Is the price really right?

“Dear Stan,

Our company is a relative newcomer to our industry, although the founders are the same people who created the industry thirty odd years ago. The founders decided to re-enter the market with a competitive offering based on superior service and advanced design. Over the last six years, progress has been difficult, but steady. In today’s economy, customers are looking for both performance differentiation and price reductions. It’s my view, as a director of this company, that we have an opportunity to take market share because our product out-performs the competition and we can afford to reduce prices to a point that I don’t believe our competition can match. Our executive in charge of sales doesn’t want to lower prices, however. His reasons are anecdotal and not evidenced. He is not paid on a commission structure. He has significant equity in the company, and we have a profit-based incentive plan.

“I am baffled by the sales executive’s insistence on not using the pricing elasticity in our margins to win more business from an entrenched competitor. What’s going on?

Signed,

D. Lemma”

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Dear Mr. Lemma,

Sales professionals are indoctrinated early in their careers to resist price reductions by CEOs who think that sales people will always argue for a price reduction to win business when they don’t have the skills to sell performance and value. It’s true that it is not uncommon for a sales person to complain about having higher pricing structures than the competition, and to rely on pricing more than on the value of the product, when attempting to convince a buyer. When the product has little to offer in terms of differential performance, their complaint may be justified.

If the CEO feels that the sales staff is simply lazy or unskilled, however, she may flatly refuse price concessions as an easy way to grow sales, but without profitability. So if a person has been trained in this resistance, they may not recognize when it is actually a strategic advantage to reduce pricing. So how can one tell that a price drop is strategic and not admission of product weakness in a stable or growing market?

First, let’s agree that competition is built first upon two levers: price and performance. “Performance” means the features, quality, cost-effectiveness, reliability, ease of use, etc., of a product or service. “Price” means the purchase cost, plus maintenance, depreciation, space requirements and other related hard costs. Applying these two levers depends on a couple of things. One is whether or not the company has the ability to create an offering of superior performance. Another is whether the company has the gross margin to “give” in order to create a sustainable business model overall. Other strategic levers include supplier dynamics and the resultant impact on cost of goods sold, the demand rate for the offering, the number of rivals, potential substitutes, etc. Harvard professor Michael Porter describes such factors in his “five forces” analysis of industries and participating companies.

The “five forces” approach to a strategic price reduction begins with identifying where the company is within its industry structure. For example, when a market has been established, like yours was over thirty years ago, and demand begins to grow, the building demand creates an attraction to new entrants into the competition. Your company’s founders not only created the market, they later became new entrants into that same market with a new offering. If your company’s sales rate is not rising faster than the entrenched, dominant supplier of your product type, that means your product’s performance is insufficiently superior to compel customers to incur the “switching” costs (both real and imagined) connected to purchasing your products. Customers would have to incur risk as well, since your company is new and as yet unproven. To make such a switch, your performance offering would have to be considerably better in almost all respects.

Now this is where strategic pricing reduction can assist. New entrants into a market typically compete on both major levers: they provide a superior offering at a significantly attractive price to entice the customer to accept the potential switching costs. Once the new entrant has achieved market penetration rates that demonstrate self-sustaining behavior (that’s another column) then pricing can begin to move up. As long as demand out-paces the price escalation rate.

Pricing is one of the most difficult business decisions any company makes. Current customer relationships may be at risk when a move is made, and ensuring that the pricing decision can be tested for effectiveness in a measured way is critical. Price moves that are precipitous or ill-considered can turn a market against a company for a long time.   So this decision cannot be made through emotion, reflexes, anecdote or “gut feel”. It takes data and logic and careful planning. The resistance you are getting from your sales executive seems to be reflexive and trained. Appeal to his logic and ask for data. You may help him approach the question strategically instead of emotionally.

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