DISCOVERING HIDDEN PRICING POWER

by Donald V. Potter

Over the last few years, many companies that tried to raise their prices were unsuccessful. They lost volume as customers shifted purchases to competitors that had not raised prices or found substitutes for the product itself. Ultimately, many of these companies had to lower prices again — sometimes dropping them even further than they were before the attempted price increase, in an effort to recapture lost share.

It doesn’t have to be that way. Even in a mature and complex market that is resistant to across-the-board price increases, there are still numerous ways to raise effective prices and to increase market share with deft use of price. Pricing policy, if wielded wisely, can still be a powerful tool.

A company’s effective use of the pricing tool in a price-sensitive market requires more flexibility and market knowledge than is needed in a less hostile environment. Pricing opportunities in highly competitive markets are often hidden from the eyes of both customers and other competitors. They have their greatest power when they remain veiled.

The pathways to these pricing opportunities are not hard to find. They lay in three actions a management can take to use price effectively in a market that appears intolerant of price increases: changing the structure of the price, building more subtlety into the pricing process and exploiting pricing patterns common in markets where price increases are difficult.

CHANGING THE STRUCTURE OF THE PRICE

The components of a price make up the price structure. In a market with relatively low levels of competition, a price structure tends to be simple, with few components and limited price variability. As a market becomes more competitive, however, the structure of the price becomes much more complex and prices become far more variable. As this complexity develops, a company can improve its price per unit by changing the components in the pricing package. Sometimes, this requires the company to redefine the product as well.

Bundle Benefits

Many standard products offer options. As the pricing environment becomes more competitive, a company may find opportunities to bundle options into the standard product in order to hold the price for the bundled product at the same level as the previous unbundled standard product. This works as long as the options cost less than the price would have dropped. As the sport utility vehicle market began to take off in the early ’90s, many companies entered the market with new versions. Chrysler responded by incorporating options, such as air conditioning and power steering, as standard equipment on its profitable and long-established Jeep Cherokee in order to hold its price.

Another form of bundling is offering the customer the right to buy or receive something else with the product. Lucky Stores, a large grocery store chain owned by American Stores, offered a promotion with Continental Airlines whereby Lucky’s customers could buy two discounted Continental airline tickets after spending $50 or more on groceries.

Rebate programs are also a form of bundling. These programs often have lower costs than the face value of the rebate, either because some customers do not redeem the rebate or because the company makes the rebate contingent on some revenue-generating action of the customer. Examples of the simple rebate are common today in the automobile industry, in hardware items and in many software categories.

Unbundle Benefits

Unbundling benefits takes the opposite tack from bundling. Here, the company removes a feature from the product package that had been standard and makes it into an option. The company may reduce the price for the standard product, as Nissan did in the early 1990s with its 300ZX automobile. Nissan lowered the base price of its 300ZX sports car by 4.5 percent under the pressure of falling automobile prices. At the same time, the company eliminated the car’s standard T-top, which became an option. If the car were equipped with the T-top, its price was higher than its previous price.

In another form of unbundling, the company may leave the base price alone but simply charge for benefits that had previously been part of the product. National Car Rental System faced declining prices in the leisure auto rental market. One of its responses to those falling prices was to institute a cancellation fee on several of its bargain rate rental offers.

Offer Alternative Service Levels and Price Points

Sometimes making smaller changes to the product package through bundling and unbundling is not enough to arrest the price and profit decline. In these cases, the company may consider creating new price points to meet customer demands for low-priced products with a reduced level of benefits or to offer some customers more benefits at higher levels of price and profitability.

A sharply falling price environment creates opportunities for the creation of new price points with lower levels of service. Sometimes these new price points are simply the same products and services re-priced for use during low-demand periods. In the difficult airline business of the early ’90s, the Trump Shuttle, operating in the Northeast, cut fares by more than 50 percent for travel during off-peak hours. In other cases, the new low price point is a different product with a lower level of service. Marriott faced a difficult lodging environment in the early ’90s. The company developed a number of advanced purchase product offerings with substantial savings. However, the company demanded advance payment and charged penalties for changes or cancellations of reservations. It also restricted the availability of the low-cost hotel rooms.

