The Hindu Business Line : Pricing can be a `profit-leaking' paradox

Value is in the eyes of the beholder, explains Rafi Mohammed in The Art of Pricing, and suggests various strategies and tools for companies to minimise the error in setting prices. These include empowering employees to make more money for the company, and adopting such approaches as differential pricing, versioning and segment-based pricing. D. Murali interprets the intricacies of pricing.

THE Minister for Communications and IT, Mr Dayanidhi Maran, has spoken of `at least a nine per cent drop in long-distance call tariffs' and intensifying competition in the telecom sector with the removal of further barriers. Lower prices are, naturally, welcome in the consumer camp, though competitive pricing often becomes confusing pricing, be it in airlines or communications.

The reason is simple: pricing is not a clear-cut exercise. It is an unsettling task, "involving a mixture of compromise, fly-by-the-seat-of-the-pants analysis, guessing, marking up costs, following competitors, and doing things as they have always been done," says Rafi Mohammed in The Art of Pricing, from Crown Business (www.crownbusiness.com).

The end result of the number jugglery is `a price that just works'.

You can do better, whether you are a small start-up or an industry major, because every company has hidden profits that can be released by better pricing, Rafi declares, with his experience as an economist at the Federal Communications Commission where he worked on "deregulating local and long-distance telephone rates as well as on public-policy issues that use price subsidies to make telecommunication services affordable to the poor".

Pricing is not about putting a tag with numbers on the product or service but about `creating a set of strategies to maximise your company's profit', says Rafi. He reminds us that for every product, there are at least two people willing to pay different prices. Othello presents such an instance.

"The world's a huge thing, it is a great price for a small vice," says Emilia to Desdemona when the topic is about women abusing their husbands "in such gross kind".

"Marry, I would not do such a thing for a joint-ring, nor for measures of lawn, nor for gowns, petticoats, nor caps, nor any petty exhibition; but for the whole world — why, who would not make her husband a cuckold to make him a monarch?" she opines about the vice-price equation.

An auto story

One of the first examples in the book is of Lloyd Hansen who discovered and implemented "one of the most profitable business strategies in the history of Ford".

He analysed how `an additional 1 per cent or net profit margin' impacted the company's bottom-line, and the results were stunning.

"Culling an additional penny of profit from each revenue dollar would increase Ford's net income by 33 per cent and cash flow by 45 per cent," he found.

To corroborate, the book cites a study of 1,200 large, publicly-traded companies around the world, which shows that "a net price increase of 1 per cent would, on average, result in a 11 per cent increase in operating profits".

Resuming the automobile story, one learns from Rafi about variable profits that accounted for all costs except fixed costs, ranging from less than $800 for Ford Aspire, to more than $12,000 for luxury cars like the Thunderbird. Between 2001 Q4 to end-2004, "per-vehicle revenue has increased by $2,400" in a `profit-challenged' market. "Hansen thinks that there is still more than a billion dollars in additional hidden profits that can be uncovered at Ford in the coming years," reads a snatch from the author's interview.

Pricing can be a `profit-leaking' paradox if there is no `culture of profit' in your company, because "so many people in your organisation touch pricing". Rafi's formula is, `basic information + small changes = large benefits'. So, empower your employees to make you more money, he exhorts.

"Even something as innocuous as a well-intentioned whisper to `come back tomorrow because the products in your hand will be on sale' results in lost profits." Instead, the staff could have used many other ways to `profitably enhance a customer's experience,' advises the book. With profitability information, "your sales force has the ability to steer customers toward higher-margined products".

Three rules and naked price audit

Give employees `guidelines to cut prices', counsels Rafi and provides three rules: one, prices should not drop below incremental cost; two, make the price cut targeted and discrete; and three, ensure that discounted sale does not block purchases from customers who are willing to pay full price.

Goodwill sounds good, but it is `one of the most overrated words in pricing,' cautions the author. "Managers often try to justify questionable price cuts with the belief that discounts will develop goodwill and foster relationships," oblivious to the fact that goodwill doesn't ensure `customer loyalty'.

Watch for leaks happening through your promotions, because there are `resourceful customers' out there trying to make the most of the promos, writes Rafi about possible `loopholes in rebate offers' which may not always go to `the right customers'! Also, don't squander marketing-cost budgets (that is, the total amount that can be discounted off the list prices of all sales) `on selling relatively low-priced products with thin margins'.

