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Introduction to Smart Pricing: How Google, Priceline, and Leading Businesses Use Pricing Innovation for Profitability

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Learn to gain more confidence in pulling the price lever and be innovative about pricing your own product or service.
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After a long season of back-breaking labor seeding, feeding, and growing a crop, a farmer would never say, "Time to harvest—let's take it easy." If anything, the farmer would get up even earlier and go to bed even later to make sure that every last grain was harvested. Yet supposedly sophisticated companies, run by some of the best-educated people in the world, neglect what peasants have known by instinct for thousands of years. They work hard thinking about, growing, and finding markets for their product but then pay scant attention to the decision that determines what all that hard work yields the company: setting the price.

Despite the critical function prices play in corporate profitability, we find that managers with pricing responsibilities do not usually think systematically about their pricing strategies. Most pricing decision makers never look for a strategy that could yield their product's maximum value. According to one study, only a tiny number of firms have "both a pricing strategy and research to support it." When it comes to pricing, some estimated that only about 8% of American businesses can be considered "sophisticated players."1

Oddly, nobody seems bothered by this state of affairs. Many executives we talk to about prices say, "We don't set prices. The market does!" As economists, we are not sure what this statement means. "Who is the market, then?" we press them.

To our mind, this is a reasonable question. Price setting is a tangible process with a tangible outcome—a dollar figure. The process of arriving at that number might not be tidy, but it cannot be so mysterious that it does not involve any human intervention. Someone, somewhere must make a concrete, numerical decision about the price of a product or service. Yet managers often give us a bewildered or indignant look when we ask this question and act as if the question itself were frivolous or rude. The way the managers talk about it, setting the price for a product or service is an almost automatic process, outside anyone's control. Occasionally, we get the more profound-sounding answer that "the invisible hand" sets the price—a misapplication of the famous macroeconomic observation of Adam Smith, the great Eighteenth Century Scottish economist and philosopher, on microeconomic circumstance.

Thinking of price-setting as being similar to time or the tide is a comforting idea, given how many company activities require conscious thought. But it's not actually true. When you take a closer look, the hands that set the price are almost always visible. They might not be very nimble, but they can clearly be seen in each of the four most common methods of price setting. Among the least sophisticated companies we have encountered over the years, setting a price sometimes involves not much more work than selecting a lottery number: Pick what comes to mind, say a prayer, and hope for the best. More sophisticated companies don't always do much better. They often take simplistic, ad hoc approaches, such as cost-plus pricing, competition-based pricing, or consumer-based pricing. Each of these approaches requires human intervention, and each is overly simplistic.

Cost-Plus Pricing

An overwhelming majority of U.S. companies use the cost-plus approach to set their prices. This practice also appears to be popular in other markets, even in fast-growing countries such as China and India. To use cost-plus pricing, a firm first determines its sales target and then figures out the average cost it will incur based on the sales target. The price for the product is set by taking the average cost plus a markup. For example, if the sales of Apple's iPod are 2 million units, the average cost at that output level might be $100 per iPod. Assuming that the normal markup at the company is 70%, Apple's selling price for an iPod would be $170. The size of the markup is determined either by the company's targeted internal rate of return on investment or by some vaguely defined "industry convention."

The enduring appeal of the cost-plus approach is threefold. First, it is simple. The manager does not need to look outside the company's own ledger to determine the price for a product. A casual familiarity with arithmetic is sufficient for anyone to come up with a price. Second, it is fair, or appears so. Indeed, cost-plus pricing is said to date back to medieval times when churches were involved in regulating commerce and allowed merchants to make only a fair living, not a killing. Third, many practitioners will tell you that cost-plus pricing is financially prudent because it ensures profitable sales. This guarantee of prudence is a reassuring way to dodge the high pressure involved in making a pricing decision. Such pressure can be nerve-racking at times because the effects of a pricing decision, unlike many other decisions in a corporation, are typically immediate and conspicuous.

However, none of these three reasons is sufficient justification for adopting a conventional cost-plus strategy. First, why is simple better? A quick counterexample suggests otherwise. When a consumer in China purchases a beautiful silk scarf, does she know or care about the cost of making the scarf? Most likely, she does not. In fact, manufacturers themselves might not even know the costs of their products with any degree of precision. In that case, why should a silk manufacturer set its price solely based on its costs?

