how to pull it off
By Tom Nagle
How to Pull It Off s supplies of everything from key components to temporary services grow scarcer, an unusually large number of companies are trying to manage excess demand. In the past, there was a simple solution to such problems: raise the price. Today, that suggestion often elicits a look of terror and the sputtered response, "Our customers would never stand for that!"
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This is an ominous admission: that even when demand exceeds supply, managers can no longer manage their pricing. Richard D’Aveni, professor of strategic management at Dartmouth’s Tuck School, labels this phenomenon hypercompetition and argues that it defines new rules that managers should learn to accept. But except in a few recently deregulated industries, no one has convincingly explained this shift of power from suppliers to customers. One reason is clear: Through shortsighted failures to manage pricing strategically, many suppliers have given customers the power to set prices. TOM NAGLE is chairman of Marlborough, Mass.-based Strategic Pricing Group Inc. and co-author of The Strategy and Tactics of Pricing:AGuide to Profitable Decision Making (Prentice Hall).
Raising prices, that is, when others have given their customers the power to set prices. The problem arises from negotiated pricing, a trend that began in the 1980s. In an environment of less inflation, and then recession, old pricing strategies were no longer working. Fixing those out-of-date strategies would have required a better understanding of customers and competitors than most companies had. Consequently, top managers at many companies, particularly those in business-to-business markets, opted to "empower" the sales force to make pricing decisions. They replaced fixed-price policies and strict conditions for discounting with nonpolicies that made any price negotiable so long as the sale met some minimum profit criteria. By doing so, managers thought their companies could respond more quickly to market conditions while limiting discounting
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only to situations where competitive pressure and customer resistance made it necessary. They were wrong. While freely negotiated pricing makes sense in markets with few repeat customers, it’s counterproductive in markets where customers can learn from experience. Before long, customers notice that discounts are larger and more forthcoming to buyers who appear less satisfied and are considering competitive offers. The smart customers adapt to take advantage of this situation. They begin courting competitors, offering them a piece of the business to gain negotiating leverage against their preferred supplier. Ultimately, previously loyal customers who had helped the seller to understand their needs become difficult customers who appear to require everlarger concessions to retain their business. In short, when companies replace price policies with price negotiation, they create economic incentives for "good customers" to become "bad customers" who never willingly acknowledge value and act as if all suppliers are interchangeable. To regain the power to price, managers must rebuild pricing strategies that correct these perverse incentives. They must relearn how to price based on objective value, how to demand that customers acknowledge value when they purchase, and how to reward loyalty rather than power. These are the elements of a value-based pricing strategy.
Stand Up for What You’re Worth Anchoring pricing to value requires an investment on the seller's part—an investment that shortsighted managers are often reluctant to make. In the long view, however, this investment actually saves time and money. Price negotiation takes time and usually involves people at multiple levels in the seller's organization. Moreover, price negotiation undermines prices. Pricing by policy, on the other hand, enables management to make decisions once that cover multiple customers, and management's commitment to maintaining those prices eliminates the incentive for customers to prolong the sales process in order to extract a better deal. In some cases, policies also smooth out the distribution peaks and valleys caused by customers waiting for the most opportune times to cut deals. One of our clients sells a unique but relatively simple product used in high-tech manufacturing, which adds value for its users by reducing the probability that equipment will be damaged in shipment. Last year, an existing customer demanded greater volume discounts after increasing its order substantially. In response, the company 54
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focused on how much discount the customer expected and what cost savings the company achieved from serving the customer at larger volumes. The question the company should have asked was: How much value does the product create for the customer? Answering that question precisely would have been a monumental task, but estimating it roughly wasn't difficult. The product saved time for the customer's service technicians, it saved the cost of reshipping damaged parts, and it preserved the customer's reputation for quality. Now, the relevant question: Was the value of the product to the customer less when it was purchased in larger volumes? No, the company concluded, it was greater—since when the customer was shipping larger volumes, its service technicians were already stretched thin and parts supplies were already short. The purchasing agent who had demanded the volume discount was not happy with the seller's response that there wouldn't be one. The sales rep was not happy delivering the message, since he feared for the "relationship." The purchasing agent angrily questioned elements of the seller's analysis of the product's value but did not have the data to refute it. Unhappiness notwithstanding, the customer, as expected, went ahead and ordered increased volumes—with no further discount. We have had the same experience with clients in other industries whom we have advised not to negotiate away the value of patented pharmaceuticals to buying groups, or the value of prime advertising space to large advertisers, or the value of first-time sales, in return for the promise of future business. The key to knowing how much you can demand and selling it to the customer is understanding the value that you offer before the negotiation begins. It's equally important to convince the customer that your pricing policy is not only tough but fair. Two factors are involved in doing that: First, a premium price is justified only to the extent that you can demonstrate added value relative to the competition. Second, charging a price premium for premium value is fair only if everyone has to pay it. A purchasing agent's worst nightmare is to learn that a competitor got a lower price by squeezing your salespeople a little harder.
