Pricing, the intersection at which untold numbers of buyers and sellers meet every minute of every day, lies at the core of any business — large or small, old or new, Rust Belt or high-tech, local or global. Yet pricing remains misunderstood and poorly managed, according to The Price Advantage, a new book by three consultants at McKinsey & Company. Even executives at highly successful companies may not fully appreciate how small changes in price can lead to large changes in profitability.
Several software programs have been developed in recent years to help companies strengthen their pricing capabilities. But the authors – Michael V. Marn, Eric V. Roegner and Craig C. Zawada – argue that companies can truly achieve the price advantage only by making deep and lasting changes in their organizations. Such a major shift takes time, they say, but the effort can pay big dividends. Wharton marketing professor David J. Reibstein recently spoke to Marn, a partner in McKinsey’s Cleveland office, about the major themes that he and his co-authors discuss in the book. Over the years, Marn has developed some of the most widely used analytics for identifying pricing opportunities.
Reibstein: Mike, a good place for us to start is with you defining what you mean by the price advantage.
Marn: When we talk about the price advantage what we mean is not that a company has a product with a low price relative to competition. We’ve got a much more holistic definition. We think of price advantage as a superior capability to use price as a source of real competitive advantage that at the end of the day makes your company more successful. You’ll often hear companies talk about their other advantages. They’ll talk about a purchasing advantage or a cost advantage or an innovation advantage or a distribution advantage or a service advantage. You never hear them talking about having a price advantage – that they price better than their competitors do.
What we’ve observed over the years, and one reason we wrote the book, is that we had so many clients that worked so very hard to create advantages in other areas only to give them away because they didn’t have the price advantage, because they didn’t know how to price to make sure that the advantages they created really delivered benefit. Why bother to work so very hard to cut your costs if you’re just going to pass it on to your customers without taking anything for yourself? Why bother to work as hard to innovate if you’re just going to charge the same price for the old product that you’re replacing? Why bother working so hard to be a high-service provider if you’re going to match the price of a low-service provider in the marketplace? In a lot of ways, the price advantage is more than just an advantage unto itself. It’s an advantage that enables companies to realize the benefits of the other advantages they work so hard to create.
Reibstein: My understanding of a cost advantage is that I have lower costs. My understanding of a distribution advantage is that I have easier access to distribution. But you’re not talking about a higher price or being able to command a higher price or charge a lower price than the competition.
Marn: No. We’re talking about having the capability to come up with the right price more consistently. I would insist that the mistake most companies make, if you look at it over time, is they typically price too low. They have real benefits for which they don’t charge appropriately. The error bias is much more toward companies under-pricing. But at the same time, having the price advantage would let you know when you are indeed pricing too high and appropriately adjusting downward when that makes sense. It’s not about always being too high or too low. It’s about understanding the power of having the right price for as many transactions in the market as you can.
Reibstein: You make a strong point in the book about how you can leverage a small price change into big profit changes, and I think you articulate that pretty well. I’m curious how you see the tradeoff between price and market share, where the price advantage happens to lead to more of a short-term profit advantage versus going for market share, which might gain you a longer-term advantage in terms of distribution or, ultimately, lower costs.
Marn: That’s a good question. I think you have to read The Price Advantage in the context of overall strategy. In other words, what we’re talking about in most cases is, against the backdrop of the strategic decisions you make, how can you manage pricing? If indeed a management team says, ‘We need to have 35% market share or more in this particular market to survive, to support our infrastructure, to run our plants at adequate capacity,’ then we would suggest that even if you pursue that 35% market share, there are things you can do to maximize your price that will likely improve your profitability.
Reibstein: Is the issue of price critical across all industries? Let me tell you why I’m asking that question. I was looking at the numbers that you threw out for where a company gets leverage on price and it’s more the case for companies that have very high variable costs. I was wondering about industries where the variable costs are quite low, such as the airline industry or software. I was wondering how critical you think the pricing component is in those contexts?