An alternative to offering a low price point is to offer a new premium price point with more benefits. Even tough markets will see a segment of customers who will pay more for a better product. The tire manufacturing industry had been tough for a number of years when Goodyear designed and introduced the Aquatred, an all season radial tire designed to provide better traction on wet roads. The company priced this tire about 10 percent more than its previous top-of-the-line mass market tire, but the tire sold well and improved the company’s profit position.

Link Future Purchases to the Current Transaction

Some markets allow a company to better its future position by using the pricing tool. One example is to offer “buy backs” to increase the chance that the company will win both the current sale as well as the next. A few years ago, auto makers used this technique with rental car companies. The Big Three auto makers sold their products to the rental car industry with agreements to re-purchase the cars after a period of time. This arrangement enabled the auto rental firms to offer their customers fresh product at a known price, and it increased the odds that the automobile manufacturer would be in a favorable position to obtain the business when the rental car company rotated its product line.

Another variant of this pricing technique is to offer a fixed future price to some or all customers. College tuition has been rising faster than inflation for a number of years. As schools feel student and parent resistance to this trend, some have begun to offer fixed tuition for any current student who returns to the school.

Alter Period During Which Price is Effective

Some prices are effective only for a single order. Others are effective for a long period of time. A company can change this component of its pricing structure to lock in potentially volatile customer volume or to obtain a higher price over a period where the company expects prices to fall.

Some competitors in the cellular telephone industry offered low prices for extended contract lengths because they expected prices to fall throughout the contract period as the new personal communications services came on line. They bet that the average price on their long-term contracts would beat the average on short-term contracts that had to be continually renewed.

Substitute Components of the Price

Companies in challenging pricing environments may be able to substitute components in their price structure to match costs more accurately or to improve the price’s appeal to customers.

One option is to use new components that more closely match the company’s cost structure, which can make the price more profitable. For example, after several years of intense competition in the air express market, margins were getting thin on some of the business. Federal Express took the lead in changing the price structure of the industry. Instead of using flat rate price components, it began charging for its package delivery services according to the distance a package travels. The result was that rates went down for short-distance packages and up somewhat for long-distance packages. Price and cost moved in parallel and margins improved. The rest of the industry followed Fed Ex’s lead in short order.

Another option is to change price components so that they better match what customers are trying to achieve with their purchases. A few money managers, for example, have abandoned the practice of basing all their fees on a percentage of assets managed. Some have increased the proportion of the fees they receive from the profits that their customers realize on the assets managed.

A variation of this change in components can be found in the fast food industry, which for several years watched as pricing on individual products fell. One competitor then introduced a price per meal concept called an “extra value meal.” This offered the customer a low price for what most customers wanted, which was a whole meal. While the price for the extra value meal was much lower than the a la carte prices of its components, the fast food companies realized far more volume in drinks and fries than they had seen with a la carte pricing. The customer got a good price per meal; the industry got far more volume, and both sides benefited.

Shift Some of the Price to Suppliers

In some markets, the company has enough market power to shift some of the price decline back to its suppliers. Over the last several years, the retail grocery industry has developed and fine-tuned “slotting allowances.” These allowances are payments made by the suppliers to the retail grocery chains in order to win space on the grocery stores’ shelves. These slotting allowances increase the margin on the goods sold by the retail industry and enable it to avoid some price increases for the retail shopper.

BUILDING MORE SUBTLETY INTO PRICING PROCESS

To understand why subtlety is helpful as markets become more competitive and complex, it is necessary to understand why prices are being forced downward. The short answer is: Because customers are demanding price discounts.

Conventional wisdom says that prices fall because competitors offer lower prices to gain and preserve share. In the majority of situations, though, that is not true. Competitors have very little economic incentive to offer low prices in a highly competitive marketplace. This is why:

• If a competitor already in a customer relationship reduces its prices, that price decrease suffered on the base business with that customer will be justified only if the competitor gains a much larger share of the customer’s business and therefore picks up significant extra volume. In a highly competitive market, that isn’t likely to happen.
• If the competitor outside the customer relationship offers a low price in the hope of gaining new business with that customer, it is unlikely to gain a toehold. That is because the customer is likely to offer its incumbent suppliers a “last look,” the opportunity to match the low price being offered by the competitor outside the relationship. If the lower price is matched — and it usually is — the customer is likely to stay with its current, known supplier.

