Thursday, January 15, 2009

Surviving Tough Times – Master the art of Pricing

Today, Jan 14th 2009, Nortel Networks filed for chapter-11 bankruptcy protection, Google announced a small lay-off, and the bad news on the economic front continues. This recession is nothing different than the past ones, surviving tough times takes lot more business prudence and guts.

Companies that survive such tough times are the ones that are still relevant to their customers and are the ones that still provide value to customers. Where “Value” is defined by the goods/service provided for a fee – which the customer considers as value. To be more precise, the price of the sale – determines value.

Companies typically tend to make two major mistakes when it comes to pricing:

  1. Over-pricing the product.
  2. Under-pricing the product

In both cases, the results can be devastating – if the mistakes are continued for a long period of time.

In this article, let us examine the case of two technology titans that are suffering today due to pricing mistakes.

Case of Over-pricing
Companies such as Nortel Networks stumbled in 2001 – when the tech bubble burst, and since then they still haven’t got their pricing strategy right. Customers feel that Nortel’s prices are too expensive and are shopping for alternatives from Huawei, Cisco, & other vendors.

Nortel Networks sold networking & telecom equipment for a long time, and over the period, it developed several proprietary technologies which enabled it to sell at a premium price, but as IP networks became pervasive, the technology advantage of Nortel stated to erode. But Nortel had built an expensive base and the company refused to embrace IP technology wholeheartedly. As a result, the cost structure at Nortel was high – which in turn forced Nortel to sell at a higher price – and that ultimately eroded the customer value.

Case of Under-Pricing
SUN Microsystems is another struggling company today – which is expected to file for chapter-11 bankruptcy protection soon. The company suffers from twin pricing problems: Over pricing on their server products and under pricing on their software offerings. Sun mainstay is their proprietary servers based on its UltraSPARC® processors and Solaris® Operating systems. Initially when these servers were introduced 20 years ago, they had a huge performance lead over the competition and customers loved its products. During the heights of the bubble, SUN servers were so pervasive that SUN called itself as the DOT “.” in the “DOT.Com”. With the advent of Linux & powerful Intel processors, the technological advantage enjoyed by SUN began to disappear and soon customers came to realize that they can replace the expensive SUB servers with cheap Lunix-Intel based machines. Thus SUN started to lose its value proposition.

If losing the server value proposition was bad, SUN committed blunders by creating JAVA – a free to use software. JAVA was created by SUN, but it could run on any hardware platforms including Intel server platform and was free. Customers loved the “free” concept and started developing JAVA based applications for Intel platforms – which resulted in zero revenues for SUN. Adding more to this blunder SUN opened its Solaris OS to Intel platforms – for “Free”. This allowed small time vendors to create powerful servers based on Intel/AMD processors and with Solaris OS. All this meant that SUN will not make any money from this. Lastly to rub salt on its self-inflected wounds. SUN decided to buy MySQL for ~$1 billion, thus throwing valuable cash in exchange for a non-revenue generating product.

On the software side of its business, SUN was leaving lots of money on the table. On one hand SUN was spending money to develop & maintain this software and was getting very little in return. Thus under pricing its offerings to a point where it was suicidal.

Art of Pricing

Every businessman – including the roadside food vendor knows about pricing his wares, but few really master the art of pricing. Pricing is very complex because value is very subjective and is solely determined by the customer. As a result most business are guilt of either over pricing or under pricing ( mostly under pricing & leaving money on the table).

In a large complex business, pricing is often so opaque that hardly anyone in the organization can really justify the price. So people resort to cost plus margin based pricing, which is easy to understand – but has almost no bearing on the value delivered to the customer.

Leaving Money on the Table

Probably the biggest mistake one does when it comes to pricing is leaving money on the table – i.e., providing freebies to the customer. The next common mistake is to under price or offer unnecessary discounts by wrongly packaging & thus under pricing the offering.

