Chapter-by-chapter summary of The Strategy and Tactics of Pricing: A Guide to Growing More Profitably
Thomas T. Nagle, John E. Hogan and Joseph Zale
Summary notes by John O’Malley
Summary
- A sophisticated understanding of the value a product creates for the customer serves as the bedrock input to a pricing strategy.
- Different customers will value products differently. An effective pricing strategy will leverage a segmented price structure that reflects the values and costs across customer segments.
- An integrated, strategic plan seeks to influence how customers perceive a product and its price rather than set prices reactively.
- Setting a price is difficult, and the decisions too often reflect unclear leadership and misleading data. Strategic pricing prioritizes profitability.
- Costs and competition are important considerations but not the drivers of effective pricing strategy because changes in prices alter volume and impact costs.
Chapter 1: Strategic Pricing
Coordinating the Drivers of Profitability
In the Information Age, the factors that determine profit are changing more rapidly than ever. New pricing models, such as those employed by Netflix, Ryanair, and Apple, form an integral part of some the most profitable enterprises in those changing markets. Yet, few managers train to set prices in anticipation of changes, rather than in reaction to them. Some common approaches to pricing simply reflect outmoded thinking: cost-plus pricing, customer-driven pricing, and share-driven pricing. These approaches all misunderstand the role of pricing.
Strategic pricing, on the other hand, rests on three key principles. First, the pricing strategy is value based. This means that prices reflect the differences in value across customers and over time. Second, the strategy is proactive. It anticipates those market changes, designs strategies to account for them and even dictates the terms of various trade-offs. Finally, the strategy is profit-driven. Instead of comparing prices to competitors, a pricing strategy is evaluated relative to the company’s alternative options.
These principles lead to the five-tier pyramid of strategic pricing, where each block builds on the next. Likewise, each of the following chapters expands on the nature of value creation, price structure, price and value communication, pricing policy, and price level before turning to the final component of strategic pricing: implementation. Although most companies do not need a large, central price management function, a clear strategic vision must ultimately have everyone in the organization do their part. Managers need to understand their role and have to data to execute successfully. A good strategy will seek to motivate new behaviors.
Chapter 2: Value Creation
The Source of Value Creation
Value refers here to economic value, which relies on the differentiation of one product from another. Almost no one would volunteer to pay $2.00 for a can of coke from a seller if they know that it is available in a vending machine for $1.00 around the corner, but, more practically, a swimmer on hot beach might readily pay the higher price rather than walk to an inconvenient snack shack. This differentiation value is the only component of economic value captured by price.
Understanding the nature of differentiation is critical to understanding the creation of value. The two forms of differentiation are monetary value, which is the cost savings or income enhancements that a product provides, and psychological value, which is a measure of the satisfaction and pleasure derived from a product. Therefore, the total economic value of a product reflects the value of the next best competitor (the reference) plus the net value of the differentiation between products (the differentiation value).
To return to the example of why the beachgoer is willing to pay $2.00 for a can of coke, this breakdown of value creation can explain the decision to purchase. The reference value is the cost of the soda at the snack shack, the value normally derived from drinking a can of coke. The differentiation value is the psychological value of convenience and immediate gratification. The price point that results in the sale, the $2.00, captures the the total economic value to the customer on the beach.
This process also allows for value-based market segmentation, one of the most powerful ways to maximize profitability through strategic pricing. With a segmented marketing plan and price structure, a marketer can ensure that different segments pay an optimal price, instead of charging a single price that undercharges some customers and drives others to competitors. After a marketer determines the basic criteria for segments according to commonalities in purchasing behavior, they can identify the values that drive purchasing decisions within segments. These value-drivers do not necessarily correspond intuitively to segmentation criteria, and a deep understanding of the total economic value of a product helps identify specific value drivers. Then, after creating levels of segmentation and detailed descriptions for marketers, as illustrated in the two tables below, it’s time to move into the pricing strategy.
