Mimiran

If you’re reading this blog, you probably know the dramatic profit impact of small price improvements.  (For a company running at 10% net margin, a 1% price improvement increases profit by 10%.)  Yet even when companies want to improve pricing performance, they often feel like they are at the mercy of the market.

If you’re truly in a commodity market, you are in fact at the mercy of the market.  Either focus on your cost, or differentiate to decommoditize.

Few businesses are in true commodity markets.  And for a lot of these businesses, especially at the SMB level, the first barrier to improved pricing is the one the business owner can control most directly: themselves.  Many business owners look at their costs, tack on a “fair” profit, and call it a day.  Or they look at the competition and price a bit below them.  Even when costs go up, they often have trouble raising prices.

Your pricing is ultimately limited by the perceived differential value of your offering.  I’ll go into more detail on the value side in a later post, but for now let’s think about the amount of value you can capture.  You work really hard to create value for your customers.  You work proactively to make them successful.  Don’t sit back passively when it comes to capturing your share of that value.  Pricing is the monetization of value, and you should be just as proactive about that as value creation.

So don’t be the limiting factor on your pricing.  If you think you should be achieving higher prices but you haven’t asked because it makes you uncomfortable, you need to fix that.  If you are used to giving big discounts when you get nervous in sales cycles even though the value is there for the customer, you need to fix that.

Here are some exercises to help you think about this:

• The Series of Increasingly Outlandish Prices.  From Steve Blank, author of 4 Steps to the Epiphany.  When the customer asks for the price, keep getting more and more outlandish until the customers pushes back.  For example:  “It’s $1M dollars.  Per month.  Plus $2M for setup.  Plus 20% maintenance.”  The point is to help discover the price for a new offering, but it’s also useful to force you to think beyond “I think it should be about $99.”
• Double Your Price.  Someone bursts into your office and holds a gun to your head.  They tell you that you have to double your prices in a month.  (Maybe it’s your accountant.)  What would you have to change about the way you sell, your products, your services, your customers, to achieve this?  While you may not be able to actually double your prices, you can make dramatic improvements.  We used this method to double consulting prices, although it took us 2 years, not a month, to actually do it.
• Visit a Porsche Dealer.  Test drive the fastest convertible on the lot.  When it comes to negotiating the price, keep insisting that you are deciding between this car and a Hyundai Sonata that seats 5.  Keep asking the sales manager to come back with a better price.  After they get done laughing and throwing you out, compare the reaction of the car salesreps to your reaction when customers try to chisel you down on price.
• Say It to the Mirror.  It may sound silly, but if you have trouble asking for the price you think you should get, practice saying it to the mirror.  Not just the price, but why this is a great deal for the customer.  Make sure there is no hint of apology in your voice or your body language.

If you haven’t already, check out Gerhard Gschwandtner interviewing Ron Hubsher from the Sales Optimization Group on the sales negotiation process.  Ron looks at the sales process with the same philosophy I do– namely, selling value instead of price, and using that profit increase to build a much more valuable company.  However, he approaches the problem from a sales training perspective, a nice complement to the analytical approach we use.

Check it out:

I’m a big fan of analytics.  And sports (although I no longer have time to keep up with them).  So I’ve always been puzzled that with so much money and pride on the line, teams have done so little analyze data to help them win.  Sounds a bit like pricing, right?

There’s no shortage of stats in sports, just as there’s no shortage of KPIs in business.  While these numbers are interesting and sometimes even useful, they often provide little insight into true performance, and may even distort performance in a way that reduces overall effectiveness.  For example, some baseball statisticians think On Base Percentage is more important than batting average, but everyone focuses on batting average.  In business, there is a huge focus on revenue at the expense of profit.

The reason for this mismatch is not that teams hate winning or business don’t want to be profitable– it’s just that it’s easier to measure some things than others.  It’s easy to measure revenue or points scored.  It’s harder to measure profit, because cost is such a tricky subject.  And no one records whether those points came off a double screen or were set up by a teammate’s cut that drew away defenders.  (Still, we have it easy.  A friend in Africa fighting AIDS described how one of the big challenges was even measuring the scope of the crisis so they would know how to allocate resources and whether those resources were effective.)

