“The single most important decision in evaluating a business is pricing power,” Warren Buffet, CEO Berkshire Hathaway, once said. “If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”
As the quote reflects, pricing is the most powerful lever for driving or destroying the operating margins of a company. In our experience, effective pricing strategies and tactics can deliver a 2 to 7 percent increase in return on sales.
In an analysis of hundreds of companies and pricing approaches, we found four pricing strategies that deliver sustainable results (see Exhibit 1). Not every strategy will be relevant or even feasible for every company – much depends on the market context, the business strategy, and your own capabilities. Still, we’ve found that periodically reviewing strategic options is helpful in challenging established thinking and sparking new ideas about how to approach pricing.
A. Margin Expanders
For many companies in mature markets where there is heavy competition, the prudent and realistic pricing strategy involves small, incremental steps to improve margins, usually within the existing segments, products, and pricing structure. This can mean expanding margins through small regular price increases, defending against unnecessary giveaways, segmenting the offering, applying surcharges, passing on changes in cost to serve, and pricing in additional sources of value (e.g., service). This approach allows companies to expand their profitability over time without disrupting competitive dynamics or customer expectations. To succeed, margin expanders must have clear insight into margin leakage (i.e., where, when, and how the “pennies roll off the table” and what the impact of that is) and relentless discipline in rectifying the issue.
Example—Dow Corning: Price and brand differentiation.
In the late 1990s and early 2000s, the silicone industry was seeing declining margins due to commoditization, unfavorable changes in legislation, and increased competition. As the company’s web site explains, Dow Corning did a deep analysis of their customer segments and discovered a large and emerging group of price-sensitive customers who were pulling prices down. Instead of succumbing to price pressure, Dow Corning introduced a different brand (Xiameter) with different service levels, different customer experience and lower price points. The tiered pricing and positioning strategy allowed Dow Corning to target a much broader part of the market while protecting the profits of its existing offering.1
B. Pricing Disrupters
Companies in new categories or in categories under significant threat often look to bolder, disruptive pricing strategies to define or defend their business model. These approaches are often founded in a belief that more value can be unlocked for the customer and the supplier through a new model that reduces the downside or increases the upside for either party. These models can include profit sharing with customers, pricing agreements that factor in risk (e.g., cost-of-materials triggers), and changes in the unit sales model (e.g., per hour of use vs. per box). To succeed with this strategy, companies need to conduct in-depth analytics and model scenarios to understand the range of outcomes for both sides. In addition, they need to be thoughtful about how to manage the downside, how competitors will respond (disruptors can face dramatic reactions from competitors), and what to do if / when others follow suit. Companies can gain an early advantage by disrupting the pricing model, but keeping that advantage can be difficult.
Example—BASF: Change in business model by moving to a pay-for-results pricing model
BASF, like many of its competitors, used to sell car paint at a price per gallon to OEMs and automotive dealerships. Quite naturally, workshops wanted to keep paint consumption at a minimum to reduce costs, which led to lower-quality paint jobs, reflecting poorly on the customer and, by extension, on BASF. As BASF’s web site details, the company decided to go from being a paint supplier for automotive OEMs to a solutions partner with its customers to improve the final product, so they moved from price per gallon to price per painted car. Taking over the OEM’s paint shops to deliver painted cars also removed a distraction from the customers’ core business, allowing the car-painting process to become better managed. The impact? With the new pricing model, BASF reduced paint consumption per car by 20 percent and saw 20 percent higher margins and a 40 percent increase in its European market share.
C. Revenue Drivers
Pricing improvements that focus on growing revenue look at the pricing strategy as an enabler to bring in more business and drive deeper penetration in the existing customer base. This can mean providing introductory offers to bring in new customers, subscription models to build on an installed base, contracting to extend the lifetime value of a customer, and bundling to increase revenue per customer. Success in this model requires maintaining profitability (i.e., not giving away too much), keeping churn low, managing customer acquisition costs, and monitoring competitive dynamics to avoid price or share wars. “Freemium” pricing has quickly emerged as a popular pricing model in online service offerings. With the Internet pushing the marginal cost of content distribution close to zero, and a large number of new players competing for users, freemium pricing (giving the basic offering for free and charging for a premium version or additional content) has quickly caught on.
Example—Expensify: Freemium subscription model enabled fast market penetration.