Chapter 3: Price Structure
Tactics for Pricing Differently Across Segments
A company that attempts to serve customers at a single price-point tends to make large, unnecessary trade-offs between volume and margin. By nature, differentiation value changes across customer segments, and the profit potential created by those differences can be captured through strategic pricing. In the case of railroads, for instance, railroad tariffs ensure that coal and grain cost significantly less to transport than other goods. At this lower price point, railroads maximize the profits on goods that would not be cost-efficient to ship at the cost of manufactured goods. The price structure allows the railroad to cover the high costs of its infrastructure.
Whenever differentiation value changes across customers, it is possible to design different offers for different segments. In fact, effectively designed bundles will accurately understand how they create differentiated value, and customers will self-select for the bundle that most directly corresponds to their needs. One of the core questions for configuring a price structure is deciding which features to offer individually and which features to bundle. In music, most customers will pay a premium for famous headliners, but must be enticed with lower prices to attend smaller performances. Some customers, however, may be willing to pay a premium for those same concerts, and segmenting can help buoy the profitability of these smaller performances.
Sometimes, quantity, such as number of tickets sold, does not accurately capture the value of a product. In these cases, marketers might adopt new price metrics by applying the cost of the price to a different unit. Price metrics can vary substantially. A sports club could charge per hour, per visit, or for a membership. Within that membership, the club might charge yet another hourly fee for a particular feature, like a sauna. Good metrics are unambiguous, appealing to prospective buyers, and aligned with their values. Someone primarily looking for a good sauna might balk at that sports club membership. Innovative price metrics, especially ones that are more effective than competitors, can improve existing margins and expand volume.
Value can also differ among customers receiving identical benefits because the factors contributing to their perception of economic value are different. In this case, a price fence, in which different segments are charged a different price for the same product, may be effective. This is quite common. Most museums have different charges based on age or student status. However, price fences can annoy people and create an incentive for buyers to, often successfully, avoid them. Effective price fences rely on proxy metrics like buyer identification, location, time of purchase, or quantity.
Chapter 4: Price and Value Communication
Strategies to Influence Willingness-to-pay
In order for strategic pricing to succeed, customers must accurately understand the value of the product on offer. More specifically, sellers need to convince customers to perceive the differentiation value of their product. Successfully communicating value protects segments from competitors by clearly highlight the differentiated value because the customer understands why one product better fits their need than the next best alternative. By extension, communicated value improves a customers willingness to pay and, ultimately, increases the likelihood of a purchase.
Take the example of the Amazon Kindle. Many observers feared that the high price point of the first devices would put off customers who considered the switch from physical books to e-books extremely risky. Amazon had to find a way to communicate the value of a new technology. They decided on a “Meet a Kindle Owner” program where prospective customers could meet people similar to themselves and learn the benefits of owning a Kindle. As a result of this highly effective approach to communicating value, Kindle sales far exceeded expectations.
This highlights that value communication is most important when the differentiated value of a product is not obvious to potential costumers. Typically, this is the case for inexperienced buyers or, in the case of the Kindle, when the product is highly innovative. In both cases, customers may have trouble noticing the differentiated value, so the purpose of effective value communication becomes identifying the perceptions to influence and connecting the key values to the appropriate characteristics of the product.
Two characteristics play the most important roles in influencing perception: type of benefit and cost to search. Type of benefit refers to the breakdown of value into monetary and psychological value. Presenting the monetary value to someone who primarily derives psychological value from a product will probably not influence them in any meaningful way, and it may even drive them away from the product.
The other characteristic is the relative cost to search, the cost relative to the expenditure of identifying a product’s value. Someone making a $5,000 purchase can reasonably spend more time searching than someone making a $5 purchase. When investigating search goods, a buyer can easily compare features and benefits objectively. The cost of search is low. However, experience goods that are more difficult to evaluate, like which auto shop to go to, have a higher relative cost to search. An effective value communication takes both of these kinds of attributes into account and adapts the communication across each stage of the purchase as the costs change.
