will probably go further in your career focusing on learning influence and leadership.

A Horrible Pricing Story

Here is a reader story about horrible pricing. Unfortunately this is far too common.

I thought you might appreciate my recent foray into a pricing battle with my horse boarding facility.  

A lady lives on and owns a gorgeous horse farm. She agreed to let me board my horses for $250 month per horse. The barn is basic, not fancy and with no other amenities other than a sand arena, so that was a fair price.  

After 3 weeks of boarding there, she decided to increase the price to $350 to cover the cost of her new fences. I explained that I was willing to pay $300, more than her competitors charged, even though I had a longer commute. She didn’t budge. 

So now she has lost myself with 2 horses and another boarder who has 3 horses. She’s down to boarding one horse. She could not see that her feeling that her property was superior did not create a value proposition for me. I kept thinking about our class and how the value did not equate to the price.

My comments:

There are tons of lessons here:

  1. Price increases are very hard. Don’t increase prices on brand new customers.
  2. Costs have nothing to do with price. The fact that the owner spent money to build new fences is irrelevant. If the fences added value to the renters, that might matter, but not the costs to build the fences.
  3. The reader got a great deal originally. She signed a deal for $250 per month, even though she was willing to pay $300. That is called consumer surplus.
  4. You must understand value from your buyers’ perspective. Obviously, losing 5 horses demonstrates that the owner didn’t understand the value she offered, especially relative to the competition.
  5. People and businesses often don’t understand their own value. Some overvalue their products; most undervalue their products.

What other lessons do you see here?

Why Should Sales NOT be in Charge of Pricing?

A question from a reader:

Good morning Mark. The podcasts are excellent, as always. But I have noticed there may be one point you have not covered: “Why should sales not be in charge of pricing?”

Thank you for the question. I can think of two reasons why sales should not be in charge of pricing.

  1. Their incentives are wrong. Most salespeople get a commission as a percentage of revenue. This partially aligns a salesperson’s incentives with the company in that the salesperson wants to sell more revenue, but the incentives are not aligned in terms of profit. A salesperson has more incentive to discount than the company.

As a slightly exaggerated example, imagine a sales situation where the product sells for $100. The company’s costs are $90, so the company makes $10 in profit. The salesperson’s commission is 1% so he/she makes $1. Now a customer asks for a 5% discount. If the salesperson accepts this (because he/she is in charge of pricing), then the company profits are cut in half to $5. However, the salesperson’s commission went down only 5% to $0.95.

It is possible to create sales incentive plans that more closely align the company and the salesperson’s objectives, but they are harder to implement and most companies don’t do that.

  1. Salespeople often sell many different products. Their job is to build relationships and sell value, not to study competitors for each product and determine the value of your product relative to each competitor. That’s a lot of work and requires a deep understanding of your products, your markets and your competitors.

In light of these two reasons, I could see a situation where it makes sense to let sales control pricing. If they only sold one or two products, and you used an incentive scheme that more closely aligned their incentives with the company’s preferences. Both of these are possible, but they are not very common.

 

 

 

Starbucks Price Increases: Are They Leading or Signaling?

Starbucks is raising prices. In my last blog post, I discussed the pros and cons of that decision. In this post, let’s look at some more advanced issues.

When competitors announce a price increase, they typically do one of two things: They lead or they signal.

Firms lead when they are price makers. They are essentially saying, “I don’t really care what my competitors do. I’m raising my price anyway.”

Firms signal when they are trying to communicate with their competitors. In this case they are saying, “I announced this price increase. If you follow, we both will have higher prices and we both will make more profit. If you don’t follow, I will bring my prices back down.”

It seems obvious that Starbucks is a price leader. They don’t care what other coffee companies charge. Heck, I can buy coffee at McDonald’s for $1 and it even tastes pretty good … but I don’t. I go to Starbucks.

Let’s say you own a coffee shop, and Starbucks has raised their prices. What should you do? You want to make an educated decision. How much do you think your sales will increase if you leave your price alone? I’m guessing not much. The best decision is to probably just follow the leader. They will make more money, you will make more money. Win-win.

Remember, there are two sides to this “implicit communication.” One firm announces price increases. They often do that to get other firms to follow their lead. When you want to raise prices, and you are in a competitive price market, announce your intentions. Watch for followers.

The other side is listening to the “implicit communication” coming your way. Again, if you are in a price-competitive market, watch your competitors closely. When they announce price increases, follow them.

