Pricing for Profits and Growth in an Economic Upswing

With the economy on the mend, it’s time to revisit your pricing strategy

Pricing is one of the most important strategies available to managers. Illustrating the power of pricing, a study by McKinsey & Company of the Global 1200 found that if companies raised prices by just 1 percent, on average their operating profits would increase by 11 percent. Using a 1 percent increase in price, some companies would see even more growth in percentage of profit: Sears, 155 percent; McKesson, 100 percent; Tyson, 81 percent; Land O’Lakes, 58 percent; Whirlpool, 35 percent. The good news is that better pricing is not exclusively about increasing prices. Instead, it’s about offering a variety of pricing choices to attract as many customers as possible.  

Most companies set prices by marking up costs. While easy to implement, this cost-plus pricing method has no correlation to what consumers are willing to pay for a product (or service). The key to better pricing is to set prices that capture a product’s value. Value-based pricing involves thinking like a consumer. Customers decide if a price is acceptable by evaluating a product relative to its next best alternative. Are the extra features of a fancy product worth the price premium (organic vs. regular) or is the stripped down model (private label vs. brand name) attractive because of its discount? Consumers select the product that offers them the best “deal” (combination of price and features).  

Street vendors in Manhattan understand the concept of setting prices to capture value. The moment that it looks like it is going to rain, these street smart entrepreneurs double the price of their umbrellas. This price hike has nothing to do with costs; instead it is all about capturing the increased value that customers place on a safe haven from rain. Employing this value capturing practice (basing prices on the customer’s next best alternative) ensures setting the most profitable price.  

With the economy on the upswing, it’s time to revisit your company’s pricing strategy. First, since most companies don’t use value-based pricing, new profits can be earned by adopting this price setting practice. Just as important, the value that customers place on a product has evolved with the economy’s health. With increased job security and higher stock portfolios, consumers are more inclined to pay for premium attributes. Taste has also changed, which affects how consumers value a product. While frugal was “in” during tight times, premium products will become increasingly desirable as the economy improves.  

Conclusion 1: Ensure that prices are in line with how customers value your product. Offer “welcome back” promotions to lure back former customers (as well as attract new ones). These promotions appeal to customers’ “frugal fatigue” and allow them to recall how much they enjoyed your product.  

When times were tough, most companies increased discount promotions offered to B2B and B2C customers. Discount tactics such as coupons, volume deals, and marketing allowances were implemented to maintain sales. Sales forces were also empowered to offer additional discounts to retain clients. In a better market environment, it may not be necessary to continue offering these discounts. Why give away margin when you don’t have to?  

Conclusion 2(A): Revaluate your company’s discounting policy. What discounts are no longer needed to remain competitive? 

Conclusion 2(B): All B2B companies should undertake a “waterfall analysis.” The actual amount collected by a company is often very different from the purchase price listed on a purchase order. After stripping off common discounts (freight, financing, advertising, and slotting, for instance) that were cumulatively granted over the years, lucrative invoice prices often disappoint. Conversely, seemingly drab invoice prices can turn appealing when fairly compared with the true “net” prices paid by other accounts. As a result of this analysis, some clients will be targeted for margin improvement initiatives while others will be better appreciated.  

A common practice employed by branded companies during the recession was to create lower quality product versions. P&G offered discount versions of Bounty paper towels and Pampers diapers to better compete against private labels. As the economy improves, it may be possible to withdraw discount versions as consumers become more willing to pay for branded products. Just as important, there may be opportunities to offer premium products to capitalize on higher incomes and luxury tastes. An example of versioning is the early-bird, regular, and chef’s table options offered at some gourmet restaurants. Price sensitive customers gravitate to discounted early-bird specials while high-end diners willingly pay an extra $50 to sit at the chef’s table. Offering good, better, and best versions enables companies to serve customers with a wide spectrum of product valuations.  

Conclusion 3: Consider withdrawing early-bird (good) and adding chef’s table (best) options to increase profits in a healthier economy.  

Many companies rolled out new pricing plans to better serve cautious and thrifty customers. Hyundai, the car manufacturer, offered an Assurance plan to overcome a key purchasing obstacle: fearful of losing their jobs, shoppers hesitated from making major purchases. Assurance allowed buyers to return their car within a year of purchase if they lost their job. Hyundai estimates that 10% of its purchases in the first quarter of 2009 came from customers directly attracted to its job-loss program. Other pricing plans were implemented to overcome budget constraints (e.g., financing, layaway) and consumer interest in reducing price uncertainty (e.g., all-you-can-eat plans, guaranteed future prices). As the economy improves, it may be possible to discontinue many of these margin shrinking pricing tactics. 

Conclusion 4: Reconsider recession-related pricing plans to overcome budget constraints and reduce price uncertainty. 

An improving economy provides opportunities for companies to increase profits and grow by retooling their pricing strategies. Modest incremental changes can lead to significant financial rewards. Best of all, once prices are changed, new profits can start flowing in shortly thereafter. 

Now is the time for your company to reap a financial windfall by focusing on better pricing. 

Rafi Mohammed, Ph.D., is the author of The 1% Windfall: How Successful Companies Use Price to Profit and Grow (HarperBusiness, March 2010). He is also the founder of Culture of Profit LLC, a Cambridge, Massachusetts-based company that consults with businesses to help develop and improve their pricing strategy. www.pricingforprofit.com

Michael Marn, Eric V. Roegner, and Craig C. Zwanda, The Price Advantage (New York: John Wiley & Sons, 2004), 5.