Importantly, customers do not always evaluate price as strategically as marketers, especially when it comes to discounts. Studies have demonstrated that customers evaluate purchase choices proportionally rather than absolutely. Most people would walk a block to pay $2.00 for a drink rather than $5.00, but they would consider it a waste of time to walk the same block to spend $102 rather than $105. Customers also place great weight on reference prices, the standard “fair” price, and perceptions of fairness. Although the subjectivity of these perceptions may make them seem difficult or unpredictable, in practice value communication can leverage them to a marketer’s advantage. In general, marketers can set a high “regular” price in order to lower the price through discounts and promotions before raising it again without seeming unfair. This also impacts reputation and whether the price is seen as maintaining or improving a standard of living, both important components of perceived fairness. Finally, people prefer to avoid losses when evaluating differences in products. Again, minimizing out of pocket costs or framing costs against a high reference cost can account for this gain-loss framing.
Chapter 5: Pricing Policy
Managing Expectations to Improve Price Realization
All sellers eventually face difficult customers asking for price exceptions. They may be loyal customers asking for an exception during an economic downturn or highly aggressive buyers forcing ad-hoc negotiations, slowing down sales overall. An effective pricing policy is a set of rules or habits that precludes exceptions for any factors that do not reflect changes in value or cost. Pricing policy ought to be consistent across the board. Over time, unclear pricing policies can allow buyers to dictate expectations to sellers. Strategic pricing flips this problem on its head by leveraging the price strategy to influence future customer behavior. Consistent price policies dictate consistent expectations, a key component to influencing customer behavior that avoids the pitfalls of ad-hoc negotiation.
Price policy develops over time. Each request for an exception to a price is an opportunity to set a pricing policy that will predict and prevent a similar exception request in the future. Over time, buyers will come to expect these pricing policies, as long as they are consistent and transparent. These policy decisions clearly must come from market level management, but they still have to empower sales managers to stand by pricing policies even at the potential cost of a sale. While this might seem intimidating, ad-hoc negotiations only defer substantial costs that will continue from unpredictable customer behavior. A pricing policy can cover price changes associated with discounts, increased industry costs, promotional trials, and changes in competitors prices. What matters is that each policy remain consistent.
Good policies also transform purchases into a price-value trade-off rather than an effort to extort the lowest prices. There are a wide variety of buyers who might engender pricing policies. In addition to consistency of application, good price policies can rely on give-get negotiations, in which the seller refuses to make any concession that does not have some value return. The principle behind give-get negotiations, which motivates good price policies generally, is identifying whether exception requests are a product of misplaced expectations or lost value. Pricing policy seeks to manage the expectations, but an in-depth, accurate understanding of value to customers may have wider repercussions. Revisit the thinking in early chapters to review how understanding value can influence strategic pricing.
Chapter 6: Price Level
Setting the Right Price for Sustainable Profit
A lot of data is available to set a price point, and a three stage process can guide the decision. This process builds on the premise that, in order to maximize profitability, price is different for different segments. This is the final level of the pyramid. At each step of the process, it is important to consider the pay-off for invested time. Managerial experience and market knowledge is always an essential component of price setting, and it may not be necessary to spend much time where experience will suffice.
The first step is to set a price window. This window outlines the highest and lowest acceptable prices for a product as defined by its total economic value. It extends the process for estimating value.
The next step is to set the price that best captures the differential value. The goal is not to set the highest price possible. The price should drive profitability because it aligns with the overall business strategy. Jeff Bezos, in the early days of Amazon, sought to undercut distributors in order to move market share to Amazon’s online platform, which was the germ of the company that exists today. It answers core question of the price-volume trade-off: “how much volume can I afford to lose for a price increase/how much volume would I have to gain for a price decrease?” Incremental break even analysis can help answer this question. Finally, it predicts the customer response to the price point. This is perhaps the most subjective step and therefore the best served by experience. Marketers have to estimate price-sensitivity, or the sensitivity to the price-value trade-off. This is the degree to which factors other than value influence willingness-to-pay, and it includes the same factors outlined in Chapter 4, such as expenditure size, perceived risk, and gain-loss framing.
