26 Jul 2010  Research & Ideas

Yes, You Can Raise Prices in a Downturn

If you and your customers understand the value represented in your pricing, you can—and should—charge more for delivering more. An interview on "performance pricing" with researchers Frank Cespedes, Benson P. Shapiro, and Elliot Ross. Key concepts include:

  • Pricing builds or destroys value faster than almost any business action.
  • Performance pricing seeks to maximize both the customer benefit and the selling company's profitability.
  • The idea is to create more space between the value provided to customers and your cost.
  • Performance pricers make attractive returns in almost every business—at least over the full business cycle.

 

As economic turmoil continues, many companies are reconsidering their strategies with an eye toward going lean and slashing prices.

And that might work for a few companies—but very few. Instead, companies should compete "on the basis of initiatives for which their customers willingly pay higher prices," says Frank V. Cespedes, a senior lecturer at Harvard Business School, who spent 12 years running a professional services firm.

That's right. Higher prices, not lower.

"Competing on price is ultimately a bet on your cost position."

Cespedes teamed with Benson P. Shapiro and Elliot B. Ross to write the paper "Performance Pricing in Tough Times." Shapiro, an authority on marketing strategy and sales management, is the Malcolm P. McNair Professor of Marketing, Emeritus at Harvard Business School. Ross is a former McKinsey consultant and President of The MFL Group in Beachwood, Ohio.

In this interview the researchers discuss pricing strategy and what ingredients are necessary to convince customers that higher prices are worth the cost.

Sean Silverthorne: Who would benefit by learning about your research?

Frank Cespedes: Pricing builds or destroys value faster than almost any business action, especially in tough and uncertain economic conditions when price is a key and visible strategic choice. Conventional wisdom has firms cutting price in these circumstances. But most industries typically allow few firms to build a sustainable, low-cost business model, and once established, the very success of those low-cost competitors makes it difficult for others to duplicate.

Our research is for the many companies that don't compete on absolute cost advantages and low price. It speaks to firms that can and should compete on the basis of initiatives for which their customers willingly pay higher prices. The relevant readers are general managers responsible for a P&L, marketing and sales managers responsible for making product and selling decisions (including pricing), and people in operations who affect the value-delivery processes in their companies, especially in B2B companies.

Q: What do you mean by "performance pricing," and how does it benefit a company?

Ben Shapiro: Collectively, we have worked with hundreds of companies on integrating pricing, strategy, and organizational processes—the focus of performance pricing. In most firms, pricing is viewed as a tactical issue where the questions are "can we sell more units if we cut price 10 percent," and "if we raise price 10 percent, will the customer notice?"

This doesn't deal with the core issue. Performance pricing seeks to maximize both the customer benefit and the selling company's profitability. It emphasizes the collaborative aspects of buyer-seller relations over the split-the-pie aspects. The idea is to create more space between the value provided to customers and your cost. You can then enhance win-win aspects of the exchange, rather than focusing on how to divide a fixed or shrinking pie between you and the customer.

Firms can do this when they craft organizational processes that gather and analyze information across their customer portfolio. And this has important implications for strategy.

Frank Cespedes: Competing on price is ultimately a bet on your cost position, and (based on experience!) it's always worth emphasizing certain core truths: Lowering cost does not necessarily mean low cost versus relevant competition, and in any market there is only one lowest cost competitor.

"When you are providing differential value, the issue is framing price appropriately."

Alternatively, currently popular strategic doctrine has many executives sailing off, like Ahab or Sinbad, in search of "blue oceans"—market spaces where allegedly no one else is fishing. Avoiding competition is always nice work if you can get it. But most firms are better off emulating Odysseus—the sailor who sought prosperity closer to home—in the pricing opportunities inherent in their current business mix.

Q: What do successful performance pricers understand?

Ben Shapiro: They have a strategy and practices for identifying where they compete, delivering performance value to those customers, and extracting profit via their pricing process.

Most importantly, they do not set price on a cost-plus basis or adopt "average" pricing policies. Many executives believe cost-based prices are easier to explain. But when you are providing differential value, the issue is framing price appropriately.

Frank Cespedes: To use a small daily example: At the gas pump, the credit-card price is typically the default price while paying cash garners a discount. Yet, many executives seem to think treating all customers the same way is somehow fair. For years UPS prided itself on the fact that "your grandmother paid the same price GM did." When it entered the market, FedEx became the fastest company to reach $1 billion in sales in part because its pricing recognized inherent value differences between customers (residential versus commercial), orders (parcels versus documents), time of delivery (8 a.m. versus afternoon), and other variables.

There is also an unfair assumption in "fair" pricing policies: You do not determine what is fair, the customer does. An average price almost certainly means that some customers are, in effect, subsidizing others. Sooner or later, your competitors will tell them.

Ben Shapiro: Performance pricers identify and deliver value effectively because they bring together the "cost counters" and the "value generators" in their organizations. Normally, costs are the responsibility of finance and operations, while marketing and sales focus on value generators. But the only way to maximize the space between customer value generated and the selling company's costs is to get these people together so you can truly understand both sides of the equation and what the levers are.

