Are "Best Practices" Yielding "Worst Results" in Pricing?

by Tim Smith, PhD, 28 April 2004

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Executives favor using "Best Practices" when managing business activities. For the most part, these "Best Practices" enable businesses to deliver the optimal performance. Yet, an unchecked deployment of "Best Practices" for managing prices is setting some companies up for disaster. By considering attitudes towards price variances and sales incentives, we find that many companies are encouraging profitless sales.

Minimize Risk by Minimizing Variances
Excessive risk taking does not go unpunished. When executives take risks, they make calculated decisions in which the potential rewards outweigh the known risks of loss. For most business functions however, the rewards of taking risks do not outweigh the rewards of following a predictable path that will enable a smooth running operation.

In an effort to minimize risks, management will often seek to lower the variances in measured activities. The techniques of Six-Sigma and Total Quality Management have taught the current generation of managers the rewards of reducing variances thereby delivering predictable results. Likewise, executive officers have seen their stock prices drop precipitously when reporting volatile earnings and have develop techniques to "smooth earnings". The intolerance towards risks has also spread to pricing as management deploys more sophisticated techniques to measure price variances and reduce the price band associated with selling their goods and services.

In the face of excessive discounting, many Fortune 500 companies have developed an internal goal to minimizing variances from the list price. When negotiating the final price with customers, the sales and marketing team is directed to give discounts reluctantly and hold prices firm.

The goal of minimizing price variances implies that the list price for an item is somewhat near to that which the most demanding customers will extract. If we assume that most customers are somewhat alike and that all customers desire a low price, then setting the list price near that provided to the most demanding customers should lead to a reasonable price and a lower price variance. Within this set of assumptions, then by managing the process through which discounts are provided, management can expect average prices to increase.

Unfortunately, one of the assumptions made above is known to be false. All customers are not alike and some will place a much higher value on the product or service than the most demanding customers. Thus, in a price variance minimization strategy, customers that place a high value on the offer may get it at a perceived low price and the company may be leaving money on the table.

Minimizing the price variance implies that businesses are also minimizing their potential to capture value in proportion to the varying customer perception of value. The result of seeking low price variances can be lower average prices, not higher average prices, as the customers who value the offering the most ride on the coattails of the most demanding customers and get a deal they would not have extracted their own.

The alternative solution to this challenge is to rejoice in the fact that some customers value the offer much more than others and raise the list price to that acceptable by the least demanding customers. The same business processes for providing discounts can be utilized with a higher list price, but the business should anticipate providing discounts more often and under more conditions.

While the maximum price that customers will pay for an offer is usually within 25% of that extracted by the most demanding customers, in some markets the highest potential price may be 5 times higher. A price variance this high may be perceived as intolerably high, but, unlike most risks there are few downsides to extracting a very high price from some customers while leaving most customers unaffected. With high price variances where the maximum price matches that accepted by the least demanding customers, businesses are able to capture excellent profits from a few customers while continuing to serve the most demanding customers. The rewards of these good deals flow all the way from top-line revenue to bottom-line net.

(Note: Market transparency can reduce the ability to extract high price variances.)

Use Financial Incentives to Reward Desired Results
Ever since B.F. Skinner wrote Walden II, management has learned the value of using positive reinforcement to reward desired behavior. For sales, Skinner's approach takes the form of using financial incentives to reward the achievement of revenue. For purchasing agents, Skinner's approach takes the form of financial incentives for extracting greater discounts. Unfortunately, neither of these key players in the ritual of buying and selling is rewarded for delivering high margins.

In the buying and selling ritual, salespeople will identify likely prospects, explain the value proposition to the executive decision maker, and convince her influencers of the merits of their offer. Once the decision maker selects the offer, she will often move the procurement process to the purchasing agent. This purchasing agent may or may not understand the value of one particular offer over another, and may or may not understand the full reasoning in selecting one vendor over another, but will understand that their role is to extract the lowest price. This implies that while the salesperson may have made a value based sale at the executive level, the closing of the sale may be conducted in the same manner as any other commodity purchase where all value differentiators are ignored.

In dealing with the purchasing agent, the salesperson will undoubtedly be pressured to provide a discount. In their decision calculus, the salesperson must weigh the value of holding to a higher price and extracting a larger commission against the cost of loosing the entire sale due to holding too high of a price. Daniel Kahneman and Amos Tversky demonstrated that in making decisions, individuals are more risk averse than they are risk seeking. Thus, the salesperson will be more risk averse to losing the sale than risk taking to capture a higher commission.

Given the incentive structures and decision calculus, salespeople are likely to acquiesce to the purchasing agent's request for a lower price.

Fortune 500 executives have become aware of this flaw. To improve the outcome, they have created a "rule-based" decision making process that states the criteria for providing discounts and spreads the decision making authority to different individuals within the organization. In this process, the salesperson is directed to move decisions concerning price discounts to marketing managers or pricing analyst.

Salespeople would rather negotiate for a lower price within the organization than negotiate for a higher price from the customer because the immediacy and costs associated with loosing the sale outweigh the concerns of creating strife internal to the organization.

The negative organizational impact of this incentive structure and decision process is twofold. Sales begins to perceive the pricing analyst and marketing manager as the "sales prevention team" while market begins to perceive salespeople as "giving away the product". With recriminations like these, it is hard to build a cohesive team across the organization.

The important question is whether the incentives and rules yield the best prices. Given that the incentive structures are clearly not aligned with extracting high margins, we have to rely on the efficacy of the rules and their enforcement. With any set of rules, people overwhelmingly seek ways to bend them in their favor. In this case, bending the rules is aligned with the incentive structure but misaligned with the desire for high margins.

Two alternatives to the above approach are to remove all flexibility or change the incentive structure. In removing all flexibility, the sales team is given the price list and is told that there is no negotiation. This approach works best in transactional sales, where there is little variance in the value on the table. A new approach being practice by some businesses is to change the sales incentive structure from base plus commission on revenue to include a component that reflects their ability to extract a high margin. In its most aggressive form, all commission is dependent upon the sum margins rather than revenue. This latter approach works best in consultative and value-add sales, where the value of the offer will vary between customers.

Align Best Practices with Best Results
From the above two discussions, we learn that (1) reducing the variance of prices can also reduce the ability to extract higher prices from customer who value the offer the most and (2) incentives are often misaligned to encourage low margins and rules are a weak bulwark. While managing price variances is a Best Practice in business, the goal should not be simply to reduce variance, but to ensure that the price starts at the highest possible level and discounts from that price are proportional to the value as perceived by the customer. While incentives should be used to encourage performance in the sales team, these incentives should not perversely encourage the sales team to seek price discounts on behalf of their customers.

An out-of-the box application of "Best Practices" does not always yield "Best Results." To follow the adage, "don't throw the baby out with the bathwater", we should not throw out best practices in favor of chaos. We do, however, need to ensure that these Best Practices are aligned with the desired result of extracting the best price from the market with every deal.

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Author
Tim Smith, PhD is Editor of The Wiglaf Journal, Principal of Wiglaf LLC, and Adjunct Professor at DePaul's Kellstadt Graduate School of Business.

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