DonÕt Just

Set Prices,

manage
Firms need a solid and consistent
strategy to make their prices stick.
them
By Thomas T. Nagle and
George E. Cressman Jr.

Many companies set their prices without doing

anything to manage the pricing environment.

They set list prices based on their own needs and

then adjust transaction prices based on what cus-

tomers say they’re willing to pay. Only a few

exceptional companies question why someone is

willing to pay no more than a particular amount

or how that willingness could be changed.

Consequently, few companies proactively

manage their businesses to foster more

 EXECUTIVE How much should a company charge for its products or services? Many companies don’t know
how to answer this question and instead let customers and competitors drive their pricing deci-
briefing sions. To keep prices consistent and profitable, companies need to adopt a consistent pricing
structure. By strategically managing price structure, the pricing process, and value-based market communications, companies
can achieve greater profits.

profitable pricing. The difference between price setting and pric-
ing strategically is the difference between reacting to market
conditions and proactively managing them. Pricing strategically
involves managing customers’ expectations to induce them to
pay for the value they receive.
Pricing strategy is the coordination of multiple activities to
achieve a common objective: profitable prices. If managers think
about pricing only when they must set a price, then pricing
becomes a tactical exercise of matching price to customers’ will-
ingness to pay. When, however, managers think of pricing as a
process of capturing value, then pricing strategy involves man-
aging everything that raises willingness to pay closer to the
value received.
Exhibit 1 illustrates this broader perspective on pricing.
Ultimately, prices must reflect customers’ willingness to pay, but
managers can change willingness to pay by manipulating the
pricing environment. They can change willingness to pay via the
price structure (Is the price quantity-based like gasoline, access-
based like health clubs, or performance-based like investment
banking and some legal services?), the pricing process (Is the
price fixed or just the beginning of a negotiation?), or the value
message communicated (What’s the objective value created by
the product’s differentiation?).
To optimize long-term profitability, price setting must occur
■ Exhibit 1
within the context of a structure that’s value-based and a
process that’s proactive. In companies delivering good value
that customers recognize, improving pricing processes and
structures can quickly increase both margins and sales volume.
same print job with one from a less service-oriented competitor.
As a result, the company’s prices were beaten down in price
negotiations. Despite a strong market share, its costs were high
and its profits disappointing.
The solution to this company’s problem was to determine
which of its services added differentiating value for customers
and then charge for those services separately. Once the company
started thinking in terms of value, services that had been taken
for granted became sources of profit improvement. Charges for
correcting files, adapting to late delivery of files, redesigning
jobs to save on mailing costs, reducing color variability, and
scheduling jobs at peak times all became either sources of rev-
enue or incentives for customers to change their behavior to
eliminate costs. Offering customers a lower cost in return for
accepting lower service forced customers either to acknowledge
what they valued or to do without it. By unbundling service ele-
ments and charging for them, the company became more price-
competitive for jobs requiring little added service, while recov-
ering the costs and capturing the value of differentiation from
customers who needed it.
Price structure can be made more value-based either by
selecting price metrics that vary with value received, or by
The domain of strategic pricing

Price Structure
In a value-based price structure, prices change with the value
delivered. While intuitively appealing, such structures are rare.
Instead, internally focused companies usually build price struc-
tures that reflect their costs, while externally focused companies
build structures that reward customers with greater purchasing
power. In either case, they end up with pricing, and therefore
profitability, that’s not proportionate to the value they deliver.
A printing company built its reputation on quality work with
high levels of customer service. Despite this commitment, both
the company and its customers thought of the product in terms
of units of printing, with services seen merely as “value-adds.”
Because this company set prices for the commodity, but gave
away the differentiating services, it was often on the defensive
when a potential customer compared the company’s bid for the

