I have had several conversations recently with potential clients who want help in setting their pricing strategies. When asked what their current pricing strategies are, the most common answers have been, “We do it by gut feel” or “We take last year’s price and adjust it for our cost changes.” My second question is always, “What is your business strategy?” The answers to that question vary more widely. Although I ask that question second, it is more important and must be answered before setting pricing strategies.
When establishing a business strategy, the company’s leaders must answer two fundamental questions – “Where will we compete and how will we win?” That means first identifying which customer needs they intend to serve and which segments of customers to target. To serve those needs and customer groups, they must identify how they can offer advantages to potential customers versus whatever the customers’ alternatives are, i.e., which services, product feature sets and benefits have the greatest chance to attract a winning share of customers, and which processes and capabilities will enable the company to deliver those features to those customers. The company must then allocate resources to developing or enhancing those capabilities and processes that will deliver those advantages.
Once those decisions have been made, or perhaps while they are being made, the company can identify how much those services, features, and benefits are likely to be worth to customers and develop their pricing strategies. Those pricing strategies must be aligned with how the company competes.
Let’s consider some examples. Apple started in the late 1970s making personal computers. They targeted customers who wanted computers that were intuitive to use and had an appealing design. They believed there were segments of customers who would appreciate (value) the user-focused design and reliability and would pay more for them than for mass-market pcs. They offered entry-level and high-end machines, but all were priced at a premium to the mass-market computers. If Apple had simply matched prices of the DOS-based pcs, they would have communicated to customers that their computers were the same. That would have been inconsistent with their strategy of winning with superior design, reliability, and usability.
Contrast that with Apple’s entry into the music market. Their target was customers who want to listen to digital music on personal devices, and they believed they could make the process simpler than buying CDs and copying the songs to the digital player. Apple could do that by providing a library of music that could be purchased and downloaded one song at a time. In this case, their strategy was to get people using both the Apple music players and the Apple music library as an ecosystem. A premium price approach might cause customers to be more selective with their song purchases, so Apple used a very low price ($.99 per song) to encourage customers to buy much larger quantities. In these two examples, Apple used completely different pricing strategies because their business strategies were quite different.
For a different example, let’s consider Porsche who manufactures sports cars. Porsche has always targeted customers who want to go fast in a car and want a visceral driving experience. There are other manufacturers who can offer high horsepower, but Porsche’s strategy has been to provide the suspension, gear shifting, and feel of the cockpit that create more of a racer feeling than most cars. Their strategy also included building cars that could reliably take the punishment of being driven hard on a race track. Porsche offers good, better, and best levels of their cars, but they have always charged premium prices for them. To do otherwise would tell customers their cars are no better than competitors.
Porsche also charges a premium for service work. The joke among my Porsche owner friends is they never get out of a service visit for less than $700, and that is for routine work. By charging more for service, they are reinforcing that their cars are highly engineered and need the most highly trained mechanics to service them.
My last example is Costco, one of the most popular retailers in the country. Costco’s team targets customers who want relatively high quality and low prices and will make trade-offs in their shopping experience to receive them. The retailer’s strategy is to lower their cost of service by offering fewer, larger stores and spending less on store amenities, racks, signage etc.; lower the cost of products by offering much larger package sizes and buying multiple pallets of product at a time; and offer an ever-expanding lineup of low-cost private label products. Costco must compete with low prices to get customers to drive further to their stores, buy larger quantities, hunt for products in a warehouse setting, and buy private brands instead of national brands. A premium price model would never work for them.
If you look up pricing strategy in Wikipedia, you can find 29 different pricing models listed along with 9 laws of price sensitivity and consumer psychology. It is easy to be intimidated by that level of complexity. Instead of going with gut feel or last year’s price plus inflation, just tune out the choices among all those models and laws until after you have made the two basic decisions about where to compete and how to win. Your business strategy will point you to the few options that might make sense. You can think about tactics that can enhance margins without deviating from your pricing strategy, but only after the strategies are in place. Things like odd-number pricing, loss leaders, and even dynamic pricing are more tactical enhancements to the underlying strategy, not strategies themselves.
One final point to make is costs should not drive your pricing strategy. Customers will not pay more just because your costs of service are high. Your customers don’t care about your costs; they care about the price of your product or service versus the next best alternative. That said, you should not ignore costs, because they can help you identify a business strategy that is not viable. If customers don’t value the features and benefits that result from a strategy and the costs of delivering those features are high, trying to charge a premium price will not save the strategy. Conversely, if you are trying to compete on price, like Costco, you need to have a very low-cost operating structure. If you don’t have low costs, you will not make money.
So, avoid the complexity, the buzzwords, and the noise.Recognize that business strategy and pricing strategy are fundamentally about making choices regarding where you compete and how you win. If you ensure your business strategies and pricing strategies are aligned, you have a much better chance of winning profitably.
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