The aim of business is to make more profit, not to make more profit than your competitor. Play nice and everyone prospers.

Starbucks Raises Prices – Good or Bad Decision?

Recently, Starbucks raised prices on its coffee. The company said it raised the price of a tall (small) by 10 to 20 cents, or in the ballpark of 5% to 10% of the original price. What will happen?

Obviously, Starbucks has to trade off the additional profit per cup of coffee against the possibility of selling fewer cups of coffee. Let’s assume the average price increase was 15 cents on a $2 cup of coffee, or 7.5%. That’s all profit. However, let’s further assume that the variable cost (incremental cost) of a cup of coffee is 50 cents. Before the price increase, they were making $1.50 per cup in contribution margin. After the price increase, the contribution margin increased by 10%.

Further, if we assume Starbucks’ overall profit margin is 15%, meaning 30 cents per cup, they just increased their profit margin by 50% to 45 cents. The new overall profit margin for the company would be over 20%. Wow. Price increases can be very powerful.

Of course, this all assumes they don’t lose any sales. Here are three possible places they could lose business:

  1.  Competition. There may be some people who walk by both a Starbucks and another coffee shop on their way to work. They stop at Starbucks because they like it a little better and both shops charge the same price. However, with the price increase, they could save $1 a week going to the other coffee shop. They switch.
  2. Homemade coffee. Similar to competition, only now the competition is the few minutes it takes to make the coffee yourself. Much cheaper, but more effort. Given how much people seem to like their sleep, it seems unlikely that many people will wake up earlier just to make coffee. But some will.
  3. Habit rethinking. Some people just go to Starbucks every day out of habit. They don’t even think about the price. They made the decision once before that this was something they wanted to do, and they don’t need to ask themselves every day if this is still something they want to do. However, when the price is increased, they may take a few moments and rethink their original decision. Maybe they don’t really like coffee that much. Maybe they read that study that said coffee was bad for you. A high percentage will at least rethink the decision, and some will decide no.

Even though these are three reasons people might stop drinking Starbucks, most won’t. My estimate is that none of these reasons are strong enough to outweigh the 10% increase in contribution margin.

But here’s an interesting question. Given the assumptions above, what percent of their unit sales can they lose and still make the same profit as before the 7.5% price increase? The answer is 9%. If you like math, getting to this answer is kind of fun. I’ll leave it to you.

However, it is very likely that Starbucks has historical data to help them predict what will happen with this price increase. We are only guessing.

 

Price Is ALWAYS the issue. Price Is NEVER the issue.

Price is awesome. It is part of every sale. Every customer wants to buy at a lower price. Every company (or most at least) wants to sell at higher prices. It’s a universal truth.

Recently, while teaching, I asked: “What are the reasons sales gives for losing deals?” The answers are always the same. Price and product. I usually follow this up with something like this: “These are rarely the issue, but even if they are, there is still so much more to learn.” Someone in class last week responded, “Yeah, but what if price IS the issue?” This question threw me back on my heels.

That question, and my subsequent answer, prompted the title of this post. Think about one deal. What if we did lose on price? What if we could have won if we had lowered our price? This makes perfect sense. But here’s the real issue. Price is only one side of the equation. The other side is value.

Imagine that we lose a sale because we are priced higher and the buyer went with the less expensive alternative. However, we forgot to tell the buyer that there are gold bars stored in every one of our boxes. If only the buyer had known, the choice would have easily switched to our favor.

Now, think of the gold bars as a feature of our product that our buyers would really value if they knew about it. If we make sure our buyers know all of our capabilities and how valuable they truly are, then they would be willing to pay more for our product.

On every deal, buyers want lower prices. But they would settle for paying higher prices if they know they get more for their money.

When a salesperson or a company believes that price is the reason we lose, it’s a lost cause. Erase that from your mind. The reason you lose is you haven’t created products with enough value or you haven’t communicated that value to your buyers. For successful highly profitable companies, price is never the issue. They focus on value.

Both of the statements in the title is true. Price is always an issue. It’s part of every transaction. But price is never an issue is the attitude we must take to create and communicate real value. It’s kind of like asking if the glass is half empty or half full. Depends on your perspective. My perspective: Focus on the value side. Price will follow.

