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The Cost of Pricing

Want to do a better job of pricing? Understand how Value Proposition relates to pricing strategy, and how you can get more bang for your pricing buck.

A question was raised in the "Ask a Question/Find an Answer" section of the StrategyWerx website regarding pricing, and how to deal with a management group or manager that wants to price a new product cheaply to try to gain market share. I answered the question briefly in the forum, and promised to expand on the answer more in today’s blog.
Competing on price to gain market share is a strategy that almost never works unless the company using the strategy is particularly large and can leverage existing high volumes on related or adjacent products into high volume on the new product. I've encountered a desire to compete this way both in companies I've been a member of and in companies I've consulted for. It can be an extremely difficult position to argue against, and I've lost the argument at least as often as I've won it, so I sympathize with anyone dealing with this challenge.  Regardless who won the argument initially; I can honestly say that I have not seen the tactic work yet.
There are lots of books and workshops available on pricing, including my own company’s seminars and workshops on pricing strategy. But no matter how well-schooled you are on the topic of pricing, if you can’t integrate your corporate strategy and value proposition to all of your pricing activities, you will leave money on the table when you go to market.
Your overall pricing strategy is secondary to your company's strategy and value proposition. "Lowest price always" is a valid strategy, but it has to be applicable across the board, and not just on a product or two. It is also heavily dependent on volume, which is why you have to be the size of Wal-Mart or Amazon to successfully deploy that strategy. Other value propositions are customer intimacy, leading product/technology, and system lock-in.
So what’s the difference between these strategies? A lot. Remember that management is built on four concepts – planning, organizing, leading and controlling. Pricing is related to the planning, organizing and controlling functions (and of course, without good leadership none of these can be executed, but that’s a different topic).
Let’s start with a lowest-price-always strategy. If you want to offer the lowest price, two primary conditions must be present; high volume and low operating costs. High volume suggests that you already have great market penetration. Ideally, you have established (paid for) your market position through advertising and marketing, which really cut into margins, and when your margins are narrow, there’s not much to cut into.
For instance, Wal-Mart doesn’t have to spend the same percentage of their revenue on advertising as a smaller adversary, because they already have market visibility and high traffic. Also, at their size they can negotiate for much better advertising rates (print, television, newspapers, web presence, etc.) than their competitors. So market presence is already established. Here is your first argument against using low prices as a way to establish market share!! Because establishing market share requires creating visibility, and low prices have never been demonstrated to create visibility – only to take advantage of already present visibility.
Second, to compete using low prices you must have extremely low operating costs. Everything from your sales technique to your manufacturing and distribution operations must be as lean as they can possibly be. Why do you think Wal-Mart revolutionized supply chain logistics! It wasn’t that Mr. Sam set out to turn the world on its ear related to cheap supply – its that he realized that cheap supply was essential to offering low prices. But that advantage doesn’t last forever. As the supply chain was revolutionized, everyone has benefited from the advances, and as we know now, Wal-Mart has embarked on a 3-year plan to completely transform all (yes, all) of their American stores. Why? Because reducing costs is ultimately a zero-sum game. Now Wal-Mart isn’t going to disappear any time soon (grin), but if Wal-Mart is struggling with their lowest-price always strategy, it’s time to recognize that this is a really hard row to hoe.
The next strategy is customer intimacy. To establish customer intimacy requires excellence in the sales and service functions – both people and systems. It’s also a marketing strategy. What do you need to focus on excellence in sales, service, people, and systems? Margins! But customers who value a better all-around service experience are willing to pay a little bit more for the experience, so you can charge a little bit more. If you are pursuing this strategy and the customers say, “well, they cost a little bit more, but they’re worth it,” you’ve hit the sweet spot.
The third strategy is leading product/technology. This is the strategy that involves always being first to market with excellent new product ideas, leading edge technology, and innovation in meeting customer needs. Will the competition copy you? Absolutely – even if you have patents and other intellectual property. There is always a way to copy a good idea. So the companies that pursue this strategy have rigorous intellectual property efforts (expensive) and they also do product development better, faster, and cleaner than anybody else, so by the time their innovation has been copied, they’ve already moved on to the next thing. Investment in product development is not cheap, nor is the advertising necessary to get those first-adopters to start using something new and different. You need margins to do that. But customers who want the leading edge thing are willing to pay a bit more for it. Are you one of the people who would stand in line for 3 days waiting for an iPhone, or one of the people who laughed and decided to wait until the price drops? Both customer categories are important, but the leading edge value proposition companies cater to the ones who will stand in line and pay. Pricing in this case is a clue to the value of the product – to appeal to those cutting-edge-sensitive customers they need to be able to brag not only that they stood in line, but also how much they paid to do so.
Of the four value propositions, system lock-in is the smallest – the three already described probably account for 85% of all value propositions. System lock-in is when your product is so dominant – due to advertising, word-of-mouth, first-mover advantage, or intellectual property – that your facial tissue  becomes Kleenex, your MP3 device becomes an iPod, any search-engine activity becomes a Google, or your PC (regardless of make) becomes and IBM. Once you achieve system lock-in you still have to invest to maintain your advantage, and furthermore, customers don’t expect to pay less for dominant products – they expect to pay for the perceived value.
Hopefully this overview of value propositions gives you a sense of the investments you must make to achieve them, and how those investments will be reflected in your pricing strategy. Each value proposition merits a much deeper discussion of the investments and operational systems necessary to achieve them, and maybe we’ll go into those at another time in this column. But until then, ask yourself: What is my company’s value proposition, and do we convey it consistently from product line to product line and through our pricing strategy?
(c) 2007, Andrea M. Hill
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