In a highly competitive marketplace, then, prices drop not because competitors offer reductions to gain or hold share but because customers demand lower prices from their suppliers who, in turn, grant the lower prices in order to preserve the customer relationship. Customers in general have the power — but not all customers have the same incentive, savvy and leverage in seeking advantageous prices. By developing a pricing process with greater subtlety, a company can realize more revenue overall, even when prices are heading down.

Subtlety means a number of things. It means that any single price decline should apply to as little as possible of the company’s market volume. Subtlety means raising prices on ancillary benefits and services that customers do not consider when making their buying decisions. It means delaying, for a short period of time, price reductions demanded by some customers. Subtlety may also mean using discounted product more strategically to build relationships with the company’s best customers.

Set Prices Selectively Rather Than Across the Board

Many companies use a broad pricing process in order to contain the cost of pricing administration. A broad pricing process sets prices that apply to many customers and a great deal of volume. A company is using a broad pricing process when it quotes prices from a product price list applicable to all customers or establishes prices for large customer segments, geographic regions, and customer types.

But broad pricing processes can be costly when they are the pricing tools of choice in highly competitive marketplaces. This cost is often invisible because it is an opportunity cost. A broad pricing process brings all customers to the level of the best customer negotiator. Where prices are set by customers, some customers will always be below average in negotiating skills or ability. They will pay above-average prices. Others will always pay below-average prices. When a company uses a broad pricing process, the customers who are most aggressive and demanding in negotiations determine the price levels for all the customers in the broad segment. The opportunity loss occurs when some of the customers whose prices fall in a price decline do not pay the higher prices they would willingly have paid were they not unilaterally granted a price decrease by their supplier.

In a difficult price environment, a more powerful approach is to price surgically. Rather than pricing for all customers in a segment or a region or setting overall price levels for a product, a company can offer prices to ever more precisely defined customer segments.

One company facing a tough pricing market developed what it called its “cat across the carpet” program. A senior executive coined the phrase by describing a cat being dragged by its tail across a room, digging its claws into the carpet to resist the pull as long and hard as possible.

This company had been operating with margins of 8 percent and using a pricing process that set prices applicable to wide geographic territories centered around manufacturing plants. By instituting customer-by-customer pricing, the company avoided reducing prices to customers who were willing to pay somewhat more. As a result, the company increased its revenue per unit and its operating profits by nearly a full percentage point.

Move Prices in Smaller Increments

Another difficulty companies face when they move from a relatively easy to a more difficult pricing environment is the amount by which prices traditionally move in the industry. Customers in some industries have become conditioned to expect price movements, both up and down, in specific percentage or dollar increments. In a falling-price market, the size of this required price movement creates an opportunity loss for the supplier. If customers could be persuaded to accept changes in different increments, it may be possible to achieve the price position demanded by the customers by making relatively small price moves.

One competitor in the residential fiberglass insulation business did just that. In the fiberglass industry, prices move in “sixes and threes,” which refer to percentage differences from the current price. By common practice in that industry, prices move up or down by at least 3 percent at a time. This company abandoned the traditional threes and sixes entirely and moved to “net pricing,” where it quoted the customer a specific price per unit purchased rather than a specific discount on a putative list price. This company’s average discount, as market prices fell, was less than the 3 percent common in the industry, yet it was still able to maintain and even grow its market share.

Raise Invisible Prices

Sometimes nothing a company does will enable it to raise prices on a standard product or to reduce the rate of the price decline. Then the company can look for the opportunity to raise invisible prices.

Ancillary products and services usually have invisible prices. The customer often does not consider these invisible prices when making his buying decision. For example, many customers do not consider phone charges they will pay while staying in a hotel room. A customer may sign on with a low-cost long-distance carrier and not consider that he may be paying high charges for directory assistance. Each of these services provided opportunities for price increases to ease the pressure on competitive pricing for the base product.

