The neglected art of strategic pricing: too often, senior executives don't view pricing as a key responsibility. That leaves the decisions to lower-ranking managers who don't see the bigger picture, with the result that pricing loses potential effectiveness.

Every executive knows that price plays an essential role in determining the economics of a business. Yet many do not see pricing as a key responsibility of senior management. Viewing prices as largely beyond their control, they leave pricing decisions to mid-level technicians who make critical judgments without understanding the bigger picture. As a result, pricing, which should be a sculptor's chisel, more often resembles a workman's hammer.

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When you have multiple products across multiple segments and geographies, the question of what to charge different types of customers is never easy. Typically, senior managers respond to complex pricing challenges in one of three ways: They over-delegate decisions to individuals much lower in the organization; they under-analyze the situation by relying on simple default pricing models; or they employ technology as a "silver bullet" solution, supplanting executive judgment. All three responses can lead to misinformed decisions and, consequently, missed opportunities for sales and profit growth.

There is, however, an approach to building a strategic pricing capability that is grounded in collecting and integrating the right customer, competitor and cost information. This approach has yielded dramatic performance improvements at a number of global companies.

The Over-delegation Problem

Price is the variable that divides the value of a company's products and services between customers and shareholders. Nevertheless, most pricing decisions are made without reference to the company's broad strategic choices--whom to target, with what offer, through which channel, based on what competitive position. One reason for this is that pricing issues rarely make it onto executive committee agendas--rather, they are made three or four levels below a division or business unit leader by a data-crunching technician.

While executives spend a great deal of time discussing the design of products, services or product/service bundles, they do not see price as integral; it's decided later, by less senior people who at best may be given very general direction on the level at which prices should be set; "at a slight premium," for example.

Left with little guidance, the technicians' research often focuses on the appeal of different product attributes rather than on optimizing the trade-off between price and volume. Attributes do drive volume, but how and why are directly related to the product's price. Because everyone recognizes the trade-off is difficult to measure beforehand, most people either dispense with research or use simplistic approaches.

The Under-analysis Problem

Although a lot of analysis relatively low down in organizations precedes pricing decisions, the results are usually based on one of four simple default pricing models:

* competitors' pricing (usually the main factor);

* status quo, plus or minus a little nudge here or there;

* short-term earnings target ("What will it take to hit our numbers?"); and

* cost plus a premium.

There are two serious weaknesses in all of these models: First, the pricing decisions reached can fail to account for the full economic costs; and second, the predictions of the impact of a price change on volume and sales are usually little more than guesses based on past experience.

The cost structure of a product or service is a vital factor when setting a price because the ratio of fixed to variable costs of two products can be quite different. The proportion of the cost that is variable is crucial, since only variable costs will be affected by a volume shift triggered by a price change. The "cost-plus-a-premium" model does take into account costs, of course, but seldom the right ones.

Cost-plus price-setters either use fully loaded costs (fixed and variable) or draw the line between fixed and variable costs in the wrong place. A thorough activity-based analysis is needed to define cost structures accurately.

Having the right customer information is critical: The right price is the one that optimizes customer benefits and company profits. Some customer information goes into pricing decisions, but it is usually derived from attitudinal surveys (such as, "Are you happy with your current price?"). Our experience suggests attitudinal surveys alone are poor predictors of customer behavior; they must be combined with analysis of actual buying behavior to reveal what motivates customers to switch to a competing product or service.

The Silver Bullet Problem

Closely related to the under-analysis problem is the "silver bullet" problem. Increasingly, companies are employing new technologies, such as revenue optimization models, to deal with complicated pricing challenges. Rather than solve the puzzle, though, the new technologies exacerbate them by giving the false impression that pricing can be systematized. With their powerful analytical engines for aligning cost, price, profit and customer needs, they relieve managers of an apparent burden by consuming vast amounts of data. But they can turn out to be Faustian bargains.

The problem is that they are adapted from earlier systems developed for the airline and hotel industries, where fixed costs dominate and high turnover allows elasticities to be easily inferred from a few in-market tests. These technologies can certainly help with tactical, short-term attempts to eke out incremental profit, and they can generate valuable input for strategic decision-making. But they cannot replace management judgment and, therefore, should not be the sole basis for decisions.

A Different Approach to Pricing

To address these common problems, a number of companies have launched initiatives to build a "strategic pricing capability." The most successful initiatives are comprehensive and integrated. They focus on multiple areas of the organization, such as talent, strategic management process, roles and decision rights, information and technology, and mindset and culture.

By taking actions to develop pricing capabilities in each area, the companies equip their managers with new tools and knowledge to make better, faster pricing decisions. As a result, managers become better able to set prices proactively, not reactively; to revise prices quickly based on changing competitor and cost information; and to make pricing decisions more consequential and transparent.

Building an integrated strategic pricing capability requires specific, concrete steps along several organizational dimensions (see chart). The actions vary widely by company and industry, but they should all relate to critical areas for pricing strategy. Under talent, for example, steps may include the rollout of corporate training programs, the publication of resources to broaden and deepen technical pricing expertise and the scheduling of briefings on company strategy.

Under strategic management process, the actions may involve establishment of a working group to make sure pricing decisions are consistent with the company's broader strategic direction. To improve roles and decision rights, pricing managers must be given an elevated role, with responsibility for pricing decisions above the individual product or customer segment level. Information and technology systems must collect and integrate customer, competitor and cost information. And to achieve the right mindset and culture, senior managers must act as role models and encourage new definitions of "success" in pricing (for instance, rewarding experiments based on the insight they generate about behavior, not just the volume).

