THE STRATEGY AND

TACTICS OF PRICING
The Strategy and Tactics of Pricing explains how to manage markets strategically and
how to grow more profitably. Rather than calculating prices to cover costs or achieve
sales goals, students will learn to make strategic pricing decisions that proactively man-
age customer perceptions of value, motivate purchasing decisions, and shift demand
curves.
This edition features a new discussion on harnessing concepts from behavioral
economics as well as a more streamlined “value cascade” structure to the topics. Read-
ers will also benefit from:
• Major revisions to almost half of the chapters, including an expanded discussion
of big data analytics and a revised chapter on “Specialized Strategies”, which
addresses timely technical issues like foreign exchange risks, reactions to market
slumps, and managing transfer prices between independent profit centers.
• A completely rewritten chapter on “Creating a Strategic Pricing Capability”,
which shows readers how to implement the principles of value-based, strategic
pricing successfully in their organizations.
• In-chapter textboxes, updated to provide walk-through examples of current pric-
ing challenges, revenue models enabled by an increasingly digital economy, and
advances in buyer decision-making, explained through classic principles that
still apply today.
• Chapter summaries and visual aids, which help readers grasp the theoretical
frameworks and actionable principles of pricing analysis.
This comprehensive, managerially-focused text is a must-read for students and pro-
fessionals with an interest in strategic marketing and pricing. A companion website
features PowerPoint slides with instructor notes, discussion questions, and exercises,
as well as suggested readings and cases with separate teaching notes for instructors.
Thomas T. Nagle, Ph.D., is a Senior Advisor in the Pricing and Profitability Manage-
ment practice at Deloitte Consulting, USA. For over 30 years, he has developed many
of the most popular analytical tools and conceptual frameworks for strategic pricing
and profit improvement.
Georg Müller, Ph.D., is a Managing Director in the Pricing and Profitability Manage-
ment practice at Deloitte Consulting, USA. He focuses on driving top-line margin
improvement through strategic pricing for companies representing multiple sectors.
He also leads executive development on strategic pricing at the University of Chicago,
Booth School of Business, USA.
“The principles of business profitability stressed in The Strategy and Tactics of
Pricing make it an absolute must-read for all business professionals who care
about creating value and profitability for their organization. I have person-
ally practiced the knowledge gained from The Strategy and Tactics of Pricing,
operating in hyper-competitive business environments, with great success.”
—Lynn Guinn, Global Strategic Pricing Leader at Cargill, USA

“For over three decades, this book has been the most influential and highly
regarded reference for pricing professionals. New sections on today’s most
pressing business topics make it an indispensable tool to improve your com-
pany’s performance.”
—Kevin Mitchell, President of The Professional Pricing Society, Inc., USA

“The best pricing book on the planet! The go-to resource for pricing
success—powerful, practical, and profitable!”
—Mark Bergen, James D. Watkins Chair in Marketing, Carlson
School of Management, University of Minnesota, USA
 Sixth Edition

THE STRATEGY AND

TACTICS OF PRICING
A GUIDE TO GROWING
MORE PROFITABLY

Thomas T. Nagle

Georg Müller
Sixth edition published 2018
by Routledge
711 Third Avenue, New York, NY 10017

and by Routledge
2 Park Square, Milton Park, Abingdon, Oxon, OX14 4RN

Routledge is an imprint of the Taylor & Francis Group, an informa business

© 2018 Taylor & Francis

The right of Thomas T. Nagle and Georg Müller to be identified as authors of

this work has been asserted by them in accordance with sections 77 and 78 of the
Copyright, Designs and Patents Act 1988.

All rights reserved. No part of this book may be reprinted or reproduced or utilised
in any form or by any electronic, mechanical, or other means, now known or hereafter
invented, including photocopying and recording, or in any information storage or
retrieval system, without permission in writing from the publishers.

Trademark notice: Product or corporate names may be trademarks or registered

trademarks, and are used only for identification and explanation without intent
to infringe.

First edition published by Prentice Hall 1987

Fifth edition published by Routledge 2016

Library of Congress Cataloging-in-Publication Data

A catalog record for this book has been requested

ISBN: 978-1-138-73750-1 (hbk)

ISBN: 978-1-138-73751-8 (pbk)
ISBN: 978-1-315-18530-9 (ebk)

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Visit the companion website: www.routledge.com/cw/nagle

 CONTENTS

Preface xiii
Acknowledgments xv
List of In-Line Boxes xvii
List of Exhibits xix

Chapter 1 Strategic Pricing 1

Coordinating the Drivers of Profitability
Chapter 2 Economic Value 26
The Guiding Force of Pricing Strategy
Chapter 3 Price and Value Communication 56
Strategies to Influence Willingness-to-Pay
Chapter 4 Price Structure 76
Tactics for Pricing Differently Across Customer Segments
Chapter 5 Pricing Policy 106
Influencing Customer Expectations and Purchase Behaviors
Chapter 6 Price Level 133
Setting Prices that Capture a Share of the Value Created
Chapter 7 Price Competition 152
Managing Conflict Thoughtfully
Chapter 8 Measurement of Price Sensitivity 173
Research Techniques to Supplement Judgment
Chapter 9 Financial Analysis 207
Analyzing Costs and Profits for Pricing
Chapter 10 Specialized Strategies 240
Adapting Pricing to Accommodate Common Challenges
Chapter 11 Creating Strategic Pricing Capability 262
Assembling Talent, Processes, and Data to Build
Competitive Advantage
Chapter 12 Ethics and the Law 293
Understanding the Constraints on Pricing

Index 317
 DETAILED TABLE OF CONTENTS

Chapter 1 Strategic Pricing 1

Coordinating the Drivers of Profitability
Leveraging Profit into Sustainable Growth 2
Cost-Plus Pricing 4
Customer-Driven Pricing 5
Share-Driven Pricing 6
The Role of “Optimizing” in Strategic Pricing 7
What Is Strategic Pricing? 9
Value Creation 12
Value Communication 15
Price Structure 17
Pricing Policy 18
Price Setting 19
Price Competition 20
Creating a Strategic Pricing Capability 21
Summary 23 • Notes 23

Chapter 2 Economic Value 26

The Guiding Force of Pricing Strategy
The Role of Value in Pricing 27
How to Estimate Economic Value 30
Competitive Reference Prices 31
Estimating Monetary Value 33
Monetary Value Estimation: An Illustration 36
Estimating Psychological Value 41
Psychological Value Estimation: An Illustration 42
The High Cost of Shortcuts 45
Value-Based Market Segmentation 47
Step 1: Determine Basic Segmentation Criteria 49
Step 2: Identify Discriminating Value Drivers 50
Step 3: Determine Your Operational Constraints
and Advantages 50
Step 4: Create Primary and Secondary Segments 50
Step 5: Create Detailed Segment Descriptions 53
Step 6: Develop Segment Metrics and Fences 53
Summary 54 • Notes 54
viii Detailed Table of Contents

Chapter 3 Price and Value Communication 56

Strategies to Influence Willingness-to-Pay
Value Communication 58
Adapting the Message for Product Characteristics 58
Low-Involvement, Psychological Benefits 60
Low-Involvement, Economic Benefits 60
High Involvement, Psychological Benefits 61
High Involvement, Economic Benefits 61
Strategies for Conveying Value 62
Competitive-Reference Effect 65
Switching-Cost Effect 66
Difficult-Comparison Effect 66
End-Benefit Effect 67
Price-Quality Effect 68
Expenditure Effect 70
Shared-Cost Effect 70
Transaction Value Effect 71
Fairness Effect 72
Multiple Participants in the Buying Process 73
Summary 74 • Notes 75

Chapter 4 Price Structure 76

Tactics for Pricing Differently Across
Customer Segments
Challenges That Can Undermine Segmented
Pricing 79
Offer Configurations 80
Optimizing the Structure of Offer Bundles 81
Designing Segment-Specific Bundles 83
Unbundling Strategically 84
Price Metrics 85
Creating Good Price Metrics 86
Performance-Based Metrics 89
Tie-Ins as Metrics 92
Price Fences 95
Buyer Identification Fences 95
Purchase Location Fences 97
Time-of-Purchase Fences 98
Purchase Quantity Fences 99
Peak Pricing and Yield Management 101
Summary 104 • Notes 104
 Detailed Table of Contents ix

Chapter 5 Pricing Policy 106

Influencing Customer Expectations and Purchase
Behaviors
Pricing Policies and Price Expectations 107
The Emergence of Strategic Sourcing 108
Policies for Price Negotiation 110
Policies for Responding to Price Objections 114
The Problem with Reactive, Ad Hoc Price
Negotiation 114
The Benefits of Proactive, Policy-Based Price
Negotiation 116
Policies for Different Buyer Types 118
Policies for Dealing with Power Buyers 123
Policies for Successfully Managing Price Increases 125
Policies for Leading an Industry-Wide Increase 126
Policies for Transitioning from Flexible to
Policy-Based Pricing 127
Policies for Pricing in an Economic Downturn 128
Policies for Promotional Pricing 130
Summary 131 • Notes 131

Chapter 6 Price Level 133

Setting Prices that Capture a Share
of the Value Created
The Price-Setting Process 134
Step 1: Define the Viable Price Range 135
Step 2: Make Strategic Choices 137
Step 3: Assess Breakeven Sales Changes 142
Step 4: Gauge Price Elasticity 145
Step 5: Account for Psychological Factors 147
Communicating New Prices to the Market 149
Summary 151 • Notes 151

Chapter 7 Price Competition 152

Managing Conflict Thoughtfully
Understanding the Pricing Game 153
Competing to Grow Profitably 154
Reacting to Competition: Think Before You Act 159
Managing Competitive Information 165
Collect and Evaluate Competitive Information 166
Selectively Communicate Information 168
When Should You Compete on Price? 170
Summary 171 • Notes 172
x Detailed Table of Contents

Chapter 8 Measurement of Price Sensitivity 173

Research Techniques to Supplement Judgment
Types of Measurement Procedures 174
Uncontrolled Studies of Actual Purchases 175
Historical Sales Data 175
Panel Data 176
Store-Level Transaction Data 178
Analyzing Historical Data 179
Experimentally Controlled Studies of Actual
Purchases 181
In-Store Purchase Experiments 181
Laboratory Purchase Experiments 182
Uncontrolled Studies of Preferences and Intentions 185
Direct Questioning 186
Buy-Response Surveys 186
Attribute Rating 186
In-Depth Interviews 189
Experimentally Controlled Studies of Preferences and
Intentions 191
Simulated Purchase Experiments 191
Trade-Off (Conjoint) Analysis 192
Using Measurement Techniques Appropriately 197
Using Judgment for Better Measurement 198
Using Online and Mobile Techniques 200
Outside Sources of Data 200
Selecting the Appropriate Measurement Technique 201
Summary 202 • Notes 204

