HOW PRICE KILLS PROFITS


by Donald V. Potter

A few weeks ago, my seven-year old daughter offered to wash the car. My car always needs a cleaning, thanks to our two cats who are fond of walking over it, so I agreed. My daughter and three of her friends promptly washed the car. Then she returned and asked me for four dollars.

I protested that the car wash a few blocks away would have cost me only two dollars. She countered that she had promised each of her friends one dollar for helping her, and she wanted a dollar, too. "You see," she explained "the job cost me four dollars, so that's what it's going to cost you." I could see that I was either going to lose this argument or be very unpopular in the neighborhood, so I paid up. It struck me afterwards, however, that pricing decisions at many large, complex corporations mare made on a model similar to that devised in the driveway by my daughter. They both use costs to determine what price customers are asked to pay for their products.

This sounds reasonable enough, but it contains one painful fallacy: customers do not care a bit about a company's costs. If managers could think more like customers when pricing their products, their profits might increase.

A customer cares only about getting his problem solved – in other words, about the value he gets from the product. Each competitor offers a unique set of features and support meant to solve the customer's problem. The customer weighs each solution and makes a choice. If need be, the customer uses relative pricing – the difference between the price of his first choice and the price of his next-best alternative – to make his final elimination. From a customer's perspective, the primary role of pricing is to qualify difference in value among his alternatives.

Most customers make their buying decisions long before differences in price become a factor. Interviewed in focus groups, customers may assert that they made a buying decision on the basis of price. But when you isolate in most decisions, and talk through in most decisions, each level of the buying decision with an individual customer, it rapidly becomes clear that price was not the main determinant in most decisions. A customer knows he must pay something to get his problem solved, and he spends most of his buying effort evaluating the quality of the solutions, rather than the prices. Low prices alone rarely decide the customer. Few customers drive the cheapest car, live in the cheapest neighborhood, buy the cheapest machine tool or consult the cheapest attorney. Customer decisions are much more complex than that.

There is a hierarchy in customer buying decisions that goes in order of descending importance. First, a solution must fit a particular need. If a customer with cramped space in a ski cabin needs a stacked-pair washer and dryer, a company offering only a side-by-side washer and dryer cannot be in the running for the customer's money. Second, the product must be reliable. A washer that doesn't clean clothes very well, or a dryer that doesn't dry, can not be sold at any price. Third, the product must be convenient to buy. Few customers will go to great lengths to get one product over another – hardly any will even go to good lengths. Finally, the product must be priced right. The price must be "fair" compared to alternatives.

When our customer appears to be exceptionally price sensitive, we can conclude two things: the customer has attractive alternatives to the product, and he can not find a reason for choosing our product over alternatives because of anything more important in the hierarchy, so he chooses on price. The difference we offer in value does not outweigh the premium we are demanding. Viewed from the customer's perspective, price sensitivity represents a company's failure to create an important difference over competitors in the value the customer receives.

A few examples illustrate the point. One company needed an additional product to improve the productivity of its distribution channel. It found an imported product to sell and brought it to the market at a price equal to its import price plus a standard mark-up for selling and administrative expenses.

Another company enjoyed several good years following a product's introduction, but now losses were mounting as the product aged and unit sales declined. Company management was shown comparisons indicating that their aging, money-losing unit was way overpriced versus competing products, but they declined to change the price "because it costs too much to make the thing."

A third company faced another pricing problem. They had sold their products successfully for several years against model competition, but then one competitor became aggressive and started pricing his products at deep discounts. After losing a few sales to this competitor, the company became alarmed and talked of instituting a crash program to reduce costs, "in order to bring prices into line with the low-cost competitor."

In each of these examples, management assumed that the primary role of pricing was to cover costs. In the case of the third company, management also assumed that the issue of price was uppermost in the customer's mind. Both assumptions were wrong in these examples, as they are for most situations, because the assumptions are contrary to the way customers think.

If price were set by the relative value of the product offered to the customer, then costs could follow price – a concept we call "design-to-price" or "design-to-value" – rather than the other way around. Under this approach, product costs are constrained by product prices, which in turn are defined by what other alternatives the customers have. Management can then make a compelling and realistic case for cost limits at each organizational level within the company, rather than imposing across-the-board cuts. These cost limits are more realistic because they have been drawn from relative value, rather than by arbitrary prices that have been grossed up from costs.

The benefits of designing costs to fit price can spread through the entire organization. There can be more incremental mid-course corrections, with fewer crash cost reductions or the kind of hastily-conceived, forced product introductions that often fail. Sales and marketing costs can be better controlled, and the trade-offs that determine a product's viability can be better managed. In one case, a company's product had become relatively expensive, and its marketing and sales costs were rising sharply. The company lowered its product price by fifteen percent and increased its unit sales by fifty percent. Marketing and selling costs went down. The company had narrowed the premium demanded for its feature-rich product – but it still retained a healthy premium.

The relationship of costs to pricing is one of those counterintuitive business problems that yields to a little bit of fresh perspective.
Now, if I could only figure out how my daughter talked me into paying her those four dollars…

(Note: This Perspective was written in the context of the economy in 1986. While some of the companies may have changed their policies or indeed no longer exist, the patterns they exhibit still hold today.)


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