The 1% Windfall: How Successful Companies Use Price to Profit and Grow

Introduction: The 1% Windfall

There is a fundamental profit disconnect in business today. Companies work to bring a product to market by investing significant effort and money in research and development, distribution, and marketing strategies. But when it comes to setting a price—how businesses get compensated for their hard work and financial risk—most companies drop the ball. Critical pricing decisions are often made using arbitrary this is the way we’ve always done it methods. Companies are shortchanging themselves every day.

Most managers aren’t comfortable setting prices. With few pricing golden rules and little practical guidance for improvement, it’s understandable why firms have continued with the status quo. How are companies setting prices today? Most react. Instead of a driver of new profits, prices are a mix of marking up costs, maintaining margins, matching competitors, and seat-of-the-pants analyses.

Since pricing is an underutilized strategy, it is fertile ground for new profits. Focusing on better pricing is a quick path to new profits and growth. Most business improvement initiatives require significant capital investment and long seed-to-harvest periods to determine whether or not the effort pays off. In contrast, many of the concepts that I will discuss are straightforward to implement and can start producing profits almost immediately. Consider Costco’s signature $1.50 quarter-pound hot dog and soda special. A small increase to $1.52 (and carrying this percentage increase across all of Costco’s prices) would boost this warehouse club’s operating profits by 48%.¹ And here’s the best part: prices can be changed on Sunday night and new profits will start flowing in on Monday morning. I’ve seen it.

Most companies don’t realize the direct link between prices and their profits. It’s this connection that makes pricing one of the most powerful strategies available to businesses today. A manufacturing company I work with has operating profits of 5%—it banks 5 cents of every dollar of revenue it collects. If this company raised prices by just 1% (charged, say, $1.01 instead of $1.00), it would earn an extra penny per revenue dollar (its profits would be 6 cents instead of 5 cents). This extra penny translates into a 20% increase in operating profits (1 extra cent per 5 current cents of profit). This calculation, of course, assumes that demand for the product remains constant at the elevated price. The point is that a small change in price can have a big effect on a company’s financial bottom line.

A study by McKinsey & Company of the Global 1200 found that if they increased their prices by just 1%, and demand remained constant, on average each company’s operating profits would increase by 11%.² Based on my analysis of revenue and operating income data from 2008 annual financial statements, Figure I-1 reveals how a 1% price increase would boost the operating incomes of several well-known companies.

Figure I-1 1% Windfall for Select Fortune 500 Companies

THE EFFECTS OF A 1% PRICE INCREASE…

Company: Sears

1% Windfall Operating Profit Increase: 155%

Company: McKesson

1% Windfall Operating Profit Increase: 100%

Company: Tyson

1% Windfall Operating Profit Increase: 81%

Company: Land O’Lakes

1% Windfall Operating Profit Increase: 58%

Company: Whirlpool

1% Windfall Operating Profit Increase: 34%

Company: Humana

1% Windfall Operating Profit Increase: 27%

Company: Amazon

1% Windfall Operating Profit Increase: 23%

Company: Wal-Mart

1% Windfall Operating Profit Increase: 18%

Company: Home Depot

1% Windfall Operating Profit Increase: 16%

*Calculations based on 2008 annual data and assume that demand remains constant after 1% price increase.

The benefits of a 1% price increase are compounded when measured in terms of their effects on a company’s market capitalization. The value of a company—how much it is worth—is often calculated as a multiple of its current earnings. The standard convention is to multiply a company’s annual earnings by its price-to-earnings ratio (share price divided by net earnings per share) to determine its total value. In the case of Wal-Mart, given its price-to-earnings ratio of 14.56 and 2008 net income of $13.4 billion, an estimate of its market capitalization is $195 billion.³ Since a 1% price increase leads to a higher net income, this in turn boosts a company’s market capitalization. A ballpark measure of the effect of a 1% price increase on Wal-Mart’s capitalization involves multiplying the additional net income derived from a 1% price increase ($2.6 billion) by its P/E ratio of 14.56. In this case, Wal-Mart’s 1% windfall is roughly an extra $37.9 billion in market capitalization.⁴

These are very powerful results. As I tell my clients, 1% is a small number…and achievable.