The last step of the price setting process is to communicate the reason for the price to customers. Customers must understand the price and perceive it as fair. This clearly demonstrates how this step builds on all the others. Communicating a price to customers must particularly grapple with perceived fairness, which companies manage through price policies that reflect an understanding of differentiated value.
Chapter 7: Pricing Over the Product Lifestyle
Adapting Strategy in an Evolving Market
Products have a typical, and therefore predictable, life cycle. A market for a product appears, grows, reaches maturity, then declines. An effective strategy does not react to these changes. It predicts them. Profitable pricing represents the culmination of a successful plan and prediction. Moreover, while not every new product creates a new market, every new product presents new challenges and opportunities for marketers to introduce profitable price changes that reflect the different stages of the market life-cycle.
For new products at the market development stage, the critical goal is buyer education. When buyers know nothing about a product, they have little sensitivity to its price. Consider how much information they lack. They have no way to evaluate cost to search, for instance, or leverage reference prices. Competitors are few or non-existent, and the potential profits of market development far outweigh the threat of competition. Pricing strategy revolves around effectively communicating value through adaptive solutions such as promotional trials, direct sales, or manipulation of distribution channels according to the characteristics of the innovation. Diffusion of experience across customers is a critical component of market development, as early adopters, such as in the case of the Amazon Kindle, can have a massive impact on developing customer knowledge.
During the growth stage, buyers have more information and increased price sensitivity so lower prices can effectively increase market share. In particular, strategies that successfully leverage diffusion can increase reception of price reductions and promote long-term profitability. Moreover, high rates of growth limit the impacts of price competition since companies can cut prices while maintaining profitability. Through effective product strategy, marketers can establish their product as the industry standard in anticipation of market maturity. In the case of Apple, promoting their computers as user friendly allowed them charge premium prices throughout the ongoing product life-cycle. Companies may also pursue cost-leadership, in which a price captures profitability by establishing the product as the cost-efficient market product, although not necessarily by maximizing market penetration.
Strategies in the maturity stage depend substantially on how a company positions its product in the growth stage. Buyer information is at its height, as is price sensitivity. Firms can only grow by seizing competitive market share, so prices are depressed and products become homogenous. As a result, cost-leadership or sustained, well-communicated differentiation produces competitive advantage. Strategic pricing at this stage might leverage unbundling that highlights differentiated characteristics, more accurate estimations of demand and value, expansion of the product line, or reconfigured distribution. In all of these solutions, a marketer takes advantage of the increased amount of information available to maximize price effectiveness.
Finally, the market declines as new products create entirely new markets. This leaves firms with excess capacity, which dictates effective pricing. Variable or easily reallocated costs might cause prices to fall only slightly, but fixed costs can result in higher average costs and increased competition as firms consequently attempt to seize market share, often through price slashing. Effective options include proactively protecting the strongest product lines, pricing to exit the market with minimum losses, or price cutting to capture the markets of weaker competitors.
Chapter 8: Pricing Strategy Implementation
Embedding Strategic Pricing in the Organization
Implementation relies on effectively designing organizational structure and motivating incentives. Effective organization uses a combination of formal reporting and empowered flexibility. This idea can be managed along a spectrum of roles, centralization, and rights and processes.
There are roughly four roles for the pricing function to take on within an organization. It can operate as an expert resource, which provides consultation to different market groups. It can operate as functional coordinator that decides how pricing decision will be made. In the next iteration, it can operate as a commercial partner, that sets both process and price. Less than ideally, it can also take on a figurehead role that sets a price without consideration to different markets. Each of these roles can play into different levels of centralization, and they can produce a center of scale that operates at the corporate level, a center of expertise that sets an advisory price for local managers, or simply a dedicated support unit for other pricing organizations. Across this map, managers and marketers must be assigned clear decision rights to set prices and clear process rights to dictate how decisions are made.
