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The Value of Pricing Data from Your Distributors

You are about to read some details of a project I was part of that collected and analyzed some pricing data from one of our distributors. You may not be able to exactly replicate this, but you can likely do something similar or even much better.

Many years ago, when I was running pricing for a semiconductor company, we put on a huge effort to gather competitive pricing data for thousands of parts. It took us several weeks to define who the competitors were for any one part, and then we painstakingly went to the website of Digikey, one of our distributors, and collected all of their prices one by one . We also collected the prices Digikey charged for our parts. FYI, Digikey carries almost every semiconductor manufacturer’s parts and they sell anywhere from one unit to thousands of units. Companies who buy semiconductors but don’t need huge volumes buy through distributors like Digikey.

The original intent of this exercise was to make sure our prices were in line with our competitors at the point of the end buyer’s decision. We used our knowledge of the parts’ capabilities combined with the Digikey prices to create value maps for our product. We were thrilled at the outcome from our value maps, but we learned so much more.

We deciphered the way Digikey marks up our parts. It wasn’t a simple markup on every part. Their markup percentage depended on their volume and the price they paid. We created a tool so we could enter the price we wanted at Digikey’s website and the tool would tell us how much to charge Digikey. For each part, we looked at the value maps, determined what price point we wanted Digikey to set, and used our tool to the price to sell to Digikey.

We were also able to find suboptimal prices, because Digikey changed their markup percentage at specific price points. For example, if our price to Digikey was between $0.25 and $0.49 they used a 250% markup for a single unit. If our price to Digikey was between $0.50 and $0.99, they used a 200% markup for one piece. This means whenever we priced something at $0.49 they charged $1.72. If we raised the price one penny to $0.50 Digikey lowered their price to $1.50.  After learning this, we changed the prices we charged to Digikey for hundreds of products.

We found Digikey made mistakes. Now that we know their markup algorithm, we found outliers. After pointing these out to DigiKey, they agreed they were a mistake and brought the end customer prices in line with where they should be.

Knowing what all we did about how Digikey set prices, we then turned it back on our competitors to see what we could learn about how our competitors set prices. We charged the same price to Digikey regardless of the volume they sold. However, it became obvious through statistical analysis that our competitors lowered their price to Digikey at higher volumes.

Finally, the last thing we did was put together a web scraper on Digikey’s site to collect their prices monthly. The big win out of this was seeing when our competitors changed their prices so we could respond accordingly.

I just provided some specific details on how we used price data that we captured from one of our distributors. It proved to be extremely valuable. Unless you’re in the semiconductor industry, you probably won’t find the exact same things we did. However, if you sell through distribution, there may be a treasure chest of information waiting to be discovered. You never know what you will find, until you start looking.

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.

 

Question on Building a Fence in Price Segmentation

I always enjoy hearing from alumni who have taken the Pragmatic Marketing Price course:

I was in your Austin Class last May. It was fantastic, and I had a question on price segmentation for software. Our company is successful in the B2B market, but is attempting to focus on a specific segment (IT service providers). The issue is that we are selling the same software but have changed the pricing model to suit the specific market need, which is different from most businesses (sell by number of sites they use us to provide a service to rather than by the quantity of usage for a specific customer). It is two prices for the same software, so how would you stop a prospect from comparing both pricing models and simply choosing the cheapest for their specific use case?

First, congratulations on implementing price segmentation. There are many ways you can build “fences” so one buyer doesn’t buy at the other market’s price. The most common if you use a direct sales force is that you give both markets the same list price and allow the salespeople to discount one market more than the other.

However, you say you use a different pricing model for each market, which implies you charge for something different for each market. Presumably, the metric you charge for is highly correlated with how that market receives value. It sounds like you charge for number of sites to one market, so let’s call that market A. We’ll call quantity of usage to the other one market B.

Sometimes, we are lucky and things just work out. If market A uses much higher quantities than market B, then market A would be happy to pay based on number of sites. Similarly, if market B supports more sites than market A, then market B would be happy to pay based on usage. I’m guessing you’re not that lucky.

The next, relatively easy solution is to create two separate products. You put a different skin on each one even though they are identical under the hood. If you can find some features that only market A cares about, turn them off for market B’s product (and vice versa). Alternatively, you could just create data sheets that describe the features you get with one product versus the other, even though both products have all features.

The goal is to make it so anybody in market A wants to buy using that pricing model based on sites and anybody in market B wants to buy using the pricing model based on usage. They should not perceive that you’re forcing them—rather that they have a choice and the rational choice is the one you want them to make. Hope that helps and thanks for the interesting question.

