Why the Right Pricing Strategy is Important
Why is a pricing strategy so important?
“Good strategy is like great art. It’s difficult to define what it is, but you immediately recognize it when you see it.”
Here is a classic example: In the tale of David and Goliath, David was confident in his slingshot abilities and likely also well aware of Goliath’s weakness. Therefore risking the challenge and rejecting protection that would have ultimately made him slower was a very good strategy.
Unfortunately, good strategy is rare, and more often than not, the adjective “strategic” hardly has any significant meaning when added to a business function such as strategic marketing, strategic finance — or strategic pricing.
Yet, well-established rituals such as pricing-strategy is simply defined as - “We aim for profitable growth.”
Surprisingly, this vague definition somehow is is flexible enough to justify any pricing goal including both profit and revenue maximization — depending on who you talk to. Upper management and marketing typically prefer profit, while sales favors revenue. Bad pricing strategy is so common that most pricing professionals have never experienced the power of a good pricing strategy.
So, let’s see if we can change that by discussing what a pricing strategy is, outline a concept on how to develop a good pricing strategy, and look at some examples.
The Pricing Strategy Framework
In general, strategy is all about the choice, especially pricing strategy, in which you decide to do one thing and not the other.
If a company decides it is fully committed to profit, it will risk losing customers. If it aims for revenue, it can keep more customers, but may upset stockholders — resulting in slim bonuses.
On the road to choosing the right pricing strategy, there is no escape from such fundamental trade-offs. They inevitably need to be addressed, discussed, and decided.
The key objective of pricing is to support the overall strategy of the company.
The pricing strategy is the pricing manager’s theory of how to best achieve this. If the company’s objective is immediate profit maximization, then an effective pricing strategy would be focused on leveraging maximum value of the company.
One of the most useful practical books on strategy of this decade is certainly Richard Rumelt’s (2001) “Good Strategy, Bad Strategy”. In addition to his many entertaining examples, Rumelt’s book also describes a three-step framework for developing a good strategy— diagnosis, guiding policy, and coherent action.
- Does it make sense to simply follow the pricing of key competitors with an established product?
- Should you price an innovation low to keep competitors out of the market or at high to skim off the high willingness-to-pay of early adopters?
3. Coherent action: This includes the coordinated implementation of the guiding policy in the pricing methods, tools, and processes. The complexity of this task depends on the industry’s pricing requirements (e.g., number of products, differentiation between customers) and the role of the company (e.g., price leader or follower).
The tale of David and Goliath
Let’s examine the tale by equating it with ‘The Pricing Strategy Framework’ and describe diagnosis, guiding policy, and coherent action through David's point of view.
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Diagnosis: Goliath is the strongest man in the world and considered undefeatable (Threat). I’m weak (Weakness), but I’m pretty good with the slingshot — and it is a secret (Strength). Also, I’ve detected a spot in Goliath’s armor, where he is unprotected — right between his eyes (Opportunity). A clever case of classical SWOT analysis!
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Guiding policy: I can beat him if I can hit him with my slingshot before he comes too close. Therefore, I need to be agile to get one good shot at him. That is my only chance.
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Coherent action: Reject armor that was offered to me. It would only make me slower and doesn’t offer protection if Goliath hits me. Focus all attention on my first — and probably only — shot.
There are two take-aways from this example that are common for good strategy: First, a good strategy is very clear and straight-forward. Second, don’t expect others to comprehend or appreciate it before they have seen its success.
Let’s dive into more examples highlight a good pricing strategy.
The company that got America on the Internet
AOL was the internet giant of the 1990s. It's the name that introduced dial-up internet to the people and later merged as the larger partner with Time Warner in 2001. However, with the advent of broadband internet, it became clear that AOL’s dial-up business was dying down.
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Diagnosis: With its 56 kilobits per second, AOL had a much inferior technology compared to broadband’s 16+ megabits per second. But, with a multi-million user base and slow churn in many segments, there was still hope.
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Guiding policy: There was no benefit in pricing on value and substantially reducing prices to compete directly. Therefore, the focus needed to be on reducing churn.
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Coherent action: Maintain prices at $20 per month and fight to win back each lost customer by offering free months or reduced rates.
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Result: AOL had still more than 2 million paying customers and was sold to Verizon Communications for $4.4 billion in 2015.
From farm boy to business visionary
Oil lamps are a classical example of a good pricing strategy. Oil producers gave away lamps for free, so people soon had a need to buy oil to fuel their lamps.
- Diagnosis: When oil became readily available, there wasn’t enough demand for it. Lamps were unaffordable for most people even if it came with the advantage of having access to light all day and night.
- Guiding policy: Take away the initial high barrier of having to buy an expensive lamp. Make it easy for people to get used to consuming oil. The recurring payments for oil are small steps for the customers, but a major profit for the seller.
- Coherent action: Give away the lamps for free and then sell the oil.
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Result: The oil baron John D. Rockefeller became the first billionaire and controlled about 90% of the oil industry by the 1890s.
This model has been widely adapted by manufacturers of a variety of products ranging from razor blades to coffee tabs. These days, electric vehicle manufacturers are attempting a variation of this model but still have a long way to go.
In the traditional automotive business model, many manufacturers sold their vehicles with close to zero margins and earned their living by selling spare parts and services at a better margin. Today, electric vehicles are also sold at a lower cost, but they don't need many service parts, such as oil filters. Eventually, autonomous driving will also take away a large share of accident related parts. For now, it's unclear how to make money with e-mobility. The industry is clearly lacking a good pricing strategy.
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