Laying Down the Law Once you have lost the ability to communicate with users, communicating value isn't easy. Purchasing agents frequently have nothing to gain, and everything to lose, by openly acknowledging that your superior
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quality, service, or availability might be worth something. Consequently, value-based pricing requires getting their attention. There are a few ways to do that. The first is simply to let customers know that you know what your product is worth to them, as was the case in the example above. A second option is unbundling: taking away the feature or service that distinguishes you from the competition, but that the customer claims not to value. Customers who are actually willing to accept less may in fact deserve a lower price, while those who are unwilling to forgo a feature or service are forced to acknowledge its value. One high-service company selling to the paper industry exercised this option. This company’s chemical additive vastly improved a plant’s productivity, but the company’s customers needed training and technical support to achieve that benefit. The most technically sophisticated customers resented paying indefinitely for the high levels of service built into the price. Once they learned how to optimize their processes, they began buying from cheaper, low-service competitors. Less sophisticated customers qualified for ongoing training and support by buying part of their needs from the company, but gave the balance of their business to the company’s lower-priced competitors. By unbundling and pricing service separately, except when the customer signed an exclusive supply contract, the company made its product more pricecompetitive for some customers, while demanding that others acknowledge and pay for the high service they require. Third, and most important, a company must develop a reputation for being willing to walk away from a bad deal. To do so, its sales force must first understand that a bad deal is any deal that the company would not want to offer to every customer willing to meet the same criteria. While walking away usually undermines sales and market share in the short run, it often has no adverse effect on profits. In one recent case, a pharmaceuticals company with a widely used and highly valued treatment refused to grant an additional discount to a large healthcare system. Consequently, the company’s drug was removed from the approved formulary, and sales to that customer fell by over 30 percent. In the absence of a contract, however, the company was no longer obligated to extend any discount. As a result, contribution earned on the remaining 70 percent exceeded what the company would have earned by retaining all sales at the lower price. Moreover, by not making a special concession, the company maintained the integrity of its pricing. In another case, a supplier that had grown tired of General Motors’ heavy-handed price
negotiations simply stopped telling GM about its new, innovative products. GM’s competitors were happy to pay more for products that they were told would give them a competitive advantage. In the end, GM proved less arrogant when negotiating for something it needed to catch up to the competition.
Manage the Menu Eliminating price negotiation does not mean that all customers must pay the same price. In most markets, a one-price policy would not reflect differences in value received. To create adequate flexibility without negotiation, value-based pricing usually requires a pricing menu. Customers then qualify for different prices based on their ability and willingness to meet objective criteria for discounts. Some of those criteria may be under the customer’s control, such as order sizes, commitment, and service requirements. All criteria, however, must be justifiable to any customer who questions why his price exceeds that of someone else. Among our clients are newspapers that sell advertising space. Unfortunately, over the past decade or so, the largest advertisers have cleverly extracted large discounts, which have taken their rates to less than half those offered to other advertisers. The key to reversing this inequity has frequently been to change the pricing menu. Rather than simply pricing by number of column inches, these papers have learned to adjust their prices to reflect the benefits that that particular advertiser will reap
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from buying the space. Some considerations include the ad’s location in the paper, to reflect readers exposed to the ad; the geographic location of the advertiser, since newspapers often discount for ads coming from broader regions where the advertiser has a number of competitive alternatives; and potential sales gains for the advertiser, since an advertiser with higher capacity (e.g., number of seats to fill, number of retail outlets) stands to gain more from the ad than a smaller advertiser. Similarly, we have sometimes recommended to service providers that they price based on the results actually produced rather than on the service supplied, and to components suppliers that they accept as compensation a share of their customers’ contribution earned. These metrics eliminate the need for the customer to negotiate a price low enough to compensate for the risk in the seller’s performance, since the seller shares that risk fully. More importantly, they enable the seller to earn more from customers who gain more, without the need to negotiate a premium. If these actions improve profitability—and they do—why aren't they more widely used? The answer given by many managers is that their sales force cannot or will not implement a fixed-price, value-based strategy. In truth, salespeople will resist such a strategy if management's support is limited to explaining the principles and admonishing the sales force to apply them. The primary problem is that most sales incentive schemes reward people for making larger and more frequent sales, not for making more profitable sales.
