In the businesses I operated, I was always deeply involved in setting prices because I found it to be the most immediate way to impact margins and cash flow.
“Cost based pricing” establishes prices based on costs of purchases, manufacturing labor and overhead with a markup to attain profit targets.ÿ Many businesses, such as software, pharmaceuticals and services don’t have an easy job of using cost as a basis and instead set prices based on “value” to the customer.ÿ Airlines, car rentals and hotels have done a great job in dynamically assessing value based on factors such as time, occupancy levels, days of the week, length of time and charge, accordingly, when you “book” a reservation.ÿ Our sons, the jugglers, simply rely on letting their customers express the “value” of their show by how much the audience puts into their “collection hat”.
Since my businesses all had clearly identified “costs”, I had to work hard to avoid simply “marking” up the costs to set prices and to instead consider the “value” to our customers.ÿOtherwise I was leaving a lot on the “table” and missing opportunities for profits.ÿEarly on, in every business I was involved with, I would review all the pricing systems and make changes. In many instances, I heard “Jim, we could lose this customer”; often times, this did not come to pass. ÿI did not get it right every time and did lose some customers but spent a lot of time thinking about it.
ÿOne of the early realizations was that not all customers were equal and for many “price” was not the upmost criterion in their minds.ÿ Quality, delivery, or service was in some instances more important to them.ÿ Since our products were “customized”, each quote represented a new opportunity to set price. ÿWe also identified specific services that we could charge for-expedited delivery, tooling, fixturing, first-time setups and special packaging with directly related costs as well as others where there was just more “value”, such as expediting.ÿ We learned that another class of customers was very pricing focused but always wanted a “deal”, so we always priced somewhat higher to allow for some “negotiating” to keep the customer satisfied.ÿ Spare and replacement parts, especially for discontinued or “legacy” product lines always would command higher pricing.ÿ Finally, we regularly used “volume” discounting and tiering that showed how low pricing could go when volumes ramped up. ÿMany customers focused on the “3-year” out pricing. Interim, lower volume pricing, was less important to them and we were able to extract higher margins.
In the aluminum business, I personally “set” pricing on all new accounts for the first 15 years and developed spreadsheets that allowed for a lot of flexibility in making adjustments for higher pricing.ÿ In many instances, I set the bar a little higher on each new prospect to see where the “pain threshold” was.ÿ We often laid out a five-year pricing plan that showed how unit volume, investment in tooling and fixturing and common sharing of components would drive the customer’s pricing downward; insuring early higher profits in the long-cycle sales efforts.ÿ I was always willing to “walk” if necessary and “pass” on business if I did not feel we were hitting our margin targets. ÿSince “substitution” was almost always inevitable by plastics or die-cast parts, I discovered that “forestalling” the inevitable with low pricing only resulted in lower profits.
As I began to step away from the day-to-day pricing decisions and bring in a management team so we could sell the business, margins began to erode. ÿWe taught our customer service organization to use the opportunity to raise prices whenever a legacy customer asked, “What is the current pricing for this?” and more than six months had passed; they were expecting some kind of increase and we gave it to them!ÿ However, as more “professional” managers were hired, a sales force was hired and investments were made in cost accounting systems, there became much more of a focus on volume for volume’s sake and responding to sales requests for the “best price”, meaning the “lowest” price.ÿ I watched our margins drop five percentage points over 3-5 years. ÿI was unable to capture the formula to pass on my “gut” sense of what prices should be as the business moved toward being run by professional managers.
Refining my own “gut” feel for setting prices had taken practice, some lost business, and willingness to continuously change, but had paid off with higher profits achieved quickly.ÿ
Jim Sharpe (MBA `76) is one of theÿHBS Entrepreneurs-in-Residence for the 2009-2010 academic year, who ran an aluminum manufacturing business for 21 years while working with his wife, Debby Stein Sharpe (MBA `81) after both left careers at GE and large companies and sold the business in late 2008. ÿJim can be reached at: email@example.com, 310 Rock Center, 617-496-6285.