Management guru Peter Drucker understood the mechanics of business possibly better than anyone in history. But when it came to price, he found himself banging his head against a corporate brick wall.
“The worship of premium pricing always creates a market for the competitor,” Drucker explained in 1993, citing numerous examples, from fax machines to autos, where high-end manufacturers had been destroyed by more cost-conscious competition. He railed against the concept of “charging what the market can bear” and “cost-plus” pricing, where executives measure the cost of production and add a pre-determined margin to create a final price. “Cost-driven pricing is the reason there is no American consumer electronics industry anymore,” said Drucker.
Despite such warnings, businesses continue to suffer pricing disasters. From the auto manufacturer that went bankrupt by continually slashing costs to maintain the holy grail of market share, to the retailer that launched a range of value products that turned out to be more expensive than its existing special offers, nobody seems able to agree an effective strategy that resonates with consumers.
“I’d say 95% of companies don’t take the time to get the price right,” says Rafi Mohammed, author of The 1% Windfall. Robert Shaw, Professor of Marketing Metrics at Cass Business School in London, has worked with a range of leading consumer markets companies. He says pricing is often irrational, if not potentially ruinous: “Prices are sometimes set by people at the top whose only aim is to undercut a competitor, even at the expense of destroying their own products. It is often riddled with company politics.”
RIP for RRP
The recession in Western markets has brought pricing into sharp focus, particularly for the retailers who sit at the forefront of the issue in consumer markets. “Retailers have traditionally been poor at pricing, and in many instances historically priced goods at recommended retail price (RRP),” says George Svinos, Head of Retail, Asia Pacific at KPMG and a partner in the Australian firm.
Competition issues have forced them to consider more dynamic strategies, but the process of change is slow. Many companies have leaped slavishly from RRP to an Every Day Low Price (EDLP) model of the kind pioneered by Walmart, which eschews special offers in favor of consistent low margins. This approach has been aped by European discounters such as Lidl, but it isn’t an easy path to follow.
It also doesn’t work in every market – in Latin America, some Western retailers have abandoned universal EDLP, as consumers raised on a diet of two-for-one offers are simply turned off by the lack of deals. The rise of couponing in the US suggests that consumers there are more educated than ever about the intricacies of discounting.
The resulting confusion is hitting the bottom line. A September 2011 survey from Simon-Kucher & Partners says the EBITDA margin of retailers with clear, effective pricing strategies is 16%, some 25% higher than rivals. As a further example of the schoolyard mentality in play, the same survey found that 83% of respondents who were engaged in a price war said that another company had started it.
Who is getting pricing right, and what are they doing? Svinos points to warehouse club Costco, which uses the cost-plus strategy across all categories, but with a twist: “It claims to add only the cost of service to the basic price, making its margin from membership fees.” In tough times, this honesty clearly appeals to consumers: membership-fee revenue was up 10.1% in Q3 2011, alongside a rise in net profits.
Mohammed says Procter & Gamble is among a number of leading consumer goods companies that have been proactive in meeting retailers’ needs by “versioning” – introducing cheaper ranges to sit alongside existing ones rather than engage in a price war. Its Charmin Basic toilet tissue and Bounty paper towels have shaken up the sector, and it claims they outperformed even private labels as shoppers traded down in recession. P&G is not afraid to withdraw such products when it believes the market is ready to trade up again, rather than risk cannibalization: in mid-2010, it quietly eliminated its entry level range of Tide laundry products.
Others used the global downturn to try radical pricing experiments. In 2008, Best Buy offered two years’ interest-free credit on all purchases over US$999 and succeeded in increasing its market share. Burger King reasoned that consumers would trade down from restaurants and introduced its first premium range in the US in 2010. Its US$7.19 BBQ smoked ribs were seen as a gamble by many commentators in a fast-food market dominated by discounting, but soon racked up unit sales of 10 million.