Match Price Moves to the Market

Price declines spread through a marketplace at a relatively predictable rate. The largest customers receive the price decline very quickly. But for other customers, price tends to decline at a slower rate. Up to six months may be needed for a given price decline to spread fully through a marketplace.

A supplier company facing this predicament may be able to delay, for a short time, the demanded price decrease. Delay could be possible if the demanding customer does not yet actually need the price discount to remain competitive with peers. To stall the demand for a price reduction, a company will need to know how fast the price decline is actually spreading across the market and whether the price decline has yet reached the competitors or peers of the customer who has demanded the lower price. Having the knowledge to negotiate delays where appropriate requires an astute and well-informed sales force capable of monitoring both prices by customer and the apparent pricing policies of competitors.

Use Discounts Strategically to Build Relationships With Desirable Clients

There is an irony in the way some companies confront markets with excess capacity and declining prices. Low prices are painful for any management group because they destroy profitability. But when confronted with falling prices, some managements use discounted products tactically rather than strategically. Tactically, they use the low prices to off-load excess volume that exists during a period. The beneficiaries of this off-loaded, heavily discounted product, though, are usually the company’s least attractive customers. Some or all of this volume could be used strategically to build relationships with the company’s most desirable customers.

For example, a large producer of an international product found itself with excess capacity. The company’s manufacturing process required that the manufacturing facility run at all times, so this excess capacity quickly translated into excess inventory. To get rid of the excess, the company then discounted some of that product to its most price-sensitive customers to get rid of it. The remainder of the product the company sold in the international market where the company was viewed as an unreliable long-term supplier. The price-sensitive customers and the international business were the least profitable relationships for the company. Yet these customers were the principal beneficiaries of very low prices for the company’s excess product. The company had used its discounted volume tactically.

The company revamped its approach to this excess inventory. It began offering discounts to its most attractive customers in special programs designed to develop these customers’ own business and profitability. Although the product was still discounted, the discounts were lower, and the customer loyalty that resulted was far greater than with the international and price-sensitive customers. By using the product strategically, the company increased its profitability and long-term customer retention.

EXPLOITING PATTERNS COMMON IN DIFFICULT MARKETS

Tough markets tend to have a number of characteristics in common. Among those characteristics are pricing patterns typical of markets that are facing declining or low prices. These pricing patterns offer both follower and leader companies opportunities to raise their effective prices. Followers can raise their effective prices by pricing against the leader in some cases or following the leader in others. Leading companies can seek out segments that tend to tolerate higher prices.

Price Against the Leader

Large companies, and especially the top competitors in any market, are reluctant to reduce price when confronted with a declining price environment. They often believe they can sustain their higher price levels because they view their product as superior and their customers as more loyal than the average in the industry. This belief leads to the “Leader’s Trap.”

The Leader’s Trap is our term for a situation that causes the industry leader to lose both volume and unit pricing at the same time. How does that happen? When offered very low prices, some customers will defect from the leader to the low-priced competitor. This low-priced competitor then uses its resulting business, and often high utilization rates, to improve its reputation and product quality while continuing to offer low prices. The improved reputation and product quality then attract more customers of the leader and more profitability to the low-priced competitor. As volume and market share leave the industry leader, it eventually must lower prices in order to stop share loss. The leader then has both lower volumes and lower prices. The irony is that, if the leader had reduced its prices to these same lower levels much earlier, it could have avoided the share loss — but leaders seldom do that.

A good example of the Leader’s Trap can be found in the personal computer industry in the early ’90s. Both IBM and Compaq, the industry’s unquestioned leaders, held prices high in the face of strong growth by the personal computer “clone” manufacturers. After losing volume, Compaq reversed its pricing stance and recaptured much of the share it had lost to the clones. IBM was much slower to reduce its prices to match those of the clones and continued to lose both share and profitability for some time.

The tendency of industry leaders to fall into this Leader’s Trap offers pricing opportunities to other players in the industry. In marketplaces with deteriorating prices, these follower companies can continue to discount against the leader and thereby gain share, knowing that the leader is not likely to respond until a significant part of its share has defected. At least some of this share will remain with the discounting competitor since customers who tend to move on price in a deteriorating price market are often strategically attractive and loyal customers.

