Chapter 8

Dangerous Ways to Reduce or Increase Price

Now, now my good man, this is no time for making enemies.

—VOLTAIRE, ON HIS DEATHBED, IN RESPONSE TO A PRIEST WHO ASKED HIM TO RENOUNCE SATAN

Most managers know there is a right way and a wrong way to change price, and a right time and a wrong time to change it. The difficult part is determining how and when.

Dangerous price moves can destroy your business, either with sharply reduced revenues and/or competitive inroads. Yet many managers have little awareness as to which are the most dangerous price actions. For instance, the most dangerous price move by far is lowering your price, because it can alienate customers.

The Case against Lowering Prices

Many businesses lower their prices, expecting to stave off competition and win new customers; however, rarely is this so. For instance, a B2B company with a leading position in managing incorporations and legal registrations listened to customer complaints that its fees were too high and were an obstacle in using its services. The company lowered its prices by over 30 percent and was chagrined to find that business volume remained absolutely flat—existing customers had no need for incremental incorporations, and noncustomers never heard of this bargain because the whole service was far from top of mind.

Another example of the perils of price reduction was the hosiery manufacturer L’eggs, which had observed a high responsiveness to price drops. Reducing its prices, it saw a big uptick in volume, as existing customers bought ahead at lower prices. Before news of the lower prices was fully communicated to new customers, however, competitors followed suit with price drops. No competitor won in that sequence of price drops that destroyed profitability for the year.

The fundamental problem, like many issues in pricing, lies in customer awareness. Whatever the objective value of your company’s offers, that value does not matter unless customers know about it. Lowered prices require communicating to the world of noncustomers. Doing so may not be easy, despite the best efforts of your sales force or promotions managers. Lowered prices may induce some existing customers to buy more, but often they may already be saturated—it would take a very low price to push customers to buy an additional car, dentist visit, gasoline, telephone line or more ice cream. In some cases, additional volume has nothing to do with price. In some cases, lower pricing is actually damaging, as it prompts buyers to wonder if they did a poor job of negotiating, and may lead some consumers to wonder about quality.

Not so with a price increase. When you raise price, you are going to initially communicate the higher price to existing customers who know something about the value you offer. Yes, a higher price can be challenging, but at least the change affects those who know something about your value (existing customers) or those being targeted with a value message already. Noncustomers may never know the history of changes in price or value, so they are not bothered by it.

Raising and lowering prices are very different—not symmetrical in any way. Lowering prices has a much higher communications burden and risk.

Why do many rational managers believe that lowering prices is safe and useful? It’s possible that the root of the problem lies with the idea of price elasticity. Price elasticity contains the seductive notion that a single simple number will explain market buying behavior and its relationship to price.¹ This is almost never so. The idea that elasticity could do this is an insult to segmentation and context.

Elasticities have the appeal of seeming to show, in one neat number, the impact of price on volume. Further, they seem to suggest that the reaction to a price increase should match the reaction to a price decrease. While price elasticities do sometimes accurately predict short-term volume changes (e.g., in highly transparent markets such as consumer goods), they cannot say much about strategic changes or opaque markets.

Much safer than a price decrease is a moderate, unsurprising price increase. Even better: a targeted price increase. Best of all: a price increase disguised as a change in price structures. Why is an unsurprising increase good? Because buyers of all demographics share the delusion that prices are linked to costs, and they expect and can tolerate moderate price increases over time. What is “moderate” varies, which is why targeted price increases are better than across-the-board increases. In every market there are some customers on the brink of reducing their purchases and others who would not notice even a substantial increase. A strategic price increase leaves the at-risk segments alone and extracts the greatest increases from the price-unaware.²

An exception to the rule that lowering prices is dangerous is lowering someone else’s prices. Examples of this include Apple, Amazon, and others who control channels for music, books, and other entertainment. By demanding lower prices from music companies, publishers, and others, these companies have opened up markets and built a solid position for their products. The results for the victims of this market and technological power have not been as positive: witness the destruction of once-enviable margins at Sony, EMI, trade publishers, and others.

Demand Curve

Before any business considers a strategic price decrease, it should study the demand curve for its markets. Demand curves show volumes at different price points and so capture the inflection points where segments behave differently. If a formal demand curve does not seem exciting or mean much to your management teams (although it should), begin with a simple one and educate management on why this is an invaluable tool. (See Chapter 14 for more on how to build a demand curve.)

Strategic price changes attempt to make permanent improvements in seller volumes or market position; demand curves coupled with segmentation are very good tools for supporting the strategy, usually at a segment level. Managers must ask themselves which segments they’re attempting to add to their base and which segments they need to protect. Each segment, if it’s a good segmentation scheme, should be associated with a particular price range and preferred price structure. For instance, in mobile telephony, demographics and propensity to adopt technology clearly define buyer segments and willingness to spend on mobile devices. This links to a usable demand curve and usable prescriptions.