30 ❘ MM November/December 2002
establishing segmentation fences that limit discounts only to
those customers that get less value. Price metrics are the units to
which the price is applied. Film distributors can choose to
charge theaters a fixed charge per day, a daily charge based on
the number of seats in the theater, or a percentage of the receipts
earned from showing a film. They usually use the last because it
better reflects the value to the theater owner of showing the
film. Segmentation fences are criteria that customers must meet
to qualify for discounts. At movie theaters, the segmentation
fences are usually based on age (with discounts for children
under age 12 and for seniors), each of whom is assumed to be
more price-sensitive.
Airlines are masters at identifying customer segments and
establishing value-based segmentation fences. To reflect differ-
ences in value delivered to business and leisure travelers, they
offer large discounts to passengers whose trips involve a
Saturday night stay or are planned far in advance. They also
give substantial discounts to senior citizens. Segmentation
fences work well for pricing services and when the segmenta-
tion criteria is something verifiable, such as the buyer’s age
(e.g., seniors), legal status (e.g., consumer vs. business, non-prof-
it vs. for-profit), or location of purchase. When the obvious seg-
mentation criteria aren’t easily verifiable, or when the product
could be purchased by a buyer who qualified for a discount and
resold to one who did not, segmentation fences break down.
In most cases, where fences alone prove inadequate to seg-
ment markets, successful pricers must develop metrics to track
value. General Electric successfully raised willingness to pay for
its new GE90 series engines by pricing power by the hour. For
the first time, an airline could lease a GE aircraft engine for a fee
per hour flown that included all costs of scheduled and
unscheduled maintenance. Without the uncertainty of mainte-
nance cost, GE90 engines quickly became popular despite a sig-
nificant price premium. Finding segmentation fences and price
metrics that more closely track with value can drive both more
sales and margin. Exhibit 2 illustrates the challenge and oppor-
tunity in designing value-based price metrics. The trick is to
find metrics that allow prices to vary automatically, keeping
customers in the “price=value” range.
Not all value-based price metrics are related to the product
or service delivered. Better metrics may be related to the cus-
tomer. Software suppliers will send one disk to load on the com-
pany server, but will charge for it based on the number of work-
stations on which the customer will use the software. Real estate
agents charge a percentage of the selling price of the customer’s
house, only partly related to the level of service they deliver.
When value is affected by economic conditions in the buying
firm’s industry, a value metric may be tied to some objective
measure of those conditions. During the current business slow-
down, a service provider discounted prices by tying them to an
index of activity in their customer’s industry. Those who signed
a three-year contract enjoyed immediate discounts of 18% to
20%. The contracts, however, committed customers to pay high-
■ Exhibit 2
Designing value-based price metrics
er prices when increased business activity raised the index.
The key to creating a more profitable price structure is to
study how segments differ in what drives value for them and
what drives cost to serve them. The challenge then is to create a
price structure with fences and metrics that automatically
charges more when a sale creates more value for the buyer or
predictably higher incremental costs for the seller.
The Pricing Process
A value-based price structure is not, by itself, sufficient for
successful pricing. The process for setting price levels within
that structure must also be proactive. Many companies have no
formal process for making price changes or granting price
exceptions. No one can identify who in the organization is ulti-
mately responsible for the overall profitability of prices. In some
cases, no one is. Consequently, pricing is temporarily adopted
by some functional area to solve a near-term problem for one
customer, one product line, or even one salesperson. Without
criteria for making the best decision for the organization overall,
pricing decisions become inconsistent. This creates conflict not
only within the firm, but also between the firm and customers
who become aware of the inconsistency.
One large consumer packaged-goods company uses objective
criteria for establishing list prices. The actual price, however,
depends on how much each product manager decides to “price
promote” the product—either to the consumer or to the trade.
Product managers are evaluated by how well each product
achieves its sales goal. Because sales goals are evaluated quar-
terly, price promotions became a regular occurrence for many
products at the end of every quarter.
The tragedy of this process is that no one estimates the effect
that discounting one brand is having on sales of the company’s
MM November/December 2002 ❘ 31