Follow the Leader

The industry leader’s natural tendency to demand high price offers another opportunity for a follower company: To follow the leader into his relationships. Here the idea is not to discount prices in order to take the leader’s share, but rather to target the leader’s customers, seeking to become an additional supplier favorably situated under the leader’s price umbrella.

Industry leaders, especially branded industry leaders, will tend to have a higher effective price in most customer segments than will follower companies. Leading companies believe they are entitled to somewhat higher prices; many customers agree and willingly pay. Those customers, however, will often have relationships with other suppliers as well. So, while the industry leader may be the primary supplier to a customer, there may be room for a secondary or tertiary role to be filled by a follower company who seeks to benefit from the leader’s ability to extract higher prices.

A follower company can ride the coattails of the industry leader to better pricing as long as it does not use pricing to buy its way into the relationship. That would defeat the purpose. In the average customer relationship, the primary and the secondary suppliers both receive the same net prices. The same may hold true for some, though certainly not all, tertiary positions. A company’s goal, then, should be securing secondary or perhaps selected tertiary positions with the best customers of the industry leaders, eliciting from those customers price levels near those of the leaders’.

Seek Out Segments That Will Tolerate Higher Prices

Industry leaders also can take advantage of pricing patterns that are common to difficult pricing environments. Specifically, leaders should look for customers who have no real alternatives to carrying the leader’s products and therefore cannot quibble on price.

Sole source customers may offer the opportunity to gradually raise prices. A company conducted analyses of two separate businesses, one of which faced low to moderate price competition and the other of which faced intense price competition. In the business with low price competition, sole source customers tended to pay, on average, one to two percentage points more than did customers who had multiple suppliers in their relationships. In the business with intense price competition, sole source customers were paying one to two percentage points below the average. Why? The company found that the disparity was due primarily to the sales force. In the competitive market, the sales force had become so concerned with protecting the sole source relationships that it recommended lower prices for the sole source customers than those customers needed to remain quite competitive in the marketplace.

Another source of opportunity may be channels carrying the products purely to accommodate their own customers. In marketing parlance, the end users are creating pull for the customer’s products. Left to their own devices, these members of the channel would rely on other suppliers for all of their purchases. As such, they are non-strategic customers for the company and offer the company the chance to recoup some of its investment in a strong brand name directly through the pricing mechanism.

A well-known branded industry leader evaluated all of its channel customers who had placed the company in a secondary or lower role in their relationships. Wherever the company identified customers who carried its products as an accommodation for the channel’s own customers, it looked into raising prices for those customers. Often the raises put the company’s prices 10 to 15 percent above those of other suppliers in the customer relationship. Yet the company suffered very little loss of volume as a result of these price moves because the channel customers felt that they had to carry the company’s products.

As the marketplace in which a company operates becomes more price sensitive, the company must change its approach to pricing. In a less price competitive market, pricing is like sumo wrestling. The biggest and most powerful competitor usually wins the match. The highly price-sensitive market, though, is much more like judo. Here, the stronger force often lies with the opponent, and the company’s response is to use the leverage of the opponent’s own momentum in order to gain an advantage. A company facing a highly price competitive market can use cunning and subtlety to improve its returns and share with the hidden power of pricing.

(Note: This Perspective was written in the context of the economy in 1998. While some of the companies may have changed their policies or indeed no longer exist, the patterns they exhibit still hold today.)

Recommended Reading

For a greater overall perspective on this subject, we recommend the following related items: Analyses: Analysis 21: The Cause of Volatility Analysis 32: Elimination Reasons for Volatile Customers Analysis 48: Average Price Received by Competitor Analysis 49: Market Segments Where Share Moves on Low Price Analysis 50: Returns from Price Leverage Roles Analysis 51: Loss On Price Index Symptoms and Implications: Symptoms developing in the market that would suggest the need for this analysis. Leaders Stress Quality to Offset Competitors’ Lower Prices The industry is seeing its first price wars Foreign competitors are expanding with low prices Customers are more price sensitive ***