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