A Lot Less Product; A Bunch More Behavior
by Scott Benfield
If your pricing matrix includes manufacturer product groups, is this a desirable way to price? How about if a manufacturer places its list price in the marketplace? Does this limit your potential? Or, what if you give lower prices, on the same product, to customers who buy less in total annual volume versus customers who purchase more?
In each of these cases, most distributors would argue for a matrix using manufacturer product groups, pricing within the limits of the manufacturer list price, and giving a better price on an SKU to the customer who purchases more in overall annual volume. In each case, and for most buying situations, the distributor would make a serious error in pricing and leave substantial money on the table. Why? Each of the preceding situations is driven by a product headset which, for many situations, is profit limiting.
Distributors should first seek to understand pricing behaviors and then look for unique product attributes to complete their pricing. In our consultancy's pricing work with distributors over the last decade, we continually find where distributors and their pricing policies are product driven and not behavior driven. Not all products can be priced with pricing behaviors in mind, but many can. To understand the common behaviors that drive product pricing, this article is dedicated to the behaviors that drive price sensitivity of the buyer. Understanding them can help the distributor maximize return on their pricing efforts.
Price Sensitivity and the Key Pricing Behaviors
Price sensitivity is simply the buyer's perception and reaction to a product's price. Some products are more price-sensitive and others are less. Price sensitivity is a pricing behavior and is, typically, not unique to the product but how the product is marketed and positioned. Understanding the key behaviors for pricing sensitivity, sellers and marketers can position their products to take advantage of common price objections. In Exhibit 1, below, the top five pricing behaviors are listed with their definition and usage. They are defined in the remaining portion of this section.
The most common behavior that causes problems for distributors is the Reference Price Effect. Simply stated, the more a buyer purchases an item, the more price sensitive they are to that item. Fortunately, the reference price effect is limited by memory. Most buyers have, at most, a dozen prices that they can remember and benchmark for competitiveness at any given time. For most distributors, the most price sensitive items are those that make up the first 20% to 40% of sales. The remaining items are not as price sensitive. Also, different types of customers are price sensitive to different items. In a recent pricing audit, we found where a common product was thought, by the distributor, to be price sensitive to all customers. When we segmented the customer base, however, we found several segments where the product wasn't in the top 100 items purchased. Distributors should maximize margin on the items they sell the least. But not all customers buy products at the same rate and are sensitive to them, therefore, customers should be segmented before reviewing the effects of reference pricing.
The easier it is for a buyer to compare items, the more price-sensitive they are to them. This is the foundation for the Difficult Comparison Effect, our second pricing behavior. The use of manufacturer product groups and manufacturer nomenclature, in pricing, gives the buyer a clear advantage in comparing pricing on similar items with competitors. We encourage distributors to develop their own product nomenclature and use it and be aware of the Difficult Comparison Effect. We have had clients use a manufacturer's name for a product but use a proprietary product number, which is smart. When advertising products in a catalog, on the Web, or on the invoice, making the product difficult to compare typically gives the distributor a better chance at margin enhancement. When conducting pricing audits, if we see distributors using common manufacturer product numbers, product groups for pricing, or manufacturer list prices, we groan. They are, unknowingly, limiting their margin and making it easy for customers to shop price.
