The fastest and most effective way for a company to realise its maximum profit is to get its pricing right. The right price can boost profits far quicker than increasing sales volume; the wrong price can shrink profits just as quickly.
It can be a natural instinct to shy away from initiatives to improve pricing for fear of alienating, or even losing, customers but the result of not managing prices is far more damaging.
While most managers have a handle on the bulk of pricing issues, many overlook a key aspect of this most basic management discipline: transaction price management. Without realising it, many managers are leaving significant amounts of money (i.e. potential profit) on the table at the transaction level, the point where the product meets the consumer.
Some companies that have identified this problem are handling it by applying two basic concepts: the pocket price waterfall and the pocket price band. These concepts show companies where their products’ prices erode between invoice price and actual transaction price, and they help companies capture untapped opportunities at that level.
Finding the right price management strategy is an important element in running a successful business. Naturally, as markets change, so do the strategies required for price management.
The price of a product or service is often difficult to describe objectively and does depend on many factors, such as price perception or communication, customers' willingness to pay, and price modelling - but it is vital to have a systematic approach to optimizing both sales and pricing.
Start applying the right concepts
If you leverage your insights around consumer context & reference points this can turbo-charge the performance of your business by providing you with the means to significantly improve your marketing & pricing strategy.
What are the most common contexts in which your target customers develop a need to purchase your product or service – and what is meant by "context"? Context refers to those attributes that describe the environments of your target customers, such as: where they are located, time & place, who they associate with, what they are doing, what is on their minds, their current objectives & aspirations etc.
Gain insights around reference points
What reference points are your consumers using when they are interested in purchasing your product or service? How do these reference points impact on their openness to the price of your offering? Also, what is their experience after purchase.
Reference points are the points of comparison or anchors a consumer uses when assessing or experiencing your product. To use an extreme illustration, imagine two people who are given a used 2005 Toyota Corolla for free. One is a first-generation immigrant who earns £12,000 a year, whose only mode of transport is a bicycle.
The other is a multi-millionaire who already owns 4 luxury cars. Given the two people’s vastly different reference points for the free Toyota, their responses to the news about the free car will differ dramatically. After generating insights around your target customers’ contexts & reference points, you will want to explore how you can use these insights across critical aspects of your marketing strategy. In some cases how to leverage the insights will be obvious but in other cases you will have to stretch those little grey cells.
The Jelly Bean Example
In the US., 'Jelly Belly', a leader in the jellybean industry, provides us with a good example of a company that leveraged its knowledge of consumer reference points to develop a strategy that enabled it to charge premium prices for its jellybeans.
Instead of selling its jellybeans through traditional outlets, 'Jelly Belly' made the decision to sell them at speciality and giftshops, where alternative sweets included luxury chocolates.
Since the reference points of people shopping at gift shops were these higher-priced chocolates and not other jellybeans, 'Jelly Belly' could price its beans at a substantial premium to other jellybeans and still provide a cheaper sweets alternative for the giftshop shoppers.
Have you tried a Product-Sandwich?!
When was the last time you bought the most expensive wine on the shelf at the supermarket? Most customers play it safe and usually buy a wine priced “somewhere in the middle”.
Perhaps you didn't realise it but the supermarket here is employing a product-sandwich strategy, drawing you inevitably towards that mid-priced bottle of wine! The supermarket was (news to you?) controlling your purchasing habits.
In a nutshell, the strategy involves creating/selling a (very) high-priced version of your product so that the next price down appears more moderate in comparison.
Often this “next price down” would be considered expensive by the customer but in relative terms (i.e.next to the luxury-priced model) it appears reasonably priced. If implemented successfully, the net impact on your business is a boost in sales of the mid-priced version.
Why does the Product-Sandwich Strategy work?
The Product-Sandwich strategy is based on the principle that when buying an unfamiliar product or service people tend to purchase a mid-priced version of it. Why? It all comes down to risk aversion – fear of making a bad purchase and throwing money away. Most of us automatically shy away from the priciest version.
