By J.D. Richards , John Reynolds and Matt Hammerstein

  

Every executive knows that price plays an essential role in determining the economics of a business. Yet many do not see pricing as a key responsibility of senior management. Viewing prices as largely beyond their control, they leave pricing decisions to mid-level technicians who make critical judgments without understanding the "big picture." As a result, pricing, which should be a sculptor’s chisel, more often resembles a workman’s hammer.

When you have multiple products across multiple segments and geographies, the question of what to charge different types of customers is never easy. Typically, senior managers respond to complex pricing challenges in one of three ways: They overdelegate decisions to individuals much lower in the organization; they underanalyze the situation by relying on simple default pricing models; or they employ technology as a silver bullet solution, supplanting executive judgment. All three responses can lead to misinformed decisions and, consequently, missed opportunities for sales and profit growth.

In this article, we discuss each of these three problems in some detail. We then describe the case of a retail banking client that initially miscalculated the customer reaction to a series of price changes, then learned from its mistakes and developed an unusually comprehensive approach to pricing – one grounded in collecting and integrating the right customer, competitor and cost information. Such an approach has given the bank a strategic pricing capability that’s yielding dramatic improvements in its financial and organizational performance.

The Overdelegation Problem
Price is the variable that divides the value of a company’s products and services between customers and shareholders. Nevertheless, most pricing decisions are made without reference to the company’s broad strategic choices – whom to target, with what offer, through which channel, based on what competitive position. One reason for this is that pricing issues rarely make it onto executive committee agendas. Pricing decisions are made three or four levels below a division or business unit leader by a technician who crunches data. While executives spend a great deal of time discussing the design of products, services or product/service bundles, they do not see price as integral; it’s decided later, by less senior people who at best may be given very general direction on the level at which prices should be set – "at a slight premium," for example.

Left with little guidance, the technicians’ research often focuses on the appeal of different product attributes rather than on optimizing the crucial trade-off between price and volume. Attributes do drive volume, of course, but how and why are directly related to the product’s price. Because everyone recognizes that the trade-off is difficult to measure beforehand, most people either dispense with research or use simplistic approaches.

The Underanalysis Problem
Although a lot of analysis relatively low down in organizations precedes pricing decisions, the results are usually based on one of four simple default pricing models:

• Competitors’ pricing (usually the main factor)
• Status quo, plus or minus a little nudge here or there
• Short-term earnings target ("What will it take to hit our numbers?")
• Cost plus a premium

There are two serious weaknesses in all of these models: First, the pricing decisions reached can fail to account for the full economic costs; and second, the predictions of the impact of a price change on volume and sales are usually little more than guesses based on past experience.

The cost structure of a product or service is a vital factor when setting a price because the ratio of fixed to variable costs of two products can be quite different. The proportion of the cost that is variable is crucial, since only variable costs will be affected by a volume shift triggered by a price change. The "cost-plus-a-premium" model does take into account costs, of course, but seldom the right ones. Cost-plus price-setters either use fully loaded costs (fixed and variable) or draw the line between fixed and variable costs in the wrong place. A thorough activity-based analysis is needed to define cost structures accurately.

Having the right customer information is critical. The right price is the one price that optimizes customer benefits and company profits. Some customer information goes into pricing decisions, but it is usually derived from attitudinal surveys (e.g., "Are you happy with your current price?"). Our experience suggests that attitudinal surveys alone are poor predictors of customer behavior; they must be combined with an analysis of actual buying behavior to reveal what will motivate customers to switch to a competing product or service.¹