other brands.
Perhaps the reason one
brand is not meeting its
sales goal is that another
from the same company, selling
at full price, is already winning the
sales. Moreover, no one estimates how much
of the quarterly sales gain is actually sustainable sales
growth or simply a high-cost shift forward from the next quar-
ter. Consequently, the company often undermines its profitabili-
ty by competing with itself.
Companies in B2B markets commonly have even more reac-
tive pricing processes simply because, by selling directly, they
can more easily get away with inconsistent rules. Many have
eschewed fixed-price policies and strict criteria for discounting,
relying instead on non-policies that make any price negotiable
so long as the sale meets some minimum profit criteria. By
allowing these reactive, ad hoc decisions, managers often think
their companies can respond more quickly to market conditions
while limiting discounting to situations where competitive pres -
sure makes it necessary. Experience usually proves them wrong.
In markets where customers purchase a product regularly or
communicate with others who do, they learn from experience.
Before long, they notice that discounts are larger and more
forthcoming to buyers who negotiate aggressively. The smart
ones take advantage of this situation. They institute policies to
limit the seller’s exposure to satisfied users, requiring salespeo-
ple to work through purchasing agents. They begin courting
competitors, offering them a piece of the business to gain negoti-
ating leverage against their preferred supplier. And they form
buying cooperatives to increase pressure on sellers to make con-
cessions. In short, when sellers replace price policies with indi-
vidually negotiated pricing, they create economic incentives for
“good customers” to become “bad customers.”
32 ❘ MM November/December 2002
To eliminate these perverse incen -
tives, managers must create prices
that customers perceive as having
integrity. That requires setting
prices and discount levels proac-
tively, by policy, not in reaction to
individual customer misinforma-
tion and manipulation. The
development of a fixed price poli-
cy must be centralized. This
ensures consistency across cus-
tomers who might cross-ship prod-
ucts or exchange information about
prices. Ironically, centralization of pricing
policy empowers the sales force to be more
responsive in difficult negotiation. Rather than
negotiating one deal and then trying to win approval
for it at the appropriate level of sales management, a salesper-
One of the great misconceptions of
quantitative pricing research is that
customers who have been using a
product know what it’s worth to
them without being told.
son can explore multiple alternatives with the customer, know-
ing which ones have been approved already. Giving salespeople
clear direction regarding acceptable criteria for discounting
empowers them to work with customers to find a deal that’s
acceptable to both parties.
Pricing by policy isn’t always preferable to ad hoc price
negotiations. When each purchase is a unique product or serv-
ice, it’s difficult to have an entirely standard formula. Freely
negotiated pricing may also prove more profitable whenever
customers purchase infrequently. Lacking information about
their alternatives and the experience to evaluate them, they’re
more likely to seek a satisfactory purchase rather than to find
the best value in the market. Lastly, when the industry leader’s
pricing is inconsistent and unpredictable, competitors may need
to negotiate prices to remain competitive.
Still, even when justified, ad hoc price negotiations introduce
the risk that smart buyers will use any flexibility in pricing to
disconnect prices from the value they receive. As customers
learned that auto dealers exploit the uneducated buyer, they
joined auto-buying groups, such as those offered at Sam’s Club
or the American Automobile Association, that negotiate better
deals. A.T. Kearny has a very successful, and rapidly growing,
supply-chain management group that monitors industrial pric-
ing practices and trains customers to manipulate sellers to get
better deals. Freemarkets.com enables customers to create
reverse auctions, where the buyer has all the information about
the offers but the sellers see only the prices. While each of these
buying tactics is arguably unfair to sellers, they were created to
protect customers from the equally unfair and inconsistent pric -
ing policies of the sellers.
Communicating Value
Even when price structures reflect value and the pricing
process forces customers to make price-value trade-offs, value-
based pricing will have limited success unless the company’s
marketing program effectively communicates the value. Buyers
who are ignorant of the monetary value of a firm’s product and
service differentiation generally tend to underestimate it. The
purpose of value communication is to raise uninformed buyers’
willingness to pay to a level comparable to that of well-
informed buyers.
One of the great misconceptions of quantitative pricing
research is that customers who have been using a product know
what it’s worth to them without being told. We interviewed
long-time buyers of ad space, trucks, dedicated telephone lines,
