Choosing the Wrong Pricing Strategy Can Be a Costly Mistake
Published : June 04, 2003 in Knowledge@Wharton
Prices have been at the center of human interaction ever since traders in ancient Mesopotamia -- our modern-day Iraq -- began keeping records. Who doesn’t love to guess what something costs – or argue about what something ought to cost?
So it should come as no surprise that companies spend a lot of time figuring out how to price their products and services. But two professors in Wharton’s marketing department, Jagmohan S. Raju and Z. John Zhang, say firms do not always go about pricing the right way. Raju and Zhang say devising appropriate pricing strategies is more critical than ever in a world of hyper-competition. Pricing strategies also take on added importance at a time when central bankers and economists are concerned about the possibility of deflation – a broad, general decline in prices.
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According to Raju and Zhang, research suggests that pricing strategies can have a huge influence on company profits. They cite a study of more than 2,400 companies by McKinsey in 1992 showing the impact that various decisions would have on the bottom line: a 1% reduction in fixed costs improves profitability by 2.3%; a 1% increase in volume will result in a 3.3% increase in profit; a 1% reduction in variable costs will prompt a 7.8% rise in profit; but a 1% hike in pricing can boost profitability by 11%. “In recent years, business people have paid attention to many things that can influence their companies’ success,” Zhang says. “They’ve looked at organizational behavior, downsizing, benchmarking and reengineering, and companies have done a lot to cut costs. But they haven’t spent as much time thinking about the best possible pricing strategies. I think the picture painted by McKinsey is still pretty much true today. There’s a lot of room for profit improvement through better pricing strategies.” In the past, Zhang says, many companies “would set a price, stick to it and hope for the best. But that isn’t the best way to set prices. One reason companies took that approach is because pricing is difficult. You have to know what you’re doing and you have to take direct responsibility for your decisions. A lot of managers want to have a say in their companies’ pricing strategies but they don’t want to take the responsibility if things go wrong.” Raju stresses that pricing must be systematic and strategic: A seat-of-the-pants attitude can hurt the bottom line. “One of the misconceptions about pricing is that it’s a decision that can be made after everything else has been done to develop a product,” says Raju. “But, actually, pricing needs to be an integral part of the plan for taking a product to market from the very beginning. It cannot be an ad hoc approach.” Among other things, companies must carefully identify the customers they are targeting and understand how much those customers are willing to pay for a product or service. Firms also must recognize that pricing is a key tool to differentiate a product or service from those of the competition, since prices emit signals about product quality and exclusivity. In addition, it is important to take into account the distributors who will bring the product to market; if they themselves do not make enough profit, sales will suffer. What’s more, firms must realize that a pricing strategy should be long-term in nature, in that it should pave the way to take more products to market in the future.
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