How to Think About Pricing Strategies in a Downturn - Your Best Downturn Strategy? Think Twice About Price Cuts

by Nick Wreden

When times are good, pricing sins can be easily forgiven. But when the economy sours, a misguided pricing strategy can shrink profitability, warp customer relationships, and destroy a brand.

When sales and profits are plummeting and customers are demanding better deals, the instinctive response is to cut prices. This silences customer complaints, helps cover fixed costs, and buys time until the economy rebounds. A price cut can also boost sales quickly, especially when there is no money for advertising or other promotions.

But such a knee-jerk reaction may not be the best strategy, say the experts. Price cuts now may affect your company's profitability when the upturn occurs. It may signal to customers that you're an easy prey for additional discounting. And it may cloud your brand's hard-won image.

Pricing decisions should not be viewed as Band-Aid solutions for bleeding income statements, says Reed K. Holden, president and CEO of Strategic Pricing Group in Waltham, Mass., and co-author (with Thomas T. Nagle) of The Strategy and Tactics of Pricing. Rather, they should be part of a long-term strategy for fiscal fitness. When economic storm clouds gather, trim your production levels, postpone expansion plans that aren't absolutely vital to your future growth, and slash nonessential costs wherever you can. This prepares you to pursue low-value business opportunities that help you maintain your cash flow without drastically reducing your production capacity.

Crafting the right strategies will not only strengthen your business now, it will also prime it for growth later. To bolster sales while avoiding a price cut's dampening effect on long-term profitability, keep the following advice in mind:

Remember the big picture
Profitability is not the only prism through which you should view pricing. Other important perspectives include:

• Volume. Too many firms fail to account for the effects of price on volume and of volume on costs. In a recession, trying to recover these costs through a price increase can be fatal.
• Impact on customer relationships. "Sucker pricing" is the term that Eric Mitchell, president of the Professional Pricing Society (PPS), an Atlanta-based association of pricing and marketing managers, uses for the excessive pricing that occurs when companies have locked in customers through contracts or proprietary implementations. This creates ill will and tarnishes your brand.
• Impact on the industry. Price cuts not backed by cost reductions often lead to competitive counterattacks, which erode profitability.

Adjust your sales goals
"Don't fight today's sales wars with yesterday's pricing strategies," says Mitchell. Sales goals set when checkbooks were open may no longer be suitable for a recession. Executives experience what Holden calls the "coffin corner of costing" when, for the purposes of making the numbers, they overemphasize capacity utilization and become willing to cut the price of high-value products. The wireless industry, for example, generated strong demand with its low pricing but then was unable to recover its costs of capital.

Instead of sales goals, set dollar contribution goals for products, market segments, and individual customers. To do this you may have to invest in financial systems that can track process costs as well as direct costs. Moreover, setting profitability goals may mean abandoning market-share goals. After all, a large market share doesn't necessarily mean increased profitability—as the recent performances of Sears and GM show. But switching to profitability benchmarks can help you pursue other low-price business.

It may also make sense to change the basis for your pricing. Most expert believe that pricing based on value—the economic or psychological benefits delivered by your product or service—is much more effective than competitor-, cost-, or customer-driven pricing strategies. Remember, too, that the basis for customer value can shift when the economic climate changes. When times are good, customers often place a premium on your maintaining production capacity to ensure timely delivery of their orders; otherwise, their sales suffer. But in a recession, logistical services may be more valuable.

Understand your competitive advantage
In a recession, pricing should be shaped by industry position and long-term strategy. If your competitive advantage derives from a low-cost structure, cost cutting can pump up your market share, positioning your firm for a payoff when the economy improves. Dell Computer, Southwest Airlines, and Wal-Mart all use price as a weapon to leave weaker rivals by the wayside. But a common mistake, says Holden, "is to use price as a competitive advantage for high-value products by giving away services or discounting to your best customers. You erode the base of profitable customers and reduce the potential for profitability when the downturn ends."

