Marketing Expert's Corner

This article written in 2010

 

Adam Smith and Milton Friedman are probably the two most quoted names in free-market economics.  Born nearly 200 years apart, they did more to systematize and popularize micro-economic theory than just about anyone else.

And for day-to-day business decisions, micro-economics is the real story.  Of course the macro view -- how healthy is the economy? -- is important for planning purposes.  But whether to do a deal today or not, and at what price ...that's micro.

Unfortunately, all the clear thinking and rigor that their theories will give you -- the business reader -- the wrong answer on pricing.  Want profitable deals?  Read on.

The Price is Rite

Microeconomics is the home of "the law of supply and demand," and the roots (so to speak) of its examples are in agricultural commodities.  Lots of suppliers meet lots of purchasers in an open marketplace where all the information you need is in plain sight.  Transactions are done in nearly pure competition, with no politics or externalities.  One deal is essentially indistinguishable from another.  Oh yeah, and profit is driven to zero.

Do any of the words in that paragraph sound like the world you actually sell in?  Commodities?  Pure competition?  Perfect information?  Get out of the classroom!

If the housing bubble and financial disaster of the last couple of years hasn't done anything else, it has taught the world that the theories of rational pricing and efficient markets are naive at best, propaganda at worst.

The whole reason that sales and marketing departments exist is to accentuate differentiation, escape commodity price pressure, accentuate asymmetric information, and create profitable deals.  Airplanes don't defy the law of gravity any more than businesses defy the laws of economics.  But they are both able to temporarily transcend them.

With every new product introduction and price list change, marketers must go through the rite of pricing.  While there's lots of hard evidence to identify the minimum price, there's almost never a solid way to figure out the most profitable price.  Often, the best answer is to caucus with the sales leaders and get them to choose the pricing.  Although this has the poetic beauty of having the sales team own the consequences, it can also be a pretty risky approach.  That goes double if the sales team only knows how to compete on price.

Can't we do better than a rain-dance or random-number generator? 

Liar's Poker

The best place to start is with an understanding of behavior:  your sales reps and customers are human beings who act on emotion and self interest.  Timing and sequence really matter to their decisions.  To misquote Captain Kirk, pricing is not a game of chess:  it's a game of poker. 

So we have to replace micro's "continuous function" notion of pricing (lots of deals that are indistinguishable) with a discrete, Boolean function:  a particular deal is done, or it isn't.  Deals, like poker hands, are won or lost.  The trends are clear, but the individual outcomes can't be predicted with accuracy.

This applies even if you do business via ecommerce.  Many firms do their "onesy-twosy" sales entirely via the web (with no variation allowed), but move the larger deals to a sales team.  Customers go to the sales teams to get better terms, and vendors use the sales teams to get bigger deals.  I know of few situations where a $50,000 deal can be done entirely over ecommerce.

Most of the time, we tend to focus on competitive pricing -- knowing what the competitor's offer is, and finding ways to beat it on paper.  But that's the wrong place to focus, as the specific price is only a symptom, a symbol of the complex decision the buyer is trying to make.  In a market of any technical sophistication, each vendor's deal is a range of features and attributes that have to be compared...with price being just one of them.  No matter how much everyone yaks about price, it is one of several variables.  The reason for all the price negotiation is the buyer thinks that price is the only thing that's open to change at that point in the deal.  Clue #1 for price protection:  to sweeten the deal, try offering some service, consulting project, or optional add-on, rather than just a better discount.

To boil it down:  negotiate for optimum value rather than just for best price.

But we need to go further, because we all know the phrase, "perception is reality."  Deals get signed because of how the customer believes he will feel after he has purchased the product or service.  So you need to negotiate to optimize the buyer's emotional value and personal impact.  Pricing is the result of the creation of value in the customer's head.  Don't believe me?  Why are you willing to pay $1100 (without usage) to own an iPhone for 3 years? 

Taber's Ten Axioms of B2B Pricing

  1. Adults Lie.
    - Buyers don't know what they are willing to pay, particularly for new products.
    - Vendors don't know what they are willing to accept, particularly when business is slow.
    - There are powerful incentives for each side to hide information and mislead the other.
    - Pricing surveys will yield only the most basic indicators, and shouldn't be your only justification for a
      pricing decision.
     
  2. The web has dramatically improved the buyers' access to information.
    - There's a whole lot less information-asymmetry than in the past, particularly about product problems
       and vendor service levels.
    - Most vendors need to dramatically up their game in projecting (and protecting) how they are
      perceived via the web.
     
  3. Better to focus on the best perceived value rather than the lowest perceived price.
    Low pricing is a strategic advantage only if you have the lowest cost structure (or the deepest
      pockets for sustaining a price war).
    - High price that the market perceives as justified is a huge strategic advantage, particularly for luxury
      consumer goods or business services.  Tony Robbins charges $1M/year for access to his personal cell
      phone number:  the high price means that that service must be really valuable.
     
  4. Pricing models are more important (and complicated, and have bigger ramifications) than price points.
    - Be willing to have more than one pricing model, but design them so you don't create arbitrage or
      down-sell opportunities.
    - Stay away from over-complexity.  It merely confuses your sales reps and makes you harder to do
      business with.
    - Understand competitors' pricing and monitor "market price points," but know that it's a trap to match
      them.  Instead, do something better or more valuable.
    - Watch out for your channel's needs and points of resistance.  They need to make money, and it's all
      too easy to design a "better" pricing model that is poisonous to them.  Ignore this issue at your peril.
     
  5. Despite rigorous business cases, businesses are not at all consistent in their pricing sensitivity over time.  
    Once you've got a customer on board, it pays to continuously experiment with prices through bundles,
      special versions, and temporary promotions.  Figure out what price optimizes profit and loyalty now
      that they are a confirmed customer.
     
  6. Variable pricing always wins, but is much more complicated to administer.
    - Price discovery is one of the few useful concepts of economics.  Use eBay and SPIFs and channel
      promotions to find the best price.
    - Making a 1% increase in your average price -- quite achievable -- can mean a 10% increase in your
      profits.  There is no faster way to improve margins!  But make a mistake, and it works just as
      effectively in reverse.
     
  7. Repeat business is always more profitable than getting new customers
    - Find ways to build customer loyalty and resuscitate dormant accounts.
    - Create systems to milk them (special offers for the customer and explicit incentives for your reps).
     
  8. Recurring revenue models are healthier for your company, but they're more annoying to investors (because it's tougher to get big upside surprises).  You'll definitely need to modify your comp plan to accommodate their price points. 
     
  9. All-You-Can-Eat deals usually spell trouble, even if you can get them past your auditors.
    - For large discounts, it's much better to specify a very large number of seats or an extended license
      period.  Make sure to craft the terms so that future mergers or "most favored nation" deals don't get
      you in trouble.
    - Make sure the deal applies only to current products and bundles.  Then...obsolete those bundles and
      products as fast as you can.
     
  10. Freemium models need really big customer bases to really work.  The law of large numbers applies here.

An Epilogue that's a Prologue

Way long ago, I wrote this on pricing and licensing mechanics.  It's still worth looking at.

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