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Price Fixing

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

Three Choices

A company that wants to overhaul its pricing strategy more substantively will have to address a constellation of factors, including its market, target customer base, product life cycle, and overall strategy.

Analysis completed, however, Holden says the company will essentially have only three pricing strategies to choose from: skim (high price, at least initially), penetration (low price), and neutral (midtier price). Prices are relative to similar competitive offerings. That’s a simplification, but it’s amazing how many firms get it wrong, or fail to adjust when a market changes.

Dell Computer, for example, was the master of penetration pricing in the 1980s and ’90s, Holden says. But when PC sales growth slowed in Europe, Asia, and the United States in the middle of this decade, Dell lost revenue and profits. “When markets are mature, price becomes inelastic,” says Holden; lowering the price will not create more demand, and it will often eliminate profits.

The same kind of strategic mistake is being made in wireless telecommunications services. Wireless carriers are focused on net customer additions and are slashing prices, says Weber of Simon-Kucher. But penetration pricing makes sense only if the product is “sticky” (hard to switch from), such as video-game devices. Because the U.S. mobile market is nearing saturation, there aren’t many good new customers to be had. Indeed, “the industry is [inadvertently] encouraging customers to move back and forth,” Weber says, “because the new customer gets the better deal.”

In some B-to-B markets, penetration pricing can be ineffective because there is little or no price elasticity. “A customer isn’t going to go to the shelf and spontaneously decide between buying 10 widgets or 15 widgets” because of a price difference, says White of Price for Profit.

Strategies that target customers who are less sensitive to price, as some skim strategies do, are often overlooked. While not technically using a skim strategy, Starbucks lowered prices last summer on products like iced coffees, where it now competes with McDonald’s, but raised prices on other drinks like Frappuccinos and caramel macchiatos, points out Rafi Mohammed, a pricing strategist who is author of the forthcoming book The 1% Windfall. High-margin pricing makes sense for mature products that have loyal customers and few competitors, notes Holden.

Margins and Errors

For any of these strategies to succeed, a company must be conscious of the value that its product delivers. At NetSuite, the average selling price of its ERP system for new customers continued to rise during the recession, in part because the system’s growing robustness began to attract larger firms. NetSuite’s low total cost of ownership is a value advantage, so McGeever doesn’t have to offer drastic price cuts to win new business. Indeed, “when we sell to large companies, we often have to be careful our prices aren’t so low that we aren’t taken seriously,” he says.

How do you measure the success of strategic pricing initiatives? As it turns out, profit margin is not necessarily the best metric, argues Mohammed. Cost cuts and efficiencies can boost margin and yet have nothing to do with price. Mohammed says the measurement should be total profits and growth. Is the company making more money than it did before the changes? Is it serving more customers?

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