Chapter 9 Financial Analysis 207

Analyzing Costs and Profits for Pricing
Evaluating the Financial Implications of Price
Alternatives 207
Why Incremental Costs? 208
Why Focus on Avoidable Costs? 212
Understanding the Financial Implications of Alternative
Price Levels 213
Evaluating the Potential Profitability of a Price
Change 214
Breakeven Sales Incorporating a Change in Variable
Costs 218
Breakeven Sales Analysis for Reactive Pricing 219
Mapping a Range of Potential Financial Outcomes 221
Breakeven Sales Curves 223
 Detailed Table of Contents xi

Watching Your Baseline 227

Covering Non-Incremental Fixed and Sunk Costs 228
Summary 229 • Notes 229
Appendix 9A 231
Case study
Appendix 9B 238
Derivation of the Breakeven Formula

Chapter 10 Specialized Strategies 240

Adapting Pricing to Accommodate Common
Challenges
Adapting Pricing Strategy over Category
Life Cycle 240
Pricing an Innovation 241
Price Reductions in Growth 244
Pricing the Established Product in Maturity 245
Managing Export Prices in Foreign Currencies 248
Foreign Market Sales Strategy 248
Competitive Impact of Exchange Rate Shifts 250
Four Generic Strategies for Managing Exchange
Rate Price Adjustments 250
Managing Pricing When Markets Slump 253
Creating Economically Efficient Transfer Prices 255
Summary 259 • Notes 260

Chapter 11 Creating Strategic Pricing Capability 262

Assembling Talent, Processes, and Data to Build
Competitive Advantage
Essential Elements of the Pricing Organization 268
Creating Alignment on Pricing Objectives 270
Matching the Extent of Pricing Centralization with
Organizational Needs 271
Decision Rights Specify Pricing Roles and
Responsibilities 273
Pricing Processes to Ensure Successful Strategy
Implementation 274
Performance Measures and Incentives: Aligning
Sales Incentives with Strategy 276
Systems to Support the Pricing Function 279
Data Needed to Inform the Pricing Function 279
Common Protocols for Creating Relevant
Insights 279
Customer Analytics to Guide Management Choices 280
Analysis of Win–Loss Data 280
xii Detailed Table of Contents

Customer Profitability and Cost to Serve 281

Process Management Analytics 283
Price Bands 283
Price Waterfalls 284
Pricing Systems 286
Managing the Organizational Change Process 288
Senior Management Leadership 289
Demonstration Projects 289
Summary 290 • Notes 291

Chapter 12 Ethics and the Law 293

Understanding the Constraints on Pricing
Ethical Constraints on Pricing 293
The Legal Framework for Pricing 296
The Effect of Sarbanes–Oxley on Pricing Practices 297
Price Fixing or Price Encouragement 298
Horizontal Price Fixing 299
Resale Price Fixing or Encouragement 299
Vertical Price Fixing 299
Direct Dealing Programs 301
Resale Price Encouragement 301
Price and Promotional Discrimination 302
Price Discrimination 303
Defenses to Price Discrimination 304
Promotional Discrimination 305
Competitive Injury, Defenses, and Indirect
Purchasers 306
Using Non-Price Variables to Support Pricing Goals 306
Vertical Non-Price Restrictions 306
Non-Price Incentives 308
Other Pricing Issues 308
Predatory Pricing 308
Price Signaling 309
Summary 309 • Notes 310
 PREFACE

Since the first edition of this book over 30 years ago, our goal has been to rebut
the common misperception that pricing is an afterthought to a growth strategy:
a simple process of calculating the “right” price for a product or transaction.
Over those years, both marketing practitioners and academics have largely
come to recognize that a profitable pricing strategy requires proactively man-
aging much more than just price. It requires thoughtful and proactive manage-
ment of choices about what to offer, how information about price and value
is communicated, perceptions created in the process of price negotiation, and
choices about when, where, and how to compete for market share. Today lead-
ing organizations are leveraging the principles of strategic pricing described in
this book to actively influence willingness-to-pay. They are, in effect, shifting
demand curves as opposed to just reacting to them.
To influence demand and willingness-to-pay, profitable pricing requires
looking beneath simple concepts like demand and demand elasticity to under-
stand and manage the perceptions of monetary and psychological value that
motivate purchase decisions. Mastering the value proposition enables a firm
(i) to segment prices to reflect differences in value and cost; (ii) to commu-
nicate the value of its offers to customers unfamiliar with the market; and
(iii) to create pricing policies for managing pricing issues fairly and consis-
tently. In short, this book shows managers how to move from tactically “opti-
mizing” prices in markets where they seemingly exercise little control to
managing the market strategically. When that happens, pricing becomes an
integral part of a strategy to grow profitably, rather than just a blunt instrument
to drive sales and market share.
The principles of strategic pricing, which were foreign to most business
practitioners when the first edition of this book was published more than three
decades ago, are now more widely accepted in principle. However, most com-
panies still struggle with their application. The changes in this sixth edition of
our book reflect our attempts to address this need:
• To help our readers better conceptualize the range of interrelated tasks
involved in strategic pricing, we have organized this edition around a
“value cascade” that organizes those tasks into six distinct categories.
• The field of behavioral economics has absolutely exploded since the first
edition of this book and has gained more widespread acceptance; the
chapter on “Price and Value Communication: Strategies to Influence
Willingness-to-Pay” highlights several of the behavioral economic prin-
ciples that are particularly important to consider when proactively man-
aging prices and value perceptions.
• We have substantially revised the chapter on “Price Level: Setting the
Prices That Capture a Share of the Value Created” to present a robust
process for determining appropriate price levels. The chapter reflects
the reality that companies in only a few markets (e.g., online retailing)
can map their demand, and its changes over time, with sufficient accu-
racy to set the “best” price exactly. Our approach now describes how
xiv Preface

to assemble data and process information to support a cross-functional

dialogue that arrives at “good” price decisions based upon thoughtfully
weighing the information at hand.
• The chapter on “Price Competition: Managing Conflict Thoughtfully”
provides an in-depth understanding of value-destroying price wars,
how to mitigate the damage of a price war, and perhaps most impor-
tant, how to minimize the chances of provoking destructive responses to
one’s own pricing decisions.
• The chapter on “Specialized Strategies: Adapting Pricing to Accommo-
date Common Challenges” has been added to address some of the more
technical issues that managers might encounter such as managing pric-
ing over a product lifecycle, addressing foreign exchange risks, how to
act when a market slumps, and managing transfer prices between inde-
pendent profit centers.
• A completely rewritten chapter on “Creating a Strategic Pricing Capabil-
ity” describes the process for transforming an organization to one that
embeds the principles of value-based strategic pricing into the processes
and incentives of the organization.
• Throughout this edition, we have updated examples to illustrate more
current pricing challenges, new revenue models enabled by our increas-
ingly digital economy, and advances in the study of buyer decision
making. At the same time, we have also retained a number of “classic”
examples that contain lessons that remain highly relevant and applicable
today.
As with prior editions, the primary objective of this book is to develop a practi-
cal and readable manager’s guide to pricing. Professors will be happy to learn
that we have updated the Instructor’s Manual for this edition to include new
exercises, mini-cases, and examination questions. We also provide a link to
Deloitte’s Polaris analytical pricing software to allow students to put theory
into practice by exploring real-world scenarios.
 ACKNOWLEDGMENTS

Over the years the book has benefited from the influence and efforts of indi-
viduals too numerous to mention here. Nevertheless, we would be remiss
not to acknowledge a few whose contributions have either been very large or
new to this edition. Professor Gerald Smith’s contributions to the prior edi-
tions of this book and the instructor’s manuals are still reflected in the current
ones. Professor Mark Bergen was an invaluable sounding board and source
of inspiration in developing portions of this book. Michael Goldberg was a
diligent researcher, copy editor, and administrator, without whose persistent
prodding this edition would still be “in process.” Junaid Qureshi drew on his
expertise of the gaming industry to develop a very compelling overview of
the evolution of pricing models for video games to augment the chapter on
“Price Structure: Tactics for Pricing Differently Across Customer Segments.”
Eugene Zelek, together with his colleague, Lauren Berheide, of Freeborn &
Peters once again shared his knowledge of pricing and the law to keep that
chapter current. We would also like to thank our colleagues at Deloitte Con-
sulting who have supported our efforts. Laura McGoff, Liz Lee, and Anusha
Singuluri were tremendous in helping us obtain reprint permissions, creating
the exhibits, and ensuring that we fulfilled all requirements of our firm. Lisa
Iliff provided a careful and thoughtful review of the final manuscript and Josh
Skwarczyk tracked down references and citations to support our narrative. In
addition, we had the good fortune of working with our editors at Routledge,
where Sharon Golan, acquisitions editor, and Erin Arata, editorial assistant,
were very thoughtful and exhibited great patience in guiding us to the end
product.
Finally, Tom Nagle would like to thank his wife, Leslie, for her patience
and diligent copy editing which she has generously provided through 32 years
of marriage and six editions of this book. Georg Müller thanks his wife Kathy
and son Oskar for their unwavering support and encouragement while he
spent his evenings and weekends writing and developing this book.