There are three levels of Price Management
Price management issues, opportunities, and threats fall into three distinct but closely related levels.
- Industry supply and demand. At this highest level of price management, the basic laws of economics come into play. Changes in supply (plant closings, new competitors), demand (demographic shifts, emerging substitute products), and costs (new technologies) have very real effects on industry price levels.
- Managers examining pricing in this context should understand the pricing “tone” of their markets, i.e. the overall direction of pricing pressures (up or down) and the critical marketplace variables fueling that pressure. This knowledge allows managers not only to predict and exploit broad price trends but also to foresee the likely impact of their actions onindustry price levels.
- Product market strategy. The central issue here is how customers perceive the benefits of products and related services across available suppliers. If a product delivers more benefit (value) to customers, then your company can usually charge a higher price than your competitors.
- The trick is to understand just what factors of the product and service package customers perceive as important, how you and your competitors stack up against those factors, and how much customers are willing to pay for extra benefits. Market research tools can help you understand customer perception of benefits.
- At this last level of price management, the critical issue is how to manage the exact price charged for each transaction - that is, what base price to use, and what terms, discounts, allowances, rebates, incentives, and bonuses to apply. Where concern at other price management levels is directed more toward the broad, strategic positioning of products in the marketplace, focus at the transaction level of price management is microscopic, customer by customer, transaction by transaction, deal by deal.
The three levels of price management are clearly related. If, for example, a company foresees an industrywide supply shortage of its product, repositioning the product by lowering the price would be a mistake. In the same way, the product’s market strategy should set the context for transaction-level pricing decisions.
The Transaction Pricing Opportunity
The objective of transaction price management is to achieve the best net realized price for each order or transaction. Transaction pricing is a game of inches where tens, hundreds, or even thousands of customer (and order-specific) pricing decisions daily comprise success or failure where companies capture or lose percentage points of margin one transaction at a time.
The complexity and volume of transactions tend to create a smoke screen that makes it nearly impossible to understand what is actually happening at the transaction level. Management information systems most often do not report on transaction price performance, or report only average prices and thus shed no real light on pricing opportunities lost trans action by transaction.
The pocket price waterfall and the pocket price band have proved valuable in lifting this smoke screen and providing a foundation to capture opportunity at the transaction level.
The Pocket Price Waterfall
Many companies fail to manage the full range of components that contribute to the final transaction price.
In most businesses, particularly those selling through intermediaries, invoice price does not reflect the true transaction amount. Many pricing factors come into play between the set invoice price and the final transaction cost. Among these are prompt payment discounts, volume buying incentives etc.
When you subtract the income lost through these transaction-specific elements from invoice price, what is left is called the pocket price, the revenues that are truly left in a company’s pocket as a result of the transaction. Pocket price, not invoice price, is the right measure of the pricing attractiveness of a transaction.
Companies that do not actively manage the entire pocket price waterfall, with its multiple and highly variable revenue leaks, miss the opportunities to enhance price performance.
The Pocket Price Band
At any given point in time, no item sells at exactly the same pocket price to all customers. Rather, items sell over a range of prices. This range, given a set unit volume of a specific product, is called the pocket price band.
Understanding the variations in pocket price bands is critical to realizing a company’s best transaction pricing opportunities. If a manager can identify a wide pocket price band and understand the underlying causes of the band’s width, then he or she can manipulate that band to the company’s benefit.
When pocket prices vary over a 35% range, it’s not hard to imagine how more deliberate management of such wide price variations might yield several percentage points of price improvement.
Capturing Untapped Transaction Pricing OpportunitiesManage the pocket price band
An understanding of pocket price and its variability across customers and transactions provides the basis of successful transaction price management. The entire pricing process should be managed toward pocket price realisation rather than invoice price or list price.
Pocket price should be the only yardstick for determining the pricing attractiveness of products, customers, and individual deals. All price measurement and performance gauges should be recast with pocket price used as the base for calculating revenues. Considering business from this pocket price viewpoint can drastically change a company’s perspective on the relative attractiveness of segments, customers, and transactions.
