A Price Optimization Guide
Price Your Products in 4 Steps
- A price strategy is the overarching framework that defines how the company will use price to increase market share, revenue and profit.
- Price optimization finds the highest sale amount a customer segment will pay for a product or service. It models the factors that impact quantity sold, statistically measures how customers respond to price changes, compares alternative scenarios to achieve financial goals, and identifies the optimal sale amount to achieve revenue, profit or market share objectives.
- Systemic and continuous revenue growth can be achieved with price strategy and optimization. Research shows that adoption of a formal price strategy with active price optimization increases annual revenues by 2 to 8 percent. Nearly all of the increase falls straight to the bottom line.
- Price strategy and optimization is not easy, which is why it is underutilized by most companies, and why it becomes a sustainable competitive advantage for those that overcome the challenge.
Even small changes to average price deliver a linear impact to profits. Several years ago Harvard Business Review published a study which found "a 1 percent increase in price resulted in an average profit increase of 11.1 percent." Or for a slightly different perspective, the study also stated the flip side, that a "1 percent price decrease would destroy 11.1 percent of the company's operating profit." While that study is dated, the math hasn't changed.
Pricing optimization offers an immediate impact to revenue generation and profit realization.
In fact, compared to most other revenue growth methods, it can be implemented by a small group in a relatively short period and contribute to in-year revenue generation. Nonetheless, this financial lever is underdeveloped at most companies.
Instead, most companies apply a set it and forget it pricing process built on a haphazard combination of unempirical market research, limited customer intelligence, anecdotal experience, piecemeal competitor analysis and biased influence from product owners or executives.
The problem is particularly pervasive at small and midsize companies. It's not that they don't want to do better, it's that they are not sure how. Here's how Johnny Grow has tackled this challenge with a price strategy blueprint that has been built and refined over nearly two decades.
Price Strategy and Optimization Process
This four-step holistic, end-to-end approach to price strategy and optimization is illustrated below.
Set the Strategy
Trying to tackle an ill-defined problem without a clear strategy is a recipe for failure. Pricing is a strategic action and therefore starts with strategy. And strategy starts with a clear and measurable goal. Is your goal to increase market share, revenue or profit? Don't say all three. Choose one. Each requires a unique approach.
There are dozens of pricing strategies. Many are industry specific. For example, a skimming strategy is commonly used by consumer goods companies when releasing innovative products.
A freemium, subscription, consumption or decoy price strategy is common with Software as a Service companies. A long tail strategy works well for industrial companies or distributors that manage hundreds or thousands of different items. Capture management or loss leader pricing works well in retail. Yield management strategies are essential when dealing with perishable goods.
However, all of these strategies are variants of the big three price strategies that include value-based pricing, cost leader pricing or niche leader pricing. Build your strategy using the constructs among these big three and you will maximize agility, extensibility and success.
Then assemble the pricing team.
Strategic pricing should be managed by a multi-disciplinary team with an executive sponsor, dedicated leader and cross functional members.
A marketing person may be responsible for target market measurement, customer segmentation and customer intelligence. A salesperson will bring visibility to sales processes and competitor intelligence. Product management will bring measurability to competitive advantages and the unique value proposition.
A finance person will bring analysis to inventory balances, working capital requirements, product movement (i.e., turns) and margins. A business analyst will develop pricing hypothesis, convert data into insights and compare tradeoffs. A legal person will provide pricing advice to avoid the hefty fines for country specific price policy violations.
From my experience in assembling these teams for over a decade I cannot overemphasize that all team members should possess analytical and communication skills and be thought of as problem solvers.
The size of the group will be based on the pricing strategy, goals, product complexity and number of SKUs. For small businesses, teams may be a couple people. That means those people will wear multiple hats. For large companies, there may be 10 or more people.
Whether the team is centralized, decentralized or a hybrid will depend on the company structure and whether the pricing team adopts a Center of Excellence (CoE) operating model. Companies with few or relatively simple products tend to centralize while companies operating across global markets tend to push the decision making to regional or local levels.
Price setting authority for pricing teams varies. Sometimes the teams set the sale amounts. Other times, they present cogent facts and make data driven recommendations to a governance committee that accepts or rejects their input.
Set the Price
Pricing is based on customer perceived value. And the measurement of that value lies at the intersection of market research, customer insights and competitor intelligence. Of the three, most companies struggle with customer insights.
