Informal Pricing Practices Can Backfire

CUNA’s E-Scan Newsletter
June 16, 2010 | COMMENTS

Your credit union has developed a new product you think will be a winner. You've invested in research and development, analyzed the competition, and prepared the advertising. But there's one key element you might have overlooked: What do you charge for the product?

Companies frequently don't put 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 say firms ought to engage in innovative pricing to achieve maximum profitability, but managers with pricing responsibilities often don't think systematically about pricing strategies.

The pricing function in most companies is informal at best, but companies are beginning to adopt more formal pricing practices. Gone are the days when you could merely look at what your competitors were doing and charge a similar price.

Part of the problem is that responsibility for pricing tends to be diffused. Responsibility lies with accounting, finance, and marketing people are involved, too. Pricing decisions are often made without thorough consideration, even though firms spend heavily to develop and advertise new products.

Even if a company assigns pricing responsibilities to one person, that person frequently doesn'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 affect purchasers. 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:

1. 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.”

2. 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 might 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'll lose out.

3. 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.

Raju and Zhang say effective pricing comes in two parts. One is having the organizational structure for making good decisions, and the other is identifying individuals who have the skills 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. One creative approach 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.

Companies adopting a strategic approach to pricing need to have a person or small group of people responsible for pricing. That person or group is charged with making pricing decisions from beginning to end and making price adjustments over time.

Adopting this approach, however, doesn't mean other departments abdicate their pricing responsibilities. 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.