Smart Pricing Pays Off

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May 7, 2010 | COMMENTS

Your credit union has developed a new product you think will be a winner. Money has gone into research and development, analysis of the competition, and advertising. But there's one key element you may have overlooked: What do you charge for the product?

Companies frequently don't put anywhere near as much thought into pricing as they should, say marketing professors Jagmohan Raju and John Zhang of the University of Pennsylvania 's Wharton School of Business. Raju and Zhang argue that firms ought to engage in innovative pricing to achieve maximum profitability, but that managers with pricing responsibilities do not usually think systematically about pricing strategies.

The pricing function in most companies is not well recognized, and only recently are companies beginning to adopt a formal pricing function. Absent that, companies often just follow what they've been doing for years—which may mean looking at what others are doing and charging a similar price.

Responsibility for pricing tends to be diffused—often it lies with accounting, sometimes with finance, and frequently marketing people are involved. Decisions often are made without thorough consideration, even though firms spend heavily to develop and advertise new products.

“We probably don't even spend $1,000 thinking about how to price the product,” Raju tells Knowledge@Wharton. “And if we don't price it well, then where will the money be for developing the next new product or the next new idea?” he asks.

Even in the case of those companies with pricing managers, those people frequently don't have the sophistication to actually set good prices. Zhang suggests two reasons for that:

1. Pricing is risky. The outcome of pricing decisions tends to be immediate—either good or bad. If you make a pricing decision, you have to take responsibility for it. That's one of the reasons people shun this kind of decision-making and end up simply pricing as every other firm is doing.

2. Pricing is hard. To make a good pricing decision, you have to be in command of a lot of information, and have “street smarts” to understand how the particular decision will impact consumers. A lot of people are apprehensive when making that kind of decision.

Given the difficulty of pricing decisions, firms tend to default to three simplistic approaches:

Cost-plus-pricing. Many companies have a reasonable sense of what it costs them to deliver a product or a service. What they do, often in a risk-averse manner, is say, “How much margin do I need to make on my costs so that at least I'm not wrong?” That doesn't mean that they're right, but charging prices reasonably above cost says “I'm safe, I'll be okay. “

Competition-based pricing is just looking at what others are doing and imitating it. That's also a safe approach, and in some cases, it may be fine to do that. If you have a product that's no better than the competition, you don't deserve to get a higher price. But in many settings you will lose out.

Consumer-based pricing is the third common pricing method. Essentially, a firm assesses the consumer valuation—not a bad thing to start with—and figures out how much a customer is willing to pay, and then charges accordingly.

Acknowledging the pros and cons of each traditional approach, Raju and Zhang lay out alternative approaches to pricing. Good pricing, they say, comes in two parts. One is having the organizational structure for making good decisions. Another is identifying individuals who have the skill set for making those decisions.

A skill set for making pricing decisions implies that managers think about creative ways of changing the pricing practices in an industry, as opposed to simply changing prices. “That's how you become a price leader,” notes Raju.

Granted, there are multiple ways to set a price for a product or service, and different pricing mechanisms are applicable in different kinds of conditions.

One approach receiving attention is micro-pricing, or “thinking small.” Pricing in small increments can apply to consumer goods or services, and it's based on different people consuming at different rates.

One example is cell phone pricing in developing countries, where a per-second rate may apply as opposed to a per-minute rate. Micro-pricing puts pressure on companies to measure at a micro scale, such as billing on a per-second basis. That requires technology and effort. For those able to do it, small increments in price can lead to large payoffs.

Companies willing to rethink a strategic approach to pricing need to consider having a person or a small group for whom pricing is the responsibility. That person or group is charged with making pricing decisions from beginning to end and making price adjustments over time.

But appointing a chief pricing officer, or someone with that responsibility, doesn't mean that other departments have to abdicate their responsibility on pricing. It's important for marketing, finance, and accounting to be engaged.

The role of a chief pricing officer is to bring everyone to the table, develop an organizational structure, and build a skill set. That combination allows companies to make good pricing decisions—and to anticipate higher bottom-line returns.

With the new information technologies available to consumers, the pricing environment is getting tougher. “You can imagine that the payoff for making the right pricing decisions is going to be huge,” says Zhang.