Information is Power, But Only if it is Used.
A Newsletter from Custom Decision Support Inc. & Lieb Associates Vol. 4 No. 1, Spring 1999
Pricing has become increasingly a survival decision for the firm. It is tactical, operational and strategic. This issue focuses on the pricing decision from three perspectives: nature of the business, measuring the price sensitivity and building and using market price simulators. Much of this work has been motivated by our clients' concerns and ongoing problems.
Product and Solutions Businesses
We have found it critical to distinguish between businesses that delivers products from those that are viewed by their customers as solving problems. From a sales perspective, we assume that we sell products. Though the products may consist of services as well as tangible things, we usually think of them as "products" or "offerings." However, our customers may be buying solutions rather than products. This is a critically different perspective that effects the sales value and, to a great extent, may determine the nature of successful businesses. We have found it important to distinguish between these types of businesses both for resource allocation and in pricing.
Successful industrial solutions businesses provide custom solutions to their clients problems. However, they may get paid based on the delivery of products they sell or for services. The customer value is in solving their problems. These businesses are very different from traditional product oriented enterprises in that each sale is unique and requires a significant effort in support and often in redesigned products.
Unfortunately, many industrial businesses consist of both traditional product segments and solution businesses. This results in difficulty in setting pricing policies. Traditional product businesses (either service, specialty or commodity) enjoy significant economies of scale. The more sold, the cheaper it is to produce. This is not the case, in solution businesses where sales and service expenses are significant. While experience does eventually reduce some costs in solution businesses, in no way are the resulting economies comparable to those enjoyed by product businesses.
The key pricing issue is that the value to the customer and user in these businesses exceeds the value of the physical product or service. The value is derived from the unique solution to the problem. The more unique and the more that that solution gives competitive advantage to the customer the more valuable it is.
Under these circumstances we have found that it is critical to:
1. Determine the elements of customer value frequently;
2. Segment markets based on value and customer benefits;
3. Determine who are the real competitors by segment; and
4. Price on a value basis in the appropriate segments.
The Strategic Edge: Competitive Pricing
Markets always appear to be increasingly competitive. Sales personnel are reluctant to increase price and manufacturing wants to increase sales even at the expense of earnings.
The "Best" Price
But what should be the best price. It exists between the two extremes of marginal cost and the ultimate value of the product. But the competitive environment makes the pricing decision complicated. Competitive prices influence the customer decisions. Furthermore, our pricing may influence the competitive prices and that may in turn influence the customer. A way of looking at the problem is in terms of what Irv Gross (formerly Executive Director of the Institute for the Study of Business Markets at Pennsylvania State University) referred to as the "Value Salami."
The best price depends on the assumptions of how the market is going to behave. Along the "Value Salami" we have listed five "best prices."
1. "Optimum" price gives the maximum earnings given that no competitor reacts or changes its prices.
2. "Satisficing" price is a price that produce acceptable earnings while being a small enough change from current not to induce a large competitive reaction..
3. "Competitive" price is the equivalent price of the best competitive products.
4. "Equilibrium" price is the price that would result in an "expected equilibrium" market share distribution.
5. "Minimum Regret Range" is the range of price that should produce acceptable earnings against an extreme range of competitive reaction.
Determining the best price strategy is, of course, a risk taking art. These estimates of "best" price are tools to help explore the ramifications of pricing decisions. Market price models are used to test the impact of price decisions.
Measuring Competitive Price Sensitivity
Making these price estimates require a quantitative understanding of how the market should react to a range of competitive prices. The marketing research technique of "Choice Modeling" is the preferred tool to obtain customers' reaction of competitive pricing. The procedure involves having potential customers respond to a set of hypothetical pricing scenarios. Depending on the market situation, three to eight products are given in each scenario and up to sixteen scenarios are used.
There are a number of variations in the procedures to reflect differences in products and offerings. Designing these scenarios is not straight forward and requires "statistical experimental design" procedures in their development. We have used this technique over a broad range of industrial markets successfully and have developed a high comfort level that the results are meaningful.
