By Gary Randazzo
The impact of pricing strategies can be critical for the success of new product launches, a company’s image and ultimately a company’s short and long-term success.
I have worked in several industries and found that pricing is often overlooked as a key marketing tool. In many instances pricing is driven by the sales department and is a reaction to the competition. This reaction assumes the competition knows the market better and has a superior marketing strategy.
When reacting to the competition it is important to understand that you are being drawn into a game whereby you play by the competitor’s rules. You are playing their game and changing your strategy. Your hope here is that you can play the game better or that the competitors can’t play their own game very well.
I am reminded of a time where my company was vying for the business of a key customer. The customer was a shrewd negotiator. We understood the value of the customer but valued profit and the perception that our product commanded a higher price. The customer would use the price bids to play the competitors against each other.
Our belief was that this was a no win strategy and decided to bid the price to the point where we would make very little profit and then let the competitor win the bid. We felt that winning the bid was the end game for our competitor and we took the risk that they would lower the price until they won the contract.
Fortunately, we were right, competition won the contract but couldn’t provide the needed level of service. The customer ultimately canceled the contract with the competitor and chose to pay our price for our product. As a result we were able to service the account and make a profit.
If we had chosen to win the contract, thereby adopting the competitor’s strategy we would have lost money, possibly hurt relations with our good customers who were willing to pay a reasonable price for a good product and earned a reputation as a company that placed short term gain over long term success.
PRICING TO INCREASE VOLUME
In other instances pricing is driven by financial need and the belief that dropping prices will increase sales volume and profitability. This approach is based on the belief the product has positive price elasticity. Positive price elasticity holds that as prices drop demand increases enough to insure that the lower margin per unit sold is offset by increased sales volume to the extent that overall profit actually increases.
Using reductions in price to increase volume usually works for a commoditized product that has wide use. This approach usually fails if the product is designed for a specialized use or if the marketing strategy is designed to differentiate the product from others in the marketplace. For differentiated products the volumes and profits might increase with a price reduction but the value of the efforts to differentiate the product is lost.
I was once recruited to take the helm of a company that was in a losing battle for a market that was judged to be large enough to support only one company. The company that I led was weaker, had limited financial reserves and was losing money. This company’s pricing strategy had been adopted to reduce price to gain volume and market share.
After studying the sales volume I found that regardless of the past pricing strategies the sales volume had remained constant. To me this meant that there was a specific value that was provided that was wanted and needed by the consumers. Based on this information I implemented a 17% rate increase. The action terrified the sales group and the owner’s feared financial disaster. Fortunately, sales volumes remained constant and the company went from a loss to a profit in six weeks.
In this instance it would have been easy to assume the company’s products did not have specific value and that the only way to increase profitability was to keep prices low and slash expenses. We, of course, also reduced expenses dramatically but the expense reductions alone would not have saved the company. If we had kept the pricing low we would have failed as an enterprise, and sent the message to our customers and our sales staff that our products were no different from others in the market place and had no intrinsic value.
PRICING BASED ON DIRECT COSTS
Finally, pricing can be based on the information provided by cost accounting that if variable or direct costs are covered then profits can be made. This is indeed valuable information but pricing based on direct costs only concerns itself with the costs of direct materials and labor to produce the product. This strategy is often used when adding a new product to the product mix and is influenced by the need to give the new product every opportunity to succeed.
It also heroically assumes that the established product mix covers fixed costs. This assumption doesn’t account for subtle increases that are difficult to measure such as repair and maintenance costs and administrative costs, which are usually considered as fixed.
At one point I was chairing a new products committee that had developed a new product that had a great deal of promise. The competing products in the market used different production processes and the pricing was significantly higher than was needed to cover our direct costs.
There were several on the committee that suggested that our pricing be just above our direct costs which would, theoretically, allow us to quickly capture the market.
It is important to recognize that customers do not adopt new products based on price particularly if they are satisfied with the results they receive from the products they currently purchase. I argued that a significantly lower price would not recognize the organizational expense and overhead and could possibly suggest to our customers that our product was not equal to the competition since price is often associated with value.
As luck would have it we chose the higher pricing strategy because we felt our product was superior to that of the competition. It took several years to fully penetrate the market but eventually we did capture the market and enjoyed significant sales and profit levels.
If we had adopted the direct-cost pricing model we would have been unable to afford the customer training and interface that was required to have a successful product launch. We also would have been unable to weather the time it took to penetrate the market. The customer training and interface costs were not apparent in the planning phase of the new product and were not considered in the direct–cost model.
Without adoption by the customers the product would have been labeled a loser and dropped from the product offerings. If the direct-cost model had been used and the quality reduced to allow for customer training costs the customer adoption would have been more problematic because there would have been less differentiation from the product already in use by customers.
Because the pricing strategy was based on value, the product never showed a loss using fully allocated costing models and, in the end, this product captured the market and for years has been a major source of revenue and profit streams.
The importance of pricing can be lost when faced with aggressive competition, financial challenges or a changing industry landscape but it is important to remember that pricing can be as important as any marketing strategy employed when positioning your company.
It is important to understand that pricing does not stand alone from the other elements of marketing such as product design, distribution and promotion but rather pricing helps define the value of those attributes.
Revenues and profits that could be realized by unique design, distribution and promotion based on quality can be lost when the pricing strategy is poorly employed.
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