JMS Business Strategy Applications and Tutorials   The material presented here is based on information extracted from the Pricing Strategy – An Interdisciplinary Approach book and articles authored by consultant, Morris Engelson. Index To Pricing Strategy Applications and Tutorials Good Costs, Bad Costs and Incremental Sales The Power Of Savings Strategic Behavior Questions About Market Segments The Pricing Sequence The Power Of Geometric Compounding Will The Real Price Please Stand Up   Good Costs, Bad Costs, and Incremental Sales Your business has five cost items (these can be products, or cost centers, or whatever). You have separated your costs into variable costs (VC) that flex with the level of business as a percentage of sales and into fixed costs (FC) that are independent of level of sales. Here is the result: Product  Sales %VC $VC FC Total Cost  Profit A 20 70% 14       B 20 60% 12       C 20 50% 10       D 20 30% 6       E 20 20% 4       Total 100    46 45 91 9 You decide to analyze your profit situation by allocating the fixed costs to each cost center on a percent of sales basis. There are five products and a total cost of 45, so the allocation is 9 cost points per product. Once you have done this, you realize that products A and B have an associated cost of 23 and 21 which is greater than total sales at 20 each. Clearly a cost greater than sales is not profitable. So you discontinue products A and B. But you still have a fixed cost of 45, which is now allocated to three products at 15 each. You soon find that all products are unprofitable and you go out of business. The lesson to be learned is that incremental sales can be a powerful source of profit, even when the cost is high. Deciding which is a good or useful cost and which a bad cost is not as simple as it might appear. As the Pricing Strategy book says, "Analysis is no substitute for thinking. Analysis is an aid to thinking." Index The Power Of Savings Nothing has as powerful an impact on the bottom line as reducing costs. But that has to be done with care, as the information above shows. Why is cost reduction such a powerful driver of profit? Because you can not recover a cost increase by a price increase. Usually one can only recover half the cost increase, because profit depends on volume as well as price, and these are connected by the price-demand relationship. It can be shown that in an ideal situation the profit as a percentage of sales changes in the following manner as a function of cost as a percentage of sales: Cost/Sales % 0 10 20 30 40 50 60 70 80 90 100 Profit/Sales % 100 81 64 49 36 25 16 9 4 1 0 Note that profit is only 25% when cost is 50%, and profit is only 1% at a 90% cost.   Strategic Behavior Questions Consider the following next time you need to make a strategic decision, plan for the future, or communicate or try to convince someone on a course of action. Explain in one paragraph what you are trying to do or achieve. Do it in plain language. No special terminology or jargon is permitted. Explain how what you will do is different from how it's currently done. Why is it better to do it your way? What are the obstacles to success? How will you overcome these obstacles? What resources will it take? How sure are you of success if you get the desired resources? So what and who cares if you succeed? What difference will it make? How long will it take to get a first result? How long to a final result? How will we test interim progress or results? Provide quantifiable measures. When and under what conditions will we stop the project and not continue? Will somebody want to buy this thing at a price we can afford to sell it for? Do we have the people skills and organization to build, sell and maintain this thing? Can we manufacture it? What will the competition do? Index About Market Segments A market or customer segment involves a group of buyers (or potential buyers) with similar needs and value concepts. A market segment involves a subset of customers who value substantially similar product or service parameters, and whose interests and/or needs and/or values differ sufficiently from others to be differentiated and treated differently. Choose the segments for your business, or overall market, on the basis of externals: customer interests or needs, competitor behavior or offerings, the world economic or political situation, etc. Choose which segments to compete in or emphasize on the basis of internals: what are your strengths, where can you make a difference, what are your interests, where can you win, etc. Just because a segment exists does not mean that you have to participate in it. Index The Pricing Sequence Here are the basic steps you go through when choosing a price. What is the value. What are the objectives. What is the profit. Is there a gap between customer value and your profit needs. Fix the gap. You need information on various factors, such as the following, in support of the above. Price-demand information. Market segments. Manufacturing capacity and utilization. The experience curve. Relationship to other products. Impact on the future. New product pricing factors. Incremental sales consideration. Market – growth or zero-sum. Commodity or differentiation. Defensive or offensive pricing strategy. Index The Power Of Geometric Compounding Most people have difficulty in visualizing the exponential growth of compounding. Thus, a modest 15% growth per year means doubling in size in five years. And the growth can be much greater if you look to increase market share in a growing market. Consider the following example. There are five competitors in the market, and you are number two in size. The market share positions are 55%, 20%, 10%, 10%, 5%. The market is growing at 25%/year and you decide to increase your share to 30% in 5 years. This looks like a modest growth of just 30/20 = 1.5 times in five years. But consider. The size of the market will increase by a factor of 3X at 25% per year for five years. Your sales rate will go from a current base level of 20% of 100% to 30% of 300%. You will grow by 90/20 = 4.5 times in five years, and not 1.5 times as it first seemed. What will the other competitors be doing during this time? Your increase in share will have to come from somewhere, after all. How about the market? Will it continue to grow at 25% for