One of the best feelings in business is landing a major new account. The team pulls together around a common goal and works for months or years to achieve it. They plan solutions and do battle with the competition and then come away victorious. Sure, there are concessions made along the way but big accounts have purchasing power and sharpening the old pencil to get the deal is necessary.

This is all true to a point but managers often take this old adage to the point of self-delusion. The biggest lie that they tell themselves? “This account is unique and so are the concessions. What we did here won’t affect other accounts.” Many managers are realistic though. Their version of the story is “Yes, we did it here and it will probably spread to some of our other strategic accounts but we will keep it contained.”

This is all very nice thinking but here is what really happens.  Any special concessions that you make for major accounts now become standard practice for the majority of all accounts within a few short years.

A while back, we worked with a firm that was wrestling with the fact that many of their largest accounts were starting to demand “signing bonuses.” They ultimately gave in but assured me that there was no way that this would ever happen for any but a handful of really important accounts. You probably know where this is going…I returned a few years later only to find out the majority of accounts were now negotiating…and receiving signing bonuses.

How did this happen? The way that it always does. Smart customers and sales people learn of the practice and push to extend it. Those same senior managers that promised discipline get desperate for business – and then it’s Katy Bar the Door

It can be a struggle to get managers to see past the deal in front of them.  The key is to do the analysis to show what the potential impact of the “once in a lifetime” concession of the day will have on the whole business when it spreads.  This can be done in a matter of hours with a simple spreadsheet and a few basic assumptions.  Doing so may not stop the problem immediately but it will define the full cost and leads to more formal discussions and support policies to keep things contained.  If you have more time, you can do a little forensic work and track the spread of a particularly nasty concession from one account to common practice.  Infectious disease specialists call this finding the “alpha patient.”  While the first analysis is somewhat speculative, finding the alpha patient allows you define actual historic costs to the business.

What does a stable approach look like?  Firms that manage discounts well do a couple of things.  First, they track the effects of negotiated discounts.  Second, they recognize that discounting can be an important tool but that it must be done by policy and based on objective criteria that are available to all customers with similar attributes.  Finally, they back everything up with specific sales tools, training, and incentives.

If your firm doesn’t adhere to these basic principals, we have one word of advice for you.  “Look out below.”

In this case a firm called Mobisante is introducing a field-portable medical ultrasound device/app that runs on smartphones. The scanner will cost $7,495 in a market where even entry-level equipment can cost tens of thousands. While the hardware is currently a dedicated smartphone that you must but from Mobisante, we know how this usually plays out – over time the technical limitations get worked out and an interesting technology becomes a disruptive technology that wreaks havoc with the pricing of incumbent suppliers.

The battle is usually bloody but the outcome inevitable with the attacker displacing incumbents who can’t discount their legacy products far enough to remain competitive. In this case, the outcome may not be as inevitable as one of the incumbents in GE Healthcare. A few years ago, GE introduced a low-priced ultrasound machine for emerging markets. That device, the Vscan, is now available in the US for roughly $7,900. While Mobisante is a mouse to GE’s elephant, the competition will be interesting. GE may have the technological advantage and a strong price for now. But, if equipment makers can successfully use smartphones as low-cost universal platforms, all bets are off and we will see more giants fall to the curse of incumbent technologies, cost structures, and uncompetitive pricing.

Pricing Tactic Spooks Lawyers:  Companies’ Use of Reverse Auctions to Negotiate Legal Services is Accelerating

The Wall Street Journal, August 2, 2011

I know, I know the instinctive gut reaction to anything that upsets lawyers is one of evil glee but this story about the increasing use of reverse auctions to procure legal services should serve as a cautionary tale for every business.  Every product or technology-focused company worth its salt knows that their core business is in constant danger of commoditization.  Many are making significant investments in services as a way to differentiate and maintain pricing power.  So when the hardest of hardcore procurement tactics start getting applied to high-end services, it is only a matter of time before the pricing of services of all types gets put under the microscope. Our recent experiences with a broad range of high-value service providers show that the problem is already widespread.

