In many industries, pricing is more art than science. Managers make pricing decisions without fully analyzing their long-term profit impact. Companies may have only a vague understanding of their customers’ sensitivity to price. Manufacturing firms often take a cost-plus approach rather than a market-driven approach to pricing. And even in industries with more sophisticated pricing methods, companies don’t always take advantage of opportunities to apply creative pricing strategies.
So how can you do better? Professor Hitendra Wadhwa, who in the past 12 years has helped several leading companies design optimal pricing strategies, suggests three areas for improvement.
1. Get Your Basic Economics Right
First, understand which costs are relevant to price and which are not. For example, fixed cost allocations like overhead should not be driving price.
Second, know your customers’ sensitivity to price at different price levels. Sometimes companies skimp on market research because they worry that it will take too much time. “But there are some practical and easy ways,” Wadhwa says, “to get quick checks of what the customer response is going to be — for instance, an online pricing survey, conversations with trade partners and salespeople, and analysis of sales and pricing history across accounts.”
Third, think about a customer’s lifetime value to your company. In what cases might you want to sell something at a lower price today in order to foster a long-term relationship with a customer?
Financial services companies have amassed huge databases of information that they can use to sell complementary products to existing customers. But they don’t always leverage that information to make strategic pricing decisions based on customer lifetime value. “They’re struggling with the complexity of managing multiple product lines and customer segments, with tons of data that in theory they could mine,” says Wadhwa. “That’s a situation where there’s certainly untapped opportunity.”
In the retail world, where drug and apparel stores are now starting to benefit from revenue management tools developed in the airline and hospitality industries, there is even more room to improve by getting the basic economics right.
2. Find Creative Ways to Segment Your Customers
Do you know which of your customers are willing to pay more for your product? If so, are you charging those customers a price that reflects the value they assign to the product?
Some companies are squeamish about price segmentation because they think it will annoy their customers. When Northwest Airlines announced recently that it would charge a higher price for exit row seats, which offer slightly more legroom, some customers complained that the new pricing policy was unfair.
But there are multiple ways to implicitly implement a segmented pricing strategy without alienating customers. “You can create variations of the product,” says Wadhwa. “Or you could offer the product at a high price and then selectively give discounts on a targeted basis, through one-on-one conversations with those accounts that you feel are price sensitive, without necessarily broadcasting it to everybody.”
A third possibility is to change your pricing metrics. An online employment or dating service, for example, might charge customers based on the volume of communication they engage in rather than charging a flat monthly fee. “If somebody’s a heavy user, they’re likely to be less price sensitive,” Wadhwa says. “If you’re charging everybody the same price, then you’re leaving money on the table, since those customers were willing to pay more.”
3. Reexamine the Marketing Mix
When sales of a new product don’t meet your expectations, your first instinct might be to drop the price. But perhaps you simply haven’t done enough to educate consumers about the product’s value or haven’t lined up enough support from your channel partners. And by lowering the price you may unleash a price war, drawing you and your competitors into a downward spiral. Instead, consider focusing on further differentiating your product and creating healthier long-term pricing conditions.
“In getting price right, often you have to operate the other aspects of the marketing mix,” Wadhwa says. “Price is very easy to change, and the short-term sales effect can be attractive, so it’s an instrument of first resort as opposed to last resort. But when you operate in a vacuum and you’re only focused on price, you’re ignoring the opportunity to use the other variables to your benefit as well.”
Hitendra Wadhwa is associate professor of professional practice in marketing at Columbia Business School.