NOTE
This publication contains general information only and is based on the experi-
ences and research of Deloitte practitioners. Deloitte is not, by means of this
publication, rendering accounting, business, financial, investment, legal, tax,
or other professional advice or services. This publication is not a substitute
for such professional advice or services, nor should it be used as a basis for
any decision or action that may affect your business. Before making any deci-
sion or taking any action that may affect your business, you should consult a
qualified professional advisor. Deloitte shall not be responsible for any loss
sustained by any person who relies on this publication.
 IN-LINE BOXES

Chapter 1: Strategic Pricing

The Story of the Mustang 13

Chapter 2: Economic Value

The Problem with Customer Value Modeling 46

Chapter 4: Price Structure

Evolution of the Price Metric for Mobile Video Games 90
Value-Based Pricing Finances Hamlet’s Castle 93

Chapter 6: Price Level

Factors That Influence Price Sensitivity 147

Chapter 7: Price Competition

Market-Share Myth 154

Chapter 8: Measurement of Price Sensitivity

Using Panel Data to Measure the Impact of Promotion on Choice 177
Measuring Price Sensitivity for e-Books 184
Purchase Probability Curves: A Simple Buy-Response Study—
Opportunity for a Higher Price 187
A Conjoint Study: Blue Sky Ski Company 194

Chapter 11: Creating a Strategic Pricing Capability

Assessing the Maturity of the Pricing Organization 266
Exploring New Ways to Manage a Price Increase: Lessons from Netflix 270
Creating a Sales Incentive to Drive Profit 278
 EXHIBITS

1-1 Breakeven Sales Curve Associated with Different

Price Changes 9
1-2 The Value Cascade: Strategic Pricing Requires Effective
Management of Both Value and Price 11
1-3 Value-Based Pricing Involves Offering Customers “Good Value” 13
2-1 Economic Value Estimation (EVE®) Model 29
2-2 Non-Normalized Reference Price Data 32
2-3 Normalized Reference Data 33
2-4 Examples of Value Driver Algorithms for
Equipment Manufacturer 35
2-5 Monetary Value Estimation for Dyna-Test Industrial Buyers 38
2-6 Monetary Value Estimation for Dyna-Test Academic
and Government Buyers 39
2-7 Monetary Value Profile for Dyna-Test 40
2-8 Impact of Warranty Length on Willingness-to-Pay 43
2-9 Difference in Willingness-to-Pay and Market
Potential by Segment 44
2-10 Primary and Secondary Segmentation: Catalog
Printing Industry 52
2-11 Characteristics of Three Printer Customer Segments 53
3-1 Purchase Involvement and Benefit Types for Products
and Services 59
3-2 Economic Value Messages for Low-Involvement Goods 61
3-3 Spreadsheet Value Communication Tool 63
3-4 Distribution of Value Across the Organization 73
4-1 The Incremental Contribution from Segmented Price Structure 77
4-2 Segmented Price Structure in Airlines 81
4-3 Revenue Optimizing Subscription Pricing by Segment 82
4-4 Criteria for Evaluating Pricing Metrics 86
4-5 Hosted Call Center Software 88
4-6 Step-Price Schedule for Electricity 101
5-1 Typical Capabilities of Purchasing Versus Sales 109
5-2 Cycle of Reactive Price Negotiation 115
5-3 Cycle of Proactive Policy-Based Price Negotiation 117
5-4 Buyer Types 119
6-1 The Six-Step Process for Setting Prices 135
6-2 Illustration of the Reasonable Price Range 136
6-3 Constant Profit Curve Associated with Different Price Changes 144
6-4 Breakeven Sales Changes Required Given Different
Contribution Margins 145
7-1 Thoughtfully Reacting to Price Competition 160
8-1 Techniques for Measuring Price Sensitivity 174
8-2 Regression Analysis Results 178
8-3 Use of Regression Analysis 181
8-4 e-Books: Purchase Rate by Price 185
8-5 Purchase Probability Curve for Financial Software 187
xx Exhibits

8-6 Total Revenue Estimate for Financial Software 188

8-7 Analysis of Youth-Seeking “Innovators” Segment 195
8-8 Effect of Warranty on Take Rate 196
9-1 Analysis of Music Festival Revenue Options 211
9-2 Finding the Breakeven Sales Change 216
9-3 Breakeven Sales Analysis and Simulated Scenarios: Westside
Manufacturing’s Proposed 5 Percent Price Reduction 221
9-4 Breakeven Analysis of a Price Change 222
9-5 Breakeven Sales Curve Calculations (with Incremental
Fixed Costs) 224
9-6 Breakeven Sales Curve: Trade-Off Between Price and Sales
Volume Required for Constant Profitability 225
9-7 Breakeven Sales Curve: Relationship Between Price Elasticity
of Demand and Profitability 226
9-8 Breakeven Sales Curve: Relationship Between Price Elasticity
of Demand and Profitability: Changes in Profit with More
Inelastic Demand 227
9A-1 Cost Projection for Proposed Crop of Mums 231
9A-2 Relevant Cost of Mums 232
9A-3 Breakeven Sales Changes for Proposed Price Changes 233
9A-4 Breakeven Sales Change Simulated Scenarios
(Vertical Orientation) 234
9A-5 Profit Impact of a 10 Percent Increase 236
9B-1 Breakeven Sales Change Relationships 238
10-1 Sales and Profits Over the Product’s Life, from
Inception to Demise 241
10-2 Alternative Strategic Choices for Foreign Market Sales 249
10-3 Stratagies for Managing Foreign Exchange Rate Adjustments 251
10-4 Inefficiencies in Transfer Pricing 256
10-5 Efficiency from Cost Integration 257
11-1 Archetypal Pricing Organizations 263
11-2 Operating Profit Relative to Industry Peers 264
11-3 The Foundation for a Strategic Pricing Capability 266
11-4 Assessing Each Element of the Value Cascade 267
11-5 Pricing Structure Archetypes 272
11-6 Types of Decision Rights 273
11-7 Map of Decision-Making Process for a
Manufacturing Company 275
11-8 Illustrative Data Sources for Pricing Analytics 280
11-9 Customer Profitability Map 282
11-10 Customer Profitability by Peer Group 282
11-11 Price Band Analysis 283
11-12 Price Waterfall Analysis 285
12-1 When Is Price Ethical? Ethical Constraints 294
 CHAPTER 1
Strategic Pricing
Coordinating the Drivers of Profitability

If you have to have a prayer session before raising the price by 10 percent, then
you’ve got a terrible business.
Warren Buffet1

Marketing consists of four key elements: The product, its promotion, its
placement or distribution, and its price. The first three elements—product,
promotion, and placement—comprise a firm’s effort to create value in the
marketplace. The last element—pricing—differs essentially from the other
three: It represents the firm’s attempt to capture some of the value in the profit
it earns. If effective product development, promotion, and placement sow the
seeds of business success, effective pricing is the harvest. Although effective
pricing can never compensate for poor execution of the first three elements,
ineffective pricing can surely prevent those efforts from resulting in financial
success. Regrettably, this is a common occurrence.
Complicating matters, the ability to harvest potential profits is in a con-
tinuous state of flux as technology, regulation, market information, consumer
preferences, or relative costs change. Consequently, companies that expect to
grow profitably in changing markets often need to break old rules, includ-
ing those that govern how they will set prices to earn revenues. Our interest
in strategic pricing dates back to when the telecommunications industry was
deregulated in most developed countries and new suppliers recognized that
they could gain both market share and profitability by replacing the then pre-
vailing price-per-minute revenue models with more innovative models—first
including a price per month for a bundle of “peak” minutes plus “free” off-
peak time. Later, they introduced “family plans” involving the sharing of min-
utes across numbers. Similarly, Apple quickly went from nothing to market
leadership in music sales, in large part because, after the internet slashed the
cost of distribution, it was the first to recognize that it was better to price music
by the song than by the album. And at the time of writing this edition, the
predominant revenue model for music is shifting yet again, with subscription-
based streaming services such as Spotify and Apple Music® overtaking digital
2 Chapter 1 • Strategic Pricing

music store sales.2 Producers of new online media created a new metric for
pricing ads—cost per click—that aligned the cost of an ad more closely to its
value than was possible in traditional print media. Even governments have
begun to use prices, often called “user fees,” instead of taxes to raise revenues
and better allocate scarce resources. Congested cities, such as London and
Singapore, charge to drive a car into congested areas during peak times and
highways in major U.S. cities such as Atlanta and Minneapolis increasingly
have express lanes that are kept moving even during rush hours by adjusting
a wirelessly collected price to access them.3
Unfortunately, few managers, even those in marketing, have been trained
in how to develop innovative pricing strategies such as these. Most companies
still make pricing decisions in reaction to change rather than in anticipation of
it. This is unfortunate, given that the need for rapid and thoughtful adaptations
to changing markets has never been greater. The information revolution has
made prices everywhere more transparent and customers more price aware.4
The globalization of markets, even for services, has increased the number of
competitors and often lowered their cost of sales. The high rate of technologi-
cal change in many industries has created new sources of value for customers,
but not necessarily led to increases in profit for the producers.
Improvements in technology have driven an explosion of data that
some suppliers are using to target customers they can serve more profitably:
Either because those customers are more willing to pay for the differentiation
the company can offer or because the company can meet their needs more
cost-effectively than competitors. This is especially true of consumer goods,
where manufacturers used to operate with only minimal and long-delayed
data on where and how well their products were selling in retail stores, and
pricing involved negotiating “trade promotions” with channel intermediar-
ies that may or may not have passed the savings on to end consumers. Now,
with the ability to buy almost “real time” data on how individual package
sizes are selling in types of outlets and in specific geographies, manufactur-
ers are able to develop more sophisticated pricing strategies to target specific
types of customers and competitors. At the extreme, many retailers charge
online shoppers different prices or offer them different product assortments
based on the type of device they are using to access the site, with the theory
that the type of device can signal a systematic difference in willingness-
to-pay.5

LEVERAGING PROFIT INTO SUSTAINABLE GROWTH

Learning to make sales more profitably is the key to achieving sustainable
growth in revenue, market share, and company value over the long haul.
When the first edition of this book was published more than three decades
ago, the idea that profit margins should be prioritized over growth was seen as
short-sighted. A 1975 study conducted at the Harvard Business School using
the PIMS (which originally stood for Profit Impact of Market Share) database
of historical market performance of leading global companies reported a
strong, consistently positive, correlation between a company’s market share
and its relative profitability within an industry.6 In the Harvard Business Review
article discussing this study, the authors proposed multiple plausible reasons
why a larger market share could enable a company to operate more profitably.
 Chapter 1 • Strategic Pricing 3

That led to an explosion of literature by marketing theorists and leading con-

sultancies advocating aggressively low pricing as an “investment” in growth
that would eventually create “cash cows”—exceptionally profitable revenue
streams requiring little investment to maintain them.
Unfortunately, companies that adopted this approach to pricing, more
often than not, found the theory and the eventual profitability it promised
lacking. As the PIMS database grew to cover multiple years, more nuanced
relationships were revealed. Although a cross-sectional correlation between
market share and profitability proved durable, how a company invested to
grow was shown to be a better predictor of financial success. Consequently,
the PIMS organization cleverly redefined their acronym to stand for Profit
Impact of Marketing Strategy.
More recent research by Deloitte Consulting LLP has brought further
clarity to the relationship between growth and profitability. Deloitte compiled
a time-series dataset of 394 companies, covering the period from 1970 to 2013
with exceptional, mediocre and poor performers matched by industry. The
researchers defined “exceptional performance” as a company achieving supe-
rior profitability (return on assets), stock value, and revenue growth for more
than a decade and sought to understand how a small minority of firms man-
age to achieve it. Their conclusion:
a [near term] focus on profitability, rather than revenue growth or [stock]
value creation, offers a surer path to enduring exceptional performance.7
So how do marketing and financial managers at exceptional companies achieve
sustainable exceptional profitability? It is not the result of slashing overheads
more ruthlessly than their competitors. In fact, Deloitte’s data indicates that
exceptional performers tend to spend a bit more than competitors (as a percent
of sales) on R&D and SG&A. Their exceptional profitability and, eventually,
exceptional stock valuations are built on higher margins per sale that fund
initiatives to grow revenues without compromising those margins.8
Unfortunately, many companies fail to understand that making sales
profitably should be the first priority—not an afterthought—of a strategy for
driving growth. Creating and communicating superior value propositions or
finding a way to deliver superior value at lower cost is a precondition to sus-
tainable revenue growth. Many years of experience have taught us that apply-
ing the principles explained in these pages is necessary to make sales more
profitable and at least equal with the best in the industry.
The difference between successful and unsuccessful pricers lies in how
they approach the process. To achieve superior, sustainable profitability, pric-
ing must become an integral part of strategy. Strategic pricers do not ask,
“What prices do we need to cover our costs and earn a profit?” Rather, they
ask, “What costs can we afford to incur, given the prices achievable in the
market, and still earn a profit?” Strategic pricers do not ask, “What price is
this customer willing to pay?” but “What is our product worth to this cus-
tomer and how can we better communicate that value, thus justifying the
price?” When value doesn’t justify price to some customers, strategic pricers
do not surreptitiously discount. Instead, they consider how they can segment
the market with different products or distribution channels to serve these
customers without undermining the perceived value to other customers. And
strategic pricers never ask, “What prices do we need to meet our sales or
4 Chapter 1 • Strategic Pricing