The issue isn’t whether reverse auctions are appropriate for services – in the majority of cases they currently are not.  The issue is whether those who are selling those services are well-prepared to deal with the procurement buzz saw.  In professional services, all too often the answer is “no.”  Professional services have long been thought of as the ultimate relationship sell.  “Technical” competence is the ante to get in the game but developing an intimate understanding of clients’ organizations, their business priorities, processes, and culture used to win the day.  Procurement professionals want to take all of this off the table.  In some cases, they have a valid point.  In others they are dead wrong.

Services organizations need to think about this challenge at two levels.  The first is to assess pricing potential through the lens of the product life cycle.  Services naturally move through this same cycle.  In new fields, service providers have information and expertise advantages over clients so they can charge higher prices.  For services that have moved well down the life cycle, service providers rarely have unique knowledge relative to clients.  These routine services will be commoditized and providers need to develop high-efficiency models that drive out costs and lower prices.

The second (and often the most urgent) level is development of processes, tools, and techniques to ensure that rainmakers have the ability and willingness to play hardball with procurement – particularly when they are selling and delivering high-value services.  Even small changes in deal performance can drive major increases in profitability.  In many professional services firms, “selling” and “negotiating” are dirty words.  Those firms that get over their inhibitions will adapt and thrive in the new world.  Those that don’t will shrink their way to irrelevance.

While familiarity with the principles of value-based pricing gives organizations a huge leg up, some significant perspective is required.  To help with that perspective, here’s a question to ponder:  Over the last ten years what percentage of the revenues and profits of the Fortune 500, Russell 2000 or any other group you choose can be attributed to the adoption of value-based pricing?  While I haven’t done the research, as a bit of a pricing insider, I can assure you that answer ranges from negligible to very low.

Don’t get me wrong, organizations that focus on improving pricing performance often see major jumps in both revenues and profits.  The questions is what is at the root of those results.  There are typically three stages that lead to improved pricing results over time.  The first stage typically involves getting control over unearned discounts and closing loopholes in the full set of terms under which transactions are conducted (a.k.a. the price waterfall.).  Since most firms do some form of cost-based pricing, Stage 1 benefits are often a result of becoming better at cost-plus pricing.

The second stage is focused on setting list prices that more accurately reflect customers perceptions of value and the alternatives presented by competitors.  By tempering the view of what competitors are doing with a sense of the unique value that they offer, firms at this stage are often engaging in what we call disciplined market-based pricing.  They look at competitor prices but they also adjust price levels according using data that helps define their value position relative to those competitors.  At this stage, that value data doesn’t necessarily have to be  overly scientific.  It could be based on something as simple as a survey of the sales team regarding the circumstances under which they have or do not have pricing power.  It might also come from traditional, attitudinal market research that shows customers preferences or perceptions of one product vs another.

This brings us around to Stage 3:  full-on value-based pricing.  While this should be every firm’s objective, the truth is that implementing a sustainable value-based pricing program is extremely difficult and can take years to become standard practice in the organization. It requires sophisticated knowledge of the economic benefits received by customers; changes in  market research, how competitive strategies are conceived, product management, sales practices, and incentive systems at all levels of the organization – just to name a few.

The thing to remember in all of this is that the primary purpose of doing the hard work on pricing is to achieve sustainable, long-run improvements in profitability.  Value-based pricing is not a prerequisite for achieving this objective.  All it really takes is a commitment to improving on whatever pricing approach that your firm is currently using – whether it is cost-plus, market-based, or value-based.

One of the most poorly kept secrets in the world of consumer electronics is that Apple will drop the iPad 2 on us sometime this spring.  When this happens we can expect a couple of things.  First, the iPad 2 will meet or exceed the Xoom on basic performance specifications.  Second, the price point for the highest end version may increase somewhat but Apple will generally maintain existing prices.  Finally, Apple typically uses the launch of a new generation of portable devices to reposition the previous as a lower-priced flanking product (admittedly we are in uncharted territory here with the iPad.)