In many sectors, the proliferation of the internet has turned a price war into a perfect storm. Price comparison websites have combined with location-based technology to empower consumers: when you can see on a map that a product is cheaper within walking distance, or online, you need a compelling reason to stay in a bricks-and-mortar store. Retailers are using services such as foursquare to lure consumers who actively seek discounts, armed with precise data about who (and where) they are. This issue quite literally mobilizes people: Svinos says the Australian sporting goods sector is feeling the pinch because discount websites undercut prices in real time.
Consumers share information about pricing via social networks, creating pressure points that can move markets. Gino Van Ossel, Professor of Marketing at Vlerick Leuven Gent Management School in Belgium, says that thanks to word of (electronic) mouth, consumers in his country are increasingly willing to ship purchases from neighboring Germany, which has a more competitive retail market. This issue is one of many shaping a potentially inflammatory debate within the European Union about whether retailers should be forced to offer a single price across all its markets. Meanwhile, in Australia, a coffee manufacturer lost a court case against a discount retailer importing its products cheaply from Indonesia. Many major retailers have experimented with the “grey market” in a bid to control costs.
These disputes shine a light on the complex relationship between manufacturers and retailers over price. In the UK, these issues reached a head this summer when Pepsi disappeared from the shelves of the country’s second-largest retailer, J Sainsbury, following a dispute over price rises. In many parts of the world, the annual round of price negotiations has become a heated affair that results in higher prices for already squeezed consumers.
In the midst of such issues, retailers can be pulled in many directions as they try to define a coherent pricing strategy. Svinos admires the approach favored by fashion retailer Zara, which often matches store prices with those online. But Van Ossel says the complexity of pricing information presented to consumers means “price perception” matters far more than the detail. This is the basis of behavioral economics (BE), which examines the emotional and cognitive factors behind purchasing decisions and is catching the eye of many multinational executives.
Rory Sutherland, Vice Chairman of advertising giant Ogilvy Group, is a BE evangelist. He believes too many companies adopt “a neoclassical viewpoint on price” and have “woefully underestimated the sales potential of allowing people to pay in different ways”.
“In order to buy something, I need to give myself psychological permission,” says Sutherland. “Creating a different frame of reference allows that. Some people might be susceptible to rarity buys, while others are a sucker for ‘only one left’ offers. Some are influenced by social proof (‘75 people have booked this in the past three months’). Marketers, he says, should ask themselves how many ways they can frame the same offer, then roll them out across relevant channels and markets to discover what works.
BE has influenced furniture retailers, which have learned from the way consumers value (and pay more for) items they make themselves. It has also driven the premiumization of coffee, such as Starbucks Frappuccinos. But, says Svinos, the smartest companies get the basics of pricing right: building internal decision making processes that enable them to react to the market, learning from successful strategies in their own and other sectors and listening to consumers to understand how their views of pricing are evolving. With markets in flux, they are going to have their work cut out.
Pricing strategies of successful retailers
Partitioning Removing a basic feature (like an ice-maker from a refrigerator) and turning it into an added extra people are prepared to pay more for.
Drip pricing Adding taxes or charges to a basic initial price. A tactic of low-cost airlines, it works because consumers fix on the first price they see.
Trading in People feel possessive about something they currently own. By offering them a discount to swap it for a newer model, they are willing to value it higher than they should. Consumer electronics retailers are increasingly employing such strategies.
Payday pricing Shoppers feeling the pinch will treat themselves at the start of the month, when they are newly paid – so special offers are best kept for later.
The compromise effect Put a ‘super premium’ product next to a premium one and it will look cheap by comparison: restaurants introduce an expensive item to the menu so other meals will seem more reasonable.
Sizing Many stores routinely make the discount price of an item larger than the original price on a label. Yet sales are actually higher when the original price is more prominent, and when the distinction between the two is made as clear as possible.
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George is one of KPMG’s leading consumer markets industry experts in Australia, having worked as a CFO of two national retailers for 10 years and as a senior adviser to the retail industry during the past ten years.