market share objectives?” Instead they ask, “What level of sales or market
share can we most profitably achieve?”
Strategic pricing often requires more than just a change in attitude; it
requires a change in when, how, and who makes pricing decisions. For exam-
ple, strategic pricing requires anticipating price levels before beginning prod-
uct development. It requires determining the economic value of a product or
service, which depends on the alternatives customers have available to sat-
isfy the same need. We go into much more depth on the concept of Economic
Value Estimation (EVE®) in Chapter 2. The only way to ensure profitable pric-
ing is to reject early those ideas for which adequate value cannot be captured
to justify the cost.
Strategic pricing also requires that management take responsibility for
establishing a coherent set of pricing policies and procedures, consistent with
the company’s strategic goals. Abdicating responsibility for pricing to the sales
force or to the distribution channel is abdicating responsibility for the strategic
direction of the business.
Perhaps most important, strategic pricing requires a new relationship
between marketing and finance because pricing involves finding a balance
between the customer’s desire to obtain good value and the firm’s need to
cover costs and earn profits. Unfortunately, pricing at most companies is char-
acterized more by conflict than by balance between these objectives. If pricing
is to reflect the value to the customer, specific prices must be set by those best
able to anticipate that value—presumably marketing and sales managers. The
problem is that their efforts will not generate substantial profits unless con-
strained by appropriate financial objectives. Rather than attempting to “cover
costs,” finance must learn how costs change with shifts in sales volume and
use that knowledge to develop appropriate incentives for marketing and sales
to achieve their objectives.
With their respective roles appropriately defined, marketing and finance
can work together toward a common goal—to achieve profitability through
strategic pricing.
Before marketing and sales can attain this goal, however, managers in
all functional areas must discard the flawed thinking about pricing that fre-
quently leads them into conflict and that drives them to make unprofitable
decisions. Let’s look at these flawed paradigms so that you can recognize them
and understand why you need to let them go.

COST-PLUS PRICING
Cost-plus pricing is, historically, the most common pricing procedure because
it carries an aura of financial prudence. Financial prudence, according to this
view, is achieved by pricing every product or service to yield a fair return over
all costs, fully and fairly allocated. In theory, it is a simple guide to profitabil-
ity; in practice, it is a blueprint for mediocre financial performance.
The problem with cost-driven pricing is fundamental: In most industries,
it is impossible to determine a product’s unit cost before determining its price.
Why? Because unit costs change with volume. This cost change occurs because
a significant portion of costs are “fixed” and must somehow be “allocated” to
determine the full unit cost. Unfortunately, because these allocations depend
on volume, and volume changes as prices change, unit cost is a moving target.
 Chapter 1 • Strategic Pricing 5

To solve the problem of determining unit cost before determining

price, cost-based pricers are forced to assume a level of sales volume and then
to make the absurd assumption that they can set price without affecting that
volume. The failure to account for the effects of price on volume, and of vol-
ume on costs, leads managers directly into pricing decisions that undermine
profits. A price increase to cover higher fixed costs can start a death spiral in
which higher prices reduce sales and raise average unit costs further, indicat-
ing (according to cost-plus theory) that prices should be raised even higher.
On the other hand, if sales are higher than expected, fixed costs are spread
over more units, allowing average unit costs to decline a lot. According to
cost-plus theory, that would call for lower prices. Cost-plus pricing leads to
overpricing in weak markets and underpricing in strong ones—exactly the
opposite direction of a prudent strategy.
How, then, should managers deal with the problem of pricing to cover
fixed costs? They shouldn’t. The question itself reflects an erroneous percep-
tion of the role of pricing, a perception based on the belief that one can first
determine sales levels, then calculate unit cost and profit objectives, and then
set a price. Once managers realize that sales volume (the beginning assump-
tion) depends on price (the end of the process), the flawed circularity of cost-
based pricing is obvious. The only way to ensure profitable pricing is to let
anticipated pricing determine the costs incurred rather that the other way
around. Value-based pricing must begin before investments are made using a
process that we will describe later in this chapter.

CUSTOMER-DRIVEN PRICING
Many companies now recognize the fallacy of cost-based pricing and its
adverse effect on profit. They realize the need for pricing to reflect market
conditions. As a result, some firms have taken pricing authority away from
financial managers and given it to sales or product managers. In theory, this
trend is consistent with value-based pricing, since marketing and sales are that
part of the organization best positioned to understand value to the customer.
In practice, however, their misuse of pricing to achieve short-term sales objec-
tives often undermines perceived value and depresses future profitability.
The purpose of strategic pricing is not simply to create satisfied custom-
ers. Customer satisfaction can usually be bought by a combination of overdeliv-
ering on value and underpricing products. But marketers delude themselves if
they believe that the resulting increases in sales represent marketing successes.
The purpose of strategic pricing is to price more profitably by capturing more
value, not necessarily by making more sales. When marketers confuse the first
objective with the second, they fall into the trap of pricing at whatever buyers
are willing to pay, rather than at what the product is really worth. Although
that decision may enable marketing and sales managers to meet their sales
objectives, it invariably undermines long-term profitability.
Two problems arise when prices reflect the amount buyers seem will-
ing to pay. First, sophisticated buyers are rarely honest about how much they
are actually willing to pay for a product. Professional purchasing agents are
adept at concealing the true value of a product to their organizations. Once
buyers learn that sellers’ prices are reactively flexible, they have a financial
incentive to conceal information from, and even mislead, sellers. Obviously,
6 Chapter 1 • Strategic Pricing

this undermines the salesperson’s ability to establish close relationships with

customers and to understand their needs.
Second, there is an even more fundamental problem with pricing to
reflect customers’ willingness-to-pay. The job of sales and marketing is not
simply to process orders at whatever price customers are currently willing
to pay, but rather to raise customers’ willingness-to-pay to a level that better
reflects the product’s true value. Many companies underprice truly innova-
tive products because they ask potential customers, who lack prior experi-
ence from which to judge the product’s value, what they would be willing to
pay for it. But we know from studies of innovations that the price has little
impact on whether customers are willing to try them.9 For example, most
customers initially perceived that photocopiers, mainframe computers, home
air conditioners, and MP3 players lacked adequate value to justify purchase
at viable prices. Only after trial by a small subset of “innovator” customers,
followed by extensive marketing to communicate and guarantee value to a
broader market, did these products achieve market acceptance. Forget what
customers who have never used your product are initially willing to pay.
Instead, understand what the value of the product could be for satisfied cus-
tomers, communicate that value to the currently uninformed, and set prices
accordingly. Low pricing is always a poor substitute for an inadequate mar-
keting and sales effort.

SHARE-DRIVEN PRICING
Finally, consider the policy of letting pricing be dictated by competitive con-
ditions. In this view, pricing is a tool to achieve gains in market share. In the
minds of some managers, this method is “pricing strategically.” Actually, it
is more analogous to “letting the tail wag the dog.” Occasionally, network-
ing effects make a product or service more valuable when other people are
patronizing the same brand, as was the case for example with eBay, the online
marketplace. In most cases, however, there is no reason why an organization
should seek to achieve market share as an end in itself.
Although cutting price is probably the quickest, most effective way to
achieve sales objectives, it is usually a poor decision financially. Because a
price cut can be so easily matched, it offers only a short-term market advan-
tage at the expense of permanently lower margins. Consequently, unless
a company has good reason to believe that its competitors cannot match a
price cut, the long-term cost of using price as a competitive weapon usually
exceeds any short-term benefit. Although product differentiation, advertis-
ing, and improved distribution do not increase sales as quickly as price cuts,
their benefit is more sustainable and thus is usually more cost-effective in
the long run.
The goal of pricing should be to find the combination of margin and
market share that maximizes profitability over the long term. Sometimes,
the most profitable price is one that substantially restricts market share rela-
tive to the competition. Godiva chocolates, Apple iPhones®, Peterbilt trucks,
and Snap-on tools would no doubt all gain substantial market share if priced
closer to the competition. It is doubtful, however, that the added share
would be worth forgoing their profitable and successful positioning as high-
priced brands.
 Chapter 1 • Strategic Pricing 7

Strategic pricing requires making informed trade-offs between price

and volume in order to maximize profits. These trade-offs come in two forms.
The first trade-off involves the willingness to lower price to exploit a market
opportunity to drive volume. Cost-plus pricers are often reluctant to exploit
these opportunities because they reduce the average contribution margin
across the product line, giving the appearance that it is underperforming rela-
tive to other products. But if the opportunity for incremental volume is large
and well targeted, a lower contribution margin can actually drive a higher
total profit. The second trade-off involves the willingness to give up volume
by raising prices. Competitor- and customer-oriented pricers find it very diffi-
cult to hold the line on price increases in the face of a lost deal or reduced vol-
ume. Yet the economics of a price increase can be compelling. For example, a
product with a 30 percent contribution margin could lose up to 25 percent of
its volume following a 10 percent price increase before that move results in
lower profitability.
Effective managers of pricing regularly evaluate the balance between
profitability and market share and are willing to make hard decisions when
the balance tips too far in one direction. (We will show you how to make such
calculations later in this book). Key to making those managers effective, how-
ever, is performance measures and incentives that reward them for improving
profitability, not just revenue.

