An Introduction to Pricing

Pricing is an fascinating topic and my recent reading of the book Game Changer by Jean-Manuel Izaret and Arnab Sinha provided the impetus to consolidate my notes into an article. I start with with the importance of Pricing from leading sources, perform my own analysis on the state of profitability followed by typical pricing analytics and introduce key concepts in pricing.

The Value of Pricing

The impact of pricing on profitability has been framed through the lens of a 1% change for a long time. The 1992 Harvard article, Managing Price, Gaining Profit , talks about companies being able to gain 11% of additional operating profit by being able to raise prices by 1%. The McKinsey article The power of pricing? illustrates the typical economics of an S&P 1500 company and concludes a price increase of 1% produces an impact of 8.0% on profit. ?The book version of the article, “The Price Advantage” by Walter Baker, Michael Marn, Craig Zawada presents a 1% improvement in price at Global 1200 companies resulting in 8.7% increase in profits. The article from 2019 Pricing: The next frontier of value creation in private equity? concluded that mid-sized companies could improve profits by 6% by increasing prices. All of the analyses compare a 1% improvement in pricing against a 1% improvement in volume, variable costs and fixed costs and conclude that improving pricing provides the most impact in terms of profit for organizations of all sizes.

In the book True Profit by Hermann Simon, the power of 1% is illustrated through a change in the Sales & Marketing spend. The book presents the impact on profit through improving pricing (by reducing discounts which are reflected in the Sales & Marketing spend at companies). I use the book as inspiration and conduct a similar analysis. I use public companies with at least USD 10 Mn in median revenue between the years of 2017 to 2021 for my analysis of the state of profitability(see note at the end). Out of the 17,000 companies in my dataset, the median net profit is 5.09%, and number companies with a cumulative net profit in the 5-year period is about 13,000. The median profitability does not vary significantly by company size.

I go on to estimate the improvement in Net Profit Margins through an improvement in Pricing (reduction in Sales & Marketing spend). I noticed that 46 global companies would become Net Profit/EPS positive (where earlier, they were Net Profit negative) by reducing Sales & Marketing spend by 1%. The list includes some well-known mega cap companies who have been in business for decades and continue to have such thin margins that any improvement through better pricing would benefit the companies bottom line. I also noticed about 400 companies whose net margins are about -1% who could look deeper into the power of 1% to improve their profitability. Companies of all sizes should look at pricing to identify areas of improvement.? ?

Price Analytics

A company or division can do their own analysis and identify the value of potential improvements in price and discount discipline. The following analysis (using sample data) plots the discounts (against list prices) and total % of business. The chart will indicate the degree to discounting prevalent in the business.

The analysis can be followed up by creating a scatter plot of the sales to every customer and the on-invoice and off-invoice discounts offered to each customer. In the following scatter plot of Total Quantity sold (on the x-axis) for each customer (blue dots) and the discount percentage (on the y-axis) offered to the customer, we see that several mid sized customers getting higher discounts than the largest customers. This scatter plot also represents the off-invoice discounts (size of the dot) and we notice smaller customers taking advantage of discounts much more than the largest customers. Most customers will be surprised at the weak relationship between the size of eventual discounts offered to a customer and the size of the business of the customer.

By creating an ideal discount band (grey shaded area) or discount tiers that plot the ideal discounts against the volume of sales the analysis would reveal how much the practice/execution has strayed away from the price policy/setting. Of course, companies offer multiple discount types and thus plots (such as the one below) for each discount type along with the quantities sold could be plotted for insight into the adherence to the policy by discount type.? ?

Price and Margin Waterfalls

Price and Margin Waterfalls are the most comprehensive tools available to understand the connections between Prices and Operating Margins. Price Waterfalls track the Global list price , the adjustments due to factors such as FX-adjustments follows the on-invoice and off- invoice deductions to arrive at the Net Price realized by customers.

Margin Waterfall tracks the costs and spend incurred to make, market, deliver and service the customer, product and channel to arrive at the Operating Margin.

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Together the Price and Margin Waterfall help identify areas of margin (and profitability) leakage at a granular level. Both charts can be created along dimensions of product, customer, region and channel. Off-invoice discounting (discounts such as yearly volume rebates, buy backs, etc.) should merit special attention since they result in significant margin leakage but are not visible on invoices to customers (they likely are created as credit notes and debit notes in the ERP system). A recommendation made by the book The Price Advantage is to forecast off invoice discounts and include them on invoices and make adjustments at the end of the year.? Inclusion of all discounts on the invoices makes the discounts visible to both sellers and buyers. Additional metrics to track are the price exceptions (by product, customer and channel) and policy violations (by team member).