Consequently, the easiest way to make the goal is to "cut a deal" for a large buyer, although that sale often generates little contribution. Only when the rewards closely mirror the profit contribution of sales, rather than the gross revenue, is the sales rep's selfinterest aligned with the company's. Once sales incentives are aligned, salespeople will begin clamoring for the other things they need to succeed. Successful valuebased pricing and sales require an up-front investment to understand the value delivered to customers. It is unreasonable to expect each individual sales rep to make that investment; the effort should be centralized and the cost shared. The results then need to be transformed into value-based sales tools that reflect the economics of the purchase decision. Salespeople have the right to expect productspecific sales training that focuses not only on the principles of value-based selling but also on how to apply segment-specific tools to measure and demonstrate value to customers. What these examples illustrate is that pricing need not be out of your control unless you are truly selling a commodity product. Capturing the rewards justified by superior products, service, and availability is not automatic. It requires active management of a process for comprehending, communicating, and capturing value. Unfortunately, that has become a declining art as companies react to, rather than manage, their customers' willingness to pay for value.
By Tom Nagle
Evening the Odds In Price Negotiation How to circumvent the devious schemes of purchasing agents. rice negotiation is usually a David-vs.Goliath confrontation. David, the sales rep, has much less influence over what his company sells than the purchasing agent has over what his company buys. Purchasing agents are better informed, since it is legal for them to compare prices and terms with other buyers, while it is illegal for sellers to do so. Finally, salespeople are usually paid for making sales, while purchasing agents are paid for saving money. Not surprisingly, Goliath,
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the purchasing agent, usually wins, in part because David, the sales rep, is often so disheartened that he expects to lose. While the ideal solution to this problem is to replace price negotiation with a nonnegotiable price menu, that's not always feasible. Only a quality leader can lead a market to such a policy, and only companies that could survive calling a large buyer's bluff can afford the cost of the transition. Even then, the transition from negotiated to fixed prices usually takes some time. In the meantime, it's
essential that salespeople be able to recognize and parry purchasers’ deceptive tactics. The following are some of the most common mistakes to avoid in price negotiation: Discounting the price increase. We see many clients whose pricing strategies have suffered for years from the effects of poorly negotiated price increases. The seller in this case establishes an across-the-board price increase—say 6 percent—that is then presented to buyers. Those without power are forced to take it or leave it. Larger buyers, however, often make the case that since they deserve a volume discount, they should not have to bear the full increase. Consequently, they negotiate an increase of, say, 4 percent. The seller feels happy that at least some of the increase "stuck." In fact, the seller got taken in by a bogus argument, and the cost of the mistake compounds as years go by. The large buyer who gets a 6 percent increase is already getting a discount on the increase relative to smaller buyers. For example, if the large buyer is currently paying $80 while everyone else is paying $100, a 6 percent increase for the large buyer is only $4.80 vs. $6 for everyone else. By demanding a discount on the increase, a purchasing agent is demanding that the seller pay twice for the same volume. When buyers use this tactic repeatedly, their discounts quickly compound. One client saw its prices for volume buyers drop from over 70 percent to less than 50 percent of list price in only seven years. To compensate for this loss, the company began asking for higher increases to create room for erosion with large buyers. As a result, it lost progressively more of its medium and small customers, making it ever more reliant on and vulnerable to intimidation from its largest buyers. When large buyers must have a concession, give it without undermining the integrity of the price increase. For example, rather than discounting the price increase, get a contract that delays its implementation for four months. The effective rate increase for the current year is discounted, but you begin the new year with the higher rate established and avoid compounding the discount into future years. Discounting in return for "incremental volume." Sometimes buyers will offer a seller incremental volume in return for a price concession. This is in principle not a bad idea, even under a fixed-price policy. In practice, however, sellers often get taken. Here's how. First, a buyer who offers to purchase 10 percent more volume in return for a 2 percent price discount is actually getting a 22 percent price cut on the incremental volume! Here's