Even the best organizational plan is meaningless if managers refuse to implement it. Perhaps one of the largest challenges is utilizing data to organize incentives around profitability, not volume or price. The key is to link incentives to the correct data. Two effective categories of data analysis are customer analysis and process analysis. Customer analysis seeks a deeper understanding of customer behavior, similar to the estimation of value. In addition to those estimations, analyzing performance trends can reveal how competitors are influencing customers. Building metrics around customer profitability, a combination of the average price to the cost to serve, can provide another specific metric.
In process analytics, the goal is to find leaks in profits so that new pricing policies can seal them. Two forms of analysis are particularly appropriate: price bands, and price waterfalls. A price band shows which customers pay significantly more or less than others. This is a helpful tool to identify aggressive negotiators. A price waterfall tracks the impacts of all forms of discounts as they differ from invoices. This can show where out of pocket costs are actually much higher than what an invoice records.
Of course, implementation still poses seriously difficulties. These metrics can be effectively tied to more specific and effective selling incentives, but it may still be necessary for senior leadership to exemplify a commitment to new processes. Even with demonstrations, clear communications, and well designed incentives, it can take years to reach something close to the theoretical product. However, the benefits are worth it: firms that use strategic pricing earn 24 percent higher operating incomes than their peers.
Chapter 9: Costs
How Should They Affect Pricing Decisions
Costs are critical but not obvious. Strategic pricing integrates costs and value by avoiding the mistakes of cost-plus pricing. In strategic pricing, value comes first. A marketer understands what price will capture the value of a market, which allows them to understand the role of costs. Airlines, when faced with increases in the price of fuel, do not simply charge higher prices. Instead, they raise their revenue per mile by decreasing the number of trips and maximizing the number of full-fare travelers on each flight. However, costs are extremely complicated and subject in the text only to review.
Relevant costs are incremental, which means they are the cost of changing a price, or avoidable, which means they have not happened or can be easily reversed. These costs do not simply correspond to historical information. Knowing these costs determines whether or not a market would be profitable. There are four important mistakes associated with identifying relevant costs. The first is averaging total variable costs to estimate the cost of a single unit. If the incremental cost is not constant this is misleading. Second, accounting depreciation formulas do not always use current value. Third, considering one apparent cost as totally relevant or irrelevant may miss the incremental cost and, as a result, a chance to increase profitability. Finally, overlooking opportunity costs can lead to underpriced products.
The purpose of finding these costs is calculate an accurate contribution margin. This is the measure of the price-volume trade-off and, by extension, a measurement of the relationship of a product’s profitability to its volume. This allows managers to understand how a price change must affect the market in order to maintain profitability, the key first step to making the profitable price decision discussed earlier. It is also important to consider how the fixed costs of suppliers are passed on as incremental costs, and how price coordination can improve efficiency as outlined in the discussion of the product life-cycle and the implementation of a strategic plan.
Chapter 10: Financial Analysis
Pricing for Profit
The formulas presented in this chapter expand on the articulated theory of costs. They provide a method to quantify the impact of price changes on profitability and make informed, profitable decisions that integrate cost considerations. The method is called incremental break-even analysis. Managers simply take a considered price change and create a standard of comparison to the current level, a projection, or a hypothetical. Then they apply the formula to calculate the point at which the change will prove profitable. This is a quantitative answer the challenge of solving the price-volume trade-off.
There are four cases where incremental break-even analysis can provide information about profitable pricing. In the most basic case, the formula produces the percent change in sales volume needed to maintain the same level of probability after a price change. (It can be converted into the percent change for price as well.) The formula can also be calculated with changes in variable costs or with changes in incremental fixed costs. It can even be calculated with consideration to a competitor’s price changes.
One of the most powerful tools that emerges from incremental break-even analysis is the break-even sales curve. The curve presents a range of price changes by percentage on a curve that includes the baseline. Profitable prices produce volumes to the right of the curve. Although to many it may seem unrealistic to apply economic theory to price decisions, working from the minimum elasticity can account for these concerns. However, it is important to keep in mind that the baseline should reflect the market change without a price change.