Creating information systems that correctly measure and report pocket price can be problematic. Elements of the waterfall often reside on different systems or do not exist in data systems at all. However, companies should make the investment to produce a correct and comprehensive pocket price calculation.
Effective transaction price management often requires tough customer initiatives, but incorrect or incomplete pocket price reporting gives managers an excuse not to initiate necessary pricing policies.
Once a company establishes a pocket price measure, it should drive explicit sales and marketing steps off the “back” of the pocket price band. Excellent transaction pricers look to the pocket price band and target specific actions for the best and worst 10% to 20% of transactions and customers.
Marketing and sales should target customers with transactions at the high end of the price band for increased volume. These departments should also identify clients at the low price end, marking them for action that will either result in improved price levels or their termination as customers.
Management should not exclude any low-price customers, regardless of their history or relationship with the company, from such corrective actions. The hard pocket price numbers must determine which customers require remedial price action. Price band management initiatives quickly lose credibility and momentum if exceptions are made that allow favoured customers to languish at the low end of a pocket price band.
Engineer the pocket price waterfall
The best transaction pricing mqanagers understand the leverage of waterfall engineering. A knowledge of which pieces of the waterfall matter to customers can guide not only how a company changes overall price and price structure but also how it negotiates with individual customers.
Managers shouldn’t be at all surprised if different sets of waterfall elements are important to different customer segments or different channels of distribution. Use input from sales reps.to further understand specific customer sensitivity to waterfall elements.
Pricing managers should set a quantifiable objective for each element of the pocket price waterfall, and if that goal is not achieved, they must change or even discontinue that element. Too many companies put in place a waterfall element like annual volume bonuses and leave it unchanged, regardless of its effectiveness in influencing customer behaviour. Sales and Marketing should set hard objectives for each waterfall element. For example, the objective for an annual volume bonus might be to cause sales volume to grow at an average of 8% annually in existing accounts.
Monitor the results of these efforts. If you fail to meet your objective for a waterfall element, it should either be adjusted or eliminated.
Get organisational involvement and incentives right
Transaction pricing merits broad organisational involvement because it is too important to ignore. Companies that are best at transaction price management have managers who understand its importance, set specific goals for transaction price improvement, and monitor those goals through regular and concise transaction price performance reports.
Sales force incentives based on total sales revenue are not enough of an inducement for salespeople to push for higher prices. The pricing leverage for sales revenue-based compensation is always out of balance: a 5% decrease in price, for example will cause only a 5% decrease in a salesperson’s compensation.
However, assuming average company economics, it will engender a 60% operating profit decrease for that transaction. Only sales incentive plans that abundantly reward above-average price realization and deeply penalize below average price levels will draw smart and profitable transaction price management from your sales force.
Some sales force incentive for transaction price realization is a prudent strategy because they are usually the frontline negotiators and the carriers of a company’s benefit and value message. They know the discounting limits their company will approve and will drop to those limits unless adequately compensated to do otherwise. The sales force role in transaction price management is simply too important for much progress to be made without their committed buy-in and support.
The transaction pricing opportunity is real and achievable for most companies today. The investment and risk of capturing this opportunity are low; the keys to success are mostly executional, doing a number of small things right. What is more, advances in information technology tend to make many of these small things easier than ever to do. Many companies are turning to pricing software to help smooth the way to bigger profits.
The payoff can be extremely high, both in short-term and sustainable profit improvement and in valuable strategic insights. With its extremely favourable risk-effort-reward profile, improving transaction price management may be one of the most attractive and overlooked profit enhancement opportunities available.
Remember, pricing is one function that a company can always improve – and the rewards should be high!
Related blog posts
Pricing with Confidence: 10 ways to stop leaving money on the table by Reed K Holden and Mark Burton, 2014
Pricing Strategy:tactics and strategies for pricing with confidence by Warren D Hamilton, 2014
Pricing Strategy:how to price a product by Bill McFarlane 2012