Pricing Power. What it is. How to get it.

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Many of Ibbaka's clients have begun to work on their 2018 strategic plans. We encourage people to put pricing front and center of these plans, and to have some strategic goals around their pricing. We introduced this theme in Make pricing your strategic edge in 2018. Let's go in a bit deeper, and look at one thing you should be considering for 2018. Pricing Power.

There is a famous quote from Warren Buffett on pricing power.

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"The single most important decision in evaluating a business is pricing power. If you've got the power to raise prices without losing business to a competitor, you've got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you've got a terrible business.”

From the Business Insider article 'Warren Buffett: There's Only One Thing That Matters To Me When I'm Investing In A Company'

Warren Buffett provides a nice simple explanation of pricing power here, but let's give that a little bit more context. Let's assume that most of the people reading this blog have a product with some meaningful differentiation, and want to use a value-based pricing strategy. Differentiation means that there is some set of customers, a target segment, for which the offer provides more value than the next best competitive alternative. The best way to determine this is through Tom Nagle's Economic Value Estimation or EVE(tm) framework. A simplified version of this is shown below.

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In order to calculate an EVE you need to know the impact your solution has on a customer compared to the next best competitive alternative. We will go into the details of this in another post, or if you can't wait check out the LeveragePoint site where there is in depth coverage of this. Some of the impacts are positive (green in the above figure) and others are negative (red in the above figure). The Economic value of your offer is the price of the Next Best Competitive Alternative + Your Positive Value Drivers - Your Negative Value Drivers. You can think about the price of the next best competitive alternative as the market price, the price the market has set for the commoditized part of your offer.

If you have positive economic differentiation, and you should be targeting the customers where that is true, you will normally price somewhere in your differentiation value. Somewhere, but where. This depends on two things, your pricing power and your pricing strategy. Let's take a look at pricing power.

Basically, your pricing power is how much of your differentiation value you can successfully claim. This is not how much you should claim. There can be very good reasons for pricing lower than your pricing power would otherwise allow you to (we will cover these in a future post on pricing strategy).

Pricing power depends on two main things. How much of the differentiation value you are already claiming, and a set of factors that can increase or decrease your pricing power.

Clearly if you are only claiming a very small percent of your differentiation value you will have more pricing power than if you are claiming a great deal.

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There are other factors that can impact your pricing power. One of the most important is brand. Basically, the stronger your brand the more pricing power you have. This is especially true if your brand is associated with a premium price. On the other hand, the more the perceived risk of adopting your solution the less pricing power you will have. Basically, you will have to accept a risk discount.

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Unfortunately, most early-stage innovations, especially those from startup companies, combine relatively weak brands with high perceived risk. Ouch. No wonder Warren Buffett does not invest in start-ups.

In some cases there are some clever things you can do to address this. For example, if your customer can pass on the costs of your offer to a third party, generally its own customer, then you will have more pricing power. An example is law firms and photocopy charges. Have you noticed how much lawyers charge for copying? This is not a profit center for law firms If it is for your law firm then change firms). Basically, the law firms are not motivated to enter into tough negotiations with the copy vendors as they are going to be passing along the cost anyway.

The same is true if you are a minor cost component in a very large solution. If you represent a very small percentage of the overall costs then you will have more pricing power than if you represent a significant part of the whole.

Perception is important here. Your customer has to understand your differentiation value before you can claim it.

Putting all these pieces together, one of your pricing goals for the coming year should be to increase pricing power. There are three levers you can pull.

  1. Make sure that your customers understand your differentiation value. To some extent this is a marketing investment, but it is one that the product manager needs to be closely involved with.
  2. Increase economic differentiation. There are two ways to do this. You can work to reduce any negative differentiation by matching the functionality of the next best competitive alternative or reducing your unique costs. This is never enough to succeed. You also need to invest in increasing your positive differentiation.
  3. Increase pricing power. The two most important investments here are in your brand and in reducing perceived risk. Brand matters. We have not talked about emotional value in this post, but it is real and important. One place that emotional value matters is pricing. A strong emotional appeal will increase your pricing power. Investments in brand can pay off in higher pricing power. The other side of this is reduced risk. Find out from your customers what they see as the perceived risks. Then make systematic investments to reduce perceived risk.

One exercise you can play with is a dollar allocation game. If you had $100 how much would you allocate to each of these levers?

Investment Allocation

Some rules of thumb. I generally want to see B > C (over invest in positive differentiation).

For early-stage companies, I expect B+C > D+E+A (invest more in product than marketing; this balance will change over time so that in mature markets B+C < D+E+A ).

It is critical to test with your customers and make sure they understand and agree with your value propositions. If they do not (and in most cases they will not), ask if this is because you need to communicate better or if you need to create more differentiation, or if you are targeting the wrong segment.

Investments in pricing power are some of the most important investments you can make. Discussion of this should be front and center of your strategic planning.