THE ROLE OF “OPTIMIZING” IN STRATEGIC PRICING

Economic theorists propose pricing based upon estimating the demand
curve for a product and then “optimizing” the price level, given the incre-
mental cost of production. In theory, this is totally consistent with the approach
we propose in this book, but in practice it is almost always impractical. The
reason lies in the assumption that a demand curve is something stable that
one can measure with sufficient speed and accuracy to continually optimize
it. Contrary to the assumptions that economists make when studying mar-
kets, the demand for individual products or brands within markets is rarely
stable or easily measured. The reason: Sensitivity to price depends as much on
ever-changing purchase contexts and perceptions as on underlying needs or
preferences. For example, contradicting the assumption of a demand curve,
the amount of a product that customers will buy at a particular price point is
strongly affected by the prices they paid recently. When gasoline prices are
rising, the demand for premium grades of gasoline will fall quickly by a much
greater percentage than demand for regular grades. But when prices decline
back to where they started, demand for premium grades will not recover
quickly. That is, demand when prices are going up is generally much more
“price elastic” than when prices are coming down.
More importantly, behavioral economics research over the past few
decades has proven conclusively that differences in how prices are presented
and the surrounding context can lead buyers to respond in ways that are
inconsistent with the idea of a stable demand curve that reflects fixed prefer-
ences.10 For example, if one adds a higher priced product to the choices avail-
able in a store—say a “best” version to go along with a “good” and a “better”
version—economic theory would predict that the higher-priced “best” version
would primarily draw sales from the mid-priced “better” version, which turns
8 Chapter 1 • Strategic Pricing

out to be true. What it does not predict is that the mid-priced version will at
the same time gain sales at the expense of the cheapest version even though
the prices of those two versions remain unchanged.11 To add to the instabil-
ity, we know that the demand for the mid-price product will be greater if
the offers are presented beginning from the top down rather than from the
bottom up.12
These examples illustrate just a few of the effects that appear to shift
demand curves in ways that are contextual. Still, one cannot deny the fact
that the profitability of a price increase will depend upon whether the loss
in sales is not too great, while the profitability of a price decrease depends
upon whether the gain in sales is great enough. Economists refer to the actual
percentage change in sales divided by the percentage change in price as the
price elasticity of demand. Actual elasticity depends in part upon how effectively
marketers manage customer perceptions and the purchase context, as you will
come to see in the following chapters. Moreover, many factors that influence
price elasticity are not under the marketer’s control, making precise estimates
of actual price elasticity very difficult and only rarely cost effective. Conse-
quently, we have found that instead of asking “What is price elasticity for this
product?” it is often more practical and useful to ask “What is the minimum
elasticity that would be necessary to justify a particular price change?” that
has been proposed to achieve some business objective. To put the question in
less technical jargon, we ask “What percent change in sales would be neces-
sary (which is the same as asking what price elasticity would be necessary) for
a proposed price change to maintain the same total profit contribution after a
price change?” We refer to the answer as the breakeven sales change associated
with a proposed price change.
If we create a graph of breakeven sales changes associated with different
potential price changes, we can create a breakeven sales curve that looks much
like a demand curve, as shown in Exhibit 1-1, which shows the example of a
product that earns a 45 percent gross margin at a baseline price of $10. It is a
representation of how much demand is needed to maintain current profitability
as prices change. If actual demand proves to be less elastic (steeper) than the
breakeven sales curve, then higher prices will be more profitable. If the actual
demand proves to be less steep (more elastic) than the breakeven sales curve,
then lower prices will be more profitable. Technical details about how to cal-
culate a correct breakeven sales change for any particular product and pricing
decision are described in Chapter 9.
None of this implies that research to understand demand price elasticity
is not valuable. We are simply observing that, given the usual instability of
demand estimates over the time period required to make them, attempting to
improve profitability by exactly “optimizing” price levels is usually not prac-
tical. What is valuable is research to understand how differences in identifi-
able purchase contexts (e.g., online versus in-store purchases, standard versus
rush orders) or how marketing strategies to influence perceptions of value can
influence demand elasticity. Research is also useful when developing offers
to understand the relative impact of different features and services that one
might offer on perceived value.
Finally, we should acknowledge that it is possible in a small number of
markets to measure demand price elasticity accurately in real time, enabling
mangers to track the effect of changes ranging from the weather to the daily
 Chapter 1 • Strategic Pricing 9

EXHIBIT 1-1 Breakeven Sales Curve Associated with Different Price Changes

news, to the time of day can have on them. Consumer packaged goods compa-
nies can purchase huge quantities of scanner-recorded sales data from retail
stores, far more than would ever be practical to generate from market research.
They can then build “big data” statistical models that use such data to measure
price elasticity as precisely as possible by measuring and controlling for many
contextual factors (such as alternatives available in the store and their prices,
the time of day and day of week, the size of the customers total purchase, the
store location) that can influence it. In these cases, the effort to make small
price adjustments to optimize profitability have proven worthwhile.

WHAT IS STRATEGIC PRICING?

As you probably remember from basic economics, the optimal price one can
charge is limited by the demand curve: A summary of what customers are
willing to pay to buy various quantities of volume. Pricing, given the assump-
tions of economics, is simply about optimizing the price level given that
demand. In reality, however, demand for most products and services is not
given. It is created, sometimes thoughtfully and sometimes haphazardly, by
decisions that sellers make about what to offer their customers, how to com-
municate their offers, how to price differently across customers or applications
and how to manage customer price expectations and incentives. Making these
decisions thoughtfully and implementing them effectively to maximize profit-
ability is what we call “strategic pricing.”
The word “strategic” is used in various contexts to imply different things.
Here, we use it to mean the coordination of otherwise independent activities to
10 Chapter 1 • Strategic Pricing

achieve a common objective. For strategic pricing, the objective is sustainable

profitability. Achieving exceptional profitability requires making thoughtful
decisions about much more than just price levels. It requires ensuring that
products and services include just those features that customers are willing to
pay for, without those that unnecessarily drive up cost by more than they add
to value. It requires translating the differentiated benefits your company offers
into customer perceptions of a fair price premium for those benefits. It requires
creativity in how you collect revenues so that customers who get more value
from your differentiation pay more for it. It requires varying price to use fixed
costs optimally and to discourage customer behaviors that drive excessive ser-
vice costs. It sometimes requires building capabilities to mitigate the behavior
of aggressive competitors.
Although different strategies can achieve profitable results even within
the same industry, nearly all successful pricing strategies embody three prin-
ciples. They are value-based, proactive, and profit-driven:

• Value-based means that differences in pricing across customers or appli-

cations reflect differences in the value to customers. For example, many
managers ask whether they should lower prices in response to reduced
market demand during a recession. The answer: If customers receive less
value from your product or service because of the recession, then prices
should reflect that. But the fact that fewer customers are in the market
for your product does not necessarily imply that those who remain value
it less than when they were more numerous. Unless a close competitor
has cut its price giving customers a better alternative, there may be no
value-based reason for you to do so.
• Proactive means that companies anticipate disruptive events (for exam-
ple, a new competitive threat or a customer’s decision to award business
via a reverse auction) and develop strategies in advance to deal with
them. For example, anticipating that a recession or a new competitive
entry will cause customers to ask for lower prices, a proactive company
develops a lower-priced service option or a loyalty program, enabling it
to define the terms and trade-offs of the expected interaction, rather than
forcing it to react to terms and trade-offs defined by the customer or the
competitor.
• Profit-driven means that the company evaluates its success at price man-
agement by what it earns relative to alternative investments rather than
by its market share and growth relative to its competitors. When Apple
launched its first iPhone® at $499, commentators accused Apple of over-
pricing (with less-featured competitive phones costing no more than
half as much).13 But Apple easily sold its new innovation to a subset of
“techies” and invested to ensure they had a great experience. Then, when
it cut the price to $399, many more buyers saw it as a bargain. Still, com-
petitors have soon launched knock-offs that copy each of Apple’s new
iPhone innovations within a year or so, and smartphones based upon the
Android platform have overtaken those of Apple in unit sales by a wide
margin.14 So should Apple be worried? We think not, and neither do
Apple’s investors. With most of its profits coming from smartphone sales,
Apple is the most profitable and most valuable company in the world at
the time we are writing this. Moreover, while many of its competitors are
 Chapter 1 • Strategic Pricing 11

cutting prices to penetrate large and rapidly growing but lower-income

markets like China, Apple is not. Instead, it is adding more functionality
and building more Apple stores in those markets to ensure that custom-
ers have the same exceptional experience that hooked Apple loyalists
in developed markets, investments it can easily afford given the higher
margins it earns from each buyer.
These three principles will resurface throughout this book as we discuss how
to define and make good choices. Strategic pricing is not a discipline separate
from the rest of marketing strategy; it is rather a set of principles for creating
marketing strategies that drive growth profitably.
A good pricing strategy involves six distinct but very different choices
that build upon one another. The choices are represented graphically as six
points in what we call the Value Cascade (Exhibit 1-2). The core function of a
successful firm is to create value; first and foremost for customers, but also for
the internal constituencies that rely on the firm for employment and returns
on investment. Strategic pricing is about managing value, from its creation
through its capture in price setting, in a coordinated way that enables the orga-
nization to achieve a high, sustainable return from its efforts.
The first thing that strikes most people new to the subject of strategic
pricing is that setting a price level is just one step in a multistep process that
impacts the full range of marketing decisions. If the goal of pricing profitably

EXHIBIT 1-2 The Value Cascade: Strategic Pricing Requires Effective Management
of Both Value and Price
12 Chapter 1 • Strategic Pricing

is considered only when price levels are set, then multiple marketing choices
are likely to be made in ways that will dissipate profit potential (the “gaps” in
our diagram) well before any product or service is offered for sale.
Although this book contains a chapter devoted to addressing each of
these topics individually, it is useful to have an overall vision—a map if you
will—of how and why they fit together in this particular order. Both managers
and pricing consultants are often called upon to fix strategies that are generat-
ing poor financial returns despite driving revenues. Consequently, they may
start anywhere on this choice cascade based upon their initial assessment of
the potential for improvement. For our overview, we will follow the order of
the numbers in the exhibit, which reflect the order in which you would typi-
cally need to address these issues if building the marketing strategy for a new
product or service from scratch.