A key framing of Price in the book Game Changer by Jean-Manuel Izaret and Arnab Sinha and by Thomas Kohler in the Coursera ?specialization Pricing Strategy Optimization is the thinking of price as a mechanism to share value between the buyer and seller.? Both buyers and sellers are getting value out of every transaction, sellers capture value by realizing price and buyers receive the product. The sharing of value can be brought to life by using the Margin Waterfall and overlaying the discounts on the steps of the waterfall chart. Discounts exist to serve the customer and induce the customer to buy more. Discounts that cannot be overlaid on a specific position of the margin waterfall should be a cause for concern and validity of the discount must be questioned. In the chart below, the three discounts for predictable order volume, large order sizes and ordering through online channel helps reduce cost for the seller and the cost reduction can be shared with the buyer via appropriate discount policies.

A key point to remember for sellers is that procurement teams have superior alignment to price due to cost reduction being part of a procurement teams KPI. Procurement teams are far more likely to negotiate for lower prices and discounts than sales teams (or other team members in logistics and customer service) are for higher prices. This means that companies will see lower margins unless they make a conscious and company wide effort to avoid discounts.

Determining Prices

The analytics in the previous sections help us understand how much of the List Price is being realized and flowing through to the Operating Margin. A critical point is of course charging the right prices, the ideal as noted by Robert Philips in his comprehensive book Pricing and Revenue Optimization. is to provide the right price, for every product, to every customer segment through every channel.

The typical approach to determine the right price is using the 3 Cs Cost, Customer and Competition. The Coursera specialization Pricing Strategy Optimization offered through a collaboration between the Boston Consulting Group and University of Virginia Darden School of Business provides elegant characterization of pricing through the three lenses of Economics, Customers and Competitors and draws out the dynamics at the intersections of the three lenses.

Cost Based Pricing

Cost plus pricing is the approach to determine the price of the product by first assessing the cost to source, make, market and deliver the product and apply a margin to arrive at the price. Cost plus pricing is the most frequently used price setting strategy and continues to be applicable in certain large industries such as utilities and certain government contracts. Most for-profit companies should look for alternative price determination strategies. Cost plus pricing constrains companies by being inflexible in the face of competition and unable to capture the value of the product to the customer. Cost plus pricing can work, as it does for Cost Co (Costco: Relentless Focus on the One Thing and The Resilience of Costco) where the markup is around 10-15% on most products. However, most companies lack the innovation stack such as the one at Cost Co to make it work profitably.

Of course, the key challenge within cost plus pricing is the complexity and variability in the computation of cost itself. All types of costs, Fixed, Variable, Direct and Indirect costs need to be allocated to every product to determine the cost accurately. Allocating costs based on usage is made complex because identifying the precise usage of common resources is not easy. Initiatives such as Activity Based Costing and Cost to Serve must be taken up to allocate costs as accurately as possible and arrive at true costs of a product. Costs also depend on the expected volume of sales, since lower unit costs can be achieved through longer production runs (reducing the fixed cost component) and large raw material purchases (higher discounts are offered by buyers).?

The margin waterfall can be utilized to plot the fixed and variable costs at each step of the waterfall and identify areas of focus for cost optimization.??

?Target Cost pricing is a variant of cost-plus pricing where the company first determines a competitive price for the product and works backwards to ensure that product can be made and delivered at a cost that will preserve the margins. Index based pricing, where the price (increase or decrease) is tied to an index such as CPI or SOFR rate is another useful facility to align cost increases with price increases.

Marginal Cost Pricing is an interesting case used in unique situations where the inventory or supply is limited and perishable, supply can exceed demand in short bursts and customers are willing to accept variable prices. Marginal cost is the cost of serving or delivering one additional unit and marginal cost pricing is offering the product at a markup over the marginal cost. Marginal Cost Pricing is seen most often in Airlines and Hotels where the cost of serving the customer is very low. Unused capacity (empty seats or hotel rooms) on a flight and hotel are lost potential revenue. By offering the product above the marginal cost Airlines and Hotels see millions of dollars in additional operating profits (Break Even Load Factor Snapshot). Last minute Airline and Hotel deals are an example of marginal cost pricing.

Using costs as way to determine prices is a useful starting point but customers are under no obligation to buy the products at prices set by sellers. Companies should begin by understanding what customers are willing to pay.

