This article delineates a comprehensive playbook elucidating the optimal approach for companies to navigate the intricacies of pricing during inflationary times. Mateus Barros (mateus.barros@gmail.com) is a senior strategy, analytics, and pricing advisor with more than 20 years of pricing experience. He is currently in charge of leading the Revenue Growth Management capabilities at CMI Foods, a $5B company based in Latin America. Catherine Tucker (cetucker@mit.edu) is the Sloan Distinguished Professor of Management and a Professor of Marketing at MIT Sloan. She is the faculty director of the EMBA program. She has also been the Chair of the MIT Sloan PhD Program. She also teaches MIT Sloan’s course on pricing.

The Journal of Professional Pricing, December 2023

SUMMARY

Following the COVID-19 pandemic and its attendant supply-chain shortages and periods of intense economic stimulus, the world finds that it is facing a period of sustained inflation in many countries. Such inflationary periods bring uncertainty and challenges for both consumers and businesses alike. Consumers tend to lose their pricing knowledge, prompting shifts in their purchasing behavior towards more budget-friendly alternatives, even opting for different brands. Simultaneously, the consistent surge in raw material and labor costs continues to exert pressure on companies’ profit margins.

In such a scenario, businesses must embrace agility in their operational processes, especially in pricing management. Rather than uniformly transferring escalated costs to overall pricing, companies should adopt more nuanced methodologies to allow them to understand shifts in customer willingness to pay. This article delineates a comprehensive playbook elucidating the optimal approach for companies to navigate the intricacies of pricing during inflationary times. Covering aspects from pricing strategy formulation and goal delineation to actual price establishment and implementation, this framework for price management introduces several dynamic elements that come into play within an inflationary backdrop. Conversely, the foundational principles of most pricing techniques remain relatively unchanged.

As inflationary conditions persist, this article proffers a set of strategies for companies to effectively address inflation and safeguard their profitability and continuity.

HOW INFLATION IMPACTS COMPANIES AND CONSUMERS

In recent months, the world has experienced a significant surge in inflation rates, marking the highest price increases in years. Notably, the United States has been experiencing its most pronounced inflationary period in the past four decades. There is evidence to suggest that this inflationary trend will persist in the coming months and possibly even years.

In contrast to the inflation of the 1970s, which was primarily driven by surging oil prices, the current inflationary environment stems from diverse factors. The expansion of the money supply, initiated in the aftermath of the 2008 financial crisis, laid the groundwork for the current inflationary pressures. The COVID-19 pandemic further exacerbated the situation, causing supply shortages and disruptions throughout the global supply chain.

The impact of inflation has been far-reaching, affecting consumers, businesses, and governments alike. Consumers with limited purchasing power are witnessing a steep rise in the cost of essential goods, prompting shifts in their buying habits toward more affordable brands.¹

Companies with limited pricing flexibility are absorbing higher costs, while those with greater pricing leverage are significantly raising their prices, ultimately passing on the overall cost burden to consumers. Central banks worldwide have been compelled to raise interest rates as a measure to curb inflation, with notable repercussions for consumer financing—mortgage rates, for instance, have climbed to multi-year highs, imposing constraints on consumers.

Businesses that struggle to fully pass on cost increases are witnessing a decline in their profitability. Inadequately managed companies may even face the risk of bankruptcy, which could lead to job losses and reduced incomes for many.

Inflation remains unpredictable, making it challenging to set its precise arrival time. In addition, Inflationary forces disrupt multiple variables simultaneously, including costs, prices, and consumer purchase behavior, which makes predictions even more difficult.

In times of inflation, agility and the timing of price adjustments become essential. Successful price increases need a streamlined process involving thorough analysis, decision-making, internal approvals, and, finally, equipping the sales team to effectively communicate and defend the value of products. This process must be expedited to respond promptly to unexpected inflation. Timing and a company’s speed in reacting to these changes are critical to preserving profitability and ensuring survival.

Consumer behavior in this inflationary scenario can exhibit contrasting patterns. On one hand, consumers become more price-conscious and actively seek out better deals, resulting in higher price sensitivity and increased price elasticity for certain products. On the other hand, frequent price hikes can erode consumers’ reference points for certain items, compounded by supply shortages that limit product availability. In such cases, consumers may opt to purchase whatever is accessible. The scarcity of a product and its essential nature play pivotal roles in shaping consumer price sensitivity.