Now some researchers at Queen Mary University in London have done some graph-theory analysis of World Cup matches, developing a way to visualize the balance of a team’s attack, and the “centrality” of each player.  Check out the graph for Holland v Spain.  I’d love to see them go a step further, and put a goal at the end of the pitch, and weight each edge of the graph by the chance of successful completion.  For example, a number of short passes may have a 90% completion rate, while a long ball might have a 50% chance of success, but may be more likely to lead to a goal.

Similarly, in the corporate world, a lot of effort gets expended on deals that make $0 profit (or even negative profit).  If you know where your profit comes from and know how to price those deals appropriately, you can have a huge return not just on investment, but on effort.

Who doesn’t love a bargain?  We all do, and we know our customers do, too.  But that doesn’t mean price is the only thing that’s important.  It becomes the only thing that’s important if everything else is the same.

Many companies feel they don’t have good differentiation, so they have to compete on price.  When Fortune 500 companies do this, the only implication is losing a few points of margin and billions of dollars of market cap.  When small businesses do this, they go out of business.  They either cannot sustain themselves financially, or they can’t sustain themselves psychologically.

That second problem may not seem intuitive, so let me explain.  Take a business that does 10% margins.  If the owner can raise prices 5%, she can increase profit 50%.  Or, she can make the same profit with a lot less work.  Less hours.  Less employees.  Less support calls.  Fewer customers.  Less stress.  If she feels she has to drop prices 5% to match a competitor, now she has to double sales just to get the same profit.  Even if this is possible, now she has double the orders to handle.  Double the chances of something going wrong.  She needs more people, more trucks, more inventory, more support staff.  More stress.  Even is she can keep the business afloat, at some point she’ll decide that it’s not worth trying to stay on a treadmill that keeps going faster and faster and doesn’t go anywhere.

What’s the alternative?  Be different.  Don’t let price be the only factor.  For many small businesses that sell the same commodities as larger businesses, the difference is service.  Note that a lot of the potential addressable market won’t care about your service.  They might even see it as a negative.  Don’t compete for those customers.  Go after the ones who value your differentiators(s).  The big companies have to appeal to broad markets.  That means there are niches where smaller companies can add value.  When a customer in your niche challenges your price compared to the big players, it’s a great opportunity to remind them of the value you deliver.

Remember, 10 years ago salesforce.com and Google were “niche” players in established markets.  Only hippies drank pomegranate juice or organic milk.  Blockbuster was the 800 pound gorilla of the movie rental market.

I get this question a lot.  Sometimes from people who want to think it’s some kind of magic that doesn’t require rigorous analytical thinking, usually from people who want to prove that it’s a science.  Often their desire for proof is more than philosophical.  If we are suggesting major price moves that will have real consequences on the business, they want to have as much comfort as they can in their decisions.

We want to think about pricing as scientifically as possible.  This makes executives more comfortable (and us, for that matter).  It also leads to better decisions.  Most of the price moves we recommend fall into the “low hanging fruit” category.  They are not rocket science.  This means things like “stop selling deals at negative contribution margins.”  Or “stop offering free express shipping for goods that weigh several hundred pounds.”  Even with seemingly incontrovertible suggestions like this, people want data.  Like, “how do we know that we are actually losing money on these deals?  Could we just have funny accounting?”  Or, “if we take away these deals, and we lose the customers, what happens to our overall margins?”  (Reasonable question, but typically these situations are not deliberate “loss leader” tactics– they’re just a matter of things sliding out of bounds.) In these cases, you don’t need a lot of art or science, just good analytics.  (Yes, that’s what we sell.)

More complex scenarios involve assumptions about what might happen given a certain price move, perhaps in conjunction with competitive or market changes.  Here, the ability to look at what happens on a fine-grained basis is extremely powerful.  Rather than dealing with averages in a spreadsheet, you can apply the model at the level individual accounts and transactions and roll up the results.  This often gives very different, and much more reliable forecasts than working with the averages.  Still, there is a certain amount of art involved in deciding the parameters of the model, since the selection and exclusion of data points has a big impact on the results.