 

Value-Based Pricing and Everyday Low Prices (EDLP)

Here’s a challenging question from a reader: “Value-based pricing” has made a buzz in the dialogues of pricing practitioners and academics. Should all companies change their pricing strategy to value-based pricing? What about companies with an everyday low price (EDLP) strategy?

My answer, “Yes!” Kind of. My first reaction was the emphatic “yes,” until I read the part about EDLP. That caused me to pause and think for a bit. As a specific example, should Walmart use value-based pricing? I’d argue they do, but let’s get there more slowly.

First we need to agree to a definition of value-based pricing. Here’s mine:

Value based pricing means charge what a customer is willing to pay. This is impossible. However, the goal is to always get closer and closer. In the realm of EDLP companies, I’ll use the low bar of whether their pricing methodology is more effective than simple cost-plus pricing.

Groceries, big-box retailers, distributors, and many other retailers have two characteristics that make value-based pricing more difficult. They offer thousands or hundreds of thousands of SKUs and they don’t negotiate prices with customers. Let’s look at each of these.

It is simply impractical for a company to look at each of thousands of SKUs (stock keeping units) and attempt to estimate buyers’ willingness to pay, especially trying some of the tools we typically use on larger priced B2B items. However, the large quantity of customers and purchase data they accumulate enables them to use statistical models to estimate optimal pricing. The act of watching demand fluctuate as prices fluctuate is capturing at an aggregate level what buyers are willing to pay.

These companies are also in take it or leave it (TIOLI) markets, meaning they don’t negotiate with individual buyers. This means they will never have the ability to set a price at exactly what a buyer is willing to pay. They set one price and each buyer decides whether or not to buy at that price. In these types of markets, companies should be estimating the range of behaviors of the buyers and choose the price where they earn the most profit. The statistical models referenced previously do precisely that.

The last, possibly most important, part of pricing methodologies by these types of companies is how to get buyers into their stores instead of their competitors’ stores. Think of this as value-based pricing the entire store. They typically do this by knowing which products buyers use to compare stores and making sure those prices are priced appropriately. Surely, you’ve heard of groceries advertising milk as a loss leader just to get shoppers into their store. EDLP retailers must be good at this to obtain and maintain the reputation of a low-priced outlet.

Does Walmart use value based pricing? Absolutely, at least the way I’ve described it here. They don’t use a single markup percentage for every item in the store. They have category managers determining how to price different products within a category. They surely use sophisticated statistical demand models to determine how to price. They absolutely know what products people use to compare stores.

How is this for another definition of value-based pricing? Price closer to your buyers’ willingness to pay than you are today.

Why I Quit Amazon Prime … and It’s Not Their Price Increase

Amazon Prime has been amazing in my life. For a measly $100 per year, I get free shipping on almost everything I order. But the funny thing is I don’t really care about free shipping itself.

 

I love the fact that I can just buy on Amazon and not have to shop around for free shipping.

I love the fact that I don’t have to give my credit card to lots of different companies.

I love the fact that they have my data and make it easy to order.

A few weeks ago, one of my pricing colleagues was asking why anybody was Prime, especially since their new 20% price increase. I proudly stated why the price increase didn’t bother me.

Amazon has just been my go to website … until now.

The other day I wanted to order some ZonePerfect bars. I had ordered them before. They were a decent price on Amazon. I went to check out and there was a shipping charge. I thought maybe it was one of those “add-on” items and dug in a little, but no. Turns out this is a “Pantry” item. They don’t have free shipping on pantry items. (Did I pay for shipping on my earlier orders?)

Oh, they offer free shipping if I subscribe to having products delivered to my house monthly. But why am I a Prime member?

I went to Walmart’s web site. They had the same ZonePerfect bars at similar prices and free shipping. I didn’t even have to pay for a “Prime” membership. Wow. I ordered them.

Now, whenever I shop at Amazon, I have to double check if they are charging for shipping. But wait, didn’t I subscribe to Prime so I didn’t have to check? Ugh. Hence, I’ve decided to stop shopping Amazon. I’ll use Walmart and Best Buy as my go-to sites. They offer free shipping, carry most of what I want and they don’t require a membership fee. Nice.

What’s the pricing lesson from all of this, though? Know why your buyers buy. Having your product offer less is no different than raising your price. In fact, it may be worse. Your buyers constantly make the trade-off between price and capabilities. Be clear about this. If you take away a capability, know that buyers who value that will leave—just as if you raised price significantly.