By: Thomas Nagle, Georg Muller

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As you know doubt learned before, marketing consists of four elements: the product, its promotion, its placement, and its price.

The first three elements are about creating value in the marketplace. The last element is all about capturing some (but not all) of that value in the profit you earn.

As the authors say, if the first three elements sow the seeds of business success, effective pricing is the harvest.

The authors' research suggests that companies that adopt a value-based pricing strategy and build the organisational capabilities to implement it earn 24 percent higher profits than their peers.

Join us for the next 12 minutes as we figure out exactly how to do it.

How Not To Price

First we need to start by looking at what not to do. There are three pricing strategies that some companies adopt that leads to sub-optimal results.

Cost-Plus Pricing

We'll start with the easiest one. The costs of your product usually have nothing to do with the value it creates for your customer. So, pricing based on cost is never the right strategy to maximise profits.

Customer-Driven Pricing

Figuring out what price your customer is willing to pay is not the way to maximise profits. The purpose of strategic pricing is to capture more value, not necessarily by making more sales. Some marketers confuse the second with the first.

The question you should be asking instead is "What is our product worth to this customer and how can we better communicate that value, and justify the price?"

Share-Driven Pricing

Trying to capture the most market share is ultimately a fools errand in 99.9% of the cases. Figuring out what prices you need to charge in order to meet your sales or market share objectives leads to poor decisions.

Instead, you should be looking to find the combination of margin and market share that maximises profitability over the long run.

Strategic Pricing

All great pricing strategies are based on three principles - they are value-based, proactive and profit-driven.

Value based means that there will be differences in pricing across customers or applications that reflect differences in value to those customers.

Thus, a key element of strategic pricing strategy is your segmentation strategy.

There are 6 steps to create a values-based segmentation strategy.

Step 1: Determine Your Basic Segmentation Criteria

The inputs here are basically any and all research about your market that already exists. There's no need to reinvent the wheel here. It could include industry databases, government statistics, or any other research your company has already done.

The outputs in this step are a preliminary set of customer needs, and a provisional set of unmet customer needs. Check in with your sales people to make sure you are on the right track.

Step 2: Identify Discriminating Value Drivers

The inputs of this step include in-depth interviews with customers about how and why they choose the products in your market.

The outputs of this step include the list of value drivers in your market ranked by their ability to discriminate among customers, an explanation of why each driver adds value, and whether or not customers in each segment recognise that value.

Step 3: Determine Your Operational Constraints and Advantages

Figure out where you can deliver value drivers more efficiently and at a lower cost than your competitors. Also figure out where you are constrained in delivering on value drivers by your resources and operations.

The output of this step is to have a clear picture of where you have a sustainable competitive advantage, and therefore which customers you can serve better than your competitors.

Step 4: Create Primary and Secondary Segments

Your primary segmentation should be an obvious outcome of the previous steps, and focus on your most important differentiator. Your secondary segmentation takes your primary segment and puts them into distinct subgroups according to your second most important differentiator.

Step 5: Create Detailed Segment Descriptions

Next, you'll describe your segments in plain language so your salespeople and marketing people know exactly what segments you will be focusing on.

Step 6: Develop Segment Metrics and Fences

Finally, you'll create metrics based on the segments you've created, and determine how to get your customers to accept the prices you've set for the different segments.

Price Structure

Next we move on to create the actual pricing structure.

There are three mechanisms you can use-sometimes individually but usually in combination-to create a segmented price structure: offer configurations, price metrics, and price fences.

Offer Configuration

Creating different offer configurations is one of the easiest ways to serve different segments because customers will self-select the options that made the most sense given their circumstances.

Often this means bundling together features of a product to serve the different segments most profitably.

However, sometimes it makes sense to unbundle features when it helps you enter new markets.

Price Metrics

This is the unit you use to determine volume, and it's usually in the form of $ per X. The problem with most pricing metrics is that they are often set by default or how your market traditionally approaches it. The issue is that you can leave a lot of money on the table this way.

There are five criteria to consider as you determine the most profitable price metrics to use.

A great price metric:

1. Tracks with differences in value across segments;
2. Tracks with differences in cost to serve across customer segments;
3. Is easy to implement without any ambiguity about what charges the customer has incurred;
4. Makes your pricing appear attractive in comparison to your competitors;
5. Aligns with how buyers experience the value in use of your product or service.

Price Fences

Finally we have the concept of price fences, where there is different value (and thus, different prices) even when all of the features and benefits remain the same.

It's defined as fixed criteria that customers must meet in order to quality for a lower price. Price fences around age are common, with many theatres and museums charging less for children and seniors. Other common price fences include status, such as discounts for full-time students or employees.

