Warren Buffett, the billionaire investor and CEO of Berkshire Hathaway Inc., famously said he rates businesses on their ability to raise prices and sometimes doesn’t even consider the people in charge. In 2011 he told the US Financial Crisis Inquiry Commission: “The single most important decision in evaluating a business is pricing power… If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business”. In another interview that year he added: “The extraordinary business does not require good management”, in fact implying that it doesn’t really need any management at all: “If you own the only newspaper in town, up until the last five years or so, you had pricing power and you didn’t have to go to the office.”
This might, on the one hand, seem a familiar situation to some OEM spare parts managers used to charging very high prices for proprietary parts in otherwise relatively low margin environments. On the other, overall pricing in many companies remains primarily “supply driven” and price change policy ad-hoc and arbitrary. This is, on the face of it, surprising given that the documented impact of changes in price on profitability far outweigh the impact of other levers of operational management. For example studies have shown that in industrial companies, on average, a 5% increase in price results in a 22% increase in profitability, whereas the equivalent impact for revenue increase or COGS reduction is 12% and 10% respectively. But it is less surprising when one considers that only 15% of companies (and that in very specific industries) actually invest resources and allocate reasonable management time to systematic price determination.
Other studies have shown that to set prices, 44% of companies use competition based approaches (orient themselves on prices set by competitors or “the market”), 37% use cost based approaches (mark-ups on costs to achieve a required profitability (with some nuances) –often arbitrary in itself) and only 17% use so-called value based approaches (tie price to customer perceived value). The result of price not being sufficiently fine-tuned is that companies either lose customers and contracts or leave money on the table with consequences not only for short term profitability, but also for longer term market share and competitive positioning.
It should be noted that these study results are mainly for products not services. The expectation would be that price determination in service companies or units, particularly in B2B services, is even more cost based –simply because competitive or market prices are not known. This often sub-optimizes otherwise good businesses.
The purpose here is to examine service pricing through a (short) series of articles:
– analyze standard pricing approaches
– look at how pricing affects strategy and market positioning
– evaluate how various types of pricing approaches can be applied to services, pros and cons as well as obstacles and draw conclusions.
In the meantime, if you have any ideas or comments we’d be delighted to hear and share them.
Next article in this series: Understanding pricing approaches
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Titos: Your blog post was very informative and here are my views:
Pricing in service is extremely complex. I agree with your point in your blog post that majority of pricing is determined by competition, costs and value. But as much we try can bringing science or logic to service pricing, but finally it is situational.
Service pricing in my view is mostly determined by desperation (from either side). If a service company is running full capacity with work then their pricing and confidence to present the pricing is different than otherwise if they have weak pipeline. I also feel service companies price based on strategic advantage a customer will bring – for eg: if the service firm wants to enter a market or a new vertical then the pricing will be determined by strategy.
So in my view service pricing is very fluid and most of the service firms work on composite pricing and average it based on multiple deals. It is not possible for uniform pricing structure, having said we should have a structure with base price, slabs, bring better approvals, understand losses if any we would make, keep a accurate tab on cost & profit by project etc.
My grandfather once told me “Plan for loss as much you plan for profit”.
Thanks for publishing and good luck, Ajay
Hadn’t seen this comment (a glitch in the system) so apologies for not responding sooner. Yes, you are right that capacity utilization drives price in reality. Capacity utilization is a cost driver and therefore in cost based pricing it makes a lot of sense. Strategic pricing is “competitive” pricing and equally has a place if that is the pricing method used. The other three articles in this series deal with those topics and move on to value based pricing in services, which however requires a higher level of management maturity.
In any case your grandfather was wise
best regards / Titos