A Chinese silk manufacturer we know tried this simple approach. The company set a low price of 200–300 yuan for its scarves. Its cost of production was so low that even 200 yuan would still yield a decent margin. This low price was also extremely competitive, compared to the high price of 2,000–3,000 yuan set by a French company in China selling similar scarves sourced—you guessed it—from this very manufacturer. On paper, the Chinese company looked as if it should be very competitive in the marketplace, given its huge price advantage. Yet somehow the French company still outsold the Chinese manufacturer by a big margin, even with an identical product that cost ten times as much.

The difference was so great that branding alone could not explain the outcome, a fact that baffled company strategists. Later, it dawned on the executives that the low price itself might be the problem. Most of the manufacturer's customers purchased a silk scarf not for their own use, but as an elegant gift to the wives of their bosses or guanxi (connections). Potential customers looked at the 200–300 yuan price tag and decided it was simply not substantial enough to be the kind of door-opening gift they had in mind. Many forgone sales later, the manufacturer learned to look beyond its cost and set its prices based on a better understanding of its customers and the market.

The second advantage touted for cost-plus pricing is its supposed fairness. But we think this often is not true, either. For example, if a utility company is regulated such that it can charge a rate based only on its average cost plus a fair return on investment, many economic studies have shown that the utility company will have little incentive to minimize its costs, and the rate will drift up unnecessarily in the long run. For the same reason, if other kinds of firms always succeed in passing their costs on to consumers in this way, they have no incentive to minimize their costs. Finally, if the cost of serving customers is the same, is it fair to charge all customers the same price, even if they have varying incomes and need for the product? Perhaps the answer will vary, depending on your political convictions and economic circumstances, but a little thinking makes it clear that in many situations "fair" cost-plus accounting could lead to an unfair result.

Consider an example from the pharmaceutical industry. If a drug is cheap to develop and manufacture, should it always be sold cheaply? Is a 10% markup on some cheap ingredients really a fair return on intellectual property that reduced doctor visits, hospital stays, and employee absenteeism for thousands of people?

Perhaps it would be more fair for society to reward the innovator. It might even be socially beneficial in the long run to allow a higher price as an incentive to encourage others to try to solve similar problems.

Consumers, interestingly, have a surprisingly nuanced view of fairness in cost-plus pricing. If cost-plus pricing is a fair way to set the price, then if a firm's unit cost decreases by $10, the absolutely fair thing to do would be to lower the product's price by $10 plus the markup on the cost. However, studies have shown that the fairness standard people apply to price changes is far more favorable to a firm than the cost-plus pricing rule would suggest, even when they know the precise magnitude of the cost change. In one survey, half of the respondents agreed with the statement that "fairness does not require the firm to pass on any part of its savings."2 However, in that same survey, consumers also believed that more cost savings should be passed on to consumers if the cost savings are the result of a reduction of input costs instead of an efficiency gain: If the price of jet fuel goes down, I want a discount on my ticket, but if you build a better airplane, you can keep the difference. By applying this fixed cost-plus rule, a firm forgoes its chance of achieving any gains from efficiency improvements, although its customers would not have minded.

Nor does cost plus-pricing mean that every sale is automatically profitable. Cost is often partly a function of the sales target. If sales fall short of the target, the actual cost might be higher than projected. In that case, the price could turn out to be too low. Such a shortfall is always possible because the people responsible for sales normally make the sales projection, and they have an intrinsic interest in engineering a lower price to boost sales or to make their selling job easier. Even if the sales target is met or exceeded, we don't know whether the initial price is a good price or one that a company can improve for its own financial benefit. Regardless of actual sales, cost-plus pricing does not ensure or even encourage financial prudence.

Finally, as the Chinese scarf example suggests, the biggest problem with cost-plus pricing is that it is an inward-looking approach that tends to distract a company from its customer orientation and obscure the importance of detailed market research. A corporation that develops an entrenched culture in price setting based on cost-plus pricing encourages ad hoc pricing decisions and overlooks many opportunities for price improvements. Indeed, cost-plus pricing sometimes leads companies to set consistently sub-par prices. When sales are brisk, a company will lower its price as its average costs go down, but when sales are sluggish, it raises its price to "cover" its higher average cost.

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