In the demand curve shown in Figure 8-1, note how each part of it is associated with a particular demographic segment. This curve happens to be visitors to tourist attractions in the Atlanta area. The least price-sensitive are business visitors, next is couples, next is nuclear families; the most price-sensitive is large groups, such as clubs or family reunions. When combined with demographic data, demand curves let managers visualize which shifts will happen as they change asking price. The visual combination of a demand curve and segments makes this tool come alive. Unlike elasticities, segments differ in size and so show asymmetries in size of opportunity when raising or lowering price.

Figure 8-1 Demand curve for Atlanta area attractions: segments linked with demand curves are intuitive and useful management tools.

Segment-based demand curves apply equally to B2B situations, where different segments of buyers with different characteristics occupy specific places along the demand curve. Of course if your segmentation does not reflect price sensitivity, this will not work, because it’s a bad segmentation—and suggests that managers cannot know the benefits of lowering price with any precision. Every segmentation should reflect price.³

Before raising or lowering a price (promotions aside), look at a demand curve meshed with segmentation.

Customer Characteristics

In addition to a demand curve linked to segmentation, there are other management programs to improve pricing. Changes in price structure and level should reflect customer characteristics and your objectives. Three common purposes in shifting price higher or lower, and possible approaches are:

1. Fixing a “broken” list price. In many cases companies have let their list prices drift, with automatic price increases and across-the-board increases. This can manifest itself as a large sales discount that has little to do with interaccount differences. By now you are familiar with the shortcomings of the idea of list price, and you may agree that there is no reason to fix the list price—get rid of it! Replace it with a set of contextually determined baseline prices instead.

2. Customer base under pressure. While some of the customer base is under pressure, some longer-term customers might appear to be secure against erosion. The answer is to differentiate price structure. For instance, often new customers (who are unsure of volumes) want variable pricing, while established customers insist on fixed prices. Perfect—in most markets neither side will bother to do the math to compare per-unit rates.

3. Maximizing price realization. Even when overall price level is fine, you will want to maximize price realization across accounts. Management intuition, perhaps augmented by impressions of messy scatter plots, may be that some accounts are getting a bargain, and others are showing signs of curtailing purchases and other signs of price pressure. The starting point, assuming management intuition is right, is to understand customer risk of loss. This means your company may want a risk tool, which rates the likelihood of customer cancellation because of price. (See Chapter 14.).

The benefits of this tool can be enormous. Less than half of customer defections are price driven and therefore should not be addressed through price. Indeed, lowering price can sometimes destroy trust and set in motion further purchase reviews.

These three purposes require different approaches because the root causes of the problem differ. Of course these strategies are assuming that the market is stable. How can a manager safely shift prices in a downturn?

Pricing Strategies in a Downturn

From time to time, as you have noticed, the economic environment deteriorates. What is an optimal reaction to this change in context? Which pricing strategies address falling demand in an economic downturn? The pundits generally advise you to “Wake up—pay closer attention to customers and be more targeted in your pricing.”⁴ Good ideas certainly, but what should you do specifically? Which price initiatives do, or do not, work? Is a downturn the time to lower prices?

There are five key strategies for combating falling revenues. The key to success, in all cases, is not to assume that market-facing management becomes magically smarter. You may need tools to change behaviors. Most of the strategies below focus on understanding the customer buying decision, which is the driver of price sensitivity. Know the decision and you can optimize your pricing. Again, treat price reductions with caution. lowering prices may be unnecessary. That is important to know because in some cases a global price drop will do nothing but hurt results.

Strategy 1: Adjust to the Change in Context

With the downturn, the value of your offer has changed both in aggregate and by component. For many industries, the value of your after-sale service has increased while the value of new widgets has fallen. This is a direct consequence of your customers feeling poorer or having their budgets cut. While such cuts will preclude purchase of new units or services, the old units are now integral to customers’ businesses and so must be maintained, recession or not.

Evidence of this sort of shift comes from 2010 IBM earning results. Unlike its more manufacturing-oriented peers that experienced sharp revenue declines, IBM exceeded earnings because it had shifted its business to over 60 percent service and lease revenues—which were less subject to capital expenditure cuts.

The sooner you understand which categories of spending must continue and which categories will be cut, the sooner you can adjust your price structure. We have found this analysis produces the best programs for preserving revenues. Often, a price increase on offer elements less affected by the economy will offset reduced demand for flagship products.

