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Price Fixing

With economic recovery on the horizon, it's time to revisit the wisdom of rock-bottom prices.

Call it the year of the fire sale: Squeezed by an historic recession, U.S. companies have slashed prices more deeply and cut deals more often than at any time in the past 50 years. Microsoft reduced the price of software leasing by 26%, PepsiCo created new low-price beverages and snacks, and solar-panel manufacturers braced for a 20% drop in retail prices. Even makers of heart-rhythm devices, like St. Jude Medical, saw prices fall as hospitals demanded discounts on pacemakers and defibrillators.

In their rush to revive demand and win sales, many companies simply threw out the playbook on customer segmentation and product value. “Companies moved away from value-based pricing to being highly reactive to competitors and relying on cost-plus pricing,” says Jamie Rapperport, founder and executive vice president of software firm Vendavo. “Many companies took business as long as it was priced above variable cost, in an effort to help cover their fixed costs.” Often the price cuts went hand-in-hand with head-count reductions and other cost-cutting moves.

But cost-cutting goes only so far. Now, with the economy finally swinging upward and customer demand beginning to thaw, companies should reconsider what they charge for their products. Pricing, after all, is one of the most effective levers of profitability. “There’s nothing you can do as a company as quickly to improve profitability — and nothing you can do as quickly to destroy profitability — as change your pricing,” says Andre Weber, a partner at Simon-Kucher & Partners.

It’s a delicate art, however. “Commercial price discipline is important,” says Robert M. Patterson, CFO of PolyOne, a maker of specialty polymers. “But you can’t simply raise prices every year to improve profitability. You have to innovate, innovate, innovate to expand margins, grow profits, and win new business.”

Signals of Distress

There are five signs that your pricing strategy might be due for an upgrade or overhaul, says Reed Holden, founder of Holden Advisors: (1) unit-sales volume growth slows down, (2) discounts fail to drive incremental volume, (3) competitors introduce new offerings, (4) lower-cost competitors enter the market, and (5) competitors start missing their numbers. (See “The Price Is Wrong” at the end of this article.)

Declining gross margins may count as a sixth sign. One CFO describes a situation at his company in which anemic gross margins posed an issue, and a flawed pricing model was to blame. Not only did salespeople set prices, they would “give” on price to generate business, since they were compensated on the quantity of product sold. In effect, the company was engaging in cost-plus pricing, but its salespeople were shrinking the “plus.” (See “The Many Minuses of Cost-Plus” at the end of this article.) “Any internal savings gained from raw-material cost reductions or plant and labor efficiencies were, by definition, passed along to the customer,” the CFO says.

The company shook things up in 2007. It gave the job of setting prices to marketing, changed the sales incentive to gross-margin improvement (based on each salesperson’s revenue contribution), and trained salespeople to sell product on value. Disruptions like that often entail some pain, be it sales-staff turnover or even a drop in revenue, but pricing discipline does pay off. “We preserved cost savings for ourselves and our shareholders and did not give them away in price,” the CFO says.

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