What they don't teach professional accountants is to do what Rafi calls `naked price audit'. For each account, subtract all the discounts from the agreed-upon invoice price and arrive at `the naked net price', which may offer a surprise to your managers, and motivate them to be "more restrained in handing out off-invoice discounts".

Do you know that quotas for salespeople can affect profitability? "Thrifty customers — those who are less time-sensitive and more forward-thinking — often eagerly await the predictable end-of-the-quarter fire-sale call from their salesperson. In their sprint to meet quotas, salespeople typically offer terrific deals."

Not market share but profitable volume

Focus on the right metrics of success. "Achieving the largest market share in a competitive market is rarely the most profitable operating point for a company," points out the author. "The drawback of focussing on market share is that, often, prices have to be lowered to attract more customers."

But, beware, the race may leave you with a bigger share but poorer profits. Focus on `profitable volume,' advises Rafi, to resolve the trade-off between customer profitability and market share, and arrive at "the market share point where total profits (volume multiplied by customer profitability) are maximised."

Pricing is all about value, explains Rafi, giving the example of street vendors of umbrellas who hike the price at the first hint of rain. "This increase has nothing to do with cost; instead, it's all about the increased value that customers place on an immediately available haven from rain." To use the moral of the story, you need to understand "how customers value your product and any optional features".

Get out of the fallacy that price has to be based on costs, and stop adding `a fixed mark-up on production costs', because then you mistakenly assume "that customers base their willingness to pay for a product on how much it costs you to produce it". Don't costs have any role at all? They act as `a price floor' so that price covers at least the product's incremental costs. Beyond that, it is the customer who chooses the price based on the value he or she receives from the product.

Your price has to, therefore, capture value. "At a minimum, prices for those products that you "can't keep on the shelf" should go up on Monday morning," he stipulates. An essential caveat is about yielding to fairness, especially `after a natural disaster,' when desperate customers may be willing to pay any price for basic supplies.

Value is in the eyes of the beholder, explains the book, through the auction example, and provides `the Value Decoder' as a tool to minimise the error in setting price. Decoding involves five steps, viz. price and availability of substitutes, characteristics relative to competitors, income, price/strength of demand for related products, and market environment. An insightful quote of Robert Crandall, former chairman and CEO of American Airlines, is that the airline industry is "always at the grip of its dumbest competitors," to explain `the number-one theorem in pricing' — that competitors' price affects how customers value your product.

Three strategies

Three `primary' strategies that Rafi focuses on in the book are differential pricing, versioning and segment-based pricing. "Wouldn't it be great if you had x-ray vision that allowed you to see how much each customer was willing to pay so you could discreetly offer them a price that matched their valuation?" he teases.

To help, he offers clues to develop `a multi-price mindset', and many examples. Such as, how bars can get more eligible men to patronise a bar, even at a higher drink price, when more women are attracted through reduced `ladies' night' drink prices! Not everyone cares about price, as another example on airline reservation reveals; not everyone uses `consolidators' a.k.a. bucket-shops to buy international tickets.

Versioning is a strategy that allows customers to choose from `a range of products and accompanying prices with different margins'.

Thus, restaurants price entrées with low margins to ensure accessibility to more customers; real profits come from "appetisers, side-dishes, drinks, wine and desserts," which are loaded with higher margins. "Many managers fear that if they offer a low-priced, stripped-down model, everyone will just buy the basic product. That's not necessarily true," assures Rafi.

The last, segment-based pricing, which the author considers his favourite, explains the lure of `interval ownership' in the timeshare industry and private-jet use. Companies such as NetJet offer the convenience of a private jet as `fractional interest'. "Interval shares can be sold back to the company at any time for a price that reflects the aircraft's fair market value."

Two pointers to the potential of this approach are Warren Buffett buying NetJet in 1998, and the fact that "sales to fractional jet companies now account for more than 75 per cent of the order backlog of such leading aircraft manufacturers as Cessna, Gulfstream, and Raytheon."

Rafi is positive that his ideas can start working for you on Monday morning. For that, however, you may have devote the weekend to getting at the (he)art of pricing!

Economics@TheHindu.co.in

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Pricing can be a `profit-leaking' paradox