Customer Based Pricing

Customer based pricing is the approach to determine the willingness to pay of a customer and basing the price on the willingness to pay. One could find out the willingness to pay by asking the customer directly or through a formal survey, however no customer is absolutely truthful about how much they would be willing to pay, and even if they were naively honest, they will likely find it difficult to be quantitative unless they were provide reference prices, or context or budgeting for a basket of items.

Auctions

The closest mechanism to finding what a customer is willing to pay is through auctions. English (Open and First Price) auctions provide excitement, satisfy ego and sometime (or often) end in buyer’s remorse. English auctions are the ones we imagine when someone uses the word auction where the sellers announce a base price and the bidders try to increase the bid until the highest bidder remains. Vickrey Auctions or Second price auctions are an interesting mechanism of revealing true willingness to pay. Second price auctions differ from the First price auctions in that the higher bidder only must pay the second highest bidders bid to acquire the product. Second price auctions are most useful where the item in question is valued with little variation by buyers. In situations where the valuation of parties can be highly varied, first price auctions are still the best bet for the seller to extract maximum value. A third type of auction is the Dutch or descending price auction where the counter ticks down from the highest price and whoever is first to bid gets the product. The descending price auction is used for flowers and other perishable goods which need to be moved in large amounts in a short span of time. The last type of auction is reverse auction where companies bid to supply the goods at the lowest cost, an auction used where the product standards can be specified and inspected with accuracy and the objective is to lower the cost of purchases. Reverse auctions are popular when organizations are looking to buy commodity products at the lowest price at the expense and risk of annoying the incumbent supplier.

Conjoint Analysis

An advancement of the survey method is conjoint analysis which can be used in both consumer and commercial product price surveys. Conjoint analysis presents a series of hypothetical products and prices featuring the most valuable attributes and functions of the product and directing users to choose between pairs of products. Conjoint analysis helps understand buyers’ preferences for prices as well as the value placed on key features. By conducting a Conjoint analysis through a wide cross section of buyers a reasonable price can be arrived at. Many types of conjoint analysis are available choice based conjoint analysis is the gold standard.

Demand Curve

The Demand Curve represents the willingness to pay for a product by customers. The demand curve is downward sloping indicating that as the price increases fewer customers are willing (or are able) to pay. The Demand Curve can be used to determine an optimal price by picking the point at which the margin or profits are maximized. Picking an optimal price could lead to lost revenue as there might be customers who were willing to pay a higher price and customers who were unwilling or unable to pay the listed price of the product.

Revenue losses can be mitigated by creating differentiated products (and prices). Products can be differentiated by creating variants of the products. Variants with more features target customers who desire additional features while customers who prefer a simpler product can also be served. As long as the costs of the features aligns with the prices being charged, companies will be able to achieve higher revenues and margins.

An illustrative example is a hair stylist offering a single price for every hair-cut and (since he is a stylist) spending the same amount of cost (his time) to cut the hair of every customer. The regular joes get the advantage of getting a stylish haircut without paying for it (whilst spending more time than they would like), while the style conscious customers get to pay far less (but might end up waiting longer in line). The same stylist could provide a 10 min, 30 minute and 1 hour haircut service aligning his cost (time) to the price to the value (buzz cut vs stylist cut) expected by the customers.

Economics 101 shows price at the intersection of supply and demand misleadingly indicating that there is but one perfect price. The classic supply and demand curve is not applicable for pricing by individual companies. Primarily because the supply and demand curves are relevant at a macro level and not at the level of an individual firm, second most products are not commodities and thus can be differentiated, thirdly price information is not widely available (or unknown by buyers) allowing sellers to set higher prices (skimming).

Demand Elasticity

Demand curves can also help understand if, when and by how much prices can be raised or dropped to improve margins. Demand Elasticity of price measures the change in demand through a change in price. Demand for a product depends on various factors and elasticity can be computed for each of the factors such as price (price elasticity of demand), Income for consumers and for and budget for enterprises (Income elasticity) and the price of alternatives (cross-price elasticity). ?In the following example, the price elasticity of demand is 1.69 indicating medium price elasticity. Price elasticities of 2 and above indicate customers who are price sensitive and below 1 indicate customers who are price insensitive.

Value based Pricing

Pricing a product can also be done by quantifying the value placed on the features of the product. By referencing the price of current or next best alternative and layering the (variant or new) features offered by the new product or offering, the price of the product can be determined. By evaluating the cost of (adding) new features with the value and prices that customers are willing to pay (using conjoint analysis), products can be priced to be profitable and gain market share.