A PROFIT OPPORTUNITY FOR COMPANIES

Whether the size of a company’s 1% windfall is high or low (as measured by operating profit margins, market capitalization, or additional profits), pricing is an important strategy for every business. It is a primary variable in determining profit, as well as a key attribute that consumers consider before making a purchase.

It’s surprising how many people within an organization care about and touch prices: CEOs searching for fast profits, CFOs focusing on revenue (instead of cutting costs) to improve financial health, marketing managers setting prices, product managers counting on price to meet their P&L responsibilities, and sales managers seeking new ideas to help with their daily pricing negotiations. Clearly, pricing is an important strategy for many levels of a company.

Without a general philosophy on how to approach pricing issues, it’s inevitable that a range of conflicting pricing fiefdoms set up camp within a company. It is common to encounter various managers who want to keep my margins above a target percentage, mark up my costs by a fixed amount, or be the king of market share. Every company has a few who want to give my customers as many discounts as possible. It’s rare to meet a manager focused on using a mix of pricing strategies to make the most profit.

The unavoidable result of these competing pricing philosophies is confusion and frustration. With no means to resolve these differences, it’s understandable why many employees end up with an Oh well… attitude toward pricing. This lackadaisical resignation leads to missed profits and opportunities.

Because of their challenging experiences and the role that pricing plays in their jobs, I’ve found that staff members are interested in discussing and learning more about pricing. After he read my first pricing book, The Art of Pricing, Larry Waxman, president of Waxman Industries, told me: I like to gather our management team together to discuss our business. Pricing is a good topic that brings my team together—everyone is interested in it. And while I call it a ‘pricing meeting,’ we always end up talking about other issues too. Pricing is a common denominator throughout a company.

No team can achieve the best results if its members cannot agree on the goals and actions necessary to reach them. Once, while I was moderating a pricing discussion among senior executives of a Fortune 500 company, one participant sat up straight in her chair and said, Now I finally feel that we are on the same page. And she was right. These executives had a history of bad pricing experiences, and there was an ongoing conflict over how to set prices. Money was being left on the table daily.

This book starts a crucial conversation about pricing that needs to take place within every organization. It creates common ground for better pricing. Most employees take pride in the products and services they provide and want their company to succeed financially. But to do better, they need pricing guidance.

This book helps to solve the universal challenge that every company in the world faces: What pricing strategy should I create for my products and services?

IDEAS THAT EVERY COMPANY CAN USE

Having written for academic journals and conducted technical research in a variety of settings, I am well versed in the academic concepts that underpin this book. However, brainstorming in an ivory tower is a long way from helping manufacturers set profitable wholesale prices for Wal-Mart and Wendy’s. This book incorporates insights gained from spending the last twenty years working on pricing issues in public policy and the private sector. For most of my career, I’ve worked directly with companies on their pricing strategies. Today my clients range from a mom-and-pop barbecue restaurant in a small town to multinational companies on Wall Street.

Throughout the book, I will share success story interviews that I conducted with managers in a wide variety of industries. These stories showcase the victories of managers who have faced challenging pricing problems. The straightforward pricing strategies they developed and applied have reaped generous windfalls. If these managers can price for profits and growth, you can too.

When I start working with a team of managers on their pricing strategy, it is common for them to caution, Pricing is unique in our industry. And it’s true—most industries have their own pricing nuances. This book highlights and shows techniques to profit from fundamental consumer pricing behaviors that are relevant to all products and services. The ideas and strategies build a foundation to create a pricing strategy for every company in the world: any product or service, domestic or international, B2B or B2C, sole proprietors to conglomerates, even nonprofits.