Here, the political setting has as much importance as the mathematics.  If people perceive that a pricing adjustment is about assigning blame for past behavior, their natural response will be to divert or diffuse blame, often by attempting to explain why certain pricing actions were good, rather than asking whether they were good.  On the other hand, if the environment rewards people and teams working together to find opportunities going forward, without assigning blame for what has already happened, people are more willing to look at whether better actions would lead to better results.  The math, economics, and analytics can be identical in the two situations, but an opportunity-focused organization will get much better results than a blame-focused organization.

Even assuming that you are in an opportunity-focused organization where everyone is trying to be objective, you can still run into issues of selection bias.  Ironically, some of this bias is enabled by the capabilities of the very software that’s supposed to provide fact-based analysis.  Powerful, flexible software that lets you easily exclude certain data points and run scenarios or flag deals much more effectively than Excel is handy, but you can always find another set of scenarios to run or ways to look at the data.  We’ve found some organizations get so excited about having better visibility into pricing performance that they get sucked into analysis paralysis, at least temporarily.

In these situations, there’s a lot of pressure up and down the chain of command to come up with solid, statistically valid decisions.  Which makes perfect sense.  But you can now crunch numbers in so many ways that you can, if you want, create almost any scenario.

Indeed, the same situation has happened in medical trials.  Computing power lets companies essentially run lots of experiments in parallel, and cherry-pick the results they want to see.  (Check out this great article on Ars Technica, We’re so good at medical studies that most of them are wrong.)  I often tell people “we’re running a business, not an FDA study.  We need to make a decision by Friday, so we have to go with the best information we have.” Then if we’re doing consulting work, we usually have to run the numbers one more time, with another set of assumptions, until the executive in charge makes the decision to go forward.   Turns out, even the FDA studies have similar problems.

What does this mean?  That we should abandon hope of having a solid mathematical foundation for pricing decisions?  Certainly not.  Just that we can’t ever get to certainty.  But with some decent analytics we can do a lot better.  And that’s all we need.  We don’t need perfection, or even “optimization.”  We just need 1% better.

So is pricing an art?  A science?

Yes.

Chris Anderson of Wired said that Free is the price of the future. Some of us beg to differ. Among those with other opinions are Lincoln Murphy of 16 Ventures who published a paper called The Reality of Freemium in SaaS, and Dave McClure, who wrote Subscriptions are the new Black on his always entertaining and provocative blog Master of 500 Hats.

Lincoln notes that “free” is a marketing tactic, not a pricing strategy.  (As a pricing strategy, free can work well as a defensive move to discourage other entrants from building free or cheap products that could threaten your core business.  It’s a hard way to build a core business.)

McClure writes (rants?)

ASSERTION #2: The default startup business model for 2010 & beyond will be subscriptions and transactions (e-commerce, digital goods).

Newsflash folks: The Internet does NOT want to be FREE… It wants to GET PAID on F&*&ing Friday, just like everybody else on the damn planet.

What does this mean?  It means you have to think about the value your customers receive from using your offering, and how that value compares to their alternatives, including the option of doing what they are doing today.  Value includes both positive and negative elements.  For example, saving time might be a positive value, whose worth depends on how much time and whose time you’re saving.  Signup time or data migration time would be a negative value.  If you can’t generate a strong value proposition and get your prospects to believe it, you’re going to be in trouble.

This can be especially hard for tech companies that create cool technology and focus on the features.  Features don’t have value.  Features can create value by providing benefits, but it’s the benefits that create value.

The economy’s in a bubble! A crash! A recovery? Careful, you might get whiplash. Looking back at the roller coaster ride, a lot of companies lost a lot of money because they could not act, or even react, quickly enough. Strangely, this money rarely showed up as a line item on the corporate P&L, although the losses had a huge impact on share prices. What were these losses, and how can we apply the lessons more profitably now?

Most companies have a hard enough time figuring out “optimal” pricing in relatively static markets. List prices get revised once or twice a year, often through a process that involves more heat that light. Promotional programs and discount plans get a fancy spreadsheet model that never gets revisited to measure effectiveness.