Dynamic Pricing

The value placed on a feature or product is not a constant but depends on context. The same customer buying the same product could be willing to pay a higher price depending on the situation. A simple example is people who are late to appointments would be willing to pay extra to find a cab ride immediately. Dynamic Pricing is the ability to change the price based on the context such as location, demand, timing or situation. Dynamic Pricing makes use of machine learning to compute and publish price in real time based on various factors that influence demand of products. Digital goods and eCommerce lend themselves to dynamic pricing since prices can be communicated/changed with little cost whereas sticker prices on physical retail items require a lot of cost (printing new labels) and effort (stick the new label on the item) to make changes. Dynamic Pricing adjusts the price of the product by trying to balance Supply with Demand, effectively this is a return to the roots of a clearing price taught in Economics 101.? Dynamic Pricing not only has the effect of stabilizing demand to adjust to the signal (people unwilling to pay or unable to pay higher prices) but also results in new supply (drivers) to come on board (a purported benefit of Uber surge pricing).

Product Line Pricing

A product line is series of products offered by the seller to target different customer segments. Product Line pricing is possible under conditions where products are complex (include multiple features and the costs are significant to bring a product to market) and the customer segment is sizable enough for a unique product to be created serving the segment. Customers can select the product of their choosing and pay the price and receive the value (product).

Customers can be segmented using broad factors such as demographics (age, gender, income), location, usage and preferences (basic, power). Micro factors such as effort (discount coupons), time (airline tickets) and convenience (water at airports) can also be used to segment customers. Toyota Motor Company offers a revealing case of targeting multiple customer segments with products and prices suitable to the segments. They go to the extent of creating a distinct brand (Lexus) for luxury vehicles. Within the segments there are micro segments of hybrid and all electric versions of the vehicles.

Pricing Packages and Consumption Adjusted Margin Pricing

Even without creating a product variant, but by creating a new package size (and pricing the package) companies can gain revenues and margins. In consumer products, larger portions lead to increased consumption which has been documented extensively (The paper The impact of package size on consumption by ?ak?r, Balagtas, Okrent uses real world scenarios).

Consumption adjusted margin pricing puts the observations into practice by estimating the increased consumption of larger package sizes and incorporating the estimate to compute a revised margin for the package size. A portion of the increased margin can be offered as discount to drive increased sales. In the case below, the larger unit size of 48oz makes more margin because of increased consumption (than the smaller packages). The differential margin can be used to provide additional discounts on the larger package sizes. The example is taken from the course Customer Value in Pricing Strategy by Professor Ronald Wilcox.

Bundling and Unbundling

Jim Barksdale, the legendary CEO of Netscape declared “the only way to make money is bundling and unbundling”. Microsoft Office and Ryan Air have achieved outstanding success by following the dictum. Bundling is the process of creating a package including multiple products and offering the bundle to the customer at an attractive price. Unbundling is the opposite where a product is broken down into its most valuable components and each component is priced and delivered independently.

The practical magic of bundling can be illustrated with this example from Monetizing Innovation by Madhavan Ramanujam and Georg Tacke. The book presents an example of four segments with varying willingness to pay for two products, pizza and breadsticks.

?There are three different tactics in pricing the products and each provide a different optimal revenue.

Interesting to note, that at face value it appears that the 13$ bundle is providing a 5$ off (the total of individually priced items is $18 total), which may signal to customers that it is a better value and potentially induce customers in segments A and D to also upgrade.

?Bundling needs careful consideration and understanding of the products/features most valued by the buyers. Two approaches to bundling are having a Leader, Filler and Killer features/products in the bundle or a Good, Better and Best. Note that including too many filler and killer products/features in bundle might irritate customers who will perceive filler and killer products adding cost to the bundle.

Unbundling can be seen in action by browsing through the fees on the Ryan Air website. There are two separate prices by weight of checked-in bags, a small price for express verification and a fee for infants (as if this could be optional ??).

Digitization has been a significant driver of the Unbundling of products. Two related but enlightening examples of Unbundling are Craigslist where certain listing would go on to becoming categories through specialization (The spawn of Craigslist) and Microsoft Excel where dedicated SaaS software continue to compete with Excel (The Unbundling of Excel). I bet that Craigslist and Excel will continue to inspire multi-billion dollar companies in the future.

Double Marginalization

Before we move onto competitors, we need to analyze situations where companies compete with their own customers for profit. Companies that sells through one or more intermediaries such as distributors and retailers to end customers or consumers need to factor in double marginalization since there are two independent parties who have their own margins to consider. In such situations understanding the intermediaries’ incentives and aligning the price to the intermediaries’ revenues and margins will prevent margin loss for the manufacturer. The following example from Pricing Strategy Optimization Specialization is quite educational.