|Pricing Behaviors and Strategic Use for Distributors|
|Number||Pricing Behavior||Definition||Usage in Pricing Policy|
|1||Reference Price Effect||Buyers are more sensitive to the products they purchase the most and have a reference price in their memory||Unique to the segment. Acknowledge and make pricing gain on non-reference products|
|2||Difficult Comparison Effect||Buyers are less sensitive the more difficult comparing prices becomes||Use proprietary product nomenclature and avoid manufacturer product descriptions and numbers|
|3||Total Expenditure Effect||The larger the purchase, the more price sensitive the buyer||Large dollar purchase items, even if slow movers, may need to receive lower margins|
|4||Fear of Losing Effect||A hybrid behavior for sellers and buyers. Sellers fear losing the order with cost-plus pricing, which limits margin, and buyers prefer discounts, seeing them as gains||Use list-and-discount and not cost-plus, as discounts are seen as rewards, whereas cost-plus factors are seen as punitive|
|5||Sutbstitute Awareness Effect||Buyers are more price-sensitive the more well advertised a product price is||Consider limiting advertising of loss leader products and use price advertising only for unique products|
The larger the item is in cost, as compared to other items sold, the more price-sensitive it is. This is called the Total Expenditure Effect (No. 3) and it is something to be aware of in pricing. In a recent review, we ran across a situation where an item was priced at a 35% margin and similar to other low sales items. The problem was that the item was 10x more in cost than similar items and customers balked at the price. If low sales items are substantial in cost, then it often pays to give them lower margins. Customers won't notice and won't question your other prices.
Distributors often use cost-plus pricing and, for anything other than quotations of large volume sales, it is typically a bad idea. Why? There is a little known but powerful pricing behavior known as the Fear of Losing Effect, our No. 4 behavior. The Fear of Losing Effect comes into play for sellers and buyers. For sellers, putting a cost-plus factor on an item limits the margin gained. A few years back, we split inside sellers into cost-plus pricing and list-and-discount pricing groups. For low sales items, we wanted a 45% gross margin. The cost-plus pricers were instructed to put a 1.81 multiplier on cost. Over three quarters of them balked at the multiplier. For the list-and-discount folk, however, we got a two-thirds compliance. The list to cost was a 3x multiple which, for a 45% gross margin, was around a 40% discount to the customer. Customers also liked the idea of a substantial discount from list. When using cost-plus pricing, the fear of losing the order is greater than the gain of making margin on the product. Trying to train sellers to get over their fear of loss is a "losing" proposition. It's much better to give the customer a discount which alleviates the seller's fear and entices the customer. In the end, distribution execs should remember that cost-plus factors are punitive while discounts are a reward. Customers and pricers like rewards.
In marketing materials and on Web sites, we often find where high sales items are advertised with their price. Unfortunately, this can easily backfire. Customers may not know the price of the item and or be in a segment where the item is not a top seller. If this is the case, the distributor, unknowingly, has made the customer more price sensitive. It is typically best to only advertise a low price when the item is the most common of commodities and is paired, on the order, with other less price-sensitive items. The behavior, called the Substitute Awareness Effect (No. 5), has consequences for distributors who openly advertise price. In catalogs, we encourage distributors to advertise a list price or trade price that gives substantial room for discounting. In many instances, it makes sense to place no price in the catalog with instructions to contact the local branch. The catalog serves as informational for the customer in that it advertises the distributor's inventory but refrains from educating buyers on price. We are not proponents, in a thin margin business like distribution, of constantly advertising price, especially on a loss-leader product. Unless the company has a sustainable cost advantage in product cost or operating cost, being a low price leader is a bad idea and fills the customer with expectation of future low prices.
Product Centric and Profit Poor
The preceding pricing behaviors are good for 80% of products sold. We have used them in over 25 different vertical industries in our decade of pricing work. Most distributors place product knowledge before and in place of pricing. They assume that product features, benefits, and manufacturers have much to do with pricing. Typically, they over emphasize products and manufacturer reputation over pricing behaviors of the customer. In situations where the product has a unique technology, is an impulse item, or key to completing a finished installation, then product dynamics influence price. Otherwise, distributors would be much more profitable to ditch their product-centric behavior and learn pricing behavior. The difference in bottom line profitability is substantial.
Scott Benfield is a consultant for manufacturers and distributors in durable markets. He has conducted pricing seminars, research, and field work for clients for a decade. He is the author of "Pricing Management: Capturing Value for Distributors," along with four other books on marketing and sales in durable goods channels. His Web site is at www.benfieldconsulting.com and he can be reached at (630) 428-9311 or email@example.com.