BETTER PRICING IS FAR MORE THAN RAISING PRICES

I’ve explained the financial benefits of a 1% price increase to illustrate the power of pricing and its direct link to the bottom line. And while companies often have the opportunity to profitably raise prices, I do not advocate a draconian across-the-board price hike. There are other win-win pricing strategies that benefit both companies and their customers. In particular, every company should consider:

Setting value-based prices

Activating dormant customers with pick-a-plan

Using the power of versioning to add product variations

Offering different prices for the same product

The foundation of better pricing involves setting prices that capture the value that customers place on a product or service. This value-based pricing process begins with identifying what the customer’s next-best alternative is and then evaluating its attributes. Value-based pricing uses the next-best alternative’s price as a starting point and then adds or subtracts based on product attributes. More bells and whistles command higher prices (an organic fresh turkey versus a frozen Butterball). A stripped-down product yields a lower price (private label versus brand name).

Setting a value-based price involves thinking like a customer when setting prices. Consider the decision process you go through when making a personal purchase. Most of us evaluate a few products and choose the one with the attributes and price that offers the best deal (value) among the various alternatives. It’s important to emphasize that the value of a product or service differs by customer and value doesn’t necessarily mean the lowest price. After all, many people pay $200 for Dom Pérignon champagne, while others celebrate with $10 Korbel sparkling wine.

Many companies incorrectly set their prices based on what it costs to manufacture a product. The price that consumers are willing to pay depends on the value they place on a product, not how much it costs to make it. Street vendors in Central Park understand this principle. At the first hint of rain, they raise the price of their umbrellas. This increase has nothing to do with costs; instead, it’s all about the increased value that customers place on an immediate haven from rain. Better pricing involves capturing value, not marking up costs. Disassociating prices from costs and focusing on capturing value is often a big change for managers. But doing so is fundamental to pricing for profits and growth.

When companies shift to value-based pricing, prices often end up rising. For years, customers may have been smiling and thinking, I would have paid more. And the truth is, most companies have room to raise some of their prices by 1%. Would an extra 1% (25 cents or so) have caused you to put this book back on the shelf? Companies are usually hesitant to admit that their new pricing strategy resulted in higher prices…it isn’t exactly endearing to their customers. Cleveland-based industrial manufacturer Parker Hannifin hasn’t been shy about acknowledging the benefits of setting prices in a manner that captures the value that customers place on its products.

In 2003, Parker Hannifin abandoned its long-running practice of marking up costs in favor of setting prices based on how customers value its products. Airlines know they can get away with charging more for a seat to Florida in January than in August. Sports teams raise ticket prices if they’re playing a well-known opponent. Why shouldn’t Parker do the same? reasoned CEO Donald Washkewicz.⁵

Viewing pricing through a value-capturing lens, the company discovered that customers were willing to pay more for many of its products. For certain types of metal fittings, Parker Hannifin raised prices between 3% and 60%, with the average increase being 5%. The company claims that the upside of its price changes helped lift net income from $130 million (2002) to $673 million (2006). As a result, Parker Hannifin’s shares rose 88% in that time period (compared to a 25% increase in the S&P index).⁶

While increasing prices is tempting and easy to implement, doing so carries some downside risk unless a value-based analysis is used. Consider the 2000 Return to Love reunion tour of Diana Ross and members of her former backup group, the Supremes. With tickets priced as high as $250, at some venues there were rows of empty seats. Only 3,000 people attended a Columbus, Ohio, concert in the Value City arena, which holds 22,000, and only 1,400 tickets were sold for the 16,500 seat Hartford XL Center in Connecticut.⁷ After twelve of the twenty-three scheduled shows, the tour was cancelled.⁸ Commenting on the lackluster sales, concert industry analyst Bob Grossweiner opined: There has never been a tour bought by a national promoter that’s done as bad as this one and had a clash over money like this one.⁹ Prices based on the value that customers place on the show would have improved profits and smoothed the path of this less than harmonious reunion tour.

A VALUE-BASED ANALYSIS MAY LEAD TO LOWER PRICES

Setting a value-based price, which I’ll discuss further in Chapter 1, sometimes leads to a lower price. This strategy may seem counterintuitive, as lower prices result in thinner margins. However, a lower price can actually result in higher profits because more customers say, I’ll buy. These new customers compensate for the resulting slimmer margins.