Given the uncertainty surrounding how consumers will respond to price fluctuations in an inflationary scenario, closely monitoring customer willingness to pay becomes crucial. Blindly passing on cost increases across the board without understanding consumer reactions can be a risky strategy.

WHY COMPANIES NEED TO CHANGE THEIR PRICE MANAGEMENT MINDSET TO DEAL WITH INFLATION

The return of high inflation rates has taken many by surprise, catching even seasoned managers off guard. Few countries, such as Brazil, Argentina, and Turkey, have experienced periods of high inflation in the past. Managers in Europe and the United States, on the other hand, have little recent experience in dealing with sustained price increases and are not adequately prepared.

In the past, companies in these regions typically planned price increases once a year or often less frequently. The predictability of cost increases allowed for a well-orchestrated process, where each step was meticulously executed. This process involved comprehensive analysis,

followed by recommendations for price adjustments, approvals, and ultimately, the implementation of these changes. Sales teams were trained to effectively communicate and defend these new prices to customers.

To maintain their current levels of profitability, companies must go beyond merely planning and implementing price adjustments; they must also ensure that these price increases are effectively implemented. In other words, companies must protect sales volume to generate enough revenues and absolute margin. To accomplish this complex task, it’s imperative to enhance the accuracy of predicting how customers will respond to price increases. To gain a deeper understanding of how demand reacts to price changes across various products and scenarios, companies require a more granular analysis. This analysis allows them to discern how different customer segments perceive the value of their products and services in comparison to the closest alternatives available in the market.

High inflation has added a layer of complexity to every stage of the pricing process, making it even harder to execute. In this complex and uncertain environment, professionals should focus on aspects they can control and set the groundwork to quickly gather information, conduct the analysis, and make well-informed decisions.

Close monitoring of cost fluctuations, a deep understanding of how customer willingness to pay evolves by each segment, and governance establishment to allow sales team empowerment without leaving money on the table are typical pricing tasks that don’t change with inflation. The main change lies in the necessity for companies to execute these tasks with extreme agility. It’s no longer sufficient to have a robust pricing process, governance, established pricing tools, and methodologies alone. Companies must also foster an environment that allows for rapid responses to market conditions change.

Effective top-level management plays a pivotal role in creating such an environment that empowers the sales team with accountability, establishes the correct business direction and priorities, and implements an automated, digitalized price management process.

HOW TO STAY AHEAD OF INFLATION

Now, more than ever, companies need to have their pricing management processes up and running efficiently to navigate the challenges posed by inflation. Inflationary periods serve as a test for pricing processes, highlighting, and exacerbating any existing inefficiencies.

Prepare the organization to establish a nimble process

The initial step toward establishing a nimble and well-prepared organization capable of navigating inflation lies in implementing a robust price management process. This process demands not only the right methodologies for price determination but also a governance model that strikes a balance between empowering the salesforce and maintaining control.

A holistic price management process extends far beyond mere price setting. It comprises essential phases such as crafting a pricing strategy, defining the price architecture and price

points, enabling the sales force to execute, and monitoring, all underpinned by thorough data analysis (see Fig 3.1). This comprehensive approach ensures that the organization is not only agile in responding to market fluctuations but also equipped with the necessary tools to make informed decisions and sustain profitability amid inflationary challenges.

Fig 3.1 – Price Management Framework

In this strategic framework, companies must concentrate their growth efforts in regions with the highest potential and where the company holds a distinct competitive advantage. To achieve this, businesses require precise tools and methodologies to identify key growth areas, establish optimal pricing positions in comparison to competitors based on their unique strengths, and fine-tune prices through precise elasticity and willingness-to-pay measurements by customer segment.

Certainly, companies should develop a pricing structure tailored to each sales channel, aligning with the desired sales growth objectives. This structure should precisely outline the margins allocated to each channel.

The pricing architecture, which includes channel-specific prices and positioning relative to competitors, should be informed by the broader pricing strategy, ensuring consistency and alignment across all channels.

There are three primary methodologies for setting prices: cost-based, competitor-based, and customer-based approaches. While the first two, cost-based and competitor-based methods, are simpler and more direct to implement, they often overlook a crucial factor: customer willingness to pay, especially in times of inflation.