When conditions change rapidly, companies often get caught on their heels. For example, when energy prices rose rapidly, companies like UPS who recognized the importance of energy prices to their bottom line, and their competitors’ room to maneuver, implemented fuel surcharges and turned energy costs to their advantage. Most companies do not monitor fuel prices carefully, however, and most of them failed to take advantge of price increase opportunities or even to keep up with inflationary pressures in their supply chains.

By the time many of them had figured out they should have raised prices 6-12 months earlier, the economy had tanked and pricing power evaporated. Even then, some companies had waited long enough to react that they could still push through price increases of 5, 10, and even 12%.

Now companies have retrenched for the recession and are timid about raising prices. How will you know when? And how much? Or if you can raise prices in some industries but you have to be more flexible with discounts in others?

You need, in a word, agility. You need to see what’s happening now, not just what happened last quarter. And you need to be able to adjust how you price and discount based on that. You can’t wait for your year-end pricing review. You can’t wait for a marketing review. You need to tie into your sales team and empower them to be agile. If you don’t, your company will likely leave 10% or more of its profit on the table. You may not have to declare it as an expense, but your investors will notice the difference.

What’s your plan to close out 2009?

For many companies, 2009 has been a tough year. While many people remember the crash of the dot-com bubble, some people seem to have forgotten, and even that crash didn’t impact the broader economy the way the housing and credit market implosion did.

So how are you going to close out 2009? (If you’re in retail, good luck. I’ll write more on this later, time permitting.) Many companies are trying to sell into a buyers’ market, with less support from marketing efforts than they enjoyed in the past, fewer reps, but the same pressure to deliver.

Many companies run as hard as they can at the opportunities in their pipeline. They stay up late, fly around the globe, and try to “close” as many of them as possible. Buyers know this, and know how to extract maximum concessions by causing maximum stress.

I’d like to promise you that by reading this blog post, you’ll make your numbers and not have any stress, but I can’t. However, here are some things to keep in mind that can help improve your close rate, close time, and reduce your concessions.

Note that the concession bit is often the last thing on the minds of your sales teams. It’s something that you deal with once you get to the “negotiation” phase of your pipeline. Chances are you’re already pushed into a corner at this point. But for every 1% discount you give that don’t have to, you’re giving up about 10% of your profit. For some companies in this economy, that’s going to put you out of business.

Without further ado, here are the tips;

• Look at the characteristics of companies that buy quickly and with minimum discounting. Assign reps to focus on accounts with these characteristics. Assign marketing to find more of them. All too often, sales teams beat their heads against the wall with prospects that aren’t a great fit. They spend too much time trying to sell vitamins instead of painkillers. This stretches out sales cycles and increases discounts. (In many cases, these discounts put the deal into the red, sometimes on both a gross and contribution margin basis.)
• Give your reps information on what your best reps are doing. Sales teams have gotten a lot better at using CRM systems to share best practices on prospecting, meeting, closing, and other important sales activities. But when it comes to deal pricing and negotiation, the buyer tends to enjoy a huge information advantage. Fight back by giving your sales team information on how similar deals were priced out their outcomes. Reps sometimes just need to know that it’s possible to sell at a 10% discount rather than a 12% discount (a change that might mean a 20% swing in profit).
• Have a Plan. Know what your goals are and what you need to do to hit them. Make sure the entire organization is on board to avoid last minute problems with price exceptions. Know when you’re doing to walk away.
• Have a Plan B. We’ve all seen situations at the end of the quarter when the carefully crafted sales plan from the beginning of the quarter gets torn up and the company enters “Wild West Mode.” Margins go down, and customers get trained to put you through the same process next quarter. To avoid some of this pain, set up contingency plans so that if certain conditions occur, you can change some of your sales and pricing parameters. For example, having a specific plan for responding to competitive price cuts not only reduces stress, it also reduces destructive price wars.

Best of luck with the rest of the year. Would love to hear how you’re implementing these practices, or others.

I wrote a couple weeks ago about Value, Scarcity and Pricing in the Age of Superabundance. Now there’s a timely report about the concentration of profits among cell phone makers from Bernstein Research analyst Toni Sacconaghi. Sacconaghi estimated that while Apple only accounts for 8% of the revenue among handset makers, it gobbles up an astounding 32% of the profit in the industry. (If you exclude losses at Sony Ericsson and Motorola, the number drops to only 25%.)