Expensify, an online expense-reporting and management system established in 2008, uses a subscription model offering customers 10 free scans per month for its receipts-scanning and transaction-organizing service. Users can elect to upgrade to one of the tiered subscription models based on their needs. The service became hugely successful; by 2012 Expensify was used by over 100,000 companies.
D. Sales and Pricing Pioneers
Perhaps the most radical pricing strategy is to go after large-scale sales growth and radical margin change simultaneously. This is about more than just finding a new channel or replicating an established model from another sector; it’s a new way of thinking about pricing. Sales and Pricing Pioneers drive top-line growth by implementing completely different ways of working to find new pockets of growth and value, such as introducing new services or new business models that integrate new portions of the value chain. This approach is most often used in relation to new technological advances (e.g. tablets, apps, cloud computing) with the potential to disrupt the business environment. To succeed in this model, companies need to pay constant attention to balancing the objectives of sales growth with margin attainment while making selective adjustments to strategy when necessary.
Example: Rolls-Royce: New software advances to lure risk-averse customers.
The term “power-by-the-hour” first appeared in aircraft engine vocabulary in the 1960s. Rather than selling capital-intensive engines, Rolls Royce sold airlines “power-by-the-hour” contracts that charged a fee for every hour a plane flew. According to the company’s annual reports, it was an answer to the airlines’ capital shortage and its frustration with unpredictable service costs. It was a win for airlines since the more the plane flew, the more revenue they earned. Rolls Royce considered it a win, too, since the company had bolstered aircraft engine performance by acquiring software companies to collect cockpit data and monitor engines, allowing them to develop predictive maintenance technologies that kept aircraft flying more. In addition, Rolls Royce differentiated its services, offering four packages with increasing degrees of service. According to the company’s annual reports, the bundled solution increased customer loyalty with a more tailored offering (“Pay only for what you want”). This radical approach to pricing provided the company with underlying services revenue growth of 9 percent per year between 2004 and 2011 and led to a greater than 30 percent improvement in average time between engine removals.
Moving up the curve
While these four models show different pricing strategies, which strategy to choose depends on the depth of a company’s commercial capabilities, its customers, the marketplace, and the appetite for risk.
We have found that companies generally progress along three phases of a maturity curve, each with its own set of goals and necessary capabilities:
- Phase 1: Ticket to play. These companies have emerging-to-strong analytic capabilities that help them form and execute against a pricing strategy. They are aware of the pricing situation in the market and understand the pricing schemes of their competitors and of companies they aspire to emulate. This basic competitive intelligence, however, does not necessarily extend deeply into pricing, and companies at this level rarely have experts dedicated to pricing analytics and insights about pricing behaviors.
- Phase 2: Pushing the boundaries. Here companies are masters of the traditional pricing model and are experimenting with new variations—bundling, segmented offers, partnerships, etc. This approach requires more sophisticated capabilities and tools that move beyond analysis to developing even more granular views of prices and needs by product, customer, channel, and region. Those insights feed into product development, marketing messages, sales-force quotas, and overall company aspirations. These companies have instituted a systematic process for reviewing deal wins and losses, checking competitor pricing, understanding what customers want, and making the necessary price adjustments. Their pricing teams push to understand what is driving the customer. An effective organization in this phase has cross-functional teams who meet at least monthly to discuss pricing, analyze historical data, and decide on actions to take based on the insights derived from analysis
- Phase 3. Pioneering new models. Companies at this level have stretched the traditional pricing model as far as they can (or want to), and have decided to differentiate themselves with a new model. This requires a common commitment to the importance of pricing, dedicated pricing leaders, well-defined pricing processes, and performance management that supports those goals. These more innovative companies embrace a test-and-learn approach, where new pricing models are quickly tested on the front lines, results reviewed, and adjustments made. They understand that innovation doesn’t happen in a vacuum so they invest in experiments, learn from them, and develop a comfort with failure. In many cases, there are dedicated and nimble cross-functional teams tasked with driving innovation. When ready to commit to a new opportunity, for example, these companies are able to identify and secure the necessary talent (either from within the organization or outside) and get them on the job quickly. Speed and action are at the heart of these organizations.
Companies considering evolving and deepening their pricing capabilities need to understand how pricing fits into the business’s overall strategy. Only at that point does it make sense to evaluate various pricing models and develop a forward-thinking commercial organization that sets prices, and doesn’t just take them.
- Gary, Loren, "Dow Corning's Big Pricing Gamble," Harvard Business School, Mar. 7, 2005.