Finally, performance pricers relentlessly communicate their value. An example is PACCAR, producer of Kenworth and Peterbilt trucks in a market viewed as a commodity by others. Throughout 70 consecutive years of profitability—a period from dirt roads to superhighways, from the Great Depression to the current "Great Recession"—PACCAR has maintained a price premium and outperformed the S&P 500 by several orders of magnitude. One practice among others that sustains this performance: PACCAR provides a 26-page white paper on its Web site detailing expenses incurred during the life of a truck. You can input fuel costs, "tire rolling" coefficients, and vehicle weight to quantify the savings of a PACCAR truck versus lower-price alternatives. You can do the same for resale value by individual truck specification (PACCAR sells lots of custom trucks); for maintenance; for driver retention (useful information if you run a fleet of trucks); and for financing and fixed costs. The company also provides a primer on increasing fuel economy aptly titled "Push Less Air Pull More Profit."

Frank Cespedes: Other performance pricers employ different means, but all practice a principle that behavioral economists now emphasize: the importance of salient feedback in affecting customer choice, especially when long-term costs of a purchase (health care, trucks) or one's behavior (eating, driving habits) are hidden while up-front price is highly visible.

Q: Within-industry returns: Why is this important to performance pricers?

Frank Cespedes: Warren Buffett said that "when an industry with a reputation for toughness meets a manager with a reputation for brilliance, it is the industry that keeps its reputation intact." In pricing, it's tempting to blame the industry. But research at HBS and other places1 shows that within-industry differences in profitability and returns are typically much greater than across industries. Buffett knows this, investing in "bad" industries like furniture retailing while avoiding seemingly "glamorous" industries like software.

"Industry is not destiny."

Take the airline business, for example, which, over its history, has an accumulated net loss in the billions—a classic B-school example of a structurally unattractive industry. A joke has it that if an investor had been at Kitty Hawk, she should have told the Wright brothers, "Don't do it: it's a bad use of capital!" Yet over the past two decades, Ryanair's ROE was often comparable to the best returns in the pharmaceutical business—a traditional example of a structurally attractive industry. Similarly, PACCAR and others drive prices and returns above their compatriots. Industry is not destiny.

Elliot Ross: This should encourage business leaders not to accept low returns because it's a "price-driven" industry. Performance pricers make attractive returns in almost every business, at least over the full business cycle. There are likely to be periods in a major downturn when even the best will have low returns, but these firms know that price cuts are almost always a one-way street, and they do not sacrifice their long-term viability and positioning for short-term volume. The research should also encourage managers to disaggregate their markets and seek out the differences and opportunities often hidden in current pieces of business.

Q: Pricing opportunities occur at what you call the "piece of business" level of competition. What does this mean? Can you give an example?

Ben Shapiro: An analogy may be helpful. Ted Williams, the last baseball player to hit .400, was a student of his art. He emphasized that hitting is a pitch-by-pitch discipline: "My first rule of hitting was to get a good ball to hit. I learned down to percentage points where those good balls were." Williams actually charted the results and coined the term "happy zone" for that area of the strike zone where "I could hit .400 or better [versus] the low outside corner—where the most I could hope to bat was .230."2

Elliot Ross: The same applies to pricing. The product is what the product does. A product can and usually does have different value depending on the context, thereby supporting different prices for the specific piece of business. For example, the paper stock purchased by a magazine printer for the cover and for certain ad inserts is the same in composition and weight. But the value for an ad insert is dramatically higher because the paper can't be ordered until a few days before the print run, while cover stock can be ordered four to eight weeks in advance. As a result, the POB for ad inserts carries a fully justified higher price.

Frank Cespedes: A POB is not the same as an account—the basis for most firms' segmentation schemes but too broad a unit of analysis for performance pricing purposes. Neither is a POB an order, which is the focus of sales efforts but is really an output of a POB situation. More formally, we define a POB as "a separable buying decision, driven by a customer's buying unit and its needs in a specific context, and made in relation to your perceived performance versus competition and substitutes." All the terms here count:

    Separable buying decision: A POB occurs when a seller locates a customer need and solution that lowers a buyer's acquisition, possession, or usage costs.

    Driven by a buying unit: Companies don't buy, people do. Performance pricers target buying units within accounts. Selling higher-priced solutions to purchasing, for instance, rarely works.

    In a specific context: As with magazine paper stock, the value of a product or service varies for different customers, different buying units at the same customer, or the same customer in different contexts. What's the value of flowers delivered on—versus the day after—Valentine's Day? Or of one-stop choice? The Cheesecake Factory lists 200 items on its menu, including 40 kinds of cheesecake. The average per-person check and return visits per restaurant are an estimated 50 percent higher than the industry average. In the kitchen, a modular menu process (revised every six months) keeps costs lower than the added customer value.

    In relation to perceived performance: Delivering performance versus alternatives is key and perceptions matter, which is why communicating value is so important. Companies make money where the spread between cost and perceived value is greatest, and our research is about that relationship and the places where leaders should look.

Q: Discuss the "gap" between customer value and price, and why it represents "the essential driving force for the customer to buy."