In numeric terms: assuming your “normal” revenue mix is 70 percent new sales, 30 percent maintenance services, and the recession causes new sales to fall by 20 percent, we find that often you can make up much of that fall by raising maintenance and spare parts prices (by as much as 50 percent in some cases!). To avoid customer rebellion, naturally, finesse, messaging, and superior bundling techniques are required to pull that off.⁵

Strategy 2: Improve the Value Message

This strategy is linked to the first strategy; in a nutshell, it says that customers do not always realize the value of what you offer. While many sales forces say they sell value, in fact most do not. This is because in good times, in many industries, a sales rep does not do best by selling value. Rather the rep does better by raising awareness and inserting himself into an existing buying process. In a downturn, the value communication role becomes more important.

To have sales sell value, equip and train the sales force with specific messages and evidence of your product’s or service’s value. For instance, engage third-party evaluators to compare their product with competitors. Credible third-party evaluators are plentiful: often university professors will evaluate your product for little more than the cost of samples. Evaluation organizations such as J.D. Powers and Associates, are very important elements of a value message when customers are parting with their money with increasing care.

Strategy 3: Make a Third Party Pay (e.g., the IRS)

Many companies believe that once the product or service has been delivered, the pricing process is over. Wrong. We find that many buyers are able to obtain reimbursement of their costs and that a majority of buyers can be educated on the tax consequences of their purchase. You as the seller have an impact on both taxes and reimbursements, and you neglect an important element of net realized price if you ignore these impacts.

The means to bringing this about is to understand your customer’s tax or reimbursement opportunities. For instance, if you sell to lawyers who can obtain client reimbursement on electronic research but not on books, sell your electronic and print research in bundles; on the invoice allocate most of the price to the electronic. Another example: if you sell bundles of telephone and video services, do not allocate them equally on the invoice; allocate more of the bundle price to the potentially tax deductible second telephone line, and educate customers on why you have done so. A final example: if you are a not-for-profit performing venue selling 10 performance season tickets for $300 (average price = $30) and individual performances for $50, then grant season ticket holders who donate back tickets for an individual performance they cannot attend a tax credit of $50, not $30.⁶

Strategy 4: Better Identify Customer Behavior

How will your customer cut costs? Can you get your product out of the scope of your customer’s cost reduction program? Given how simple some austerity efforts are, this should not be a difficult question to answer.

Starting with the extreme case: if your erstwhile customer simply decides to spend nothing, you may have to try to arrange to sell based on future payments or future obligations. More likely, your customer will decide to reduce all expenditures over a certain dollar amount. In that case, if you have a $25 subscription price, cut it into two chunks of $12.50 each and see if that flies under the radar.

Often, business customers cut by accounting categories, in which case if capital expenditures are being cut, try to fit more of your purchase into operating expenditure categories. Experience says that this does not happen easily, but it is possible if attempted in conjunction with some symbolic but material change in the offer. For instance, one medical equipment manufacturer offered a limited-time reduction in the cost of its equipment, but only if purchased with a new expanded-scope maintenance program. The substantive change included shifting the initial stock of spares from the equipment to the maintenance program (and making the spares broad classes of parts, not just specific parts, which had the benefit that the spares did not need to be stored at the customer).

Strategy 5: Plan Scenarios and Make Price Adjustments

All downturns are not alike. For pricers, the key scenario question relates to whether they are looking at inflation or deflation. Additional questions would have to do with the costs of inputs, downstream products, duration, and recovery mechanism.

Scenario planning is the tool that has historically performed best for companies planning for downturns. Shell Oil is superb at applying this technique, for example. Comparing two previous downturns highlights differences that should be part of your scenario planning:

The mid-1970s recession manifested itself with very high inflation, high unemployment, and high commodity prices (particularly oil). That recession ended as oil prices dropped with deregulation of that industry and the collapse of OPEC (Organization of Petroleum Expotting Countries).

The 2008–2009 recession saw a spike in oil prices and an emerging split between luxury items, low-end goods, and commodities. Inflation split: some goods went up in price (oil) but others fell (real estate and midrange automobiles). Consumer confidence crashed but later recovered, although consumer markets remained split between high unemployment and prosperous segments.

What business environments (i.e., contexts) are ahead?

Let us suppose the future includes a period of declining prices, followed by inflation. This scenario means holding the line on existing list prices but relaxing discounts as a discrimination tool between prosperous customers and those who are languishing.⁷ It’s a good excuse to move to contextual price bases. For almost anyone who drops prices under pressure, the message to customers must clearly include “We are dropping prices now because our costs are falling, but when inflation starts to rise next year you should budget for increases.” For many B2B companies, it means that long-term contracts being negotiated today must have contingencies based on inflation rates (e.g., if inflation tops 7 percent, there is an automatic adjustment incorporated into the agreement).

