Part 2: Company Price Environment

Pricing Objectives and Guidelines

Capsule: The basic rule is to raise the price until it attracts a competitor or chases away a customer. Usually the competitor, rather than the customer, sets the upper limit on the price. Company guidelines follow these objectives by adopting primarily Defensive or Offensive tactics in pricing.

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Symptoms and Implications:

The Company's pricing policy serves as a bridge between the Company's value proposition and its cost management task. The pricing policy first ensures the Company's performance and Price Points present an attractive value proposition to customers. This requirement demands that the Company allow competitive prices and customer net cost savings on the use of the product to guide its own pricing. At the same time, pricing policy helps the Company make an attractive return on investment. Cost and return management goals may seek higher prices for the Company's products.

These two demands on the price conflict with one another. In practice, the Company makes trade-offs by emphasizing one objective or another, depending on the near-term pricing environment. Where prices are likely to fall, the Company adopts defensive pricing guidelines to protect and raise sales volume. Where prices are increasing, the Company adopts offensive pricing guidelines to raise margins. The Company applies these guidelines to each customer relationship.

Two Basic Price Objectives

The objective of a Company's pricing policy is to set the Company's product price at the highest level that a customer will pay and at a level low enough to prevent a competitor from gaining attractive sales volume in price competition with the Company. The Company must find a balance between two potentially conflicting actions:

  • First, the Company seeks to raise its prices to the highest level a customer will pay for its products. This action raises margins to produce profits, at the possible expense of sales volume.

  • Second, the Company must keep its price low enough to discourage a competitor from: entering the market, if it is not currently in the market; entering one of the Company's customer relationships, if the competitor is not presently in the relationship; or from gaining share of the Company's current customer base where the Company shares a customer relationship with the competitor. This action seeks greater sales volume to protect or raise profits, at the possible expense of margin on each sale.

The competitors' capacity and will to underprice the Company usually sets the upper limit on the Company's price for the product. Customers may be willing to pay higher prices than they pay today. But, those higher prices would, in many markets, attract competitors who would attempt to gain the customer relationship with a lower price.

The Company's view of price and margin direction comes into play here. If the Company foresees a falling price and margin environment, it follows pricing rules that are defensive, meant to protect current customer sales volumes. If, on the other hand, the Company expects a rising price and margin environment, it adopts more offensive pricing tactics, meant to raise prices while protecting Core customer relationships.

For Falling Price Environments

The balance between the market's demand and capacity informs a company's pricing actions against competitors. In a market where both the Company and the industry are in overcapacity, the Company sets its pricing policy by following three basic rules:

  • First, raise or maintain price in any customer relationship where the customer is not price sensitive due to the Company's unique benefits for that customer. Note that any price increase must still leave the customer with a clear net cost savings from the use of our product.

  • Second, reduce the price where competition will allow the Company to enter a customer relationship, or to expand within an existing customer relationship, on the basis of that low price. This low price must be above the Company's cash cost and should not cause a reduction in the prices for the Company's other relationships. There will be many of these opportunities in Deteriorating markets. But, the Company will see few of these opportunities in a Hostile market.

  • Three, match any lower price of other competitors either in one of our customer relationships or attempting to enter the relationship. This latter rule, which the Company may have to invoke frequently for several years, should signal to both customers and competitors that the Company intends to make price a commodity as long as the industry is in overcapacity.

These rules lead to defensive pricing guidelines for the Company to implement in the near term. With defensive guidelines, the Company stresses the actions to increase or protect sales volumes and emphasizes the second of the two basic price objectives. The guidelines address Company actions with each customer:
  • Match competitive price reduction offers with all current customers. This price-matching policy extends to all Core, Near-core and Non-core customers who produce a positive cash flow on their purchases from us.

  • Discount to gain new customer sales volume where the Company finds a competitor in a Leader's Trap. Each of these arrangements must generate cash, net of any spreading of the low price offer to other customers. This policy applies first to Core customers and then to Near-core and Non-core customers, in turn.

  • Encourage Last Look for all Company customers. The Company must know about competitive pricing initiatives with its customers in order to counter them.

For Rising Price Environments

In the more fortunate circumstance where capacity falls short of demand, industry prices will be high or rising. In this situation, the Company would raise its prices as fast as market demand management allows. The Company has no incentive to set prices below those of competition since it is likely to be sold out of its current capacity. Rather, its primary incentive is to match, or perhaps even exceed, average industry pricing based on its objectives for each customer. It may, in these circumstances, keep some customers at industry pricing and others above industry pricing, depending on how valuable the customer relationship is to the Company in the long term. The more valuable the customer relationship is to the Company, the more likely the Company would hold its prices at industry average for the customer.

In these markets, where demand exceeds capacity, the Company may be short of capacity. It may have to allocate its product output. In doing so, its first priority is to support its Core customers. In such a market, the Company should use its pricing policy for its support of Core customers. This objective implies that the Company would raise its prices to its Non-core and Near-core customers by enough that they will either become long term Core customers or will seek other sources of supply for the product.