how that works: Assume that the buyer is spending $1,000. He offers to purchase 10 percent more volume, which means he would be buying $100 worth of additional product at the pre-discounted price. If the buyer receives a 2 percent discount on that $1,100 worth of product, he gets $22 off, which is 22 percent off of the $100 of incremental volume. If sellers actually calculated that incremental discount, many would never be willing to make such a large concession. Actually, the cost of the concession is usually far more than what the seller gives up in that year, since most sellers fail to segregate the extra discount from the base price, perhaps in the form of a year-end rebate. Consequently, the 2 percent price concession becomes incorporated into the basis for all future negotiations. If you're going to give a discount for incremental business, focus the entire amount of the concession on the increment, or give it as a rebate. This has the added advantage of protecting you from duplicitons buyers who promise more business to get the discount, but never order the incremental volume. With the discount focused entirely on the increment, they don't get the savings until they deliver the volume, and the lower price doesn't get incorporated into the buyers' expected price level. Segregating the service value. Companies that focus on volume rather than value in their price negotiations often get suckered into pricing only the commodity aspects of their product and giving away the valuable aspects. For example, we have seen many clients give their largest customers priority in scheduling and delivery. A sharp negotiator never gives away something that is scarce and valuable. A client in the transportation business found itself losing its high-margin customers because of its inability to guarantee delivery, while its lower-margin, but higher-volume, customers got priority. After this company put a price on expedited service, the high-volume customers that truly needed priority were forced to compete by paying a service premium. Those who refused to pay the premium opened up opportunities for this company to win back more servicesensitive customers. As a result, the company increased both its total revenue and its revenue per shipment. Contracts with one-sided obligations. Some of the most costly mistakes are made by companies that sell products with highly seasonal demand and limited capacity to serve that demand at peaks. Smart buyers negotiate, and naive sellers accept, contracts based on annual purchase volumes. With no constraint on when they must purchase, smart buyers
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With no constraint on when they must purchase, smart buyers usually find that they can get better deals elsewhere for off-peak purchases.
usually find that they can get better deals elsewhere for off-peak purchases, at a time when everyone has capacity and is eager for incremental volume. Then, when supplies are tight during the peak season, they purchase all their contract obligation. Why is this so bad? Because, when supplies are short, it’s often possible to sell at higher-than-contract prices. Suppliers under contract, however, must serve their contract customers first. The contract becomes nothing more than a one-sided constraint on the seller not to raise prices when the market value of the product is greatest. Not surprisingly, in these cases, the high-service suppliers, with whom everyone signs contracts at slight "premium" prices, often end up using their capacity less effectively and therefore remain less profitable than many of their lowerservice rivals who take whatever prices they can get. When we find a client with this problem, we help them design a peak/off-peak pricing strategy. Fixed-price contracts, which some sellers prefer, contain contingencies that limit the peak-period quantities that buyers can purchase at the contract price to some multiple of what they purchase during off-peak months. They also get priority for additional amounts, but only at the higher spot prices that noncontract buyers must pay. Fixing the price/performance ratio. The idea that price should be proportionate to performance is so commonly accepted that challenging it usually requires extensive buyer education. Still, it should be challenged, since
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the rewards are large and the logic behind it flawed. The problem lies in allowing your product or service to be positioned strictly on relative performance, rather than on relative value. If offered the choice between two cancer treatments, one of which was 40 percent more effective than the other, would you refuse to pay more than a 40 percent premium for the superior drug? Unless taking 40 percent more of the cheaper drug could produce the same result, a price much greater than the proportional performance difference is obviously justified by the value of the lives saved and the related healthcare costs avoided. Now, consider some less dramatic examples. If you could buy advertising that reached all of your potential customers in an area, would you pay no more than twice as much for it than for advertising that reached only half of your potential market? That’s exactly what many large advertisers argue, claiming that they should pay no higher "cost per thousand" for a large publication than for a small one. Similarly, some technology buyers argue that a chip or a switch that operates twice as fast should cost no more than twice as much. In both cases, however, negotiators are focusing on performance rather than on value. We helped a large newspaper overcome this problem by showing management how to estimate the impact of advertising and to quantify that impact for buyers. By calculating how much gross margin various advertisers would forgo if unable to reach a segment of their potential customer base, we demonstrated that the value to them of the incremental "reach" from ads in the newspaper was many times the incremental rate. Moreover, we calculated what it would cost advertisers to reach the same number of potential customers by using alternative ad media. Taking into account the duplication that would occur and the need to prepare and coordinate different campaigns, the cost was still many times more. Similarly, by quantifying the value of greater reliability in terms of avoided warranty costs and added value to the end customer, a high-tech company convinced its buyers that a disproportionate premium was justified. In each of these cases, the seller’s disadvantage in price negotiation may be a devious purchasing agent—or simply a buyer who understands no better than the seller the true value of the product being purchased. In either case, when you understand your product's value and communicate that value to buyers, you create buyers who know the value of what you are offering them and who know that you know. The net result is a lot more leverage in price negotiation and, as a result, a lot more profitability.