five more years? What will you do if the market does not grow or your competitors fight back? Certainly, an aggressive strategic plan is not all bad. We all know of cases where somebody struck it rich. But just in case, try to protect yourself with a contingency scenario and have respect for the power of large numbers. Index Will The Real Price Please Stand Up I recall a conversation with a Japanese marketing manager who asked for the price of a very sophisticated electronic device I was involved with. My response was, 78,000. He was astonished. Only 78,000 yen for such a complex instrument. But, of course, I was thinking in dollars. The price was several million when computed in yen. "Ah," you might say, "the confusion comes from a change in currency type." Not so. After a few years of serious inflation, the dollars price tag might double. Does that mean that the price also doubled? That would be like saying that the price in yen is really different than the price in dollars. But we know that the item has only one real price, whatever that is. This is why we have discounted financial computations in order to get rid of currency valuation price distortions. The real price is not the dollar or yen amount, but rather the value of the good or service in question. The currency amount is the numeric measure of the value, and not the value (read price) itself. The thing (read price) is different from the measure of the thing, because the thing being measured has intrinsic properties that go beyond the measured designation or description. The above sounds like an interesting philosophical discussion, but what does it have to do with business pricing? Quite a bit, actually. Sophisticated and superior price positioning will always consider that the price represents value and not just a currency amount. Let's strip off some of the obscuring complications, due to our complex economic system, and get back to the very basics. Imagine that a farmer with a leaking roof arranges to have it repaired. Payment is with two chickens and a bushel of corn. What is the price? Two chickens and a bushel of corn, apparently. Who's the buyer and who's the seller? It would appear that the farmer is buying roof repair services, and the roofer is the seller. But suppose the roofer needs food. He comes to the farmer and asks what he could do to pay for a couple of chickens and some corn? Now the repair work is the payment and the farmer is selling food which the roofer is buying. What's constant in this story? The value of the exchange. The roof repair is worth the chickens and corn, and vice versa. In the most basic transaction we have an exchange of equal value between the two parties. How do we know that the values exchanged are equal? The equality is a given, once the transaction takes place. Otherwise, the party that was to receive a lower value would refuse to participate. But we know that people frequently get into a business transaction which is not to their advantage. So can we still talk about equal value? Yes we can. This is because value only has meaning as a mental perception, or belief. Value is not like a physical quantity, such as distance, that can be measured irrespective of people. Value only has meaning as a personal belief. That is why advertising works. Value perception can be changed. So here we have a first useful insight. The price needs to match the value. But suppose it doesn't? Well, we can change the price, but we might also not change the price but rather change the value. For the former, we compete as a commodity. All that counts is the monetary price. For the latter, we compete on a differentiated basis. We look at the value as the price, and the money is set to match the value. The farmer doesn't pay for roof repair with corn today. But we need to keep in mind that the currency amount is a surrogate for corn, and chickens, and many other things. A change in the value, that is price, of corn will ultimately have an effect on the price of roof repair and on many other things as well. Furthermore, the farmer doesn't barter for his corn or chickens one at a time. We're dealing with a mass market. And that means that we're dealing with many, rather than one, perceptions of value. Hence, it's not possible to perfectly match price to perceived value for all potential buyers. This gets us into the need for market segmentation. A market segment involves a subset of customers who value substantially similar product or service parameters, and whose interests and/or needs and/or values differ sufficiently from others to be differentiated and treated differently. The price, as should be clear from the above, needs to match the buyer's perception of value. Too high a price and the buyer will not buy. Certainly the buyer will be happy with a lower price. But this can cause many problems to the seller. For one thing, a super bargain will significantly increase volume with all sorts of attendant problems in manufacturing and distribution. For another thing, too low a price may not provide the seller the requisite profit needed to stay in business. "I'll make it up on volume", is a nice joke. But high volume will kill you if you're losing money on every sale. Hence the concept of the ideal price as a price that matches both sides of the transactional equation. The buyer pays a monetary price equal to perceived value, while the seller receives a monetary payment that matches needed profit. This equilibrium point is unstable because of external forces, such as competition. Therefore, the pricing decision cannot be based on a static assessment. It's a dynamic condition that can only be maintained through constant movement. Pricing is more like ice skating than standing a four-legged table. And like skating, there are a large number of variables involved, and not enough time for thorough analysis before you must act. Here's where strategy comes in. A strategic framework will permit quick reaction decisions based on general principle without getting into too many details for which there is no time. So, "will the real price please stand up?" It will if you're nimble enough to act in real-time to a continuously changing business situation. Otherwise, the price will go out of balance and so will your business. 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