United Kingdom: Pricing Strategies To Beat Commoditisation

Last Updated: 1 March 2012
Article by Terry Irwin

Few would dispute the fact that the internet and other sophisticated technologies have radically changed the business environment, often in ways we can't even detect yet. And prices and margins in virtually every industry are facing downward pressures as never before. But what does the future of pricing strategy look like? That depends on whom you ask.

Experts tend to agree on the symptoms of the problem and the overall diagnosis, but they do not agree on the cure. All acknowledge that new technology, unlimited access to information and increasing global competition are conspiring to "commoditise" entire industries and force prices into a seemingly endless downward spiral. Their opinions diverge, however, when it comes to the response they believe CEOs and companies should take to counter those relentless market forces.

The value-added approach to pricing strategy

Some experts recommend that businesses facing constant demands from customers to lower prices should take a value-added approach to pricing strategy. In essence, they feel that companies can overcome commodity pressures and maintain high margins by finding narrower market niches to compete in, and then focusing on adding value to the customer in order to differentiate themselves from the competition. When customers understand the difference you bring to the table, they willingly pay a higher price.

The low-cost approach to pricing strategy

Others believe that the value-added mindset is a relic of the old economy, and that in the new economy the process of commoditisation is inevitable and unstoppable. By fighting it, you only make matters worse by raising your costs, which makes it impossible for you to lower your prices and still make money.

In a world where customers have many suppliers they consider to be equals, the only way to make money is to continually lower your cost structure so that you can compete on price. Companies that continue to employ a value-added approach to pricing strategy will soon cost themselves right out of business.

Tailoring your pricing strategy approach

Which pricing strategy is right for your business? Only you can decide. However, whether you adopt the value-added or the low-cost approach, a well-thought-out pricing strategy will generate far better results than a knee-jerk response to competitive pressures or changing conditions in the marketplace.

Basic pricing strategies

In developing a comprehensive pricing strategy, you need to take account of five crucial factors:

  1. Competition
  2. Customers
  3. Financials
  4. Perceived value
  5. Marketing objectives.

In addition, give due consideration to the following principles.

  • Set prices according to your market, customer and competitive needs.
  • Adopt a long-term pricing perspective.
  • Find creative ways to reward retention.
  • When in doubt, start high.
  • Collect information about major competitors.
  • When possible, set internal target prices.
  • Convey target prices to your salespeople.
  • Design and budget for promotional pricing.

Beating the competition

What happens when a very large competitor decides to enter your niche? Instead of trying to compete on price with someone who can sell a product for less than it costs you to make it, we recommend a two-pronged approach:

  1. Defend your territory. Study your customer base to determine which niches and distribution channels are most secure. Then focus all of your resources on dominating those areas.
  2. Attack on service. Huge companies may have economies of scale but they can't respond as quickly as small companies or provide anywhere near the same level of service.

For many companies, especially those in commodity industries, pricing is primarily a function of managing margins and costs. To support this process, we recommend conducting an annual profit-price review. This entails a half-day meeting with your management team to review your overall pricing strategy and accomplish three specific goals:

  • Review the costs embedded in your price structure and eliminate the ones customers don't want or won't pay for.
  • Review your volume discounts and adjust where appropriate.
  • Conduct a bottom-ten review to eliminate unprofitable customers.

We also recommend nominating a "champion of pricing" – someone whose main focus is to track the effectiveness of your pricing strategies in the short and long term. Unless someone pays regular attention to it, pricing tends to get put on the back burner, which can cause you to miss out on a substantial amount of additional revenue.

Today's pricing challenges

Over the years, we have seen a lot of changes in pricing strategy. There are three major pricing challenges in the current environment:

  1. Justifying your price
  2. Proving your price is fair
  3. Pricing for a relationship.

1. Justifying your price

  • Create a buyer review checklist. Publish a pamphlet or tip-sheet that educates customers about how to buy your product or service – for example, How to buy from an ad agency or Ten tips for purchasing data storage services.
  • Make things real. Provide testimonials praising your product or service. This is especially relevant for service companies. Anything you can do to make your benefits more tangible will enhance your ability to maintain price.
  • Supply references. Ask your clients to write letters of recommendation. Give prospects a list of satisfied clients to call.
  • Provide an exceptional guarantee. One of the best ways to distinguish yourself from the competition is to offer a guarantee that far exceeds industry standards.
  • Shout your value. Never assume that customers know you and your reputation. The burden of proof rests on your shoulders.

2. Proving your price is fair

  • Use precision pricing. Single out your best product – the one with the highest perceived quality – and promote it at a very small discount. This creates an image of fairness for other products of yours that customers see as more of a commodity.
  • Offer a "de-featured" brand. For example, Marriott now offers Residence Inns at significantly lower prices than its flagship hotels. Although the quality and service are lower, the cheaper rates create a perception of fairness for the higher-priced hotels.
  • Reward volume buying. Offer discounts to customers when their purchases reach a certain volume. Give them longer to pay their invoices, or offer other incentives that don't necessarily change your price but still create a perception of fairness.
  • Unbundle your services. Set a price for all the services you currently don't charge for, such as free delivery or free service calls. Include the cost of those services on the invoice but don't add them to the actual total. This lets customers know that your price includes more than what they think they're paying for.
  • Offer incentives. Give your best customers small product rebates at the end of a quarter. Offer discounts on slow-moving items.