How to Pull It Off s supplies of everything from key components to temporary services grow scarcer, an unusually large number of companies are trying to manage excess demand. In the past, there was a simple solution to such problems: raise the price. Today, that suggestion often elicits a look of terror and the sputtered response, "Our customers would never stand for that!"
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This is an ominous admission: that even when demand exceeds supply, managers can no longer manage their pricing. Richard D’Aveni, professor of strategic management at Dartmouth’s Tuck School, labels this phenomenon hypercompetition and argues that it defines new rules that managers should learn to accept. But except in a few recently deregulated industries, no one has convincingly explained this shift of power from suppliers to customers. One reason is clear: Through shortsighted failures to manage pricing strategically, many suppliers have given customers the power to set prices. TOM NAGLE is chairman of Marlborough, Mass.-based Strategic Pricing Group Inc. and co-author of The Strategy and Tactics of Pricing:AGuide to Profitable Decision Making (Prentice Hall).
Raising prices, that is, when others have given their customers the power to set prices. The problem arises from negotiated pricing, a trend that began in the 1980s. In an environment of less inflation, and then recession, old pricing strategies were no longer working. Fixing those out-of-date strategies would have required a better understanding of customers and competitors than most companies had. Consequently, top managers at many companies, particularly those in business-to-business markets, opted to "empower" the sales force to make pricing decisions. They replaced fixed-price policies and strict conditions for discounting with nonpolicies that made any price negotiable so long as the sale met some minimum profit criteria. By doing so, managers thought their companies could respond more quickly to market conditions while limiting discounting
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only to situations where competitive pressure and customer resistance made it necessary. They were wrong. While freely negotiated pricing makes sense in markets with few repeat customers, it’s counterproductive in markets where customers can learn from experience. Before long, customers notice that discounts are larger and more forthcoming to buyers who appear less satisfied and are considering competitive offers. The smart customers adapt to take advantage of this situation. They begin courting competitors, offering them a piece of the business to gain negotiating leverage against their preferred supplier. Ultimately, previously loyal customers who had helped the seller to understand their needs become difficult customers who appear to require everlarger concessions to retain their business. In short, when companies replace price policies with price negotiation, they create economic incentives for "good customers" to become "bad customers" who never willingly acknowledge value and act as if all suppliers are interchangeable. To regain the power to price, managers must rebuild pricing strategies that correct these perverse incentives. They must relearn how to price based on objective value, how to demand that customers acknowledge value when they purchase, and how to reward loyalty rather than power. These are the elements of a value-based pricing strategy.
Stand Up for What You’re Worth Anchoring pricing to value requires an investment on the seller's part—an investment that shortsighted managers are often reluctant to make. In the long view, however, this investment actually saves time and money. Price negotiation takes time and usually involves people at multiple levels in the seller's organization. Moreover, price negotiation undermines prices. Pricing by policy, on the other hand, enables management to make decisions once that cover multiple customers, and management's commitment to maintaining those prices eliminates the incentive for customers to prolong the sales process in order to extract a better deal. In some cases, policies also smooth out the distribution peaks and valleys caused by customers waiting for the most opportune times to cut deals. One of our clients sells a unique but relatively simple product used in high-tech manufacturing, which adds value for its users by reducing the probability that equipment will be damaged in shipment. Last year, an existing customer demanded greater volume discounts after increasing its order substantially. In response, the company 54
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focused on how much discount the customer expected and what cost savings the company achieved from serving the customer at larger volumes. The question the company should have asked was: How much value does the product create for the customer? Answering that question precisely would have been a monumental task, but estimating it roughly wasn't difficult. The product saved time for the customer's service technicians, it saved the cost of reshipping damaged parts, and it preserved the customer's reputation for quality. Now, the relevant question: Was the value of the product to the customer less when it was purchased in larger volumes? No, the company concluded, it was greater—since when the customer was shipping larger volumes, its service technicians were already stretched thin and parts supplies were already short. The purchasing agent who had demanded the volume discount was not happy with the seller's response that there wouldn't be one. The sales rep was not happy delivering the message, since he feared for the "relationship." The purchasing agent angrily questioned elements of the seller's analysis of the product's value but did not have the data to refute it. Unhappiness notwithstanding, the customer, as expected, went ahead and ordered increased volumes—with no further discount. We have had the same experience with clients in other industries whom we have advised not to negotiate away the value of patented pharmaceuticals to buying groups, or the value of prime advertising space to large advertisers, or the value of first-time sales, in return for the promise of future business. The key to knowing how much you can demand and selling it to the customer is understanding the value that you offer before the negotiation begins. It's equally important to convince the customer that your pricing policy is not only tough but fair. Two factors are involved in doing that: First, a premium price is justified only to the extent that you can demonstrate added value relative to the competition. Second, charging a price premium for premium value is fair only if everyone has to pay it. A purchasing agent's worst nightmare is to learn that a competitor got a lower price by squeezing your salespeople a little harder.
