Please note: this interview conducted by Megan O’Brien first appeared at Brainyard, which you can find here.
- The cost of doing business is rising as everyone grapples with supply chain issues, labor shortages and inflation.
- Companies now need to decide how to offset these increases to protect margins and whether to pass higher costs on to customers.
- Communicating proactively, framing an increase in context of the value proposition and using data-based approaches are all key to raising prices without alienating customers.
Since March 2020, the cost of doing business has skyrocketed. Disruptions — not just supply chain snarls, port congestion, labor shortages and demand upsurges but also rising raw material, energy and transportation costs — have been cited as the factors behind rising inflation.
While those issues are largely pandemic-induced and transitory, many economists fear that inflation will be more persistent than originally anticipated. The general consensus is that while the prices of energy, transportation and logistics will likely go down, other costs, like wages and some commodities, probably will not.
It’s evident that many companies are preparing for higher costs to be long-term, a fact bolstered by the announcements of price increases from major companies like General Mills, Procter & Gamble and Starbucks. Now comes the big question: Should your company follow suit? To answer that question and cover the logistics of doing so, we spoke with Frank V. Cespedes, senior lecturer and author.
In general, does the current economic climate mean that companies should raise their prices?
Frank V. Cespedes: For most, though not all, companies, the answer is yes, for a few reasons.
An increase in cost of goods sold (COGS) is historically a common and widely accepted rationale for price increases. When General Mills announced price increases [in September], it cited rising labor, transportation and supply-chain costs. FedEx and UPS have also announced higher shipping rates in 2022 due to driver shortages, higher pay and rising costs.
In most markets, there are not many opportunities to raise prices and provide sales and service people with a rationale that’s unlikely to raise eyebrows.
Still, be mindful of your vertical, customer base and market. Pricing builds or destroys value faster than almost any other business action.
Price and profit studies in multiple markets have documented how a 1% boost in price realization typically means a gain of 8-12% in operating profits. The exceptions are in markets and companies where scale economies, capacity utilization and first-mover advantages make market share and volume a potential source of advantage. In those markets, the current situation raises opportunities to gain share if competitors raise their prices and you don’t.
Is there a general amount that COGS should increase before you consider raising prices?
FC: It’s specific to the business. Think about it this way: If you look at most retailers, there’s a reason we use the phrase “supermarket margins.” They’re working on margins typically of 1-4%. So when COGS goes up a percentage point, that’s a big deal in that business.
On the other hand, there are software businesses where margins are in excess of 50%, so the cost increase threshold is obviously going to be different.
Should companies tell their customers about a price increase?
FC: Be proactive. If you are not proactive, others will be and control the messaging. In today’s information-rich markets, comparative pricing is increasingly easier to do and more visible to prospects and customers. Sites like Edmunds, Kayak and many others facilitate this in multiple consumer categories.
And in B2B markets, you’ve increasingly got buyer forums where people share information about product and pricing.
“Trying to ‘fly below the radar’ is tough and not necessarily a profit-maximizing option for most firms.”
Should companies raise prices on all products or just some?
FC: One of the things I think the current situation is motivating companies to do is to take a good look at the data they use to make these decisions. And the answer to your question is going to depend on whether the firm has the relevant data to answer that — many do not.
They rely primarily on two sorts of data. One is accounting data, which in many companies obscures the economics of individual products. The reason is what accountants call “peanut butter allocations.” To make a peanut butter sandwich, you put down a lump of peanut butter, then you smooth it evenly across the bread. That’s the way many companies, especially manufacturing companies with multiple products, allocate their overhead. They simply smooth it across the product line. And then, over time, it obscures the real margins and the real economic value or loss of individual products.
The other set of data that they often rely on, especially in B2B businesses, is from CRM, but that data is infamously noisy because of the human component. As with any IT system, if the inputs are unreliable, it’s garbage in, garbage out. And the way most firms input CRM data is extraordinarily inconsistent. One rep considers a lead this, and another rep considers it that. One rep says, “This is the most popular product,” and the other rep says, “That is the most popular product,” based on specific territory or account characteristics.
So the bottom line is: To answer the question of raising prices on all products or the most popular, you need accurate data that many companies just don’t have. However, the pandemic, the supply chain shocks during the recovery and changes in buying behavior are — or should be — motivating companies to clean up the data they use as inputs for pricing decisions.
Once you have decided which products or services for which to raise prices, is it better to do so incrementally or all at once?
FC: This I would argue depends on your pricing structure. Let me make a distinction here between a price and pricing. Ultimately, in a free market, the price is going to be determined by supply and demand. But pricing is something the selling company sets up. So the question of whether a company should raise the price once or incrementally depends on the way its pricing structure and process works.
There are a number of businesses — many durable goods businesses and many B2B supply contracts — in which you sign an annual, two-year or three-year contract. And if you’re going to raise a price, [the end of the contract is] when you do so. You do it all at once. On the other hand, there are lots of other businesses — SaaS businesses and others that use subscription-based pricing models — at which you can make a series of relatively small, incremental price increases over the course of the contract that really add up over the course of the subscription in terms of annual recurring revenue.