Marn: I would make the case that the pricing lever is crucially important in all situations. What you often see happening in high fixed-cost, low variable-cost businesses is that, despite the fact that gross margins are very high, it’s not uncommon for actual operating profits, or earnings before interest and taxes, to be relatively thin. So the leverage of improving pricing is just as high on the bottom line. The way it trades off versus volume might be a bit different. But, that said, the upside of improving pricing is still equally powerful. Quite frankly, I think the one time I would take care about backing away from a strategy driven by understanding very carefully the tradeoff between price and volume and margin, would be a situation where you think your market is growing very, very quickly — in other words, situations where early penetration into a market or development of markets is crucially important. But any market that has grown to maturity where growth rates aren’t wild and where competitors have settled in – the payoff of doing this well, whether you have a heavy fixed cost or heavy variable cost structure, is extremely high.
Reibstein: What readership do you envision for the book?
Marn: We wrote this book for individuals in businesses who have a role in pricing. We believe there’s a role for the general manager, the CEO. There’s a role for the VP of marketing. There’s a role for the product manager. There’s a role for the sales manager. There’s a role for the salespeople. We wrote this book for the whole range of individuals up and down the hierarchy of most organizations who play a role in pricing decision-making.
Reibstein: What was your motivation for writing the book?
Marn: At McKinsey we’ve been doing pricing work as a major part of our marketing efforts for the better part of 20 years. It’s one of the largest single function areas of marketing in which we help clients. The thing that’s amazing is, you would think that after 20 years there would be a bit of a collective awareness of the pricing opportunity and of the basic frameworks and tools to create price advantage in organizations. It continued to amaze us that we would go into some business units of very good companies, Fortune 1000 companies, companies all around the world, and start talking about pricing as if we just turned on the light bulb for the first time. Our thought was by writing this book we could give managers a practical way of understanding and capturing this still-elusive opportunity for so many companies. Twenty years ago, I would have thought, golly, there wouldn’t be a need for a book like this because everyone had signed on to the powerful ideas around pricing. But we’re sitting here in 2004 with 50% of companies not being good at this. It’s one of the biggest surprises of my professional life.
Reibstein: Actually, I share in that amazement and, frankly, some disappointment that industry is not moving along a lot faster.
Marn: When you find a company that is really good at pricing, it goes beyond doing the Excel spreadsheets. Courage is required to really nail this. A lot of companies don’t do a very good job of creating the institutional courage to price right. It’s easier not to price well. It’s easier to cave in when customers ask for low prices, or competitors lob a low price into a situation. It takes a lot of intestinal fortitude to do it well. I’m wondering out loud if that behavior has prevented this from catching on like other more cut-and-dried management function improvement processes over the years.
Reibstein: Are there some industries where you think achieving price advantage is more developed than others?
Marn: I cannot point to one industry and say 80% do this well. It comes down more to individual players in a variety of industries.
Reibstein: I’ve been surprised to see how well the chemical industry does it.
Marn: I think a few chemical companies have really stepped up their game in pricing in the last five years or so. But I cannot point to a single industry where the top five players all do pricing well. Typically, you find zero or one in an industry that do it really, really well. Or maybe two. And that, to me, is what’s so exciting about pursuit of the price advantage. It’s not something everyone has already. It is still an advantage that can really cause you to stand out in terms of your performance. This is not about playing catch-up. This is about getting out ahead and investing in creating an advantage that most others in your industry probably don’t have already.
Even industries that invest tens of millions of dollars in pricing processes and systems don’t do it all that well. Look at the airlines. For all the sophistication they have in how they price, the performance of airlines today is not that great. You wouldn’t put a big part of your investment portfolio into airlines. In the specialty chemical industry a couple of players do it really well. In consumer packaged goods there are a couple that do it well and a bunch that don’t. You look at service industry and there are a minority that do it well and most don’t. You go right down the list and there’s no one industry you can point to and say across the board this is one industry that’s got it really nailed.
Reibstein: I want to pick up on something you said earlier – that there’s always a temptation to cave in. Where do prices really end up being set in a company? You talk in the book about how pricing departments have sprung up in companies in the last 10 years. But it’s one thing to have the price set at corporate and another thing when you get down to the front line where the salesperson is talking to the customer. First of all, how much of whatever ends up happening concerning pricing really happens on the front line rather than at corporate? And, second, how much leeway should you give the sales force in determining prices?
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