What about inflation itself—how to handle that? The contextual answer is to avoid large numbers. What does that mean? It means that a 9 percent price rise will get more attention than a 6 percent price rise, and a double digit will get more attention than a single-digit-rise. Further, the power of compound growth mathematics says that the only way to avoid larger increase numbers is to catch increases early.

To illustrate this point: if two sellers both are priced at $100 per widget, and because of steady inflation they must both move to $200 in five years, the first two years are critical. If Company A does two years of 7 percent increase, it must do three years of 21 percent price growth to get to $200. Company B, on the other hand, could do 14 percent per year for all five years (ugly, but better than 21 percent). This would mean a gap would open up by the second year between inflation-aware Company B and unaware Company A. That needs to be addressed, but we find that often at the beginning of inflationary cycles, customers are not as sensitive to price rises as they are in the middle of them. In the inflationary period of 1972 to 1978, prices rose rapidly, but retailer profits were up initially in 1973.⁸

Any deflation highlights a peculiar management conundrum. Most companies of any size sell to the market at different realized prices. We recommend that while prices are falling you avoid the temptation to simplify or regularize pricing. In other words, do not consolidate rate cards or contracts.

While the initial impression and reaction by senior management to a view of actual rate cards is often “What a complicated mess!” a downturn is not the moment to simplify. There are usually many small customers or distribution partners buying at higher rates because your product or service is not a major expenditure to them. These customers or partners often will not examine price, and the change can only provoke scrutiny—as some software providers have found, let sleeping dogs lie.

Being proactive in the five ways listed here is foundational for success in periods of inflation and downturns. Recommended prescriptions do not include simplifying your pricing—that will not address a changing environment.

Summary: Cheap Tools for Depressing Times

The best way to manage pricing during a downturn is to understand customer decision processes and market transparency. But that does not mean managers will suddenly grow their pricing skills and understand the customer decision processes any better than before. To help with this, your company should build inexpensive pricing tools and insist on their use. Context and segmentation should be used to understand likely market reactions and demand.

When a downturn or inflation comes, pricing grows in importance because management price actions become less routine and strategy is required. Scenario planning is very useful here. Be cognizant of corporate pricing culture, however: economies change more rapidly than corporate culture.

Notes

1. Especially Arc Elasticity, which is never useful. Point elasticities are more useful managerially for short-term tactics in highly communicative commodity markets. Some software provides estimates of elasticities. But although software prevents scrutiny of elasticity hidden inside systems, it does not actually improve the accuracy of elasticities. For instance over any longer time horizon, elasticity will fail to point out the asymmetry between price increases and decreases.

2. Of course, if you are General Motors and can ensure that every potential buyer knows about your price change, this would be less of a worry. The “employee discount” program of 2008 to 2011 quadrupled its Web traffic and increased sales materially. Acendmarketing.com focuses on tracking of Web traffic.

3. In fact, price sensitivity should be primary in defining a segment. R. Frank, F. Massey, Y. Wind, Economic Principles of Market Segmentation, Prentice-Hall, 1972. All too often segmentation seems to be a captive of stock data and channel economics.

4. We suppose that includes the authors of this book, but we claim to be a better class of pundit.

5. Or if you can be fortunate and be solely in the purchase category that thrives. For instance, people turned to painting their houses in the 2008– 2009 recession rather than building. “For Sherman-Williams, a Rosy Outlook in Recession,” The Wall Street Journal, December 24, 2008, p. B7.

6. The idea is that the market sets price. While the customer may get the same ticket stub as always, the value and ability to price are different. While the orchestra may be the same, the price of a single performance is not the same as a series as observed by Gayle Maurin, theater guru. So, if the season pass holder turns back in a single performance ticket, it’s worth the single performance price of $50, not $30 ($300 divided by 10 performances). This is the hardnosed contextual value assessment, and shows why markets do not always abide by people’s “common sense.” Note Einstein’s quote: “Common sense is the collection of prejudices acquired by age 18.”

7. Compare “Luxury Spending Is Back in Fashion,” which reports that jewelry, recreational vehicles, and luxury cars are growing robustly, but “the rising tide isn’t lifting all boats.” USA Today, October 27, 2010, p. 1A. On the other hand, in an article on chain stores like Walmart, management is quoted as saying, “The slow economic recovery will continue to affect our customers, and [we] expect they will remain cautious about spending.” “Retailers Are Sold on Frugality,” The Wall Street Journal, August 18, 2010.

8. Timing matters for price changes provoked by inflation, just like all other changes. It’s not linear, however: early is better in many cases. “Higher Prices Looming, Many Companies Say,” The New York Times, December 2010, p. A17.