As an executive and private investor, George Stelling has helped many struggling businesses improve their gross margins and profits. During his career, George has developed innovative pricing strategies, managed and restructured pricing organizations, and changed the fundamental tenants of pricing tactics management in technology and consumer companies. “Companies that undertake price-management improvement programs with a point of view that understanding price elasticity differently typically see between a 3 to 5 percent improvement in profits after eighteen months,” he says.
Like many people’s personal cash flow controls, small changes in the management of pricing processes, policies, and strategies can make a huge difference in profits. The balance of supply and demand is sensitive — a decrease in price will expand demand and an increase in price will chase away customers. But the key is to segment your customers based on their willingness to pay for a certain product or service and to test various pricing methods and tactics. “Segmenting customers based on what they’re willing to pay,” says Stelling, “can be a powerful way to improve profitability in any business.”
Understanding what the customer will pay
The first step toward improving profits using price management is to understand what customers are willing to pay for a product or service and why they buy. In addition, it is critically important to analyze pricing variability, as you will often find that discounts, whether in the form of upfront price reductions or back-end rebates, influence a customer’s willingness to buy a product. “Understanding this ‘pocket margin’ — the real amount of money a company makes on a product or services after all discounts, rebates, and other factors are deducted — is often difficult to do, as companies often don’t systematically track all parts of the pricing waterfall,” says Stelling.
Take, for example, the luggage business and its various customer segments and price points:
- Price Point 1 (lowest price, highly price-sensitive customers): There will always be customers who want the cheapest possible bag companies can offer at an acceptable quality with minimal features.
- Price Point 2 (lower middle-tier customers who aspire to certain feature sets): There are a lot of possibilities to make a bag better, by offering specific features, and customers are often willing to pay for extra quality or additional features. Some people might pay more for a little extra durability, or for a lighter-weight material or a telescopic handle that extends easily. Bags are often destroyed in transit, and airlines are usually putting pressure on customers to pack smaller and lighter, so for many it’s a good investment to go up to this next price point and also enjoy some extra features. Companies often give this segment of customers specific rebates for buying their bag through a direct channel, where the manufacturer has more gross margin and can offer a discount to customers who buy within a certain window of time.
- Price Point 3 (middle-tier customers who demand certain features): This bag can be more durable, more unique, and — as a huge bonus that some people will pay for — offer a warranty against travel damage. This bag moves up in price point, and a lot of people will opt for the extra warranty, particularly if they travel on airlines a lot. The key difference is partially the income level of the customers, but also understanding their need for the product and the added warranty. For frequent travelers, a good bag is critical to save them from having to buy over and over, while people who only travel once or twice a year may not find it necessary.
- Price Point 4 (luxury buyers who demand style and function): All kinds of clothing and bags have designer options that can be highly coveted and expensive. It’s not always an option for marketing or consumer companies to tout a name brand, but when they can, luxury customers are often willing to pay more for the style and status of having a designer bag. In the case of luggage, these brands still need to be lightweight and durable while still meeting the functional needs of the customers, since that’s always the most powerful sell.
To understand customer preferences for products or services, one must employ a market-research technique called conjoint analysis. Conjoint – also known as trade-off analysis – is a market research and statistical method where customers choose, typically software program, what features they’d like to see on a product, then create their own versions of the product at different price points. Pending input from enough customers, conjoint analysis can be a powerful way to identify customer preferences or ‘value propositions’ and develop a point of view on how big the market might be for a particular bag or piece of luggage. “I’ve used software-based conjoint tools since the mid-1990s with great success in identifying customer product, service, and distribution channel preferences,” Stelling explains.
Product or service segmentation analysis is not the only way to create differential pricing strategies. Some pricing strategies ask customers to perform certain actions to get the lower price point, such as clipping coupons, participating in a survey, or mailing in rebate forms, which not everyone is willing to do. Other strategies focus on selling refurbished or secondhand items, where the customer receives a discount upfront. For companies, the most often used tactic is to offer price discounts to companies if they buy in bulk, with very clearly defined volume discounts. The technique – called price-volume discounts – is used extensively in a variety of industries. It’s the basis of the “big box” store model used by Walmart, Best Buy, and others. The rub is to measure what volumes are actually purchased, if you are discounting based on price-volume relationships.
Finding the optimal price
Pricing work starts by asking a few fundamental questions about the company’s underlying business model and strategy: Is the company positioning itself as a quality leader in the space or are they recognized as the low-cost producer? Is the business model one where direct sales to customers are common or is the company using distributors or both? Is the product or service complicated, thereby needing a formal request of quote process, or is it an easy to understand product and simple sales process? How often are rebates used and how are they structured and captured?
Once these preliminary questions are answered, various analytical techniques may be used to understand buyer segmentation. Then, one must start to formulate strategies to bump up gross-margin dollar capture. “Understanding how much it costs to offer the good or service, including labor and channel costs is very important,” says Stelling. “You should not sell your product below cost unless you plan to liquidate it just to recapture some cash.”
Once you have a grasp on customer segments, needs, and costs to serve, dive into the execution part of price optimization: quote management. Managing a quoting process with real time price inputs is a challenge for even the most sophisticated companies. Many smaller firms approach quote management as a clerical function, and it is an important strategic lever.
Many B2B companies offer quotes to customers in different channels and across different geographies without understanding that their customers, who are often global or more sophisticated in terms of their purchasing processes, are looking at multiple quotes with different prices from the same supplier. “Large B2B suppliers often compete against themselves as they offer different prices in different countries or in different currencies,” he says. “Smart customers will arbitrage the quotes and use the one with the lowest price.”
In addition to quoting against themselves, companies often don’t focus on the interrelationship between pricing and inventory levels in their distribution channels, Stelling explains. This is crucial: if you have a lot of inventory in your channels, you want to work with your distributors to use pricing to improve sales of that inventory “before thinking about pushing more product into the channel via price discounts to your distributors.”
Finally, Stelling says that an integral part of any price-management program involves the use of key performance indicators (KPIs): “You should be measuring your quarter-over-quarter discounts, your gross margin dollar capture, your commitments to volumes, and your quote conversions at a minimum. If you’re not doing these, you are missing real profit improvement in your business.”
Quadrillion Partners successfully helps companies improve their profits including by developing and implementing new pricing strategies using data and process-driven approaches to value creation. This is just one of the numerous tools used as part of the 10^15 Method. Learn more about our 10^15 Method.