Strategic pricing does not ignore the problem posed by fixed or sunk costs. It simply notes that considering those costs is irrelevant to setting a price because they do not affect the profits the price will produce. The question of how to cover fixed costs is an important question of profitability that can be more clearly answered when firms understand the impact of price.
Chapter 11: Competition
Managing Conflict Thoughtfully
Effective responses to competitors leverage competitive advantage, not price. Price cutting, especially to make the next sale and without due consideration to strategy, can undermine the whole industry and irreversibly change a market, often to the disadvantage of the firms that resorted to price slashing. Sustainable, successful companies leverage their competitive advantage, which emerges from value differentiation. It can be reflected in the value of serving a highly specific customer segment, or it can be geographic and leverage convenience. Many American breweries maintain a competitive advantage by promoting their beer as the standard for a particular region. Advantage may also be based on variety, which takes advantage of cost-sharing and highly specific differentiation. Microsoft focused on developing computer operating systems, giving the company strong differential value in the computer industry while sharing costs with hardware manufacturers.
When competitors do changes prices, its important to react thoughtfully. Besides lowering prices, it is worthwhile evaluating how many customers will be attracted to a new competitor because of values like convenience, making them immune to reactive price changes. It may be the case that only one segment of customers is attracted by a discount. A response may call for new communication. Analysis may reveal that any retaliation would not be profitable. By carefully collecting and announcing information, firms can react to competitors in far more sustainable ways than simply slashing prices in a bid to grow market share.
Chapter 12: Measurement of Price Sensitivity
Research Techniques to Supplement Judgement
Estimates of price sensitivity can helpfully supplement managerial knowledge and expertise, but they cannot replace it. Experienced managers often have the strongest sense of which customers represent a product’s key market, know most acutely the factors that affect a sale, and can recommend appropriate parameters for research. On the other hand, most marketing decisions are highly subjective, and the information provided by estimates can serve as a guide or illuminate new information.
Research methods do differ in accuracy, cost, and applicability so its important for managers to assess the potential benefits of the information, without cutting corners. Techniques differ between highly controlled and totally uncontrolled. The added cost of controlled research is often worth it since uncontrolled environments have too many variables to allow for accurate information. Controlled analysis overwhelming tends to produce superior data.
Research can also track either actual purchase information or intentional purchase. Although information about actual purchase decisions is highly desirable, it is difficult and costly to acquire. In a controlled environment, however, measurements of intention and preference can prove highly predictive. Conjoint analysis, in particular, can match price sensitivity to specific differentiated characteristics.
The possibility for different research techniques also depends on the stage of the product development. Obviously, purchase information is not available for products in the early stages of development. This is when conjoint analysis tends to be the most helpful. Once the product is available, controlled in-store or laboratory experiments are possible, and, at the maturity stage, historical purchase data is easier and cheaper to obtain.
Chapter 13: Ethics and the Law
Understanding the Constraints on Pricing
Ethical constraints on pricing are meaningful from the standpoint of personal and societal ethics. However, beyond personally considered ethical stances, small changes can often bring suspect pricing policies into line with both the law and profit. In the United States, price competition is enforced through anti-trust law, as administered criminally by the Department of Justice, and civilly by the Federal Trade Commission and private parties. In the last decade, anti-trust law has focused on demonstrable economic effect, allowing a great degree of creativity for price setters. Some forms of prohibited price activity include price-fixing among competitors or price encouragement between suppliers and distributors. They remain, largely, per se illegal but some ambiguity in the application of the law has allowed them to become permissible in the last thirty years. Other key areas of ethical concern include price discrimination, promotional discrimination, non-price vertical restrictions, predatory pricing (in which the seller prices to harm their own profitability), and price signaling. However, these restrictions are rarely enforced due to the need to demonstrate economic harm over intention.
Code For Cash blog 