 

Price Increases: Big and infrequent, or small and annual?

Amazon just increased the price of Amazon Prime by 20%. Wow! That’s a big jump all at once. The good news is this was the first increase in 4 years. In 2014, they increased the price by 25%. These big price increases must impact their subscriptions.

Instead of trying to determine if this latest price increase was good or bad, let’s consider: Should they do 20% all at once or should they have done 5% per year? Unfortunately, there isn’t a clear answer, but here are the arguments on both sides.

Smaller, yet more frequent, price increases seem good if they can condition their subscribers to expect these annual increases. After working many years in the technology industry, where annual price decreases were expected, I was pleasantly surprised to be exposed to the life sciences industry where people just expected a 2%-3% increase every year. That was a lovely feeling, raising prices every year without much pushback. The question though is: Do you expect an annual price increase from Amazon? They could probably condition you to expect it.

Larger, infrequent price increases have two things going for them. First, every time any recurring revenue business increases prices, they are asking their subscribers to rethink their decision. If the price this month is the same as last month, customers already made that decision … It’s easy to just pay the bill. However, if the price went up, customers tend to reevaluate whether they really need that product or not. Even if the price didn’t change, doing something that causes paying customers to rethink their decision is probably not brilliant.

Second, is prospect theory. (OK, skip this paragraph if you’re not technical.). Turns out Daniel Kahneman and Amos Tversky introduced us to a theory that showed “losses loom larger than gains.” But the relevant part of that theory here is that the pain felt by losses has diminishing marginal returns. This means that the pain of losing $5 in two different circumstances is bigger than the pain of losing $10 once. In other words, the cumulative pain of four annual $5 price increases is greater than the one-time pain of a single $20 price increase.

So what’s the right answer? If you commit to annual price increases and condition your market to expect them, then it’s probably better. I watched this in wonder in the life science industry. However, if your market doesn’t expect price increases, save them up and deliver them all at once.

Of course, the best answer could come through testing, but that will take years. Does anybody have any data they can share?

 

 

Confused Buyers Don’t Buy—Or Do They?

An important rule I teach in the Price course is that confused buyers don’t buy. If you have a complex price list, then this is your buyer’s experience.

He has a 30-minute break between meetings and picks up your price list to figure out what the company needs. He spends the entire time trying to determine which parts go with which other parts, what options he needs and why one option is better or more expensive than another option. After 30 minutes, he needs to go to his next meeting and puts your price list back on the corner of his desk … never to be looked at again. Confused buyers don’t buy. They are afraid of making a mistake.

One way to simplify your buyers’ decision is by creating a good, better, best product line. We’ve discussed that in this blog before.

The hard question for today is: Should pricing ALWAYS be simple? Although I’m tempted to say yes, there are examples of very successful companies in industries that have confusing pricing. Cell phone service is an example. I’m pretty sure I signed up for an $80 per month package with Verizon, but my bill is never $80. My wife and I use the same data plan, and there’s an extra fee for that. I’m making payments on my phone, another fee. I have an international plan, more fees. I went to the Verizon Web page to figure out why my bill is what it is, and I can’t figure it out.

I was thinking the other day, should I switch to AT&T? After all, I would get a discount on my DirecTV bill (another very confusing bill) if I switch. I asked the AT&T guy what it would cost me and, of course, he told me a number lower than what I pay to Verizon. Should I believe him?

Wireless providers intentionally make their pricing confusing to keep us from easily comparing plans. They have the low teaser rate, but by the time you actually get what you want you don’t really know how the price got so high.

Why do they do this? Imagine they had an all-inclusive, no extra fees pricing model. Now it’s very easy to compare Verizon and AT&T. Regardless of what they want us to believe, there isn’t a huge amount of differentiation between them. That leaves price as the main feature we would use to compare providers. That would cause price competition, driving down margins and profitability.

In the absence of product differentiation, obfuscating pricing can reduce price competition.

Another reason wireless companies get away with it is we (okay, I) have to have wireless plans now. They are vital to our existence. At least they feel that way. We will jump through hoops to buy the service, while we may not for a product that wasn’t as important.

Confused buyers don’t buy is a great rule to price by. But like most rules, it isn’t universally true. There are exceptions. Just be very careful when you break the rules.

Ability to Pay vs. Willingness to Pay

In a recent Pragmatic Marketing Price class, one student “corrected” me to say it wasn’t willingness to pay that matters in pricing, rather it was ability to pay. It was challenging to change his mind, mostly because he was in the middle of an emotional pricing situation with his son and a local college.

