What to price? What to optimize? How to optimize? Three key pricing questions
Steven Forth is a Managing Partner at Ibbaka. See his Skill Profile on Ibbaka Talent.
Several general trends are combining to push pricing to the front of leadership conversations. The immediate cause is the uptrend in inflation which is causing many companies to take a new look at their pricing. There are even larger forces at work.
Long term, the big trends are demographic change and how to respond to climate change.
Medium term, these are reflected in the stress on the supply chain and the ‘great resignation’ which is really just code for the many ways in which work is changing.
The result of all of these changes is a ground swell in innovation. Organizations are innovating in all sorts of ways, from business models, to the organization of work, to supply chains and partnerships, to products and services. The result is a surge of interest in pricing.
Pricing is a broad field, and many people are asking where to start. This can be broken down into three questions.
What to price?
What to optimize?
How to optimize?
Many in the pricing industry gravitate to ‘How to optimize?’ This is generally what is taught in pricing schools and is the focus of most pricing consulting firms. Below are the results of a recent poll on the Professional Pricing Society’s LinkedIn Group.
Pricing optimization is the wrong place to start. Going fast in the wrong direction can have poor outcomes.
This leads to the alternative, ‘What to optimize?’
Jeff Robinson has been doing some important work in this area that he is documenting in a series of books. The first of these is Pricing for Growth (which has an excellent supporting website). (Watch for our interview with Jeff, which will be published on this blog soon.)
He argues that the driving purpose of pricing is to find ways to increase the value of the company and that there are five ways to do this.
New customer revenue acquisition
Existing customer revenue expansion rate
Existing customer revenue churn rate
Annualized profit
Present value discount rate
Too often, pricing is used to improve profit margins. This is only one of the five determinants of company value, pricing can impact all five. In many cases, the biggest contribution will come from increasing the long-term growth rate, and this should be the goal of many pricing optimization exercises. There is a basic problem with all of this though. It assumes that it is obvious what should be priced. This is no longer the case.
Begin by asking what to price
Modern services and products have many components and collect a lot of data. There are many different ways to package and even more ways to price. Begin by asking what to price.
You answer this question by asking what creates value for the customer. That is the central question that all pricing needs to begin with.
The answer lies in discovering how to connect the value metric (the unit of consumption by which the user gets value) with the pricing metric (the unit of consumption for which the buyer is charged). The importance of connecting value and pricing underlies the current interest in usage based pricing. In fact, it is not usage we are primarily concerned with, it is the usage that results in value to the customer.
Different users get value in different ways. This is why most pricing projects should begin with a value-based market segmentation. A value-based market segment is a group of users who get value in the same way and who buy in the same way. Pricing architectures (such as tiered pricing or Good Better Best pricing) are built on the foundation of a meaningful segmentation.
Pricing is not once and done
Some people think about pricing every few years, dust off their pricing model, and make a few adjustments. This is how you fail at pricing. Pricing exists in a system of interacting parts. Every pricing action provokes a response, from customers, from competitors, and within the different parts of the pricing system.
So we need to redraw the sketch we started with. Rather than a cascade, pricing choices occur in cycles, with back channels between each of the choices leading to the need to answer questions again and to take new actions.