Laying Down the Law Once you have lost the ability to communicate with users, communicating value isn't easy. Purchasing agents frequently have nothing to gain, and everything to lose, by openly acknowledging that your superior
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quality, service, or availability might be worth something. Consequently, value-based pricing requires getting their attention. There are a few ways to do that. The first is simply to let customers know that you know what your product is worth to them, as was the case in the example above. A second option is unbundling: taking away the feature or service that distinguishes you from the competition, but that the customer claims not to value. Customers who are actually willing to accept less may in fact deserve a lower price, while those who are unwilling to forgo a feature or service are forced to acknowledge its value. One high-service company selling to the paper industry exercised this option. This company’s chemical additive vastly improved a plant’s productivity, but the company’s customers needed training and technical support to achieve that benefit. The most technically sophisticated customers resented paying indefinitely for the high levels of service built into the price. Once they learned how to optimize their processes, they began buying from cheaper, low-service competitors. Less sophisticated customers qualified for ongoing training and support by buying part of their needs from the company, but gave the balance of their business to the company’s lower-priced competitors. By unbundling and pricing service separately, except when the customer signed an exclusive supply contract, the company made its product more pricecompetitive for some customers, while demanding that others acknowledge and pay for the high service they require. Third, and most important, a company must develop a reputation for being willing to walk away from a bad deal. To do so, its sales force must first understand that a bad deal is any deal that the company would not want to offer to every customer willing to meet the same criteria. While walking away usually undermines sales and market share in the short run, it often has no adverse effect on profits. In one recent case, a pharmaceuticals company with a widely used and highly valued treatment refused to grant an additional discount to a large healthcare system. Consequently, the company’s drug was removed from the approved formulary, and sales to that customer fell by over 30 percent. In the absence of a contract, however, the company was no longer obligated to extend any discount. As a result, contribution earned on the remaining 70 percent exceeded what the company would have earned by retaining all sales at the lower price. Moreover, by not making a special concession, the company maintained the integrity of its pricing. In another case, a supplier that had grown tired of General Motors’ heavy-handed price
negotiations simply stopped telling GM about its new, innovative products. GM’s competitors were happy to pay more for products that they were told would give them a competitive advantage. In the end, GM proved less arrogant when negotiating for something it needed to catch up to the competition.
Manage the Menu Eliminating price negotiation does not mean that all customers must pay the same price. In most markets, a one-price policy would not reflect differences in value received. To create adequate flexibility without negotiation, value-based pricing usually requires a pricing menu. Customers then qualify for different prices based on their ability and willingness to meet objective criteria for discounts. Some of those criteria may be under the customer’s control, such as order sizes, commitment, and service requirements. All criteria, however, must be justifiable to any customer who questions why his price exceeds that of someone else. Among our clients are newspapers that sell advertising space. Unfortunately, over the past decade or so, the largest advertisers have cleverly extracted large discounts, which have taken their rates to less than half those offered to other advertisers. The key to reversing this inequity has frequently been to change the pricing menu. Rather than simply pricing by number of column inches, these papers have learned to adjust their prices to reflect the benefits that that particular advertiser will reap
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from buying the space. Some considerations include the ad’s location in the paper, to reflect readers exposed to the ad; the geographic location of the advertiser, since newspapers often discount for ads coming from broader regions where the advertiser has a number of competitive alternatives; and potential sales gains for the advertiser, since an advertiser with higher capacity (e.g., number of seats to fill, number of retail outlets) stands to gain more from the ad than a smaller advertiser. Similarly, we have sometimes recommended to service providers that they price based on the results actually produced rather than on the service supplied, and to components suppliers that they accept as compensation a share of their customers’ contribution earned. These metrics eliminate the need for the customer to negotiate a price low enough to compensate for the risk in the seller’s performance, since the seller shares that risk fully. More importantly, they enable the seller to earn more from customers who gain more, without the need to negotiate a premium. If these actions improve profitability—and they do—why aren't they more widely used? The answer given by many managers is that their sales force cannot or will not implement a fixed-price, value-based strategy. In truth, salespeople will resist such a strategy if management's support is limited to explaining the principles and admonishing the sales force to apply them. The primary problem is that most sales incentive schemes reward people for making larger and more frequent sales, not for making more profitable sales.