VALUE CREATION
It is often asserted as a truism that the value of something is whatever someone
will pay for it. We disagree. People sometimes pay for things that soon disappoint
them in use (for example, time-share condominiums). They fail to get “value for
money,” do not repeat the purchase, and discourage others from making the
same mistake. At the other extreme, people are often reluctant to pay any price
for radical new innovations simply because they lack the experience, either their
own or that of someone else whose judgment they trust, from which to judge
the value that the innovation could bring to their lives. For companies trying to
gain share in established markets by creating differentiated product and service
offerings, the challenge is simply to get customers already in the market to pay a
premium price that exceeds the added cost to deliver that differentiation.
Of course, it is sometimes possible to deceive people into making one-
time purchases at prices ultimately proven to be unjustified, but that is not
a viable strategy for an ongoing enterprise, nor is it our agenda in this book.
Our intention is to show marketers how to create value cost-effectively and
convince people to pay prices commensurate with that value. We expect that,
as a result, those of you who apply these ideas will contribute to an economic
system in which firms that are more adept at creating value for customers are
most rewarded with higher margins and market value.
Some companies that have exceptional technologies and capabilities with
the potential to create great value fail to convert them into offers that generate
exceptional, or even adequate, profitability. They make the mistake of believ-
ing that more, from a technological perspective, is necessarily better for the
customer. One of us worked for a company making high-quality office furni-
ture that was disappointed by its low share in fast-growing, entrepreneurial
markets. The company wanted a strategy to convince those buyers what more
established companies recognized already: That highly durable office furniture
that would hold its appearance and function for 20 or more years was a good
investment. But it took only a few interviews with buyers in the target mar-
ket to recognize the problem. Companies in this market expected either to be
bought out in five years or be gone. The problem was not that customers did
not recognize the differentiating benefits of the company’s products. It was that
the target market saw little value associated with those benefits.
Exhibit 1-3 illustrates the flawed progression of cost-plus pricing and the
necessary progression for value-based pricing. Cost-based pricing is product
 Chapter 1 • Strategic Pricing 13

EXHIBIT 1-3 Value-Based Pricing Involves Offering Customers “Good Value”

driven. Engineering and manufacturing departments design and make what

they consider a “good” product. In the process, they make investments that
incur costs to add features and related services. Finance then totals these costs
to determine a “target” price. Only at this stage does marketing enter the pro-
cess, charged with the task of demonstrating enough value in the product to
justify pricing to customers.
If the cost-based price proves unjustifiable, managers may try to fix
the disappointing sales by allowing “flexibility” in the price. Although this
tactic may help meet the sales goal, it is not fundamentally a solution to the
problem of pricing profitably. That problem will arise again as the features
and costs of the new products continue to mismatch the needs and values of
customers.
Solving the problem of product development and costing disconnected
from value to the customer requires more than a simple fix. It requires a com-
plete reversal of the process. For value-based pricing, the target price is based
on an estimate of value, not costs. The target price then drives decisions about
what costs to incur, rather than the other way around.

The Story of the Mustang

Product development driven by value-based pricing is still the exception,
but not among the most successful product launches. One early example
of a successful new product built to be a “good value” was a spectacularly
successful car developed at Ford Motor Company. Five decades ago, Ford
regained its footing by building the first sports car to sell at a price point
that middle-class people could afford. From an engineering perspective, it
was not the most technically advanced. From the customers’ perspective,
it represented a better value than anything else in the market. From a sales
and profit perspective, it was one of the most successful car launches in
history and continues to sell today in its sixth generation.
14 Chapter 1 • Strategic Pricing

In the early 1960s, America was young, confident, and in love with
sports cars. Many popular songs of the era were odes to those cars. Unfor-
tunately for Ford, the cars arousing the greatest passion were made by
other auto manufacturers. Hoping to remedy this situation, Ford set out
to build a sports car that would tempt buyers to its showrooms.
Had Ford followed the traditional approach for developing a new
car, management would have begun the process by sending a memo to
the design department, instructing it to develop a sports car that would
top the competition. Each designer would then have drawn on individ-
ual preconceptions of what makes a good sports car in order to design
bodies, suspensions, and engines that would be better. In a few weeks,
management would have reviewed the designs and picked out the best
prospects. Next, management would have turned those designs over
to the marketing research department. Researchers would have asked
potential customers which they preferred and whether they liked Ford’s
designs better than the competition’s, given prices that would cover their
costs and yield the desired rate of return. The best choice would ulti-
mately have been built and would have evoked the adoration of many,
but it would have been purchased by only the few who could have
afforded it.
Fortunately, Ford had a better idea. Unlike at other companies, the
leading manager in charge of the project was not an expert in finance,
accounting, or production. He was a marketer. So Ford did not begin
looking for a new car in the design department. The company began by
researching what customers wanted. Ford found that a large and growing
share of the auto market longed for a sports car, but that most people could
not afford one. Ford also learned that most buyers did not really need much
of what makes a “good” sports car to satisfy their desires. What they craved
was not sports-car performance—requiring a costly engine, drive train,
and suspension—but sports-car excitement—styling, bucket seats, vinyl
trim, and fancy wheel covers. Nobody at the time was selling excitement
at a price that most customers could afford: Less than $2,500.
The challenge for Ford was to design a car that looked sufficiently
sporty to satisfy most buyers, but without the costly mechanical elements
of a sports car that drove its price out of reach. To meet that challenge,
Ford built its sports car with the mechanical workings of an existing econ-
omy car, the Falcon. Many hard-core sports-car enthusiasts, including
some at Ford, were appalled. The car did not match the technical perfor-
mance of some of its competitors, but it was what many people wanted,
at a price they could afford.
In April 1964, Ford introduced its Mustang sports car at a base price
of $2,368. More Mustangs were sold in the first year than any other car
Ford ever built. In just the first two years, net profits from the Mustang
were $1.1 billion in 1964 dollars.* That was far more than any of Ford’s
competitors made selling their “good” sports cars, priced to cover costs
and achieve a target rate of return.
Ford began with the customers, asking what they wanted and what
they were willing to pay for it. Their response determined the price at
which a car would have to sell. Only then did Ford attempt to develop a
 Chapter 1 • Strategic Pricing 15

product that could satisfy potential customers at a price they were willing
to pay, while still permitting a substantial profit.
Costs played an essential role in Ford’s strategy, which determined
in part what Ford’s product would look like. Cost considerations deter-
mined what attributes of a sports car the Mustang could include and what
it could not, while still leaving Ford with a profit. For what they would
pay, customers could not afford everything they might have liked. At
$2,368, however, what they got in the Mustang was a better value.

* Lee Iacocca (with William Novak), Iacocca: An Autobiography (Toronto: Bantam Books,
1984), p. 74.

In the last two decades, designing product and service offers that can drive
sales growth at profitable prices has gone in the past two decades from being
unusual to being the goal at most successful companies.15 From Marriott to
Boeing, from medical technology to automobiles, profit-leading companies
now think about what market segment they want a new product to serve,
determine the benefits those potential customers seek, and establish target
prices those customers can be convinced to pay. Value-based companies chal-
lenge their engineers to develop products and services that can be produced at
a cost low enough to make serving that market segment profitable at the target
prices. The first companies to successfully implement such a strategy in an
industry gain a huge market advantage. The laggards eventually must learn
how to manage value just to survive.
The key to creating good value is first to estimate how much value differ-
ent combinations of benefits could represent to customers, which is normally
the responsibility of marketing or market research. In Chapter 2, we define
more clearly what we mean by “value” and describe ways to estimate it.

VALUE COMMUNICATION
Understanding the value your products create for customers can still result in
poor sales unless customers recognize the value they are obtaining. A success-
ful pricing strategy must justify the prices charged in terms of the value of the
benefits provided. Developing price and value communications is one of the
most challenging tasks for marketers because of the wide variety of product
types and communication vehicles.
While much of this book focuses on how to create and measure tangible
economic benefits, customers are rarely the rational economic actors portrayed
in traditional economic theory. An exploding field called behavioral econom-
ics has documented a host of anomalies in consumer decision-making that
run counter to the traditional economic principle of utility maximization. For
example, community-held norms around fairness can limit the price a phar-
maceutical firm can charge, even if the drug is a life-saver with no viable alter-
natives. Buyers also use mental shortcuts when making decisions, often by
looking for analogous products to evaluate relative value. For this reason,
many consumers view a $30 bottle of wine at a restaurant as a bargain if the
other wines on the menu are priced higher, yet the same $30 bottle will feel
expensive if surrounded by $20 alternatives.
16 Chapter 1 • Strategic Pricing

As a result of these anomalies, we must realize that customer responses

to price are based on more than a rational calculation of value. Rather, cus-
tomers evaluate the price in terms of the entire purchase situation. Thus, one
aspect of pricing strategy is the presentation of prices in ways that will influ-
ence perceptions to the seller’s benefit. Moreover, when buyers do perceive
prices and purchase situations accurately, they often do not evaluate them
perfectly rationally. That is not to say that buyers commonly process prices
irrationally, but rather that they conserve their time and mental capacity by
using imperfect, but convenient decision rules. A marketer who understands
these decision rules can often present products in ways that lead buyers to
evaluate them more favorably.
In some instances, marketers might employ traditional advertising media
to convey their differential value, as was the case with the now famous “I am
a Mac” ads created by Apple which ran from 2006 to 2009. The ads, featuring
the actors Justin Long posing as a Mac® and John Hodgman as a PC (Robert
Webb in the US, and David Mitchell in the UK), highlighted common prob-
lems for PC owners not faced by Mac owners. They are credited with helping
grow Mac sales by an average 14.5 percent CAGR from 2005 through 2015,
significantly above industry average.16 In other instances, value messages are
communicated directly during the sales process with the aid of illustrations
of value experienced by customers within a market segment or with the aid
of a spreadsheet model to quantify the value of an offering to a particular
customer.
The content of value messages will vary depending on the type of prod-
uct and the context of the purchase. The messaging approach for frequently
purchased search goods such as laundry detergent or personal care items
will often focus on very specific points of differentiation to help customers
make comparisons between alternatives. In contrast, messaging for more com-
plex experience goods, such as services or vacations, will deemphasize spe-
cific points of differentiation in favor of creating assurances that the offering
will deliver on its value proposition if purchased. For example, when Noosa
International, an operator of resorts in Queensland, Australia, experienced a
decline in tourism after unseasonably rainy weather, they devised a “Rainy
Weather Rebate” that offered a 20 percent discount on hotel accommodations
should it rain during a customer’s vacation.17 Similarly, the content of value
messages must account for whether the benefits are psychological or monetary
in nature. As we explain in Chapter 3, marketers should be explicit about the
quantified worth of the benefits for monetary value and implicit about the
quantified worth of psychological benefits.
Price and value messages must also be adapted for the customer’s pur-
chase context. When Samsung, a global leader in cellular phone sets, develops
its messaging for its Galaxy S phones, it must adapt the message depending on
whether the customer is a new cell phone user or is a technophile who enjoys
keeping up with the latest technology. Samsung must also adapt its messages
depending on where the customer is in their buying process. When customers
are at the information search stage of the process, the value communication
goal is to make the most differentiated (and value-creating) features salient
for the customer, so that he or she weighs these features heavily in the pur-
chase decision. For Samsung, this means focusing on its phones’ big screens
and high data-transfer speeds. As the customer moves through the purchase
 Chapter 1 • Strategic Pricing 17

process to the fulfillment stage, the nature of messaging shifts from value to
price as marketers try to frame their prices in the most favorable way pos-
sible. It is not an accident when a cellular provider describes its price in terms
of pennies a day rather than one flat fee. Research has shown that reframing
prices in smaller units that are more easily compared with the flow of benefits
can significantly reduce customer price sensitivity.18
As these examples illustrate, there are many factors to consider when cre-
ating price and value communications. Ultimately, the marketer’s goal is to get
the right message, to the right person, at the right point in the buying process.

