Faculty Opinion

Getting the Price Right: What Gets in The Way?
- by Management Professor Joe Urbany

On the TV show, "The Price Is Right," contestants guess the sticker prices of a variety of products. Today, companies play a different kind of pricing game. Their challenge is to price their goods and services low enough to promote sales and high enough to protect-or increase-profits. Yet many firms get their prices wrong.

Why do companies often err in making pricing decisions? There are many reasons (particularly related to lack of information), but two have received limited attention. The first is force of habit. Managers get used to making decisions the way the company has always made decisions. They always mark up X% below their competitors. Such clear-cut rules are easy to use because they are organizationally supported and protect managers from having to make riskier judgment calls that could wind up hurting their careers. But they may not lead to the most profitable results.

Another reason companies make bad pricing decisions is that it is hard to predict competitors' reactions. Instead, they act on an intuitive belief that short-term, aggressive pricing will increase their market share and lead to longer-term profits. Often the opposite occurs. When a company cuts prices, competitors often follow suit. That makes customers increasingly price sensitive, so margins continue to erode.

It is not surprising that many firms shy away from riskier pricing strategies and stick with the tried-and-true. Organizations need to focus more directly on competitive reactions and incremental profitability.

Three That Get It Right

Three examples illustrate how companies can improve their pricing by changing decision-making routines:

1. In the mid-1990s, Ford Motor Company began to conduct consumer research to understand demand at different price points. It also asked customers to describe product features they valued, but that manufacturers had been slow to deliver.

Armed with this new information, decision makers experimented in five sales regions with a revamped pricing strategy. They lowered the price on higher-margin cars such as the Crown Victoria and the Explorer, which boosted sales in the category by 600,000 cars. And for lower-end vehicles like the Escort and the Aspire, they raised prices. The net effect? Unit sales in these regions dropped by 420,000 and market share dropped nearly two points from 1995 to 1999, but total earnings shot up. In fact, the experimental pricing policy netted profits that exceeded regional targets by $1 billion.

2. In the slow moving, paper binding industry, customers tend to relentlessly hound sales reps for discounts. As a result, Booklet Binding, Inc. (BBI) found that, despite its growing sales, profits remained flat. Rather than taking more obvious measures such as raising prices or downsizing, BBI invested in sales training and a new information program. In effect, that changed the rules of the game. Salespeople received information about each customer's annual sales patterns so they could help them place orders in advance, thereby enhancing customer service. BBI also trained its sales force to do cross-selling and to promote higher-margin, value-added products. The result? Sales rocketed to $23 million in 1996, compared to $9 million just two years earlier. Pre-tax margins were twice the industry average.

3. An industrial products firm faced aggressive competition from a new entrant. Rather than making the obvious choice-cutting prices to protect market share-the company took an uncommon tack: in the low-growth, commodity segment of its market, the firm raised prices, a move that succeeded in discouraging the new competitor from entering with low prices. In the remaining two segments, the company added faster service and guaranteed supply-features that redefined its competitive positioning to emphasize quality rather than price.

What Companies Can Do

Urbany's report suggests a variety of tactics that companies should consider to help focus greater attention on profitability as a decision criterion:

Secure top management commitment. To change the way managers make pricing decisions, leaders need to reinforce principles such as valuing profitability over market share and calculated risk taking over reactive price cutting.

Use data and feedback to improve decision-making. When price, cost and demand data are linked together in the same information system, managers can predict margins and profits more accurately. Good customer data lets them understand customer price sensitivities and the product features they value. And information about competitor behavior helps them predict likely reactions, rather than simply matching their rivals pricing decisions after the fact.

Consider letting some customers go. It may be more profitable, in the long run, to let some customers slip away and to focus instead on less price-sensitive segments.

Prime the sales force. By training sales people to promote high-margin offerings and then rewarding them for doing so, companies like Ford have enhanced overall profitability.

Boost adaptive thinking skills. To overcome deeply ingrained habits-for example, the tendency to cut prices and hope for the best-companies need to educate decision-makers to think differently about the pricing game. Simulation training can help them see pricing's long-term impacts on customers' and competitors' behavior. Managers should also be encouraged to make "vaguely right" decisions, watch what happens as a result, and then make necessary course corrections.

Manage customers' perceptions. Customers who understand the rationale for pricing changes are less likely to object. Companies may also manage the pricing issue by reducing its importance. For example, rather than nickel-and-diming against competitors, they can shift the focus away from price by emphasizing customers' needs and how they will be met.

Clearly there is no one-size-fits-all pricing strategy. But by factoring in competitors' likely reactions and incremental profitability in their decision-making process, companies can move beyond educated guessing to boost long-term profits.

 - Joe Urbany is Professor of Marketing and Associate Dean of Graduate Programs at Notre Dame's Mendoza College of Business. This article is excerpted from "Justifying Profitable Pricing," published in the Marketing Science Institute's working paper series.