Pricing is an enormously complex issue that incorporates costs, competitors, and customers. It must also accommodate profitability goals, product lifecycles, and operational capabilities, all affected by the wild card of psychology.
Posted Mar 8, 2004
CRM is one tool that creates customer equity, or the lifetime profitability of customers. Pricing is how that equity is captured.
Pricing is an enormously complex issue that incorporates costs, competitors, and customers. It must also accommodate profitability goals, product lifecycles, and operational capabilities, all affected by the wild card of psychology. Finally, pricing is part of a CRM strategy, affecting whether companies skim markets with premium pricing or penetrate them with value pricing.
Despite its importance, most firms do a terrible job of pricing. Too often, pricing results from a compromise between financial executives who seek cost recovery, and sales/marketing executives who seek sales volume. The unfortunate result is money left on the table, unprofitable production/fulfillment, or an open door to competitors.
Companies generally make three pricing mistakes: cost-based pricing; customer-driven pricing; and competitor-driven pricing.
Many firms still come up with a price by adding up all costs, throwing in a hoped-for profit, and dividing by anticipated unit sales. This approach offers beguiling simplicity and logic, but suffers from numerous flaws.
Remember Economics 101? Those who practice cost-based pricing foolishly fail to account for the effects of price on volume, and of volume on costs. This leads to such mistakes as price increases to recover higher costs. Usually, all this does is lower sales volume, which in turn raises unit fixed costs and decreases profitability.
Additionally, few firms do a good job of capturing cost data. While traditional accounting systems capture labor, machinery, and material costs, they ignore processes, which account for the bulk of costs. Without this vital data cost-based pricing is dooms profitability.
Finally, not all costs are relevant for every pricing decision. At the risk of oversimplification, the only relevant pricing costs are variable costs. Sunk costs should never be considered in pricing decisions.
This mistaken approach usually results from overemphasizing sales and market share. Practitioners believe that the greater the market share, the greater the profitability due to economies of scale. If that were always true GM and Sears would be among the world's most profitable companies. Companies that stress sales allow pricing to be set by what customers want to pay (and purchasing agents are the world's greatest actors), rather than what customers are willing to pay. Obviously, this harms profitability. In fact, it's best to never offer discounts to individual customers (except based on volume or other business rules) because ultimately all that matters is profitability, not sales or market share.
In a survey by the Professional Pricing Society 71 percent of members said their biggest pricing hurdle was obtaining competitive pricing information. It's incredible that so many are so misguided. It's important to remain knowledgeable about competitor activities, but competitor pricing is generally irrelevant for profitable pricing. One reason is that competitors may be just as clueless about profitable pricing. Second, competitor-based pricing obscures the value of CRM or other differentiators that companies deliver. Finally, competitor-driven pricing often leads firms to choose price-cutting as the quickest way to achieve sales or market share objectives. Usually such price cuts are matched, leading to lower margins and price wars.
Profitable pricing is based on two solid calculations, one internal, one external. Internally, firms must calculate the "contribution margin." The contribution margin is the difference between the unit sales price and the variable costs involved in producing the unit (remember, sunk costs have no role in pricing). Once the contribution margin is known, it is then relatively easy to determine how much sales volume would have to increase to profit from a price reduction, and how much sales would have to decline before a price increase becomes unprofitable.
Externally companies must be able to calculate the value to the customer. The difficulty of calculating customer value is why many sales forces prefer to just keep cutting prices--and profitability--until the customer signs the contract. Essentially, customer value is based on two factors: The first is the "economic value" of the offering, which results from a "reference value" (capabilities and benefits of the next best alternative), plus a "differentiation value," which is the additional, customer-defined benefits delivered by the brand. The second is customer price sensitivity, which varies according to segment, time, switching costs, available inventory, etc. Effective CRM programs should capture both values, either through customer input, communications, or behavior.
Any CRM strategy requires effective pricing. Pricing not only is a vital component of attracting and retaining the right customers, but also of ensuring that their value is maximized. Unfortunately, at many firms pricing is driven by forces other than the need to maximize profitability. Pricing is complex, but the costs of branding can never pay off unless the price is right, both for the customer and the company.
About the Author
Nick Wreden speaker and customer loyalty consultant and the author of FusionBranding: How to Forge Your Brand for the Future. Contact him at firstname.lastname@example.org
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