PRICE STRUCTURE
Once you understand how value is created and can be communicated for
different customer segments, the next choice required for a pricing strategy
is to select a way to monetize that value into revenue. We call the output of
this process a price structure and we cover the topic in depth in Chapter 4.
The most natural price structure is price per unit (for example, dollars per
ton or euros per liter). This is perfectly adequate for commodity products and
services. The purpose of more complicated price structures is to reflect dif-
ferences in value created, or ability to pay for it, from different customer or
application segments.
An airline seat, for example, is much more valuable for a business trav-
eler who needs to meet a client at a particular place and time than it is for
a pleasure traveler for whom different destinations, different days of travel,
or even non-travel related forms of recreation are viable alternatives. Airline
pricers have long employed complex price structures that enable them to max-
imize the revenue they can earn from these different types of customers, who
may be sitting next to each other on the same flight. On Monday morning or
Friday afternoon, they can fill their planes mostly with business passengers
paying full coach prices, but they are likely to be left with many empty seats at
those prices on Tuesday, Wednesday, and Thursday. While they could just cut
their price per seat to fill seats at those “off-peak” times, they then would end
up giving business passengers unnecessary discounts as well. To attract more
price-sensitive pleasure travelers without discounting to business travelers,
they create segmented price structures so that most passengers pay a price
aligned with the value they place on having a seat.
On the Tuesday morning when this was written, you could fly from Bos-
ton to Los Angeles and return two days later for as little as $324—but with
a non-refundable ticket, a $100 charge for changes, a $15 checked baggage
charge each way, and low priority for rebooking if flights are disrupted by
weather or mechanical problems. For $514 you could get the very same seats
on the very same flights, but with a refundable, changeable ticket and high
priority rebooking in case of disruption—all things likely to be highly valued
by a business traveler but barely missed by a pleasure traveler. Similarly, you
could pay $934 for first-class roundtrip travel with a non-cancellable ticket
and $150 change fee. Totally flexible and cancellable first-class travel would
cost you $1,901. With these different options, the airlines maximize the rev-
enue from each flight by limiting the seats available at the discounted, non-
cancellable prices to a number that they project could not be sold in the higher
fare classes.19
18 Chapter 1 • Strategic Pricing

More recently, more airline price structures have been designed to dis-
courage behaviors that make some customers more costly to serve than others.
The European carrier Ryanair has taken the lead in discounting ticket prices
to levels previously unseen and then charging for everything else. If you don’t
print out your boarding pass before arriving at the airport, be prepared to pay
Ryanair an extra €5 to check in. Want to check a bag? Add €10. Want to take a
baby on your lap? €20. Want to take the baby’s car seat and stroller along? €20
each. To board the plane near the front of the line will cost you €3. Of course,
you will pay for any food or drinks, but if you are short on cash you might be
well advised to avoid them. The CEO recently reiterated his plan to charge for
using the on-board lavatories on short flights, arguing that “if we can get rid
of two of the three toilets on a 737, we can add an extra six seats.”20 Do you
think this is pushing price structure complexity so far that it will drive away
customers? We thought so. But consider that in less than a decade Ryanair rose
to first place among European airlines and as of this writing continues to lead
in passengers carried, in revenue growth, and in market capitalization.21

PRICING POLICY
Ultimately, the success of a pricing strategy depends upon customers being
willing to pay the price you charge. The rationale for value-based pricing is
that a customer’s relative willingness-to-pay for one product versus another
should track closely with differences in the relative value of those products.
When customers become increasingly resistant to whatever price a firm asks,
most managers would draw one of three conclusions: That the product is not
offering as much value as expected, that customers do not understand the
value, or that the price is too high relative to the value. But there is another
possible and very common cause of price resistance. Customers sometimes
decline to pay prices that represent good value simply because they have
learned that they can obtain even better prices by exploiting the sellers’ reac-
tive pricing process.
Many cable TV companies are now suffering from this problem. In order
to attract new customers, or to get current customers to consolidate their
phone, internet, and cable TV with the supplier, they offer heavily-discounted
contracts for the first year (typically $99 per month). After one year, they raise
the rate by 20 percent or more to their regular prices. But these offers have now
become so widely advertised by multiple suppliers that many savvy subscrib-
ers have learned that they can beat the system. At the end of one year, many
simply threaten to switch after one year to a new supplier offering the same
deal. To avoid the substantial cost to manage these conversions, these same
companies empower their telephone sales reps to agree to waive, or at least
to reduce substantially, the increase for customers who object and threaten to
change suppliers. The result: Even larger numbers of customers now threaten
to change suppliers when their prices increase. Thus, a program that was
designed to induce people to become loyal customers has annually eroded the
value of the customer base.
Pricing policy refers to rules or habits, either explicit or cultural, that
determine how a company varies its prices when faced with factors other than
value and cost to serve that threaten its ability to achieve its objectives. Good
policies enable a company to achieve its short-term objectives without causing
 Chapter 1 • Strategic Pricing 19

customers, sales reps, and competitors to adapt their behavior in ways that
undermine the volume or profitability of future sales. Poor pricing policies
create incentives for end customers, sales reps, or channel partners to behave
in ways that will undermine future sales or customers’ willingness-to-pay. In
the terminology of economics, good policies enable prices to change along the
demand curve without changing expectations in ways that cause the demand
elasticity to “shift” adversely for future purchases. Chapter 5 describes good
pricing policies and will alert you to the hidden risks of poor but commonly
practiced policies.

PRICE SETTING
According to economic theory, setting prices is a straightforward exercise in
which the marketer simply sets the price at the point on the demand curve
where marginal revenues are equal to the marginal costs. As any experienced
pricer knows, however, setting prices in the real world is seldom so simple. On
the one hand, it is impossible to predict how revenues will change following a
price change because of the uncertainty about how customers and competitors
will respond. On the other hand, the accounting systems in most companies
are not equipped to identify the relevant costs for pricing strategy decisions,
often causing marketers to make unprofitable pricing decisions.
This uncertainty about marginal costs and revenues creates a dilemma
for marketers trying to set profit-maximizing prices. How should they analyze
pricing moves in the face of such uncertainty? There are many pricing tools
and techniques in common use today such as conjoint analysis and optimiza-
tion models that take uncertain inputs and provide seemingly certain price
recommendations. While these tools are valuable aids to marketers (we show
how to use them to maximum advantage in Chapter 6), they run the risk of
creating a sense of false precision about the right price. There is no substitution
for managerial experience and judgment when setting prices.
Price setting should be an iterative and cross-functional process that
includes several key actions. The first action is to set appropriate pricing objec-
tives, whether that means to use price to drive volume or to maximize margins.
In 2008, as America was falling into a recession, McDonald’s used penetration
pricing to take significant market share from premium coffee shops during a
time when customers were increasingly price sensitive. Once consumers tried
McDonald’s new premium coffees, they found that the taste was excellent, and
many opted not to switch back.
The second action is to calculate price–volume trade-offs. In the case of a
10 percent price cut for a product with a 20 percent contribution margin would
have to result in a 100 percent increase in sales volume to be profitable. The
same price cut for a product with a 70 percent contribution margin would only
require a 17 percent increase in sales to be profitable. We are frequently sur-
prised by how many managers make unfortunate pricing decisions because
they do not understand how to make and use basic breakeven sales change
calculations to evaluate pricing decisions.
Once the price–volume trade-offs are made explicit for a particular pricing
move, the next activity is to estimate the likely customer response by assessing
the drivers of price sensitivity that are unrelated to value. Two coffee lovers
might value a cup of premium coffee equally. Despite placing equal value on
20 Chapter 1 • Strategic Pricing

the coffee, the retiree on a fixed income will be much more price sensitive than
the working professional with substantial disposable income. Conversely,
either of those individuals may be willing to pay the price at a premium coffee
shop rather than purchase a much cheaper but equally good cup of coffee at
an unbranded café nearby because the lower price at the unbranded café leads
them to infer that its coffee is more likely to be of inferior quality.
The marketer’s job is to estimate how price sensitivity varies across
segments in order to better estimate the profit impact of a potential pricing
move. There are different ways to accomplish this task across different types
of markets. For example, we describe these tools and how to use them in
Chapter 8.

PRICE COMPETITION
The final set of strategic pricing choices that managers must make to maxi-
mize growth profitably involve dealing with price competition. We are deal-
ing with it last because making decisions that affect competitive pricing is
an ongoing part of price management. Generally, these decisions occur after
one has figured out how to create differentiating features and services and
to capture a share of their value in revenues. But in most markets, the largest
portion of price is determined, not by value-in-use to the customer, but by
competition.
The potential market value of a product or service is composed of two
parts: Value that is the same as that offered by the competitive alternatives
(Reference Value) and value that differentiates it from competitive alterna-
tives (Differentiating Value). For example, when a new restaurant opens in
a busy area, the competitive reference value is the prices already being
charged for lunch by other restaurants nearby. However, some customers
may not be deterred by a premium price if they value a unique style of food
or particular location.
Managing price competition involves influencing the reference value. In
some markets, the reference value can be taken as given, determined by mar-
ket supply and demand, and so requires no management attention except to
adjust prices whenever the reference value changes. Even a large oil refinery
selling wholesale gasoline and heating oil will command such a small share of
the market that it can take the market prices of undifferentiated alternatives
as given when setting its own prices. Price competition becomes much more
challenging, however, when a seller commands a large share of a market.
This is because competitors are likely to react to whatever pricing decisions
it makes. Even the owner of a single retail gas station or pharmacy in a local
market with only one or two alternatives must generally expect that competi-
tors will notice and react to changes in its prices, thus affecting the revenue
impact of pricing decisions. Anytime that a firm has a large share of even a
small market, the ability to anticipate and manage the dynamics of competi-
tion will become as important to its financial success as decisions about how
to set prices that reflect its differential value.
Many successful companies have suffered huge dents in what was an
otherwise smooth trajectory of profitable growth when they failed to anticipate
and manage how competitors might react adversely to a pricing decision. In
 Chapter 1 • Strategic Pricing 21