Consequently, the easiest way to make the goal is to "cut a deal" for a large buyer, although that sale often generates little contribution. Only when the rewards closely mirror the profit contribution of sales, rather than the gross revenue, is the sales rep's selfinterest aligned with the company's. Once sales incentives are aligned, salespeople will begin clamoring for the other things they need to succeed. Successful valuebased pricing and sales require an up-front investment to understand the value delivered to customers. It is unreasonable to expect each individual sales rep to make that investment; the effort should be centralized and the cost shared. The results then need to be transformed into value-based sales tools that reflect the economics of the purchase decision. Salespeople have the right to expect productspecific sales training that focuses not only on the principles of value-based selling but also on how to apply segment-specific tools to measure and demonstrate value to customers. What these examples illustrate is that pricing need not be out of your control unless you are truly selling a commodity product. Capturing the rewards justified by superior products, service, and availability is not automatic. It requires active management of a process for comprehending, communicating, and capturing value. Unfortunately, that has become a declining art as companies react to, rather than manage, their customers' willingness to pay for value.
By Tom Nagle
Evening the Odds In Price Negotiation How to circumvent the devious schemes of purchasing agents. rice negotiation is usually a David-vs.Goliath confrontation. David, the sales rep, has much less influence over what his company sells than the purchasing agent has over what his company buys. Purchasing agents are better informed, since it is legal for them to compare prices and terms with other buyers, while it is illegal for sellers to do so. Finally, salespeople are usually paid for making sales, while purchasing agents are paid for saving money. Not surprisingly, Goliath,
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the purchasing agent, usually wins, in part because David, the sales rep, is often so disheartened that he expects to lose. While the ideal solution to this problem is to replace price negotiation with a nonnegotiable price menu, that's not always feasible. Only a quality leader can lead a market to such a policy, and only companies that could survive calling a large buyer's bluff can afford the cost of the transition. Even then, the transition from negotiated to fixed prices usually takes some time. In the meantime, it's
essential that salespeople be able to recognize and parry purchasers’ deceptive tactics. The following are some of the most common mistakes to avoid in price negotiation: Discounting the price increase. We see many clients whose pricing strategies have suffered for years from the effects of poorly negotiated price increases. The seller in this case establishes an across-the-board price increase—say 6 percent—that is then presented to buyers. Those without power are forced to take it or leave it. Larger buyers, however, often make the case that since they deserve a volume discount, they should not have to bear the full increase. Consequently, they negotiate an increase of, say, 4 percent. The seller feels happy that at least some of the increase "stuck." In fact, the seller got taken in by a bogus argument, and the cost of the mistake compounds as years go by. The large buyer who gets a 6 percent increase is already getting a discount on the increase relative to smaller buyers. For example, if the large buyer is currently paying $80 while everyone else is paying $100, a 6 percent increase for the large buyer is only $4.80 vs. $6 for everyone else. By demanding a discount on the increase, a purchasing agent is demanding that the seller pay twice for the same volume. When buyers use this tactic repeatedly, their discounts quickly compound. One client saw its prices for volume buyers drop from over 70 percent to less than 50 percent of list price in only seven years. To compensate for this loss, the company began asking for higher increases to create room for erosion with large buyers. As a result, it lost progressively more of its medium and small customers, making it ever more reliant on and vulnerable to intimidation from its largest buyers. When large buyers must have a concession, give it without undermining the integrity of the price increase. For example, rather than discounting the price increase, get a contract that delays its implementation for four months. The effective rate increase for the current year is discounted, but you begin the new year with the higher rate established and avoid compounding the discount into future years. Discounting in return for "incremental volume." Sometimes buyers will offer a seller incremental volume in return for a price concession. This is in principle not a bad idea, even under a fixed-price policy. In practice, however, sellers often get taken. Here's how. First, a buyer who offers to purchase 10 percent more volume in return for a 2 percent price discount is actually getting a 22 percent price cut on the incremental volume! Here's