If Apple does all of these things – which are based on prior actions with products like the iPod, iMac, and laptops – then Motorola will be forced to make a price move within a few months of introducing the Xoom to maintain reasonable positioning.  This will create the perception that they are reacting to rather than anticipating a rather predictable (but prodigious) competitor.  The key question for Motorola is:  “If it is highly likely to happen why aren’t you getting out in front of it?”

Two things stuck me about this apparently illogical transaction.  The first is that this is a growing revenue stream for airlines – meaning offering a bad deal to many customers is paying off.  The second is why this appears to be working.  There are two elements to this – one rational, one not-so-much.  The rational play is that some frequent fliers buy the bonus miles to top off their accounts and get to an award level that enables them to redeem miles earned the hard way – flying.  From an economic standpoint this one makes sense, it may enable me to spend $100 in order to redeem miles for a $500 ticket – a pretty good deal.

The not so rational play owes to the faulty ways that we humans often process pricing information.  We see what appears to be a relatively small out of pocket expense – particularly when compared against the cost of the ticket – in order to get something that we place a high value on; frequent flier miles.  While I’m sure that there is an official behavioral economics term for this, let’s call it the Law of Small Numbers.  It applies when customers have a strong psychological reaction to what they are buying or when the price difference is small enough that it is not noticed.  We don’t feel that it is necessary to do the math.  These effects are why airline passengers will pay 3 cents per mile for something that is worth half that.

The Law of Small Numbers is a very important tool for pricers.  As even small increases in prices can have a dramatic impact of profits.  Think about it, what would be the impact on your bottom line of an increase of 0.25% or even 0.5%?  Given the minimal effort to implement and the fact that most customers won’t even notice, it’s a no-brainer.

What AT&T and Comcast are doing makes sense once you consider the nature of a pricing model that includes an all-you-can-eat-option.  Your highest volume customers pay the lowest per unit price while consuming significant resources.  This is fine when there is plenty of capacity and marginal unit costs are effectively zero.  And this was the model for service providers for many years as the supply of bandwidth was virtually unlimited.

Times and costs have changed.  AT&T and Comcast both have made significant investments in their networks to keep up with demand.  Since the costs of these upgrades are both incremental and avoidable, they need to be considered when making pricing decisions.  Conversely if either provider were to forgo upgrades they would have bottlenecks in their systems.  Where there are bottlenecks, there are opportunity costs which, in turn, need to be considered when setting prices.

Which brings us back to fully-bundled pricing -To maintain margins, these new costs have to be borne by somebody.  If the all-you-can-eat option is maintained, the full impact of these costs has to be passed onto the majority of customers who are more modest in their demands.  They, in turn, subsidize the highest volume customers.  Problem is that this makes lower-volume (and lower cost-to-serve) customers prime pickings for aggressive competitors who can offer lower prices and still make a good margin.  This type of pricing problem is pervasive and poorly understood.  With our business-to-business clients it is caused by “strategic” accounts that drive big volumes.  What AT&T and Comcast have figured out is that you need to look at your customer base as a portfolio with each segment returning different margins.  The key to effective pricing strategy is to understand and manage trade-offs and subsidies between and amongst these segments to maximize revenues and profits.

Unfortunately, taking on a pricing improvement initiative “because we want to make more money” is a recipe for a waste of money – and time.  While I like simple, clear goals this one is too big and broad to be useful.  The problem is that pricing needs to be aligned against a broader set of objectives.  They don’t have to be complicated but they do have to be clear and easily understood.  The best ones are related to a clear vision for how to grow the business:  which customers are being targeted and why?  which offerings promoted?  what position is being established against which competition?

The inability of management teams to answer these basic questions is a surprisingly common problem.  Yet, these are the very types of questions that are needed to guide an organization as they help to define “success.”  Without clear answers even the best managers feel like they are lost in the woods without a compass.  Under these conditions, pricing becomes a lowest common denominator activity.  Managers use it in the most conservative way possible; to close deals and keep revenues flowing.  So while it may be possible to cobble together enough support to take a hard look at pricing, the effort is not likely to garner any real support when it comes time to do the hard work of making changes.  When you think about it, this makes perfect sense.  If managers are not sure where they are going but feel like they’re making some progress against even hazy objectives, without either a strong directive from above or a clear and compelling statement of business objectives and purpose for price, all but the most confident managers are going to keep their heads down and avoid the hard work of taking on pricing change.