Customer-based pricing reflects what a firm hears from customers about their prices. There are two flaws to this approach – first customers rarely encourage firms to charge higher prices if they are justified, but more importantly, it ignores the role of a firm in educating customers actively about value rather than accepting their passive judgment.

In summary, each of the three pricing methodologies offers its own set of advantages and disadvantages. Companies stand to gain by employing a hybrid approach, integrating elements from all three methods. Finding the optimal balance among these approaches becomes crucial, a balance influenced by factors such as budget constraints, time-to-market considerations, and the significance of the pricing decision. Indeed, the more pivotal a pricing decision, the more sophisticated the techniques employed for price setting should be.

After defining the price, successful price management depends on sales force enablement to allow an effective implementation. An agile price execution relies on a well-defined price management process, where tasks are clearly outlined with assigned responsibilities.

Have a clear strategy and stick to it

In the face of unpredictable and frequent cost increases, coupled with uncertainties about changing consumer habits and willingness to pay, companies must react quickly and navigate such challenges effectively. This demands a well-defined, agreed upon, and widely communicated pricing strategy and rapid access to cost and market information.

A well-defined strategy provides the necessary guidance to quickly respond with tactical decisions that align with the strategic business goals. Having clarity regarding business objectives, such as identifying which products and channels require aggressive growth versus those needing defense and profitability protection or understanding the allowed price positioning in comparison to competitors, proves invaluable in swiftly determining the appropriate response during unexpected cost increases.

Have a robust pricing governance

A well-established pricing governance model serves to promote an agile process. Predicting interactions across different departments, clearly defining responsibilities (specifying who is responsible, accountable, consulted, or informed at each step), and having clear criteria for escalating pricing decisions are prerequisites for an agile organization. While having an agile process for pricing increases is crucial, it is equally important to understand the situations in which companies, instead of increasing, should maintain current prices or offer discounts to preserve business and protect volume.

Centralized price increases are more efficient, but the sales force should possess a certain margin for negotiation when faced with pressure. They require a degree of “controlled freedom” meaning they can negotiate up to a certain level to balance between protecting volume and ensuring profitability.

The pricing process should be governed by a model that empowers the sales team with the right tools for decision-making. This model must strike a delicate balance between granting autonomy to the sales force and maintaining control. In essence, the involvement of top management in the process should be guided by the strategic importance and financial implications of each pricing decision.

Monitor and anticipate the market – the role of shifting input costs

Though costs should never be a primary driver of pricing decisions, we recognize that they can act as constraints on firms’ pricing decisions. They represent an important floor to firms’ prices. It is undesirable in the long run to price at a level which means that the firm cannot recover costs.

Changes in costs can also affect another important constraint on a firm’s prices which is their competitors’ prices. Anticipating competitor price movements is essential for estimating the extent of price increases they should implement.

To maintain an agile approach to combating inflation, it is crucial to monitor raw material costs and competitors’ prices. Anticipating and understanding the movements in these two key variables is essential to protect profitability.

For example, a multinational food company in Latin America, heavily dependent on wheat costs, has established a dedicated business unit specifically tasked with purchasing wheat in futures markets. This proactive measure serves to mitigate the volatility associated with raw material costs, ensuring stability in their supply chain.

In the United States, a restaurant chain employs digitally monitored websites to constantly track competitors’ prices. With this data-driven approach, they are empowered to make well-informed decisions regarding their pricing strategies.

Meanwhile, a European telecom company organizes workshops before implementing any price changes. These workshops simulate potential reactions from competitors, allowing the company to refine its strategies based on these simulations. This careful and methodical approach enables them to anticipate market dynamics, ensuring that their pricing decisions are well-calculated and responsive to competitors’ moves.

By proactively engaging with these key variables, these companies exemplify the importance of agility and foresight in monitoring the market to tackle inflation.

Set high goals and differentiated price increases

Recognizing that every business may have areas of margin leakage or clients bound by long-term contracts that don´t allow price adjustments, companies should consider implementing higher price increases than they need to protect profitability.