how that works: Assume that the buyer is spending $1,000. He offers to purchase 10 percent more volume, which means he would be buying $100 worth of additional product at the pre-discounted price. If the buyer receives a 2 percent discount on that $1,100 worth of product, he gets $22 off, which is 22 percent off of the $100 of incremental volume. If sellers actually calculated that incremental discount, many would never be willing to make such a large concession. Actually, the cost of the concession is usually far more than what the seller gives up in that year, since most sellers fail to segregate the extra discount from the base price, perhaps in the form of a year-end rebate. Consequently, the 2 percent price concession becomes incorporated into the basis for all future negotiations. If you're going to give a discount for incremental business, focus the entire amount of the concession on the increment, or give it as a rebate. This has the added advantage of protecting you from duplicitons buyers who promise more business to get the discount, but never order the incremental volume. With the discount focused entirely on the increment, they don't get the savings until they deliver the volume, and the lower price doesn't get incorporated into the buyers' expected price level. Segregating the service value. Companies that focus on volume rather than value in their price negotiations often get suckered into pricing only the commodity aspects of their product and giving away the valuable aspects. For example, we have seen many clients give their largest customers priority in scheduling and delivery. A sharp negotiator never gives away something that is scarce and valuable. A client in the transportation business found itself losing its high-margin customers because of its inability to guarantee delivery, while its lower-margin, but higher-volume, customers got priority. After this company put a price on expedited service, the high-volume customers that truly needed priority were forced to compete by paying a service premium. Those who refused to pay the premium opened up opportunities for this company to win back more servicesensitive customers. As a result, the company increased both its total revenue and its revenue per shipment. Contracts with one-sided obligations. Some of the most costly mistakes are made by companies that sell products with highly seasonal demand and limited capacity to serve that demand at peaks. Smart buyers negotiate, and naive sellers accept, contracts based on annual purchase volumes. With no constraint on when they must purchase, smart buyers
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With no constraint on when they must purchase, smart buyers usually find that they can get better deals elsewhere for off-peak purchases.
usually find that they can get better deals elsewhere for off-peak purchases, at a time when everyone has capacity and is eager for incremental volume. Then, when supplies are tight during the peak season, they purchase all their contract obligation. Why is this so bad? Because, when supplies are short, it’s often possible to sell at higher-than-contract prices. Suppliers under contract, however, must serve their contract customers first. The contract becomes nothing more than a one-sided constraint on the seller not to raise prices when the market value of the product is greatest. Not surprisingly, in these cases, the high-service suppliers, with whom everyone signs contracts at slight "premium" prices, often end up using their capacity less effectively and therefore remain less profitable than many of their lowerservice rivals who take whatever prices they can get. When we find a client with this problem, we help them design a peak/off-peak pricing strategy. Fixed-price contracts, which some sellers prefer, contain contingencies that limit the peak-period quantities that buyers can purchase at the contract price to some multiple of what they purchase during off-peak months. They also get priority for additional amounts, but only at the higher spot prices that noncontract buyers must pay. Fixing the price/performance ratio. The idea that price should be proportionate to performance is so commonly accepted that challenging it usually requires extensive buyer education. Still, it should be challenged, since
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the rewards are large and the logic behind it flawed. The problem lies in allowing your product or service to be positioned strictly on relative performance, rather than on relative value. If offered the choice between two cancer treatments, one of which was 40 percent more effective than the other, would you refuse to pay more than a 40 percent premium for the superior drug? Unless taking 40 percent more of the cheaper drug could produce the same result, a price much greater than the proportional performance difference is obviously justified by the value of the lives saved and the related healthcare costs avoided. Now, consider some less dramatic examples. If you could buy advertising that reached all of your potential customers in an area, would you pay no more than twice as much for it than for advertising that reached only half of your potential market? That’s exactly what many large advertisers argue, claiming that they should pay no higher "cost per thousand" for a large publication than for a small one. Similarly, some technology buyers argue that a chip or a switch that operates twice as fast should cost no more than twice as much. In both cases, however, negotiators are focusing on performance rather than on value. We helped a large newspaper overcome this problem by showing management how to estimate the impact of advertising and to quantify that impact for buyers. By calculating how much gross margin various advertisers would forgo if unable to reach a segment of their potential customer base, we demonstrated that the value to them of the incremental "reach" from ads in the newspaper was many times the incremental rate. Moreover, we calculated what it would cost advertisers to reach the same number of potential customers by using alternative ad media. Taking into account the duplication that would occur and the need to prepare and coordinate different campaigns, the cost was still many times more. Similarly, by quantifying the value of greater reliability in terms of avoided warranty costs and added value to the end customer, a high-tech company convinced its buyers that a disproportionate premium was justified. In each of these cases, the seller’s disadvantage in price negotiation may be a devious purchasing agent—or simply a buyer who understands no better than the seller the true value of the product being purchased. In either case, when you understand your product's value and communicate that value to buyers, you create buyers who know the value of what you are offering them and who know that you know. The net result is a lot more leverage in price negotiation and, as a result, a lot more profitability.