Here are a few key points of analysis that can help paint a clear picture of how a firm is managing pricing.  For each major product line:

• What is the delta between list prices and ASP?  What are the trends?  This is one of the most fundamental measures of pricing performance.  Firms that are heavily reliant on discounting to drive sales are not in a secure position and tend to become even more reliant on discounting to move units as competition intensifies.
• What impact do changes in ASP have on earnings and share price projections?  This is what the Trefis analysis is doing.  In the Motorola example a 1% increase in ASP correlates to roughly a 0.6% increase in share price.  Keep in mind that according to their methodology the handset business accounts for only 27% of the share price.  It’s easy to see how the share prices of firms that have fewer product lines are going to be far more sensitive to product pricing performance.
• What is the sensitivity of revenue and earnings projects to changes in price, product volumes, and product mix?  This is really a test of the quality of revenues.  Are key products falling out of favor and/or requiring more discounts to move them?  Is the company ceding the low end of the market to more aggressive competitors and thus seeing the size of its market footprint shrink? Are they doing desperate things in the market to hit revenue projections?
• Finally how does the firm being analyzed compare to its principal competitors?  At the end of the day, firms that have pricing discipline will outperform less disciplined competitors, their revenue and earnings projections will be more reliable, and they will have healthier businesses over the long run.

If pricing professionals want to rivet the attention of senior management on the benefits of connecting prices to value, they have to become much more proficient in speaking the language of value themselves.

• IBM eXFlash technology would eliminate the need for a client to purchase two entry-level servers and 80 JBODs to support a 240,000 IOPs database environment, saving $670,000 in server and storage acquisition costs.

• A 1,000 user SQL Server 2008 database will cost $50,000 on a two-socket eX5 system. IBM is expected to be the only vendor to deliver a two-socket system in this space, therefore users of competitive systems will have to purchase a four-socket server to run a 1,000 user SQL server database and pay $100,000. Pricing based on Microsoft List Pricing as of January 2010. Pricing model used is per processor licensing which is based on $24,999 per physical socket on the server (logical cores are not counted)

These numbers don’t take into account additional savings in space, power, labor, or maintenance.  So what we have here is a really interesting dilemma.  How the heck do you price something that potentially brings hundreds of thousands – maybe even millions – of dollars of benefit over and above competitive offerings when those competitive products cost around $7,000?

In theory IBM could get a significant premium here.  Based on the data above, a pure value-based pricing approach would point to prices that range from 3 to 50 times what the competition is charging.  After doing a little internet sleuthing, I found prices on the IBM Canada website that seem to indicate that new machines are priced roughly at parity with inferior competitive offerings.

Pricing innovations really does present a dilemma.  On the one hand, why not go with premium pricing?  Maybe cost-conscious customers won’t buy, no matter how compelling the value is.  Also, it is a safe bet that IBM wants to move quickly to grab share before competitors move in.  And yet, the value seems so compelling.  This is the other side of the Innovator’s Pricing Dilemma – worrying too much and under-pricing what seems like a breakthrough technology. Unfortunately this is what usually happens as nervous managers take the safe route.

So let’s assume a market share grab has something to do with this but let’s also give IBM credit for being a well-run company.  What questions should they have addressed to support such low pricing?

• For each unit sold, is there a significant stream of ancillary revenue from additional hardware, software, and services?  If so, how much is it?
• Do customers tend to be loyal?  Put another way is market share sticky?  If so what is the value of each point of market share gained?
• Is IBM’s technological advantage going to be short-lived?  If so, how long before a credible competitor appears and what is their likely price point?

Pricing is so much more than analyzing value and setting price levels proportionally.  As these questions indicate, it has to be conducted with a view toward a specific set of strategic goals and honest assumptions about the competitive environment.  Did IBM get it right here?  It’s hard to tell but my bet is that they have left a lot of money on the table.