3. Pricing for a relationship

  • Use tiered pricing. Create different categories of pricing that motivate customers to do more business with you but also save them money over the long term.
  • Bundle your products and services. Even if you don't lower your price, the customer assumes that it must be a good deal because you took the trouble to bundle it.
  • Simplify the pricing presentation. Make it easy for customers to understand your pricing proposition and determine whether or not it's fair.

The key is to make short-term pricing decisions with a long-term perspective. All pricing decisions should be based on your company's need for stability, controlled competition in key markets and the loyalty of established customers.

How to win a price war

Waging a price war is more than just trying to steal market share by offering a lower price. Rather, it is a long-term marketing/costing exercise that requires you to look at who you are, what business you are in and how you serve your marketplace. To win a price war, we recommend three strategies.

  1. Don't fight on all fronts. Instead, pick your battles and focus all your resources in an area where you can definitely win.
  2. Maximise your strengths. Narrow your niche until you can dominate it. Dig in where nobody can compete with you.
  3. Create alliances to eliminate enemies. Form an alliance with your sales team by helping them to fully understand competitor businesses and what they are delivering. Also, find ways to link up with companies whose customers use the kind of product or service you provide, so that they can refer these customers to you.

How to improve perception

Your ability to get the price you want depends to a large extent on how your customers perceive your product and service offering. To enhance your customer's perception of value:

  • Analyse failures, returns and customer complaints.
  • Generate enough profit to enable you to provide high levels of service.
  • Identify what you do that is different from what your competitors do, and concentrate on those areas.
  • Stay consistent in what you deliver.
  • Never quote a price without a value statement.
  • Track and measure customer service.
  • Offer unique and powerful guarantees.
  • Help your customers to get maximum value from your service offering.

People buy because of who you are, not what you do. Find out where your company really makes money and be very careful about diluting that. Above all, be selective about customers. In the 21st century, making money will have more to do with the customers you don't take on than those you do.

Value pricing in a commodity world

These days, it seems that every customer wants it better, quicker, faster and cheaper.

One way to combat the seemingly relentless pressures on pricing is to base your pricing structure on the value you deliver to customers, not on the cost of goods and services you sell. There are three ways to help customers to understand your unique value.

1.

Differentiate, differentiate, differentiate. Ask: "What do we do better, faster or more easily than our competition?" Then create a profile of the ideal customer for those benefits and focus all your resources on serving that customer.

2.

Provide real value. Solve the customer's problems and meet their specific needs by understanding the four principles of value:

  • Value, not price, is always the issue.
  • The customer – not you – defines the value.
  • Value and service are your only real offering; it's difficult to differentiate on the product itself.
  • It's not what you sell; it's how you sell it.

3.

Focus on the customer's customer. It's your job to educate the customer about how to make money with the goods and services you sell. Don't expect them to figure it out on their own.

Avoiding commoditisation

Customers make buying decisions based on the "components of value" you offer. Examples include time, expertise, information, convenience, quality, guarantees and payment terms. The challenge is that each customer values different components.

To avoid commoditisation, identify the specific items of value for each customer, set them up in order of importance, and then reduce your value to quantifiable terms. Remember that value, not price, is always the issue.

The ultimate goal is to climb out of the commodity box so that you can engage in value pricing. With value pricing:

  • You get high-margin (premium) pricing.
  • Price is compared with the customer's increased profits.
  • The price is recoverable by the increased profits.
  • Price is not discounted.
  • Price is based on the customer's improved profits and yield.

The secret of value pricing lies in addressing the customer's perception, not yours. The name of the game is not what you sell, it's how you sell it.

Pricing strategies for the new economy

The defining element of the new economy is a fundamental shift in the way we exchange goods and services. We have moved from a world where products and services are sold to a world where they are bought – a subtle but very important difference. When customers are buying, as opposed to being sold to, three critical factors come into play.

  1. Customers have already researched the product or service, either on the internet or through their engineering or purchasing department.
  2. They have already found at least two or three alternative suppliers, any of which they feel comfortable buying from.
  3. They know exactly what they want and how much they are willing to pay for it.

Once these factors exist, any hope of selling the customer on your value-added flies right out of the window, never to return. The only thing left to dicker about is price. You can't fight the trend of commoditisation and you can't beat it. What you can do is learn to manage the process so that you still turn a healthy profit. In order to do so, however, you must come to grips with the realities of the new economy.

Old economy thinking

New economy reality

You can increase profits by raising price.

The only way to increase profits is by lowering costs.

You can raise price (or at least maintain margins) by adding value and convincing customers you are "special".

The only way to compete is to improve your quality and productivity so that you can lower your price.

When you are asked to lower price, the best strategy is to do more for the customer.

When customers demand lower prices, do less, not more.

A great relationship with the customer allows you to charge more.