medical capital equipment, OEM parts, and financial services
that have spent millions each year on items without understand-
ing their value. They o en had a preference for a particular sup-
plier’s reliability, service, or differentiation, but had neither a
quantitative nor a qualitative understanding of the economic
value associated with that preference. Consequently, the highest
quality suppliers in those markets were consistently vulnerable
to suppliers who could offer a precisely quantified price advan -
tage in return for forgoing qualitative advantages that seemed
merely “nice to have.”
Value quantification is a good sales tool when buyers are fac -
ing extreme cost pressures and are, therefore, very focused on
ge ing the most for their money. Since healthcare reimburse -
ment systems were changed to give hospitals and doctors a
financial incentive to practice cost-effective medicine, pharma-
ceutical companies have been forced to go beyond their tradi -
tional claims that a product is more clinically effective. Some
now offer purchasers elaborate tests to show that differentials in
effectiveness are worth the differentials in price.
Value communication is possible for more mundane prod-
ucts as well. A supplier of long-haul trucks quantified the value
of features contributing to driver comfort by quantifying their
impact on driver retention. A packaged-goods manufacturer
quantified the value to retailers of its product’s fast turnover ,
thus justifying its higher wholesale price. A telecom company
quantified the value of its superior reliability by estimating the
revenue loss to customers of interruptions in their data lines.
It’s harder to communicate value when products are sold
through distribution channels, unless the channel is willing and
able to do the task. Otherwise, the seller’s only direct contact
with the buyer may be via a short, generic advertisement or the
external information on the packaging. In such cases, value
communication is more likely to be suggestive rather than pre-
cisely quantified. Skytel a empted this in an advertisement
titled: Reason #8: Why you need Skytel if you have a cell phone.
The reason: “Sometimes you’d rather be informed for 5¢ than
interrupted for 10¢.” Since a pager message actually costs less,
the implicit value message is that anyone with a cell phone
would find a pager to be a good value.
Some end benefits resulting from the purchase or use of a
product aren’t readily quantifiable. Relating the purchase and
use of the product to qualitative benefits can nonetheless effec-
tively influence customers’ willingness to pay. Michelin has tra-
ditionally raised the perceived value of its high quality by asso -
ciating it with the safety of a buyer’s family. Hallmark support -
ed the premium prices of its greeting cards by associating the
purchase with the extent to which buyers “care to send the very
best.” AT&T ran a campaign to convince small-business buyers
not to switch to lower cost carriers by reminding them that “it
isn’t just your telephone, it’s your business.” In these cases, the
advertisers assume that customers believe they offer a higher
quality or more reliable product. The purpose is to convince
potential buyers the difference is worth paying for.
Keys to Success
Successful pricing depends on much more than simply
selecting the right price level. Even when the level of price is
justified by the value delivered, other elements of pricing strate -
gy can undermine its viability. If price metrics don’t track value,
a significant share of customers will object and refuse to pay the
price. It would be wrong to lower the price across the board,
however, because many other customers may find the price
totally justified by value received. The challenge is to find a met -
ric that tracks with differences in value or a fence that enables
price discounts to stay targeted where needed to make the sale.
If customers are always looking for discounts and withholding
purchases until they get them, the problem may not be that the
price is too high. It may be that customers have learned that price
resistance is rew arded. The pricer’s challenge, then, is not to fig-
ure out how much to discount; it’s to reestablish price integrity.
If customers want a company’s superior product or service,
but consider the price premium too large, the problem may be
one of customer perception rather than of economic reality. The
pricer’s challenge then is to coordinate the company’s advertis -
ing, sales, and distribution network to justify the price.
Although each of these appears as price resistance, changing
price is not the most profitable solution for any of them.
Successful pricing involves developing processes, str u ctu res, and
communications that make value-based prices acceptable.
About the Authors
Thomas T. Nagle is a Group Leader in the Cambridge, MA office of
Strategic Pricing Group, a member of Monitor Group. He is
co-author of The Strategy and Tactics of Pricing, now in its fourth
edition. He can be reached at tom_nagle@monitor.com. George E.
Cressman, Jr. is a Senior Pricing Strategist at Strategic Pricing Group,
a member of Monitor Group. He can be reached at
george_cressman@monitor.com. For more information, visit
www.strategicpricinggroup.com.
MM November/December 2002 33