Ben Shapiro: The gap is the difference between the customer value provided by the seller and the cost to the selling company (including, ideally, the seller's opportunity cost of capital). The only way to create a win-win customer relationship is to focus on maximizing that total space.

"Try selling something at exactly its perceived value and you will likely fail."

Think of it this way. The difference between price paid and cost is supplier profit. This much is clear and part of everyday commercial language. But interestingly, there is no common phrase for the spread between customer value and price. Economists call this "surplus," a word that suggests it is discretionary. For good reason, surplus never caught on in business lingo; try selling something at exactly its perceived value and you will likely fail. We call this gap "customer benefit," and it is the driving force for customers to buy. They want to receive more total value than the price paid, and they want that difference to be as high as possible. That is what defines a good deal: From their perspective, those customers got more than they spent.

Great pricers constantly mine this gap to identify opportunities, and they mind the gap over time, seeking ways to extend perceived value. To mine the gap, focus on how you can

  1. Create more customer value.
  2. Increase customers' perceptions of value.
  3. Cut costs without decreasing customer value.
  4. Do some or all of these things simultaneously.

The most profitable and sustainable pricing opportunities in a business are the result of examining POBs with these questions in mind.

Frank Cespedes: You must also mind the gap over time. When UPS acquired Mail Boxes Etc. and FedEx acquired Kinko's, they helped to mind the gap for growing e-commerce sales deliveries. Neither firm can compete with the post office on individual residential delivery: Their costs would rise inexorably and at prices that consumers (or retailers) are unlikely to pay. But the acquisitions provided a convenient distribution channel for residential customers who want to drop off or return goods ordered online, and moved new volume into their existing infrastructures. One result is higher share for these firms, and a cessation to their price-oriented "parcel wars"; another is a burgeoning Web-print business at their retail outlets.

Q: You characterize performance pricing as hard work. What must business owners understand to get started? What tools do they need?

Frank Cespedes: If you're a monopolist, then your reward is a quiet life. But most companies must work at pricing. The confluence of particular customer preferences and producer economics establishes the "happy zone" POB by POB. But notice that the same forces causing executives to bemoan their pricing circumstances also generate the means to manage in the zone. Customer Relationship Management systems often supply the relevant data, but are they used? Activity-based costing methodologies (pioneered over two decades ago by Robert Kaplan and Robin Cooper here at HBS) typically uncover dramatic differences in real profitability by product, customer, and order, but do managers act on this information? As usual in business, the first levers are leadership and management, not technology or legacy habits.

Elliot Ross: After that, the tools needed are not exotic or complex. They involve good business and economic analysis to understand what your customers really buy and how. In many B2B selling situations, for example, there is an organizational boundary between customer personnel who see the value and those who see the price (for example, procurement). Relevant sales training helps to ensure that all members of the buying team understand total value and that people at the seller understand the costs.

With external customers, one useful tool is a jointly created value statement shared with everyone of relevance at the buying company. Often, while the purchase order is signed by procurement, the value is spread over a large, dispersed buying company. Without these statements, it's easy for the seller not to receive full credit for its value delivered. Conversely, a useful internal tool is what some firms call the "offering tracking system," which details the benefits and costs of features and services. Generated cross-functionally, it facilitates communication between the field and operations before sales negotiations, and improves information and learning from win-loss analyses after sales results.

Q: What can companies do to instill performance pricing into the fabric of the organization?

Elliot Ross: In our experience, the best tact is the "sandwich" approach to organizational change: drive the concept from the top while developing skills and a track record at lower levels, usually through pilot programs in discrete business or product groups. Especially for salespeople, a price is a moment of truth, and success breeds attention and willingness to implement.

Ben Shapiro: Then look at incentives. Pricing to reflect value-adding performance while paying the sales force for volume rarely works. Yet most sales compensation meetings are still annual exercises in comparative pay scales, not integrated strategy -> price -> profit -> pay discussions. This approach also requires a deep understanding of customer value versus cost.

In most firms, the best knowledge of value is held by a combination of people in sales, marketing, service, and operations, while costs are managed in procurement, production, product groups, and finance. How often do they come together in a structured way to discuss value versus cost? Great pricers make that dialogue part of their culture. Their management meetings develop a common language and keep cross-functional information flows current and accessible.

Frank Cespedes: There is a mind-set dimension to this process: take responsibility for pricing with an outside-in approach to value. Few customers wake up in the morning wanting to pay a higher price. But most seek value. By voting with their feet, customers ultimately determine what they will pay. But it is management's responsibility to frame and deliver the value proposition, including the pricing process where the leverage—up and down—is tremendous.

Footnotes:

1. See, for example, the following stream of research over the past two decades:

  • R. Rumelt, "How Much Does Industry Matter?" Strategic Management Journal (1991): 167-185
  • A. McGahan and M. Porter, "How Much Does Industry Matter, Really?" Strategic Management Journal (1997): 15-30
  • P. Ghemewat and J. Rivkin, "Creating Competitive Advantage," HBS case no. 9-798-062
  • S. Jackson, Where Value Hides (New York: John Wiley & Sons, 2007).

2. T. Williams and J. Underwood, The Science of Hitting (New York: Simon & Schuster, 1971), 36-37.