The summer 2005 employee pricing blowout sale by the Big Three automakers (Ford, GM, and Chrysler) illustrates the benefits of lowering price. Approaching a new model year with unprecedented inventory levels, another ordinary summer sale wasn’t going to clear the lots. To demonstrate its commitment to offering its best prices, General Motors took the revolutionary step of offering to the public the prices that its employees pay for vehicles. Ford and Chrysler followed with similar plans. The concept of employee pricing resonated with consumers—everyone appreciates getting an insider deal. In its first month, Ford’s sales rose by 29%, Chrysler’s went up by 32%, and GM tallied a 41% sales increase, making it the third best sales month in history.¹⁰

PICK-A-PLAN: ROLL OUT NEW PRICING PLANS

Customers are often interested in a product but refrain from purchasing because the selling strategy does not work for them. While some want to purchase outright, others may prefer another pricing plan such as rent, lease, prepay, or all-you-can-eat (or use). A pick-a-plan strategy activates these dormant customers. Pick-a-plan is the concept of offering a pricing plan that generates growth by better understanding and better serving customers. Providing a pricing plan that satisfies a key need of an underserved segment can generate big growth.

Some companies base their entire business strategy on a new pricing plan. A great illustration of the power of pick-a-plan pricing involves my friend Fred Straus. For his seventieth birthday, Fred decided to splurge on a weeklong Caribbean vacation with his wife, children, and grandchildren. Inquiring about his destination, he emphasized: "I have to go to an all-inclusive resort—it would kill me to see my grandchildren on the beach drinking $5 Coca-Colas all day." What a fascinating response…and a pricing concern that most of us can relate to. It’s interesting that, of all the attributes available when booking a Caribbean vacation (island, hotel characteristics, local activities, price, and so on), an all-inclusive price was at the top of Fred’s list. By offering an all-inclusive plan, resorts satisfy an important need of customers like Fred who value and are willing to pay a premium for the freedom of not having to think about the price of every meal, drink, or activity while on vacation. Offering this pricing option moves a resort to the top of the list for these vacationers.

DIFFERENTIAL PRICING: OFFER LOWER PRICES

The law of demand, as illustrated by a downward-sloping demand curve, offers a key pricing principle: some customers are willing to pay more than others. Differential pricing is the strategy of selling the same product to different customers at different prices.

Customers are often interested in a product but hold off purchasing because it is too expensive. The drawback of lowering prices to attract these price-sensitive customers is that profit is lost from those who are willing to pay the current higher price. One option to minimize this loss is to offer targeted discounts. This strategy can be accomplished by creating a hurdle that customers must jump over to receive a discount. The notion is that only price-sensitive customers will jump over the hurdle to snare the discount. Customers who don’t make this effort (less price-sensitive customers) will continue to pay current prices.

An example of a hurdle discount strategy is the TKTS theater ticket booths in London and New York. On the day of the performance, many theaters sell their excess inventory through these TKTS booths at 25% to 50% off. Value-conscious consumers line up daily in hopes of getting a good deal on a theatrical experience.

This strategy does a good job of segmenting discount-oriented from full-paying customers. Suppose that you are vacationing in London and seeing The Phantom of the Opera in the famed West End theater district would be a trip highlight. Would you forgo purchasing full-price tickets in advance to wait in line in hopes that tickets (and perhaps good seats) are available? Probably not. Those who want to see a specific play (higher-valuation customers) pay full price, while those who care less which play they see (lower-valuation customers) queue up for a discount.

VERSIONING: ADD PRODUCT VARIATIONS

While it’s possible to offer a handful of differential prices, it’s not realistic to set a unique price for every customer interested in a product. The popular strategy of versioning involves using a core product as a base and adding/subtracting attributes in a manner that appeals to more customers.

A common versioning tactic involves offering good, better, and best product versions. Those who highly value a product purchase the best version, while customers with lower valuations select the good or better products. In summer 2007, Scholastic