the early 1990s, Alamo Rent A Car (now owned by Enterprise Holdings) was
the most profitable (as a percentage of sales) rental car company in America,
despite being only the fifth-largest. Its low-cost operating model enabled it to
dominate an entire market segment: Leisure rentals for tour packages to places
like Disney World in Florida and Disneyland in California. Within those mar-
kets, Alamo could essentially set its prices assuming that the prices of larger
rental car competitors would remain unchanged. But Alamo’s management
was impatient for growth and had the cash to pursue it. Within the United
States, a much larger and lucrative rental car segment was business travel
originating at airports. Moreover, demand for cars at Alamo locations peaked
during holiday periods when the demand from business travelers at airports
peaked during non-holiday periods. Thus Alamo’s management figured that
if it could win even a small share of the business market by undercutting the
rates of the market leaders, Hertz and Avis, Alamo could generate a lot of
profitable growth.
That was not to be, for reasons that in retrospect were entirely predict-
able. As planned, Alamo began moving to on-airport locations beyond its
core leisure markets and setting prices that undercut the market leaders. But,
Alamo underestimated its own vulnerability. Hertz and Avis had previously
shown little interest in serving tour groups which, since they arrive in waves,
could create backlogs unacceptable to their valuable business clientele. But
once Alamo began attacking their prime markets, it was bound to get their
attention. Within two years, Hertz opened the largest car rental facility in the
world in Alamo’s most lucrative market—Orlando, Florida. While the long
lines at Alamo created a profitable opportunity to earn commissions from
selling people tickets to attractions, Hertz’s 66 counters and luggage-transfer
stations made the transfer from plane to rental car easier and faster for tour-
ists with lots of stuff in tow. To fill this facility, Hertz began undercutting
Alamo’s deals with European tour operators, who proved much more willing
to switch suppliers to save a few dollars per car than were Hertz’s business
customers that Alamo was trying to woo. That year, Alamo’s profits fell into
the red and its operations were sold the following year to another rental car
company.22
The lesson here is not that a profitable company should not attempt to
grow share. It is that companies must anticipate competitive reactions and
avoid competing where they lack the capabilities necessary to profit despite
those reactions. This is not to argue that underpricing the competition is never
a successful strategy in the long run, but the conditions necessary to make
it successful depend critically upon how competitors react to it. The goal of
Chapter 7 is to provide guidelines for anticipating and influencing those reac-
tions and integrating them into one’s plan for strategic pricing.

CREATING A STRATEGIC PRICING CAPABILITY

Over the past decade, pricing has risen in importance on the corporate
agenda. Most top executives recognize the importance of price and value
management for achieving profitable growth. Yet given this strategic impor-
tance, it is surprising to us how many firms continue to organize their activi-
ties so that pricing decisions are made by lower-level managers who lack
22 Chapter 1 • Strategic Pricing

the skills, data, and authority to implement new pricing strategies that align
with changes occurring across markets. This tactical orientation has financial
consequences.
Our research has found that companies that adopted a value-based pricing
strategy and built the organizational capabilities to implement it earned 24 per-
cent higher profits than industry peers.23 Yet in that same research, we found that
a full 23 percent of marketing and sales managers did not understand their com-
pany’s pricing strategy—or did not believe their company had a pricing strategy.
This lack of awareness demonstrates the challenges involved when developing a
capability for pricing strategy which requires input and coordination across func-
tional areas including marketing, sales, capacity management, and finance.
A successful pricing strategy requires the support of three pillars: An
effective organization, timely and accurate information, and appropriately
motivated management. In many instances, it is neither desirable nor necessary
for a company to have a large, centralized organization to set prices. What is
required, however, is that everyone involved in pricing decisions understands
their role in the process. So while a product manager might set a price, a central-
ized pricing organization might have the right to define a process for evaluating
the impact of that price or to set a policy for when it can be offered, sales man-
agement and operations management might have the right to provide input on
particular elements of the process, and senior management might have the right
to veto the decision. Too often decision rights are not clearly specified, changing
the pricing decision from a well-defined, value-driven process to an exercise
in political power, as various functional areas vie to influence the offered price
without necessarily considering overall profitability or strategy.
Pricing decision-makers require quality information. Once managers
understand their role in the price-setting process, the first thing they generally
ask for is more data and better tools. When one considers the data requirements
for making organization-wide pricing decisions, this response is not surpris-
ing. To make informed pricing decisions, marketing managers need data on
customer value and competitive pricing. Sales managers need data to support
their value claims and defend price premiums. And financial managers need
accurate cost data and volume data. Collecting these large volumes of data
and distributing them throughout the organization is a daunting task that has
led many companies to adopt price management systems that are integrated
with their data warehouses and ensure that managers get only the information
they need. While not every firm needs a dedicated system to manage pricing
data, everyone must address the question of how to get the right information
into the right manager’s hands in a timely fashion if they hope to keep their
pricing strategies aligned with changes occurring in their markets.
Successfully implementing a pricing strategy also requires a firm to moti-
vate managers to engage in new behaviors that support the strategy. All too
often, people are given incentives to act in ways that actually undermine the
pricing strategy and reduce profitability. It is common for companies to send
sales reps to training programs designed to help them sell on value, despite
paying them solely to maximize volume. When sales reps or field sales man-
agers are offered only revenue-based incentives, it is hard to imagine them
fighting to defend a price premium if they think that doing so will increase
their chances of losing the deal. However, incentives can be developed that
encourage more profitable behaviors.
 Chapter 1 • Strategic Pricing 23

A senior salesperson we know was recently promoted to regional sales

manager for an area in which discounting was rampant. He began his first
meeting by sharing a ranking of sales reps by their price realization during
the prior quarter. He invited the top two reps to describe how they did those
deals so profitably and the bottom two reps to describe what went wrong. He
then facilitated an open discussion among the 30 reps on how challenges like
those faced by the bottom two reps could be managed better in the future.
At the end of the meeting, he told them that this exercise would be repeated
every quarter. One month into the subsequent quarter, sales reps were ask-
ing to see where they stood in the rankings, suggesting that they were highly
motivated to engage in productive behaviors to avoid a low ranking before the
next meeting.
Chapter 11 describes in more detail the structural elements that need to
be built into an organization to enable it to adopt and implement strategic
pricing effectively.

Summary
Pricing strategically has become essential the value cascade. Companies operating
to the success of business, reflecting the with a narrow view of what constitutes
rise of global competition, the increase in a pricing strategy miss this crucial point,
information available to customers, and the leading to incomplete solutions and
accelerating pace of change in the products lower profits. Building a strategic pricing
and services available in most markets. The capability requires more than a common
simple, traditional models of cost-driven, understanding of the elements of an effec-
customer-driven, or share-driven pricing tive strategy. It requires careful develop-
can no longer sustain a profitable business ment of organizational structure, systems,
in today’s dynamic and open markets. individual skills, and ultimately, culture.
This chapter introduced the stra- These things represent the foundation
tegic pricing value cascade containing upon which the strategic pricing value
the six key elements of strategic pricing. cascade rests and must be developed in
Experience has taught us that achieving concert with the pricing strategy. The first
sustainable improvements to pricing per- step toward strategic pricing is to under-
formance requires ongoing evaluation of stand each level of the cascade and how it
and adjustments to multiple elements of supports those above it.

Notes
1. Warren Buffett, interview with the apple-s-itunes-overtaken-by-stream
Financial Crisis Inquiry Commis- ing-music-services-in-sales.
sion, May 26, 2010. 3. For an overview, in July 2014 the U.S.
2. Lucas Shaw, “Apples iTunes Over- Department of Transportation pub-
taken by Streaming Music Services lished a primer on congestion-based
in Sales,” Bloomberg, March 22, pricing: http://ops.fhwa.dot.gov/
2016. Accessed at www.bloomberg. publications/congestionpricing/
com/news/articles/2016-03-22/ sec2.htm.
24 Chapter 1 • Strategic Pricing

4. 82 percent of holiday shoppers will Perceptions,” in S. Ward and P.

go online for shopping research Wright (eds.), Advances in Consumer
prior to going to an actual store, Research, Vol. 1 (Boston, MA: Asso-
Deloitte 2015 Annual Holiday Sur- ciation for Consumer Research,
vey: Embracing Retail Disruption, 1974), pp. 359–369; Robert Slonim
Deloitte Press, October 2015. and Ellen Garbarino, “The Effect of
5. Christo Wilson, “If You Use a Mac or Price History on Demand as Medi-
Android, e-Commerce Sites May Be ated by Perceived Price Expensive-
Charging You More,” Washington ness,” Journal of Business Research
Post, November 3, 2014. Accessed 45 (May 1999), pp. 1–14. Market
at www.washingtonpost.com/post researchers can suppress this effect
everything/wp/2014/11/03/if- when estimating demand by ran-
you-use-a-mac-or-an-android-e- domizing the order of presentation,
commerce-sites-may-be-charging- but the actual demand will depend
y o u - m o r e / ? u t m _ t e r m = .5cdd7 upon the actual order of presenta-
d3a2efb. tion in real markets.
6. Robert D. Buzzell, Bradley T. Gale, 13. Katie Hafner and Brad Stone,
and Ralph G.M. Sultan, “Market “IPhone Owners Crying Foul Over
Share—A Key to Profitability,” Har- Price Cut,” The New York Times,
vard Business Review (January 1975). September 7, 2007.
7. Michael E. Raynor, Derek Pan- 14. “Gartner Says Five of Top 10
kratz, and Selvarajan Kandasamy, Worldwide Mobile Phone Vendors
“Exceptional Performance: A Increased Sales in Second Quar-
Nonrenewable Resource” Deloitte ter of 2016,” Gartner Inc. press
Review, 18 (2016), pp. 37–55. release, August 19, 2016. Accessed
8. Michael E. Raynor and Mumtaz at www.gartner.com/newsroom/
Ahmed, The Three Rules: How Excep- id/3415117.
tional Companies Think (New York: 15. Peter F. Drucker, “The Information
Penguin, 2013), pp. 111–156. Executives Truly Need,” Harvard
9. Marco Bertini and Luc Wathieu, Business Review (January–February
“How to Stop Customers from 1995), p. 58.
Fixating on Price,” Harvard Busi- 16. “Global Apple Mac Unit Sales from
ness Review (May 2010). Also see 1st Quarter 2006 to 3rd Quarter 2016,”
Andreas Hinterhuber and Stephan Statista. Accessed at www.statista.
Liozu, “Is It Time to Rethink Your com/statistics/263444/sales-of-
Pricing Strategy?” MIT Sloan Man- apple-mac-computers-since-first-
agement Review, June 19, 2012. quarter-2006.
10. For summaries of a broad range 17. Cali Mackrill, “Queensland Resort
of these anomalies, see Richard H. Offers Discount if it Rains,” The Tele-
Thayler, Quasi-Rational Economics graph, March 28, 2013. Accessed at
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ably Irrational: The Hidden Forces if-it-rains.
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Contrast and Extremeness Aver- 19. The projection process for airline
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Monroe, “The Influence of Adap- for Price War as Aer Lingus Costs
tation Levels on Subjective Price Leap,” The Telegraph, June 2, 2009.
 Chapter 1 • Strategic Pricing 25

Accessed at www.telegraph.co.uk/ 22. “Rocky Road—Alamo Maps a

finance/newsbysector/transport/ Turnaround,” Wall Street Journal,
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