I do not claim myself to be a master of pricing, but I do know the basics of price theory. I can also confess to the mistakes of leaving money on the table.

The most common reason why companies leave money on the table is “Customer service” or perceived customer value by offering free services. This mistake often happens with large customers. Companies are so enamored with such large customers, that they are willing to offer several freebies in the hope of keeping the customer happy. This practice in turn makes the customer even more demanding and that can soon turn into a death spiral if things are not brought under control.

Surprisingly, there is a very easy way to control this problem – Say “Yes – we can offer that (service/product additions) for a fee”. Customers tend to push the supplier as much as possible and they will push till the point the vendor says he will have to charge for it.

Under pricing

Under pricing occurs when the vendor is willing to sell a product/service at a price point below what the customer is willing to pay. For example, the customer is willing to pay $100 for a product, but the vendor has marked the price as $75. In such cases, the customer appreciates the discount provided and quickly grabs the product. Such pricing errors are quite common in everyday business – especially when it comes to intangible services.

Couple of years ago, I happened to meet an entrepreneur – Shankar Subramaniam who runs a consulting/training firm called NineDots. Within the first few meetings, I became clear to me that Shankar was under pricing his services. We then looked at the service offering and repackaged/re-branded it as results driven consulting services. This simple exercise helped him raise the fees by almost 3x!

How to catch pricing errors?

Pricing errors happen in almost all businesses and is often difficult to catch small errors. But big mistakes such as Over pricing or heavy discounting is easy to catch - via accounting data.

If a product/service is over priced, then the demand for the product/service drops at a rate disproportional to the industry standards, thus indicating over pricing error. Folks at Nortel know that the demand for their products is falling or their market share is falling. Customers were opting for Huawei or Cisco equipment. Even the investors knew it and punished the stock price, yet the management could do little.

In small businesses, entrepreneurs know by instinct that when demand drops disproportionately, they need to lower the prices. But in very large businesses – things are not that easy – but that does not mean that it can’t be done.

In case of under pricing error, the demand raises rapidly and to a point that it can overwhelm the company. But entrepreneurs know that when demand increases beyond a point, they have to raise prices. The easiest way to catch such pricing errors is to do a basic Du-Pont analysis for your business line & compare it with that of the nearest competitor. Simply stated if your ROI (return on Investment) is lower than that of the competition, then there is a pricing error. Du-Pont analysis helps in determining if the errors exist, but it does not tell much on correcting it, so it is a good starting point.

Multi-Part pricing & Dynamic Pricing

Thanks to world of computers, today companies can run sophisticated pricing models which allows dynamic pricing. Sabre Systems developed by American Airlines allows AA to reprice tickets every 6 minutes based on the demand & capacity. Similarly there is complex software for pricing for retail clothing, commodities etc. This system of dynamic pricing allows little pricing errors.

Multi-Part pricing is another way to reduce pricing errors. Multi-part pricing allows for pricing at different levels: One price for product acquisition, another price for maintenance and another price for service etc. Gillette is a very good example of multi-part pricing. Gillette sells razors at a discount and makes money on the blades. Similarly HP sells printers at a very low price (sometimes at a loss) and makes money on the cartages. Similarly Oracle, SAP etc have developed multi-part pricing for their products.

Closing thoughts

Pricing is an art. Of the 4 P’s of marketing, Price is the most complex. To get the right price almost requires the 5th P – Prayer. If you are in business, then spend great amount of time on regular basis to determine if you have got the right pricing.

My marketing professor once told me “As a marketer, your best friend must be an accountant” This lesson is not to be forgotten – so if you are involved in making pricing decisions, then befriend the accountant and go through the valuable accounting data to come up with your pricing analysis, and from that analysis develop your selling price.

In tough economic times, it is vital to get the pricing right. Correct pricing and aligning the operation costs with the price becomes the key for success in these tough times. Take this opportunity to revisit your pricing and cost structures so that you can emerge out of this recession stronger and better than your competition.

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