The college was digging deep into details of his income and his assets. They clearly wanted to know how much he was “able” to pay. This situation was so top of mind to my student and an obvious learning experience—only he learned the wrong lesson.

Colleges like this execute an extremely effective means of price segmentation. They set a very high list price, but then offer discounts in the form of financial aid to students from families who are not wealthy.

Most companies (who are not colleges) have to find and use more surreptitious means to determine a buyer’s willingness to pay. Car dealers look at the clothes buyers wear or the car they drive to the dealership. Movie theaters ask to see a student ID card. Airlines try to distinguish business travelers from vacation travelers. Online retailers look to see if you’re shopping from a PC or a Mac.

Colleges are in the unique situation where they can get their buyers to provide detailed financial information. Buyers only do this in exchange for large discounts, so it’s worth it. This gives colleges fantastic information they can use to determine the size of their discounts (financial aid).

But is this ability to pay or willingness to pay? In this one case, they may be very similar. Colleges assume a family is willing to pay some large percentage of their income to educate their children. Could they pay more? Sure. They could pay 100% of their income. Or they could pay more than 100% by taking out loans. But are they willing?

I’m not wealthy, and I don’t drive a Ferrari, but could I? Sure. If I didn’t worry about retirement or have any other hobbies that require spending money, I could take out a huge loan and drive a Ferrari. I’m able, but certainly not willing.

Besides adopting value-based pricing, price segmentation is probably the single most valuable pricing strategy you can implement. The trick is trying to determine how much customers are willing to pay and finding a way to charge these different customers different prices.

Often willingness and ability are highly correlated, but don’t confuse the two. Pricing is always about your buyers’ willingness to pay.

 

You Must Be Confident of Your Value to Win at High Prices

How confident are you and your sales team that your product is worth its price?

The answer to that one question is a fantastic predictor of how much you discount your product. People that don’t believe their product is worth it have a very hard time winning at high prices. Instead, they discount to a “reasonable” price.

A highly profitable attitude and belief is that my product is so worth its price that I feel sorry for people who don’t buy it. If they bought from the competition, they didn’t make the best decision because I failed to communicate the value well enough.

This isn’t a game. This is truth. Are your products that good? Are they that much better than your competitors? If you don’t believe it, you are probably discounting too much.

If your products aren’t that good, then that is where you should focus. Listen to your market. Only add new features that buyers would pay for and users would use. Be better than your competitors. When you add the right features long enough, you will gain that confidence.

In fact, you will hear your own users tell you stories that strengthen your confidence. If you’re not confident, work on your product first. Have price in your mind and in your research, but realize your products have to add value before anyone will buy them.

Comments on “Three Rules for Making a Company Truly Great.” (Hint, It’s About Pricing.)

I just read for the first time a Harvard Business Review article, “Three Rules for Making a Company Truly Great,” by Michael Raynor and Mumtaz Ahmed (April 2013). The rules come from a statistical analysis of thousands of companies over decades.

Here are the three rules as written in the article:

1. Better before cheaper—in other words, compete on differentiators other than price.
2. Revenue before cost—that is, prioritize increasing revenue over reducing costs.
3. There are no other rules—so change anything you must to follow Rules 1 and 2.

When I read these three rules, here is what I read:
1. Pricing is important.
2. Pricing is important.
3. Pricing is the only thing that’s important. (Exaggeration?)

Let’s be a little clearer on why these all say “pricing is important”:

Better before cheaper. This says, “Don’t compete on price.” Build products that are better than the competition. The price you can achieve in a competitive market depends on only two things: the price your competitor charges and how much better you are than your competitor. If you’re not better, then you are probably competing on price.

The authors claim companies should be focused on making products, services or support better. Absolutely. I would add to that: Choose to resource the projects that add the features your market values more. In other words, the capabilities that enable you to charge a higher price. Focusing on price focuses you on better.

Revenue before cost. Revenue is made up of two components: price and quantity. Many companies expend copious resources increasing quantity by managing their sales force, motivating their sales force and even training their sales force. However, they practically ignore the other side of revenue: price.

Companies have an immense opportunity to increase revenue by managing price more effectively. That doesn’t mean just charging more. It means understanding your customers’ willingness to pay, using price segmentation, building products that matter to your segments. It’s not a trivial task, but it is amazingly profitable. Focusing on price has a huge impact on revenue.

There are no other rules. Confession: In my world (my mind?), price is my hammer and the whole business world looks like nails. What I love about this article is these authors explain to us how valuable it is to be able to swing that hammer. You probably still need other tools, but the truly great companies all focus on price.