Confessions of the Pricing Man: How Price Affects Everything

by Hermann Simon

I have said on many occasions that over the long term, only a profit orientation can serve as a rational guideline for pricing.

Despite this insight, revenue-based compensation remains the most commonly used form of incentive for salespeople. This tends to lead to discounts which are too high and prices which are too low.

Under normal circumstances, the price which generates the maximum revenue is much lower than the price which maximizes profit.

I strongly recommend that companies switch to profit-oriented incentive plans. In making that switch, companies do not need to sacrifice simplicity or confidentiality. One simple approach is to link the commission or incentive to the level of discount . The lower the discounts a salesperson grants, the higher his or her commission.

The situation is similar to trading on a stock exchange. Whoever has better information over future trends will have an opportunity to make more money.

Ryanair is particularly creative in inventing and collecting surcharges.

Surcharges are an appropriate way to take advantage of higher willingness to pay in peak periods.

Price cuts in off-peak periods often have little effect, but price increase s in peak periods can have a significant effect.

When a company offers its customers additional value, surcharges provide a way to extract some of that value.

Often the value of a product depends on how quickly it becomes available or how quickly a customer can access it.

Another interesting idea is to offer additional services in exchange for a surcharge

Surcharges are also a way to make some alternatives less attractive and steer customers to others.

Normally the price elasticity for surcharges is lower than the elasticity for the base price . But sometimes we see the opposite effect.

Only through carefully planned and executed market research does a company stand a chance of avoiding such damage to its image.

The à la carte price model does carry risks and must be introduced carefully and with forethought.

The Internet has helped drive the usage and appeal of auctions. The most widely known example is eBay .

Columbia University professor William Vickrey proved that it is optimal for a bidder in these auctions to reveal his or her maximum willingness to pay

In auctions the idea is normally to extract the maximum willingness to pay from the bidder.

In the context of this book, we consider a crisis to be a collapse in demand.

a crisis induces a “buyer’s market.” The balance of power has shifted in favor of the buyers.

These developments of supply and demand lead to massive effects on prices. A crisis causes one or more profit driver s—price, volume , and cost—to develop to the company’s detriment.

From a profit perspective, it is better in a time of crisis to suffer a volume decline than a price decline

Under normal circumstances, managers tend to show a preference for a “lower prices, constant volume” alternative, but this tendency becomes more pronounced in a time of crisis . The effort to keep sales and capacity utilization up, and keep people at work, takes precedence. But in a time of crisis, that can be precisely the wrong approach.

The problem begins in the factory. If there is pressure to keep people working and to produce the corresponding amount of goods, this excess will suppress prices. Low variable unit costs and high fixed costs , which are a blessing in good times, become a curse in a crisis. High fixed costs need to be spread across the largest possible number of goods. At the same time, low variable unit costs mean that it is still possible to get a positive unit contribution despite low prices. All of these factors conspire to put formidable pressure on the sales force, which uses price concession s to try to move the required volumes.

An indispensable prerequisite for intelligent pricing is a precise understanding of the relationship between price and volume

The most common reactions in a crisis are also the most incorrect ones: cutting prices or increasing discounts.

A volume crisis means that a company sells fewer units at the same price. But by no means is the opposite true: it does not mean that a company can sell the same number of units as before if it cuts its prices. That is a grand illusion which is rarely fulfilled. Why is that true? There are two reasons. First, the crisis has altered the demand curve , shifting it downward, which means that a company doesn’t sell as many units as it used to at a certain price. The previous demand curve no longer applies. Second, price cuts or steeper discounts do not yield the desired upturn in sales , because competitors are also cutting their prices. This fact alone dashes any hopes the company may have had of increasing its market share or defending its previous volume.

If there is no way to avoid a price cut or a price concession any longer, then one should structure the price cut in such a way that it minimizes the negative margin effects and maximizes the positive volume effects.

For a price decrease , the more the customer notices it, the greater the positive volume effect will be. This places the onus on the supplier to use communications to increase the price elasticity of the product or service. Empirical studies have shown that a volume increase from a price cut is significantly higher when the action is supported with special price-oriented advertising , additional placements, or special signage. This volume increase is more necessary than ever during a crisis , but precisely in such tough times, communication budgets are also limited. This presents the company with a dilemma. The company might need to make more price reduction s, but lacks the money to communicate them effectively.

Using goods as a means to deliver a discount improves volume , employee utilization, and profit. This kind of offer has an additional advantage. If the manufacturer designates it as a temporary measure during the crisis , it is easier to rescind when the crisis ends. Trying to restore the “crisis” list price of $8,330 back to its pre-crisis level of $10,000 would be much harder.

The biggest challenge facing pricing in the modern world is overcapacity

Overcapacity is typical as a market enters its mature phase, as companies overestimate growth potential, and also typical for a market’s decline phase, which companies often do not anticipate.

“No one can make any money in our business. Every single company has too much capacity. Every time a project comes up for bid, someone needs it desperately and offers suicidal prices. Sometimes it’s us, sometimes it’s a competitor . Even though four suppliers make up 80 % of the global market in our business, no one makes any money.”

“As long as this overcapacity remains, nothing will change.”

This means that the complex interplay between price and capacity is a top management issue of highest priority.

If competitors do not follow the move, or counter it with their own capacity increase, then cutting one’s capacity can be dangerous.

Signaling, or the announcement of a company’s intentions or plans, is one legal way to help determine the appropriate course of action in face of the prisoner’s dilemma. One should therefore consider using signaling systematically as an instrument for capacity management and not only for price.

The path to rational, reasonable, profitable prices often requires the elimination of excess capacity.

Crises change the supply and demand-situation in a market and therefore create an opportunity for companies to analyze and rethink their price propositions. One should not confine oneself to price decrease s, but instead think more broadly and also consider the alternative.

Panera upgraded its menu and raised its prices.

Panera’s revenue rose by 4 % in 2009 and profit by 28 %.17 Apparently the people in Panera’s target segment were willing to pay higher prices for higher value.

Price wars are one of the most effective ways to destroy profits in an industry for a long period.

“In a war, the atomic bomb and price are subject to the same limitation: both can only be used once.”

Starting a price war in an industry is easy, but a price war is hard to stop, creates tremendous mistrust, an...

This study shows that overcapacity is the most frequent trigger for a price war . That is especially true for commodity product s or services, i.e., those with little differentiation and for which price is often the decisive purchase criterion.

The best methods to avoid a price war are to curtail aggressive statements and behavior and to set realistic targets for revenue, volume , and market share.

Communication and signaling are essential for avoiding or ending price war

Price communication should decrease the probability that customers and competitors misinterpret a price action or the motivations behind it.

This makes signaling the method of choice if a company wants to reduce the risk of a price war.

I summarize my insights into price war s very simply: there are smart industries and there are self-destructive industries. What is the difference? The smart ones avoid price wars, and the self-destructive ones get stuck in them. The smart ones are profitable; the self-destructive ones incur losses or destroy profits. The problem is that it only takes one self-destructive competitor to render an entire industry self-destructive. That’s why it is better to have smart competitors.