Leverage your segmentation strategy
Especially if you have high fixed costs, use pricing to generate incremental revenue from your segmented customer base. Strive for "first-class," "business-class," and "economy" pricing, the way the airlines do. First-class customers receive extra value with minimal discounting; economy customers get minimum value. Such segmentation based on price sensitivity creates sales opportunities that can offset losses in other areas, especially since there is often little difference in production costs among the offerings. In addition, a premium offering such as Nokia's new line of luxury mobile phones can motivate price-sensitive buyers to move up to midrange offerings in the pursuit of additional value.

Offerings can be segmented not only by value added but also by time (for example, peak-load purchasing), location, or purchase quantity. "The more you can slice and dice your prices and offerings without affecting your brand, the more you can sustain profitability," says Mitchell. Dynamic pricing represents an extension of such a segmented pricing strategy; here, prices shift instantaneously in response to changes in supply and demand. Although the practice doesn't suit every company, early testers of dynamic pricing software have been pleasantly surprised to discover how much more they can charge without affecting sales volume. The consulting firm Accenture reports that a price increase of just 1% can improve operating profits by 11% if sales volume remains constant.

Pamper loyal customers
Losing a customer now represents a double whammy: It drains customer equity and raises the cost of acquiring a replacement. Keep your best customers happy by bolstering loyalty programs or providing additional services. Consider offering product training or other classes for your B2B customers—not only will it augment the value you offer customers, it will also make it more difficult for those customers to switch to another provider.

But don't make the same mistake the wireless industry did. When carriers offered attractive deals to new customers but didn't make those same offerings available to existing customers, high churn rates resulted.

Plug revenue leaks
Companies can run aground on pricing gaffes once covered by the high tide of a good economy. A common oversight is not recovering all the costs involved in services, delivery, or other processes, says Mitchell. Set minimum order quantities so that processing costs won't eat all the profits. Strengthen your collection efforts to shrink the time between orders and receipt of payment. Without undermining customer value, establish a price menu for "free" services such as delivery or favorable payment terms. When sold separately, such offerings increase revenue opportunities. They also provide a benchmark value for customers who formerly discounted them because they were free.

In a recession, revenue leaks also occur because sales forces become less resistant to customer pressures. They knock down the price until the sale is won, despite the impact on profitability. Ideally, prices should be negotiated based on business rules—volume, delivery, financing—and not according to the negotiating skills of purchasing agents. They should also be based on the value to the customer. But sales forces often oppose value pricing because it usually means higher prices and a greater willingness to walk away from price-sensitive deals. To encourage the desired behavior, compensate your sales force based on its contribution to profitability and/or customer equity, not just on sales volume.

Shift the battleground
When you negotiate with customers, include other factors besides the payment amount—for example, payment terms or ongoing training—in the conversation. Some additional suggestions:

• Change the volume requirement to raise revenue and lower unit costs.
• Bundle products that increase customer value. For example, Cadillac's OnStar global positioning system is a standard feature on all its cars.
• In exchange for a discount, ask for a multiyear contract to smooth out your revenue and production variability.

Protect your brands
Brands become more valuable during a downturn because they offer defensible margins. Sales of cosmetics often rise during a recession, notes Harvard Business School professor Nancy F. Koehn in Brand New. The reason: They represent affordable luxuries or offer a psychological boost. So don't cut prices on your premium brands during a recession; they can be sold without discounts through word-of-mouth or channel promotions that increase visibility and appeal.

Despite the risks associated with poor decisions, only 11% of the respondents to the PPS survey of 124 of its members said that senior management is primarily responsible for pricing. "Successful companies," says Holden, "have CEOs who are very involved with a well-developed pricing strategy at the beginning of the strategic process, and who empower pricing managers to be tyrants about the execution of that strategy."

Excerpted with permission from "How to Think About Pricing Strategies in a Downturn," Harvard Management Update, Vol. 7, No. 3, March 2002

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Nick Wreden is the author of the forthcoming book Fusion Branding: Strategic Branding for the Customer Economy. He is based in Atlanta and can be reached at MUOpinion@hbsp.harvard.edu.