This is a great example of how diffential value has a huge impact on profit. By creating and sharing a value surplus between buyers and your company, you can dramatically increase profit. The flip side of this is that if you can’t differentiate, you end up in the commodity trap and you have a good chance of having negative profit. (Motorola made a ton of money in the cell phone business when a phone that made calls and was really slim was differentiated.) If you’re in the commodity business, you have to find a nice in your market where you’re actually differentiated.

For most people, throughout most of human existence, scarcity was paramount.** Now we live in an age of not just abundance, but superabundance. The agricultural revolution created abundance– not by today’s standards– in food. The industrial revolution created abundance in manufactured goods. The information revolution not only created an abundance of communication and information, it also dramatically increased our ability to move production to cheaper locations and manage the complex supply chains that resulted.

Buyers–both individuals and businesses- benefited from a huge increase in supply, selection, and a huge decrease in price. We also ended up with a superabundance of credit, which helped fuel appetites for the endless array of cheap goods.

For sellers, however, the situation was often disastrous. Many local businesses succumbed to larger competitors with lower unit costs and lower prices. Even large, successful businesses found themselves on a treadmill, running faster and faster but never getting a sustainable competitive advantage. You might have just moved manufacturing to China, only to find a competitor had achieved lower costs in Vietnam. This is before we even get to the internet, where prices are literally going to zero in many cases.

So what can we do about this?

We need to rediscover scarcity. In many cases, we’ll have to create it. This is not as simple as producing “limited editions.” This won’t work for everybody. (If anyone has any information on how Nomenus Quarterly is doing, please let me know. The trendy magazine made the New York Times after cutting production from 50 to 10 and raising prices from $2500 to to $6500 per issue.) Rental car companies have had success raising prices after trimming their fleets. It may be easy to make a car cheaply, but having one available at the airport when you need it is a different story.

And that is the key to rediscovering scarcity. You have to understand what the customer needs that’s hard to deliver. At one point, just making something was enough. Now, whatever you can make, chances are someone else can make and offer more cheaply. In pricing, after all, you’re only as smart as your dumbest competitor, and chances are some new MBA is looking to make a name for himself by getting 25% of your market, even though it’s a dumb move for everyone. (We’ll talk about the latest round of Google v Microsoft in another post.)

In an age when a device as mind-boggling complex as a supercomputer’s worth of processing power is a commodity, the silicon itself has little value. But the ability to turn it into a data center takes some skill. The ability to do it tomorrow, in a certain location, with training, monitoring, and reliability guarantees is actually really valuable.

Whatever it is you’re selling, think about how your customers use it, and how there are situations when the overall experience creates scarcity bottlenecks. This could be the fact that while Southwest flies 10 cheaper flights a day, if you actually want a seat at the last minute, you’ll be forking over $1000 to Delta. Or if your customers require extremely high reliability or precision. Or if your customers order commodities from you, but require logistical and service support to deliver them to the right people, at the right time, and perhaps even set them up. Note that this does not mean you can charge all potential customers high prices all the time. It means that certain segments place a value on your offering, at least some of the time. Understand this, deliver what they need, and price appropriately.

A lot of this comes back to the one thing that is getting less and less abundant as everything else becomes superabundant: time. If you can save your customers time, you can make money. If you can save them more time than alternative solutions, you can make a lot of money. If you’re stuck on how to create scarcity, start with the customer’s time, which is already scarce.

** This goes all the way to our genes. Before Quik-E-Marts, our craving for sugar and fat helped keep us alive. Now it gives us heart disease. For more on this somewhat-related topic, check out the New Yorker article XXXL: Why are we so fat?

In addition to the genetic arguments, the article notes that the price of food, especially calorie-rich, nutrient poor sodas and other processed food, has fallen sharply. (This is partly due to increased efficiencies in farming and industrial food processing, and also partly due to subsidies that encourage production of food that we probably shouldn’t be eating. The cheapest, simplest, least-likely-to-happen step we could take to improve our healthcare situation would be to end subsidies for corn.)