Pricing should be on the agenda for your next board meeting.
The economy has turned. Inflation is headed up over 8% per year and could go over 10% in the United States. Interest rates are rising in response, and the economy could tumble into a recession (two consecutive quarters of contraction). Business, as usual, is not an option.
Of course, inflation is not the same across industries. Some industries are seeing extreme inflation, like energy and industries highly dependent on energy, while others, like medical commodities, are actually seeing deflation. The question is not ‘What is the level of inflation in my industry?’ but “What is the level of inflation in my customers’ industries?”
Boards need to help their companies develop the resilience to survive these changes and prepare them to adapt to a changing environment. One step towards doing this is to ask some basic questions about pricing.
- Can we increase/decrease prices?
- Should we increase/decrease prices?
- What impact will a price change have on our customers?
- How will our competitors respond to a price change?
- What are the long-term implications of a price change?
Can we increase prices?
Before deciding what action to take, it helps to know what actions can be taken. With price changes, it helps to start with the simplest questions.
- If we increase prices, how much volume can we afford to lose and maintain the same revenue?
- If we increase prices, how much volume can we afford to lose and maintain the same profit?
- If we decrease prices, how much volume can we afford to lose and maintain the same revenue?
- If we decrease prices, how much volume can we afford to lose and maintain the same profit?
To establish a general framework, here are some basic assumptions that will be typical of many SaaS businesses (SaaS business dynamics are different than those of companies selling fixed goods or even software licenses and professional services).
Here is a simple set of assumptions.
- Current price 100 per unit per year
- Current volume of 1,000 per year
- Variable costs 20 per unit per year (gross margin of 80%)
- Fixed costs of 20,000
Let’s test a 10% price increase and a 10% price cut.
For the price increase of 10%, one can have volume decline by 11% and keep profit constant, 9% and keep revenue constant or 17% and keep the profit margin constant (there are some businesses that are managed on profit margin).
For a 10% price cut, one needs to be able to grow volume by 14% to keep profit constant, 11% to keep revenues constant, and 25% to keep the profit margin constant. In a recessionary environment, it may be difficult to realize these volume gains even with lower prices.
Note that the volume that keeps revenue constant leads to lower profits.
The first thing to do is to see if the changes to the volume are credible. This is usually done through conversations with sales, though there are a number of different revenue prediction packages that can help with this.
Systematic testing of price changes will help define the freedom of operation that you have to change prices. One can even construct a drawing that shows the range of price increases and decreases that should be revenue neutral. This can help frame discussion on pricing.
Should we increase prices?
Let’s assume that you do have some latitude to change prices (most companies do). That does not mean you should change prices. Price changes need to align with and support strategy and not be reactive or the result of competitive or cost pressures.
Different companies will adopt different strategies in a recession.
- Focus on our most valuable customers
- Cast as wide a net as possible and expand our customer base
- Keep our current customers at all costs
Any of these could be appropriate, and one could have different goals for different market segments. Some companies may even use the combination of inflation, higher interest rates, and a recession as an opportunity to target certain competitors and incent switching.
Any decision to change prices should be part of a specific business strategy to achieve one of the above goals. Price changes should be part of larger campaigns to create more value for customers.
When increasing prices, make sure that more value is being delivered and combine price increases with value enhancers. These could be improved service packages, additional functionality, access to data … anything that delivers more value to your customer. Be careful of justifying price increases as a pass-through of costs. Buyers have become skeptical of this and may even ask for assurances that if your costs go down your prices will also go down. This is an assurance few companies are willing to offer.
Reducing prices has to be framed carefully so as not to lower the reference point for value. There are several tactics to do this. Link the price reduction to an economic indicator relevant to the customer’s industry. This makes it possible to naturally adjust prices in response to economic changes.
What impact will price change have on our customers?
The change in economic conditions will impact different customers in different ways. Some of your customers may be in counter-cyclical industries. They do relatively better when the economy contracts. Many financial companies benefit from higher interest rates. The energy sector is enjoying windfall profits from the short-term spike in energy prices. Not all customers are alike.
- A simple framework to segment your customers is the following.
- Is the customer advantaged or disadvantaged by the current economic changes?
Is the customer getting more value or less value from your solution?
This is a bit too simple, of course. One needs to drive down to specific value drivers and variables to really understand what is happening but it does give a place to start. Boards should ask their leadership teams how their current customers are distributed across these four segments.
How will our competitors respond to price changes?
Competitive alternatives always factor into pricing. One question that needs to be answered at the next board meeting is: “How are our competitors changing their pricing and discounting?”
This does not go far enough, though. Changes in economic conditions can also open the field to new alternatives. So go on to ask: “What new areas can we now compete in?” and “Who are our new competitors for these new opportunities? (These are the industries where your ability to deliver Value to Customers is increasing.)
“What new competitive alternatives could enter the market?” Competitors should not drive pricing, but they provide part of the context for pricing strategy and can be expected to respond to any pricing moves you make. If you decide to raise prices, will competitors take advantage of this to raise their own prices, or will they use this to attack you? If you drop prices, will competitors follow your prices down, or will they try to hold the line? These are simple questions, but playing out these different scenarios is part of the pricing strategy.
What are the long-term implications of price changes?
Pricing is a long-term game. Companies that are simply reacting to market forces and external economic conditions are not going to win. Long-term pricing strategy execution requires data. One needs to be able to see the results of past actions and pick out trends and patterns.
In most companies, this data exists, or existed, but is scattered across multiple applications and kept in different data formats. It is only analyzed when a crisis forces the company to reframe its pricing. This is not good enough going forward. Value and pricing data need to be collected and analyzed as part of day-to-day business activity. One successful industrial company reports monthly on the impact of pricing (including discounts) on revenue change. This attention to detail helps them see market changes early and take action to make sure that pricing is making a positive contribution to the business.
Pricing strategy requires perseverance, strategic alignment, and long-term execution. These are areas where the board should be engaged and provide guidance and support. Rather than dipping in and out of pricing, the board should have a standard set of pricing questions that are part of every meeting.
- How is pricing aligned with overall strategy?
- How is pricing contributing to revenue and profit?
- Is price aligned with the value we deliver?
- What is changing that will lead us to change our pricing?