Services Pricing

Pricing Services: Understanding Pricing Approaches (Part 2 of a Series)

Company pricing approaches have to deal with two issues: The first is how to determine, fix or set appropriate prices; The second is how to actually get the prices that have been set, i.e. avoid significant changes (e.g. excessive discounting) by frontline management or the sales force to a degree that the intended effects of the pricing strategy are negated. This second issue becomes quite significant with increasing company size and complexity and decentralized organizational structures. We will examine both issues sequentially in this and further articles.

First of all it is important to recognize that pricing does / should not happen in a vacuum, but must support a company’s objectives and strategy for a specific product /service in a specific market. For example a strategy of pursuing market penetration and growth for a new product will require a different pricing strategy than the pursuit of profit maximization over time for a mature product. Furthermore pricing should be understood as a continuous process. Changes in economic and market conditions, the competitive environment or customer needs often warrant changes in pricing strategy and modifications to prices.

Over the past 25 years management practice (and academic research) has defined three fairly distinct (i.e. generic) types of pricing approaches:

  • Cost based pricing
  • Competitive or market based pricing
  • Value based pricing

Cost based pricing: This approach bases pricing on costs as determined by management accounting. The aim is to set a mark-up on costs that satisfies some internal constraint or target, such as margin or return on investment. At the time of pricing, aspects relating to demand (such as customers’ willingness to pay or price elasticity), competition, capacity utilization or efficacy of cost structures (direct costs and overhead) are mostly ignored. In this sense it is both an ineffective and inefficient form of pricing, guaranteed to frequently leave money on the table or lose business. Nevertheless it is often used in many industries –particularly those where market or competitive pricing data are hard to get or where customer perceived value for the product or service is difficult to determine. Industries where “one-off” projects or contracts are the norm are a case in point. What companies therefore in effect do in this case is not really set a price, but a margin/return target (usually fairly high in the hierarchy, derived from the company’s medium term financial targets and usually based on some “gut feel” understanding of the market and competitive situation) and therefore implicitly assume that all competitors have similar cost structures, provide similar solutions, follow similar strategies and that there exists an accepted (by the markets and shareholders) profitability level for the industry. The effect of this pricing approach is highly problematic, however it often persists in various industries for a long time, mainly because it is simple and because many competitors do, in fact, behave similarly, particularly in mature industries. When there is change however (e.g. through technology or competitive entries) such approaches can be dangerous. Companies can and do react by either trying to drive costs down or by reducing required margins. The former is difficult at short notice, the latter deprives the company of profitability.

Competitive or market based pricing: This approach bases pricing on information and data on market or competitive price levels for similar products or services as far as they exist or are known, again ignoring aspects relating to demand. Obviously it requires significantly more effort in acquiring and analyzing such data and requires furthermore a good understanding of how products and services compare with each other. This is easier to do in some industries and products/services than others, for example in those industries where products are fairly standardized and can therefore be sold based on standardized list prices (excluding discounts) and have a generally acceptable set of features on the basis of which comparisons can be made (consumer products, automobiles (pace branding), standardized industrial products and machinery). Nevertheless, even in these cases it involves a considerable amount of effort and sophisticated analysis. For non-standardized products and services it becomes even more difficult. In addition basing own pricing on prices of competitors entails the risk of starting price wars.

A purely competitive or market based approach in reality does not exist (commodities and identical products / services being exceptions), but in fact must be accompanied by some proxy of customer value –the difference between the benefits a supplier provides to a customer and the price it charges.

A value map plots the relationship between benefits and price:

Value Map

Figure 1: Value Map (adopted from Ralf Leszinski, Michael V. Marn: Setting value, not price. Mckinsey Quarterly 1997, Number 1)

Normally competitors will align along a so called Value Equivalence Line (VEL): At any price / benefit level there is a clear choice for customers. However some competitors may choose to position themselves to the right of the line (offering more benefits for the same price) to gain market share, while others may find themselves to the left of the line, thus losing market share.

Three issues are important here: First, it is not necessarily clear which benefits convey value. Or, in other words, it is more clear for some products (e.g. standardized products with generally accepted benefit attributes) than for others (e.g. one off products or services). Furthermore, as noted also above, often the value map is not known, simply because information on pricing or attributes included in offerings is not known. Second, it is not necessarily the case that customers are spread evenly along the VEL. If that were the case, suppliers could all be expected to have roughly similar market shares. Customers however tend to cluster depending on the dynamics of their own industry and perception / understanding of benefits. For example many customers define explicit minimum or maximum benefit levels (e.g. delivery reliability, quantified quality of components etc) and will not buy outside of these “brackets”, deeming what is below as too risky and what is above as excessive and not required. Another example are customers who set specific price caps based on internally derived value perceptions and budgets. Third, the VEL cannot be perceived as static. The positioning of a competitor to the right of the curve, either through the offering of superior benefits or a price cut can trigger a general repositioning through a price war, possibly benefiting customers, but negatively impacting the profitability of the industry as a whole –as has been seen numerous times.

There are many analytical tools that can help establishing VELs for an industry, such as conjoint analysis, which can help quantification of the benefits dimension, though they are more useful for some types of products than for others

We will not delve deeper into competitive pricing, but will conclude with the thought that there are two critical success factor here: First is a deep understanding of which and to what degree benefits are important to customers in terms of assessing value and therefore how to compare competitive offerings. And it is here that most mistakes are made. For example, as we also noted in a context of another article many companies misjudge customer needs in maintenance and support services offering additional benefits, when customers are essentially price capped. Second is the issue of perception. Customers will pay for benefits only to the degree that they are also perceived as such. This is particularly the case in services, especially outcome based services, where the outcome is not certain and hence, to a degree, discounted. We will discuss the meaning and ways around this in one of the following articles in this pricing series.

Next article in this series: Value based pricing

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