Techno -Tips Building Market Price Modeling Decision Support Systems
The Techno-Tip column consists of suggestions and comments for data analysis. It is intended to help analysts and managers directly involved in the analysis of business data.
The purpose of market models and simulators are to forecast the impact of changes in strategy including pricing, new products and position. Market pricing models have been particularly effective when based on marketing research data.
We have used Microsoft EXCEL to construct user friendly decision support systems that incorporate market models and simulators. Market models consist of mathematical expressions that directly describe market behavior. Simulators, on the other hand, combine separate individual customer decision models to represent the market. Market models tend to produce much more efficient decision support systems. However, with modern personal computers even large scale market simulators are sufficiently fast.
Building Market Models
Pricing models and simulators are based on estimates of the market demand that reflects the competitive price sensitivity of the market. Typically marketing research data (either from Choice Analysis or Concept Price Testing) are used to develop price sensitivity expressions. Two types of demand expressions are typically used, (1) linear or classic demand and (2) stochastic or "S-Shaped" demand.
The decision support system shown below computes share based on both types of demand. The linear models have the unfortunate characteristics of being able to predict both negative shares and shares exceeding 100%. As such, we tend to use the "S-Shaped" demand functions for forecasting.
These pricing decision support systems allow for a number of "best" price estimates, discussed above, that are intended to assist the strategy formulation process. The "optimum price" represents the price that yields the maximum contribution earnings. The contribution earnings are taken as the share times the difference between the price and the marginal costs. Marginal costs are assumed to be constant in most situations.
We have found that decision support systems are more compelling when dynamic graphic displays are incorporated. EXCEL allows for the dynamic graphing of data. In this example, earnings and share are displayed. Changes in competitive prices will change the curves. This is constructed using the Data Table capability in EXCEL along with the charting capabilities.
Commentary - Industrial Auto-Immune Disease
Many firms suffer from "industrial auto-immune disease." While in a mild case it is survivable over the long haul it is likely to be fatal. The malady that I am referring to is the impact of cost control on business development. Cost control is critical for the survival of any enterprise. It is, in fact, the immune system of the firm. The single most dangerous agent against a firm is run away costs. All successful managers must, in long run maintain cost control.
The "turn-around-experts" and "clean-up artists" such as "Chain-saw" Al Dunlap, have mastered the tools of railing-in costs. For the otherwise dying firm, this is not only praiseworthy but a necessity. It is critical in these situations to stop the "hemorrhage."
The problem arises with internal growth. Growth requires investment and risk-taking. Tightly imposed cost control environments are inherently inconsistent with this objective. When people are punished for spending an extra few hundred dollars, few will ask for millions no matter how good and supportable the idea.
I have found that few executives can manage tight cost control, economic "clean-up," and new internal business development. Executives who focus on cost control tend to look for growth in acquisitions rather than internal development. Unfortunately, this type of industrial auto-immune disease has become endemic in American industry during the 1980's and 1990's.
For otherwise healthy businesses, cost control must continue but should not be handled directly by senior management. It can be handled by audits, policy, targeted programs, and corporate culture. However, it is critical for internal development that the reporting line should encourage risk-taking and therefore, appropriate spending. It is critical that the development personnel, managers, analysts and technologists feel free to request funds with a reasonable likelihood of approval.
We have recently upgraded our computer systems. The voice recognition systems reviewed in the last newsletter (IBM Via Voice) worked better with the much high capability system. However, we still found it not acceptable for general use.
There are several e-mail chat lists on business analysis and marketing. Recently we have joined a number of them on industrial marketing. The topics are interesting but they tend to result in some heavy e-mail traffic and unsolicited advertising. I will try to review some of the most interesting of these topics in future newsletters.
We have been debating whether we should make the newsletter an annual versus a biannual publication. I appreciate any comments and contributions from you. You can get in touch with me at Custom Decision Support, Inc., Phone (610) 793-3520. Fax (610) 793-2531 or E-Mail at email@example.com
Gene Lieb (Editor and President)