The last three years have hit companies hard. Between the COVID-19 pandemic, supply chain disruption, high inflation, and tightening monetary policy, companies have had to scramble to maintain demand and margins on their products. Yet many of them have misused or not fully applied one of the most powerful levers for addressing the problem: Pricing.
In fact, during the first quarter of 2023, S&P 500 companies’ revenue grew by 4.3%, yet their profits were down 3.3%. While there are many factors at play, one primary reason is that many of these companies’ pricing increases are not keeping up with cost increases.
It’s a misstep that companies can’t afford, especially as indicators of a recession continue to appear. The typical response to an economic downturn is to implement price-cutting measures, including resorting to large discounts. And while these tactics can work in some cases, they can prove to be costly especially for B2B services companies and technology firms offering software- and data-as-a-service. In fact, you may be giving away margin and profitability, without stimulating demand or increasing sales volume.
Why do discounts often fail to produce the desired results? Consider this hypothetical exercise for a product that sells for $100, with a 30% margin. If you were to offer a 10% discount, you’d need to generate a whopping 50% increase in demand to get back to profit-neutral. That’s extremely hard to do! By contrast, if you increased the original price by 10%, demand would have to drop by 25% to revert to profit-neutral — a change that’s very unlikely to happen in most industries.
In other words, pricing is a vital tool for restoring profit stability. Whether you are a CEO, a pricing leader, or a private equity investor looking to improve the margin performance at a portfolio company, there are several ways you can use the capability to significantly improve your bottom line.
1. Use tactical pricing strategies to preserve margin
In the near term, you should include annual price escalators in all contracts. Software-as-a-service and other tech companies traditionally have been able to negotiate 6% to 7% hikes in North America. Now with high inflation, some have been able to ratchet that figure up to 10% without alienating customers. The percentages typically are lower in Europe; regardless of the region though, sales teams must keep a consistent strategy when it comes to imposing, adjusting, and negotiating over escalator levels.
Another helpful lever in negotiations is to establish list prices, which quite a few companies don’t have. List prices are an implicit signal for the value that the product or service delivers. That allows you to have a conversation about cost and value tradeoffs, giving you a better chance of defending a certain price position. List prices also can serve as a critical value anchor to begin negotiations, which means you might not have to discount as much as you would otherwise.
Further, it’s useful to take a fresh look at your pricing waterfall and determine where you might not be getting the full value that you’re delivering. For instance, with interest rates soaring over the last year or so, there are probably opportunities to plug pricing leakages with adjustments to payment terms. This could include incentivizing early payment or charging greater interest rates or penalties for delayed payment. Additionally, as labor and energy costs have risen, many companies are not charging enough for shipping or expedited services. All of these below-the-line items impact margins and profitability… and therefore warrant increased scrutiny.
2. Leverage strategic pricing for bigger, longer-duration gains
There’s an important rule in pricing strategy: How you price trumps how much you price. Companies have found creative metrics that align with the value that’s being delivered, helping them stand out from competitors while also reducing price sensitivity. A classic example is Michelin’s usage-based pricing model, where customers pay more as they use the product more. Although Michelin’s tires lasted 20% longer than those from other brands at the time, the company couldn’t charge 20% more and still maintain demand. But by instead charging enterprise customers for the mileage their fleets drove, they were able to generate the full revenue that their more-durable tires merited.
The “how you price” rule also comes into play when repackaging products. By bundling products or features together, you can use the more-popular ones to create higher demand for the less-popular ones, as long as they make sense to be bundled together. Before Microsoft began selling its Office apps as subscriptions, for example, it used to bundle all of them together in a standard package, using the ubiquitous Word to raise demand for the lesser-used PowerPoint. You also can offer packages in a good/better/best structure, allowing you to set up goalposts that align the value delivered with the price you’re charging. Customers tend to negotiate within those goalposts, improving your ability to enforce pricing discipline and avoid excessive discounting.
One additional benefit when you roll out new packages is the opportunity to approach clients that are in the middle of their contracts about renewing early. Taken together, in the technology sector repackaging techniques can help drive 30% to 40% increases in annual recurring revenue, with only low-single-digit attrition. While not all industries will see price increases of that magnitude, optimizing the way in which products are bundled is still a key tactic to pursue.
3. Enable the pricing and sales organization
The ultimate price-setting and decision-making authority should reside with your pricing organization rather than with sales. When building the pricing organization, make sure that you are adding leaders and analysts who are well-versed in strategic and value-based based pricing, and training and upskilling existing team members on those topics. Meanwhile, your salesforce would also likely benefit from additional training on negotiation tactics and value-based selling. Conducting strategic planning sessions ahead of each negotiation helps to review the customer’s preferences, determine what concessions you can offer, and identify what sequence to offer them in.
Unfortunately, the positive effects from better training don’t always last long. To ensure consistency of the sales team’s performance, firms should make use of data and tools that assist with pricing strategy setting, pricing analytics and performance tracking, and pricing executional support. A configure price quote (CPQ) tool can provide guardrails that allow salespeople to negotiate while still preserving margin. And to remove the burden of reviewing deals via email, many pricing tools have workflow management capabilities that can route deal approvals to the appropriate person and track them through the process.
Don’t wait to optimize pricing
With a potential recession upon us, now is the time to take action to restore profitability and help weather the storm. Take advantage of all the available pricing measures at your disposal. The right combination can restore profitability at a time when others are over-discounting and help position you for success in the years to come.
Lastly, do not make pricing changes a one-time exercise. Build the capability and process in-house so you can constantly monitor for any changes in the macroeconomic and competitive environments and develop an agile pricing response accordingly. Embark on that pricing journey today!