Taken together, these steps create a virtuous circle of performance resulting in improved financial returns and (ultimately) increased enterprise value. (For a real-world example, see sidebar, "How ABN AMRO Built a Strategic Pricing Capability").

Increasing Importance of Pricing

From banking and retail to technology and telecom, many industries are undergoing fundamental transformations. Companies are focused as never before on increasing value to customers as a way to grow their top line. Yet despite its pivotal role in determining how much value stays with the customer and how much flows through to shareholders, pricing continues to be neglected or underexploited. And given the more complex product linkages emerging (such as wrap and offset accounts in banking, or integrated voice and data offerings in telecom), the need to focus on pricing will become more acute.

The good news is that today's challenges represent tomorrow's opportunities. Companies that commit to developing a sophisticated pricing capability based on better customer, competitor and cost information will have a distinct advantage. While others struggle with complicated pricing challenges, they will have the insights and--more importantly--the organizational conditions necessary to grow revenues and profits faster than existing rivals, as well as the new entrants knocking loudly on the door.

RELATED ARTICLE: How ABN AMRO Built a Strategic Pricing Capability

Executives at ABN AMRO, a leading global bank based in Amsterdam, thought they knew how customers would react to a series to rate and fee changes in its retail savings product line. But instead of increasing value to both the customers and the bank, the results fell well short of expectations.

So, the executives decided to pursue a more comprehensive and integrated approach to pricing. First, they began collecting better data on their customers, competitors and costs, and combined the data to understand customer sensitivity to pricing changes, competitors' likely reactions, the effect their reactions would have on customer sensitivity and how all these changes would impact the bank's bottom line.

Next, they set about creating the organizational conditions needed to make the most of the information. They focused on five areas:

Talent -- A new corporate training program of multi-week workshops was rolled out to all savings product managers. This led to the publication of a "savings pricing practitioners guide," now available to all product managers, to broaden and deepen technical pricing expertise and knowledge of company strategy.

Strategic Management Processes -- A new "pricing management team," consisting of three senior managers, was formed to debate alternative pricing strategies and ensure decisions were consistent with the broader retail bank strategy.

Roles and Decision Rights -- The pricing management team also assumed responsibility over decision rights on pricing, rather than leaving decisions to each product area. In addition, a new "pricing analyst" was appointed to continuously look for opportunities to refine pricing decisions across all savings-product customer segments.

Information and Technology -- The bank decided against buying a proprietary software solution and started instead with a simpler, spreadsheet-based tool. Although lacking sophisticated scenario-based modeling capabilities, the tool included all the critical inputs for decision-making and produced a much clearer picture of the expected impact of pricing moves.

Mindset and Culture -- The bank installed a core group of senior managers with the expertise needed to develop pricing decisions grounded in not only the company's economics, but also competitor and market realities. These managers began acting as role models for other product areas and shared what they had learned to encourage the emergence of standard pricing approaches for all products and new definitions of "success."

Results

After just six months, the new strategic pricing capability began to show significant results. It gave rise to new pricing strategies that were forecast to increase revenue by 0.5 percent, leading to a 10 percent jump in savings product operating profit. These gains were expected to create $100 million in intrinsic value.

Organizationally, behavior started to change as new decision-making standards emerged. Proactive knowledge-sharing between the savings-product area and other retail product areas arose. Scenario analysis began leading to better debates about alternatives for pricing. And, by clarifying the links between pricing and performance, the improved information gave senior management more confidence that time spent on pricing was time well spent.

RELATED ARTICLE

Developing an integrated strategic pricing capability ...

Talent                     ** Technical pricing expertise
                           ** Deep and wide knowledge of company
                              strategy
                           ** Corporate training programs
Strategic                  ** Clear linkage to "strategic" decisions
Management Process            (which customers? what offer? how
                              positioned?)
                           ** Price position relative to competitors
                              becomes a focus of performance management
Roles and Decision Rights  ** Elevated role for pricing managers
                           ** Redefined expectations for senior
                              management
Information                ** Deep understanding of customer attitudes,
and Technology                behaviors and economics
                           ** Timely, dynamic decision support
                              information
Mindset and Culture        ** Senior management role models
                           ** Common language and standards
                           ** New definitions of "success"

... generates new behaviors ...

** Pricing based on strategic intent, not profit targets

** Prices set proactively, not reactively

** Pricing changes agreed upon quickly and based on an evolving fact base

** Pricing decisions are consequential, and transparently so

** Pricing "successes" celebrated as much as new product launches and new customer acquisitions

... which create a virtuous circle of performance

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RELATED ARTICLE: take aways

* Senior executives tend to look past pricing as a point of strategy, often delegating it to lesser-ranking managers who look at it more technically.

* Senior management tends to make several mistakes with pricing: they over-delegate it, under-analyze it or treat a technology application as a "silver bullet."

* Strategic pricing capability should be grounded in collecting and integrating the right customer, competitor and cost information.

* Given the more complex product linkages that has been emerging, the need to focus on pricing will become ever more acute.

J.D. Richards ([e-mail]) is a partner in Marakon Associates' Chicago office. John Reynolds ([e-mail]) is a senior manager in the firm's London office. Matt Hammerstein, a former senior manager with the firm, is Director of Group Strategy for Barclays PLC. This article was adapted from one in the company's Marakon Commentary, Winter 2005.