Do you have any tips for how companies can best present price increases to their customers?
FC: First of all, if there is a real increase in COGS, prioritize that rationale in [messaging around] price increases. And, in many B2B markets, be prepared to share that COGS information with important accounts.
In messaging, the key issue is framing, and often re-framing, your value proposition in the context of the price increase. In many markets, if you do not reframe, either the sale will fail or the increased price will not be attainable.
For some businesses, this means simply reminding customers about the value. For others, it may mean doing something else with your product or service — adding a feature, for example. There are often opportunities to “sweeten the pill” by accompanying price increases with a service benefit or additional low-cost product feature that, in turn, creates opportunities for increased customer retention or a longer contract, for example.
To do that, first make sure you understand usage and the relevant unit of value from the customer’s perspective. This will vary over time as a market develops, and it’s especially varied in newer online or platform businesses.
“The issue here isn’t what the seller means by value or what the engineers at the seller mean by value. Instead, it’s what the customer means by value.”
In most markets and companies, there is a dispersion of value in the customer base. Different customers and segments value the same product or service very differently. But the company tends to cite one price across that spectrum of value and segments.
Also, as the pandemic demonstrated dramatically, markets are always changing. As a market changes, what customers mean by value also changes.
For example, there were a number of businesses that in the past said, “I’m going to go with the lowest-priced offshore supplier for this product.” Well, in the past 18 months, a lot of companies have come to the realization that a supplier that charges more but allocates capacity to them or can help them out in a crunch, that insurance premium, in effect, is worth it. So when you are raising prices, make sure that you understand what the customer’s perception of value is today, not yesterday.
Should price increases be permanent or rolled back once disruptions ease?
FC: This is a situation-specific issue. Ultimately, supply-demand issues will determine whether a price is sustainable. So, in the current situation, it’s important not to confuse a COGS increase due to a temporary disruption with a supply-demand imbalance.
How can companies know whether new prices are both optimized for the market and sustainable?
FC: To judge whether price increases are sustainable, the key is price testing. Because price is such a potent weapon of value creation or destruction, price testing should be an ongoing practice at firms, but it’s not. There is surprising inertia at companies when it comes to price testing and an over-reliance on surveys.
Surveys are by far the most common way that companies try to get some sense of their customers’ price elasticity or inelasticity. There are a couple of problems with surveys when it comes to making pricing decisions. One thing we know for certain from market research is that there is very often a difference between what people say in surveys and their actual marketplace behavior. A classic example is surveys about products in many environmental or green categories. A high percentage of respondents are [for the green option] in the survey, but then in their marketplace behavior, they will trade that option for convenience or a lower price. So the first big problem is what people say versus what they do. This is an instance of what economists call revealed versus stated preference.
But online technologies have made it increasingly viable for companies in most industries to do A/B testing and other tests in which you have the same product at two different prices in different distribution channels or different online media. And there, you’re testing not what people say in a survey but their actual behavior. They either click or they don’t click, they either move to the next stage or they don’t move to the next.
Internally, how can companies make sure any needed price increase goes smoothly?
FC: Make sure that the people who actually communicate with customers know what they’re doing and how to frame the value proposition, or reframe it if necessary, in the context of the price increase. In the vast majority of companies, including small to midsize companies, that is the job of the sales force. So, this becomes a core sales management activity.
The most important data is what target customers value about a product or service. And, in many B2B businesses, that’s not only a segment-specific bit of data, but very account-specific. As a result, the really important information about [buying behaviors and value] is locked in the head of the individual salesperson or account manager. It becomes visible only when you do a good performance review.
And that’s my advice for many companies: To get that information and make those very crucial pricing decisions, strengthen your performance review processes. Make sure your sales managers take reviews seriously and that information is flowing. Because when sales managers do sloppy or what I call “drive-by” reviews, they’re not only perpetuating a culture of underperformance in sales, they’re inhibiting the flow of vital information for pricing in the organization. So it’s not just an IT issue. As always, it’s also a management issue concerning the way we handle the people who have to frame a price to the customer.
Moreover, smaller to midsize businesses especially often rely on a couple of big accounts. A very common phenomenon is the 80/20 rule in the customer base: 20% of the customers account for 80% of the sales. Make sure the people who deal with those customers are able to frame or reframe what you’re doing and understand how those major accounts perceive value. You can’t lose a lot of money on small accounts. You ultimately test pricing and your value proposition with those big customers, so that would be my advice on how to set priorities.
Any concluding thoughts about price increases you would like to share?
FC: The market is going to do lots of things for reasons that are outside of the company’s control. Pricing affects the bottom line — usually faster and deeper than almost any other business action. You have to make those decisions quickly while still moving forward. You’re basically trying to change the sail while the ship is in the open sea and you don’t control which way the winds are blowing. So it’s interesting, it’s complex, and it’s an area where uncertainty is built in.
But I think the fact that something is complex and uncertain should not be seen as a rationale for doing nothing. That’s a pretty good recipe for getting disrupted and becoming obsolete, or missing pricing opportunities in a changing market.