Using the common practice of putting all customers on the same allocation based on a percentage of last period's purchases is ill-advised. This policy creates a "failure" with Core customers. Good Core customers will forgive rising prices in a product-short market. Their memories are much longer, and their understanding much lower, if we fail to deliver the product they need to exploit their own markets. Far better to let Non-core customers wait for product.

In a Reprieve market, industry demand exceeds current industry capacity. Times are very good for industry profits. In this type of market, the Company follows five pricing rules. These are offensive pricing guidelines:

  • First, while following industry prices up, ensure that the Core customers have first call on the Company's capacity. This is critical to the Core customers' success. Just as a shortage of critical components and raw materials restricts the capacity and raises prices and margins in our industry, so a shortage of capacity in our product reduces the capacity and raises the margins in our customers' industry. This is the time the customer needs us most. It provides us with an unusual opportunity to win future sales from our Core customers based on our superior Reliability in a time of shortage.

  • Second, raise prices to our Non-core customers until they seek other suppliers. These customers use us to keep their prices low in times of Hostility for us. We must use their purchase volume to support our far more important Core customers in times of product undercapacity.

  • Third, where the Company still needs capacity to support current Core customer demand, raise prices to Near-core customers in inverse order to their long-term profitability to us. The Company raises prices, first, to the lowest return customer who is Near-core, second, to the next lowest return customer, and so forth. The Company continues this process until it has caused enough Near-core customer purchase volume to leave for other suppliers to meet the Core customers' needs.

  • Fourth, raise prices to the Company's Core customers in inverse order of the size of the customer's annual purchases from the Company. This process raises the prices on the Core customers purchasing smaller quantities from the Company before those purchasing larger quantities. As a complement to this fourth guideline, the Company may consider helping its Core customers obtain product during times when the Company is out of capacity. In several commodity industries, we have witnessed astute companies purchasing product from other industry suppliers in order to keep their Core customers from suffering shortages.

  • Fifth, consider substitute products and potential new entrants as probable limiters on the higher price levels. This guideline applies only when the Company determines the level of industry prices. It commonly applies to industry leaders with very strong brand names in industries with normal to high levels of marketing and sales expenses. This action keeps the long term sales volume in the current industry and reinforces the ability of the industry leader to set favorable price levels well into the future.

Pricing Objectives Questions

  • What do the conclusions reached about future industry prices (see Diagnose/Pricing/Industry Price Outlook) and current customer price sensitivity (see Diagnose/Pricing/Price Sensitivity Among Customers) suggest about the opportunities the Company has to raise prices to increase margins or to reduce prices to increase market share?

  • Which competitors are likely to oppose a price increase? A price decrease? (See Diagnose/Pricing/Competition and Their Knowledge, Capacity and Will).

  • What objectives will the Company set for its pricing policy? These objectives must strike a specific balance between increasing price for margin and decreasing price for market share.

  • What specific pricing rules will the Company follow with each Very Large and Large customer who currently is a Core, Near-core or Non-core customer? These rules consider the competitors who share the customer with us.

  • At what price does each customer Size/Role segment become attractive for the Company? This question assumes that the Company might serve an average, unknown, customer in each Size/Role segment. What minimum price level produces a Core, Near-core and Non-core relationship for the Company?

  • If the market's competitors typically allocate their available supply to deal with an excess demand situation in the industry:

    • Which companies are likely to be out of capacity first?

    • How will those companies allocate their available capacity?

    • Which customers will receive less than their needs?

    • How will those customers fill their unmet needs?

    • As prices rise, how much does demand decline?

  • If product capacity is short of demand, how will the Company allocate its available supply?

Guideline Application to Customers

These guidelines apply to each customer relationship the Company has or plans to have over the next 12 – 18 months.

In a falling price environment, the Company would develop specific pricing plans for each Large and Very Large customer it serves or plans to serve. Each of these customers is important enough to warrant specific individual consideration. The Company would issue broader directives to the sales force and marketing staffs to cover the implementation of these guidelines with the smaller, and far more numerous, Medium and Small customers.

In a rising price environment, the company would also develop specific individual plans for each Very Large and Large customer. With Core customers, the Company would plan to provide the appropriate level of capacity support for these customers' growth needs. With Non-core customers, the Company would plan the timing for specific price increases over and above normal industry price increases to free the capacity these customers use. Finally, with Near-core customers, the Company would plan the order in which these customers will receive prices above industry standard price increases, again to free capacity in support of Core customers.

With Small and Medium customers, the Company would develop specific plans only for the Core customers. The remaining Near-core and Non-core customers would be subject to broader guidelines issued by the Company for implementation in the field.

More Pricing Objectives Questions

  • What specific plans does the Company have for each Very Large and Large customer for the coming 12 – 18 months?

  • What guidelines does the Company plan for Medium and Small customers over the next 12 – 18 months?

  • How will the Company implement its guidelines for Medium and Small customers without incurring excess overhead in the process

With specific objectives and pricing guidelines established, the Company next turns to the task of defining where the specific opportunities to change its price to gain margin or share might lie.

Return to Basic Strategy Guide Step 20

Summary Points

Next: Price Change Opportunities