Customer loyalty is dead.

Does this mean you should completely forget about trying to differentiate your business, or stop trying to stand out from the crowd? Not at all. You still need a quality product or service, or you won't even get into the game. And you still need to look constantly for new and innovative ways to solve customer problems and serve their needs.

But once the customer makes the decision to buy, you must stop playing the value-added game and stop selling. All that does is increase your costs and lower your ability to make a profit.

To many, this sounds like a bleak – rather than a brave – new world. However, you can make money in the new economy by adopting these strategies:

  • Accept the reality of commoditisation.
  • Acknowledge that the customer has already made the decision to buy.
  • Think less, not more.
  • Stop selling and start negotiating.
  • Abandon the idea of fixed costs.
  • Become world-class at cost accounting.
  • Focus on net profit, not gross margin.
  • Just say no to unprofitable deals.

Making a profit in a commodity world

The secret to making money in a commodity world is to proactively manage the process of commoditisation. Specifically:

  1. Stop selling and let the customer buy.
  2. Focus on reducing costs.
  3. Manage your "Kenny Rogers" line.

1. Stop selling

When customers are ready to buy, most companies send in their highly trained (and very expensive!) salesperson to try to convince the customer how special they are. Instead:

  • Acknowledge that the customer has already made the decision to buy.
  • Stop trying to prove you are "special".
  • Send in a negotiator, not a salesperson.
  • Focus on meeting specs at the lowest price.

2. Reduce costs

  • Make it easy for customers to find you.
  • Stop making cold calls.
  • Eliminate unnecessary collateral expenses.
  • Stop entertaining customers.
  • Retrain your sales force (or consider eliminating it altogether).

3. Manage your Kenny Rogers line

Every business operates along a continuum. On the right-hand side of the continuum are high-margin, value-added products or services. On the left are low-margin, commodity products or services.

In between, there is a certain point at which you can no longer make a profit. That point represents your Kenny Rogers ("Know when to hold 'em, know when to fold 'em") line. In a commodity world you can't afford to accept business to the left of this line.

Your biggest challenge is that customers keep trying to push your Kenny Rogers line to the left. In other words, they keep asking for lower and lower prices, often to the point where your margins shrink to zero or you are actually making a loss.

To make money under such conditions you have to manage your cost structure by deliberately moving your Kenny Rogers line to the left before your customers ask you to. This requires constant innovation to increase productivity, reduce costs and improve your ability to buy from your suppliers – all so that you can lower your costs before your customer demands it.

To manage your Kenny Rogers line:

  • Don't let fixed costs determine the position of the line.
  • Unbundle your products and services.
  • Don't assume competitors have the same cost structure.
  • Be prepared to open your books.
  • Constantly improve your ability to buy.
  • Stay ahead of the curve.

If you can run ahead of your customers' demands to lower prices, you can put some money in your pocket or gain market share with your lower cost structure. Once customers start demanding lower prices, you can afford to move with them.

In today's world, customers and competitors can move your Kenny Rogers line to the left in a heartbeat. Your job as CEO is to create a long-term plan to manage that process. Harness your company's energy and resources on the left-hand side, and get creative at improving productivity and lowering costs.

Staying supplier of choice in a commodity world

As the supplier who is already doing business with the customer, you can usually charge a little more than competitors – primarily because the customer doesn't want the hassle of replacing you.

However, this doesn't mean the customer thinks you're better than supplier number two or number three. Your only advantage is that the customer feels comfortable with you and would rather not make a change unless someone comes in with a significantly lower price.

In this environment, three critical pricing questions arise:

  1. How much can you charge over and above the competition before your customer considers switching?
  2. How low do competitors have to come in before they can seriously challenge your position?
  3. What would a competitor have to do in order to lower its cost structure enough to offer that price?

How to keep the top spot

When you're the supplier in place and one of your competitors suddenly offers a much lower price, don't automatically assume it is willing to lose money on the deal. And don't assume it is offering an inferior product or service. The competitor may have found a way to lower its cost structure, which means it can now make money at a level you can't afford to match. Or perhaps its price doesn't include the same level of service as yours, which means your current offering may include things the customer doesn't want or need.

Either way, don't rush back in and try to convince the customer how special you are. Instead, focus on lowering costs and moving your Kenny Rogers line to the left.

How to depose the leader

If you're supplier-in-line number two or three and you want to dethrone supplier number one, you can't just match its price. You have to beat it. This means purposefully and deliberately moving your Kenny Rogers line to the left so that you can offer a lower price and still make money.

Don't stop moving

Overall, the ideal strategy is to become the supplier in place and then continue moving your Kenny Rogers line to the left faster than your competitors and your customers. When you reach that position, you then have two equally good choices:

  • Use your position to put money in the bank until your customers and competitors catch up to your new Kenny Rogers line.
  • Use your lower cost structure to take clients away from competitors.

Whether you're the supplier in place or trying to attain that position, the name of the game is to get good at moving your Kenny Rogers line to the left. In a cost-conscious, commodity world, it's the only way to make money.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Authors
Terry Irwin
 
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