Customer insights measure what customers value, how they make purchase decisions and how much they are willing to pay. When combined with price elasticity models or conjoint analysis you can predict how customers will respond to price changes.
Accuracy is improved with data model specificity so it's important to segment customers by several measures, including:
- Explicit criteria (i.e., company size, geography, industry)
- Implicit criteria (i.e., behaviors, sentiment)
- Product purchase history (i.e., product categories and SKUs)
- Sales history (i.e., win/loss, pricing, discounting and competitors)
- Transaction history (i.e., purchase history, DSO, bad debt), and
- Post-sale financial impact (i.e., customer lifetime value, customer tenure, cost to serve and profitability)
It sounds like lot of variables, and it is, but this level of analysis surfaces strengths, gaps and opportunities for precision pricing.
The models then deliver several types of analytics. For example, they answer important questions such as which customers or customer segments will be most impacted with a specific price change or what's the tradeoff among market share, revenue and profit for any given price?
They display key performance indicators (KPI) such as Revenue per Capacity Unit (RPU). They show how those KPIs align with customer value drivers and how the KPIs impact market share, revenue and profits when price is changed.
They recommend optimal sale amounts by product, product line, customer segment, channel, geography or other dimensions pursuant to market, revenue or profit targets.
The better pricing optimization models allow predictive analytics, such as What-If analysis and scenario based pro forma revenue, margin and profit projections. They can also provide confidence levels and forecast financial impact over specific time-based horizons.
It's also been our experience that the best pricing optimization models are not black box forecast projections. They are instead transparent recommendations with stated assumptions and displayed logic that can be modified by human judgment.
When you can measure and see the tradeoff between volume and profits and forecast the impact to current and future period revenues and profits for any given price, you have shifted from haphazard price determination to strategic pricing.
Get the Price
Optimized pricing only works if its correctly implemented so the next step is to move from price optimization to price realization.
The steps needed to achieve optimized prices include sales process support, clear communication, sales enablement training and governance.
- Sales Process Support
Pricing optimization becomes undermined if objective prices are offset with subjective discounting. In fact, research and our own experience show that unmanaged discounting will negate 30 to 60 percent of the optimized price value.
Without internal controls, business-to-business (B2B) companies incur revenue leakage in the forms of sales discounts, off-invoice giveaways (i.e., freight fees), superfluous financial terms and rebates.
Steps to prevent price erosion include sales discount policy and guidance, workflow-based discount approval processing, and timely price alteration detection on quotes, proposals, sale orders and invoices.
As important, sales management should consider changes to compensation management to align with the success of the new pricing initiatives. That may include calculating salesperson incentives based on gross profit rather than revenues.
Value-based messaging to the salesforce and customers should occur well before increased prices are introduced to the market.
We recommend a three-step approach.
First, have marketing or product management create value-based communications that clearly articulate product innovation and customer value by customer segment. For complex solutions or where you sell to multiple buyer stakeholders you may also need value-based messaging by persona. Also recognize that increased prices become much more defensible when tightly aligned with the company’s competitive advantages, brand promise and unique value proposition (UVP).
Second, educate the salesforce with supporting data, customer value drivers, competitor intelligence and proof points which validate new pricing decisions. Sales enablement training may be needed to deliver effective sales messaging.
And third, sales managers must champion and reinforce the changes and price policy with sponsorship and continuous communications.
Lastly, governance is needed to bring transparency, inspection and adaptation to strategic price programs.
New prices must be monitored for realization, systems must surface deviations in real-time and reporting should identify what's working and not working.
Reporting should show price change financial impact by customer segment, product line, line of business, region, salesperson or other key variables. The financial impact should be compared to budget or forecast.
Inevitably, you will find that certain salespeople excel with the new pricing. Your program will accelerate if you learn from their experience and share the lessons for all.
Pricing optimization should continue as long as calculated sale amount recommendations increase revenue and profits. That means as long as you are doing it correctly you are never done.
It's generally a good idea to start small with a pilot to prove the concept. But an incremental start only delivers an incremental benefit. To move the needle on the profit and loss statement or achieve competitive advantage you need to evolve to a transformational approach. And the best way to do that is using a price optimization maturity model.
A price optimization maturity model approach will yield more value at each stage in the journey, create momentum and turn strategic pricing into a core competency.