The following demand schedule for a manufacturing cost of 30$ and the corresponding end customer demand shows clear optimal price to be charged to the end customer. The max profit pool (which must be shared by all players in the distribution chain) is $ 3,280 at the end customer price of $ 70.

Let’s assume that the manufacturer is very generous and decides to price the product at $ 50 (sharing half the profits with the distributor). ?From the perspective of the distributor, pricing the product at $ 70 results in a profit of $ 1,640 whilst pricing it higher at $ 100 results in $ 2,000 of profit. Thus, the distributor will price the product at $ 100 maximizing his margin at the expense of margin for the manufacturer.?

But, by offering a quantity discount of $360 if the distributor holds the price at $70 and sells 82 units, the distributor would end with a profit of $2,000 ($1,640 in margin + $ 360 in incentives). The $ 360 in incentive payments for the manufacturer since his margins with the incentive are higher by 50% ($ 800 without incentive and $ 1280 with the incentive). The manufacturer does not realize the ideal margin but does prevent margin loss due to double marginalization.

Competitor pricing

Beyond own economics, distributors and customers, pricing is set in a competitive environment so a keen eye on competitor products and their price points is vital. Two key tools to analyze prices in a competitive setting are the Price Piano and the Price Ladder.

Price Piano

Price Piano plots the products of a single category and prices of the products along with competitor products from the same category to identify hot price points and open price points.

Hot price points are where products exist from all players in the market making the price point highly competitive. Open price points are where opportunities are available since no product exists from any player ($16 in the above example) and a price point ($38) where a competitor product exists but none from the company. Adding the channel and intermediary (wholesaler, distributor or retailer) dimension to the price piano analysis can also reveal additional opportunities to optimize prices.

Price Ladder

A price ladder goes deeper into the analysis to plot the features available in the products and the features offered by competitors to align the products and the price. The price ladder is illustrated using a line up of phones from the two similar companies (N and O). The price ladder reveals the premium that buyers are willing to pay (or at least the companies think so) for increased RAM and Capacity and superior Cameras.

The phones N-P1 and N-P2 and O-P2 and O-P3 are identical except for the increase in RAM and Capacity. The price differential indicates that upgrades to RAM and Capacity are worth about $ 50- $70. ?The superior camera can command a larger premium, the camera capabilities are featured prominently in advertisements of Company O and the large difference in price points between the two companies can be explained in part by the differences in screen and battery size but mostly by Camera superiority.

Market Analysis

Pulling back from individual products and analyzing a market based on the dimensions of profit pool and current market share helps identify areas of growth and threats. By plotting the market size (size of the pie) and the market shares of top four players in each product category (along the x-axis) and customer segments (along the y-axis) provides a comprehensive view of the battlefield. I copy the memorable terminology from the Coursera Pricing Strategy Optimization specialization. The battlefield helps identify castles, where one or two players are dominant (blue and orange players in row 2), battlefields (row 1 where heavy competition is present), grass lands (row 3, where the profit pool is large and there are no dominant players) and deserts (small profit pools in row 1). In all of the below charts, the purple represents the others or small players or potential future profits because the segment or category is growing.

Using the analysis, the company represented by blue (who are strong in a particular Product Segment (row 2) can look to make a play on row 3 (as large profit pools available) and avoid making a play in row 1(where the profit pool is smaller and hotly contested).

Pricing in the face of competition gets deeper and broader into the Strategy and Tactics of pricing. I will post another article on it. I have breezed through the vast, fascinating and vital topic of Pricing. I started with noting the importance of pricing followed by an overview of the key concepts in Pricing. There is lot more to cover in Pricing Strategy and Execution. I always chuckle at the phrasing "directionally challenged" in this representation of Pricing Strategy and Execution from the enlightening book on pricing, The Strategy and Tactics of Pricing by Thomas T Nagle and Georg Müller.

Lots of notes to consolidate. :-)

P.S. Net Profits as reported are not really “true profits”, distorted as they are by accounting assumptions, Stock based Compensation and treatment of Intangible Investments amongst other subjective assessments. A key point to remember is that net profits are accounting profits and not economic profits. The book The End of Accounting by Baruch Lev and Feng Gu was a revelation for me. This is the book to be read again and again to understand companies and their financial performance. I used the book and other material to try and quantity the historical profitability of companies in this article True Profitability.