Most price fences fall into one of the following 4 categories:

1. Buyer Identification Fences. A barber charging different prices for short hair or long hair is an example.
2. Purchase Location Fences. You'll notice when you travel that gas is cheaper in some locations rather than others.
3. Time-of-Purchase Fences. Early-bird specials are a common one here.
4. Purchase Quantity Fences. There will often be discounts for purchase quantities.
   
   

Price Setting

Now that you've decided on your pricing structure, it's time to actually decide the prices you'll charge for all of the different variations you've created.

There are 5 steps to this process.

Step 1: Define the Viable Price Range

Your price floor for a positively differentiated product is the price of the next-best competitive alternative. For a negatively differentiated product it is the variable cost of delivering the product.

Your price ceiling for a positively differentiated product is the maximum amount a fully informed customer would pay. For a negatively differentiated product it is the price of the next-best competitive alternative.

Step 2: Make Strategic Choices

Next, there are three alternative strategies you can explore.

• Option 1: Skim the market. This is where you go after only the most profitable customers in a market. Luxury brands follow this strategy. This strategy usually requires a substantial commitment to communicate your differentiating factors.
• Option 2: Penetrate the market. This is where you set a price low enough to attract and hold a large base of customers. This only works if a large portion of the market is willing to change suppliers because of a lower price.
• Option 3: Neutral pricing. This means making a decision to not use price alone to gain market share or to restrict it. This is the option that most companies adopt.

Step 3: Assess Breakeven Sales Changes

Economic theorists suggest that in order to set proper prices you should focus on mapping your demand curve (the number of units you would theoretically sell at each price point), and then optimize for the total profit.

The problem is that it's almost always impractical to do that.

Instead, focus on two simple questions to clarify your thinking:

• How much sales volume can I afford to lose before a particular price increase would become unprofitable?
• How much sales volume do I have to gain in order for a particular price decrease to improve profitability?

Step 4: Gauge Price Elasticity

Next, estimate how sensitive your market is to pricing changes. Running price experiments and purchase intention surveys are practical and cost effective ways to do that.

Step 5: Account for Psychological Factors

Finally, after all of the logical steps are done, we must take into account one very important factor - we are dealing with human beings that don't make decisions rationally.

We'll cover many of those ways in the next section on communicating value.

Price and Value Communication

Now that you have your pricing figure out, you need to communicate it to your target audience.

It requires you to clearly communicate the quantifiable benefits you've figured out in the previous steps, but it also requires you to understand the psychological factors that come into play when a person makes a purchasing decision.

Here are a number things to keep in mind as you decide how to convey value to your customers:

• Competitive Reference Effect. If the customer has little knowledge of the category, they'll often pick an option in "the middle of the pack."
• Switching-Cost Effect. Customers are less sensitive to price if there is a high switching-cost between suppliers.
• Difficult-Comparison Effect. Customers are less sensitive to price when they have difficulty comparing alternatives.
• End-Benefit Effect. A customer's price sensitivity is influenced by how important the end-benefit is to them.
• Price-Quality Effect. In luxury good and exclusive product marketplaces, the price is a measure of quality. In the customer's mind, higher price = higher quality.
• Expenditure Effect. Customers are more price sensitive when the expenditure is larger - either in total amount or as a percentage of budget.
• Fairness Effect. Customers are more willing to accept market prices for one-time transactions. However, when they anticipate future interactions, they expect the price to be "fair or reasonable."
  
  

Pricing Policy

Once you've determined your pricing and how you'll communicate it, you'll need to actually get your customers to accept your pricing policies.

Good policies allow you to achieve your short-term objectives without causing your customers, sales reps or competitors to adapt their behaviour that undermine your ability to hit your volume and profit targets.

Bad policies do the opposite.

For a number of reasons, you should have a pricing policy that covers the most common circumstances you'll encounter, and then ensure that you stick to them across the board.

Here are some of the different items you should have a documented policy around:

• Responding to price objections.
• Implementing pricing increases.
• Transitioning from a flexible to a policy based pricing. If you don't have pricing policies today, you'll need a plan for a transition period.
• Promotional pricing. If you are going to employ promotional pricing, you'll need strict and clear guidelines around it.
  
  

Price Competition

Engaging in price wars with competitors never ends well. So, unless you've chosen a low-cost pricing strategy, the general rule is to avoid it at all costs.

However, if you do find yourself in a situation where a competitor changes their pricing strategy and you feel like you need to react, ask yourself the following five questions first:

1. Is there a response that would cost less than the preventable sales loss? Focus your reactive price cut on only those customers likely to be attracted by the competitor’s offer.

2. If you respond, is your competitor willing and able to cut price again to reestablish the price difference?

3. Will the multiple responses required to match a competitor cost less than the avoidable sales loss?

4. Is your position in other (geographic or product) markets at risk if a competitor is successful in gaining share?

5. Does the value of the markets at risk justify the cost of response?