In addition, a “one-size-fits-all” approach should never be applied to a price increase. When increasing prices, companies must consider the different product elasticities and tailor price adjustments accordingly. In the retail sector, for example, businesses should avoid significant price hikes on “traffic driver” products, where consumers are highly price sensitive. Instead, they concentrate their price increases on “long tail products” or items with less price sensitivity.

Understanding consumer willingness to pay and how it has evolved with inflation is crucial for making precise decisions about diverse price increases. Being aware of these changes enables companies to implement targeted and effective pricing increases across their product range.

Review contracts

The effectiveness of price increases is also influenced by transactional costs incurred by customers. Unnecessary discounting, misdirected marketing efforts, and low-performance

accounts can erode a company’s profitability significantly. When reviewing contracts’ terms and conditions, it’s possible to identify inefficient customer incentives. In times of inflation, it becomes crucial to reassess conditions such as early payment bonuses, late payment fees, freight charges, volume commitments, delivery windows, and other elements that contribute to higher costs to serve.

A robust discount policy operates on a “give-get” logic, meaning that if a company offers a discount, it should receive something of value in return. This could include higher-margin product sales, reduced cost-to-serve, or more favorable payment terms, among other benefits. For example, by offering a “volume discount,” the company expects more sales at a given discount, while with a “sales mix discount,” the company expects customers to buy more profitable products.

Working on these terms with a “give-get” logic will improve the return on discounts given, especially when customers adopt profitable behaviors beneficial to the company.

Prepare the sales team to negotiate

In times of inflation, negotiations become more frequent, demanding the sales team to be well-prepared and empowered to quickly make decisions, ensuring profitable deals. Empowerment involves not just responsibility but also the ability to react promptly and decisively. During negotiations, the sales team must have a clear understanding of the trade-off concessions that can be made and those that are non-negotiable. They need to discern which customers are worth making concessions for and when it’s better to let them go if they don’t agree with price increases. In essence, they should have well-defined negotiation targets and walk-away thresholds.

To bolster the sales team’s confidence, providing them with in-depth knowledge about the product’s value and the company’s competitive advantages becomes crucial. This knowledge equips them to defend against competitors’ price attacks effectively, ensuring they can articulate and justify the value proposition, even in challenging negotiation scenarios.

Incentivize the sales team correctly

It is well-known that revenue-based incentives can prompt the sales team to reduce prices in exchange for volume. It´s a rule of thumb to measure the sales team’s performance based on price realization, meaning the invoice prices after deducting all applicable discounts, rebates, promotions, and other transaction costs. This incentive structure becomes particularly critical in inflationary times when, alongside implementing price increases, addressing transaction costs that could erode margins becomes equally important.

Working on variables beyond price, such as payment terms and other contract specifics, adds complexity to the sales job but is equally crucial. Managing these intricacies effectively ensures a balanced approach, safeguarding profitability.

FINAL REMARKS

High inflation rates have persisted after the initial shocks of 2021-22, indicating a trend that organizations need to recognize and prepare for. Without proactive action, firms risk losing margins and the ability to remain profitable.

Effective leadership is crucial in helping organizations navigate these inflationary challenges. Creating strategies for how to deal with this new inflationary environment should become a top priority on the CEO’s agenda, creating a sense of urgency for implementing agile price management processes. Also, at the C-level, it is crucial to caution the organization against the revenue illusion caused by inflation. During inflationary periods marked by constant price increases, focusing solely on revenue is misguided. Instead, emphasis should shift toward preserving and maximizing profit margins.

Inflation also puts established pricing processes to the test. Now, more than ever, companies require agile pricing strategies with a governance model that strikes a balance between granting the sales force autonomy and involving C-level executives in critical decisions. Sales teams should be empowered and made accountable for most pricing decisions. They need to be trained to negotiate effectively, justify product value, and defend product prices.

If we want firms to remember one thing from this article, it is that a uniform price increase across all products is not advisable during inflationary times. If certain segments of the population experience reduced effective income due to inflation, companies may consider holding off price hikes for these segments while adjusting prices more than the inflation rate elsewhere.

In summary, inflationary periods challenge existing pricing processes, highlighting and exacerbating any inefficiencies. Strong C-level leadership is essential to elevate inflation as a top priority, creating awareness, and implementing robust pricing strategies. These strategies are vital for managing inflation without compromising profit margins and competitiveness.

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