Inflation is hitting every sector of the economy, and almost every company we talk to is grappling with raising prices to compensate for their rising costs. Invariably someone will say, “Raising prices is value pricing, right?” Our answer is, not really. Although value pricing could lead to an increase in price, it could also lead to holding price or even lowering price.
Value pricing is always relative to your customers’ next best alternative (NBA). During inflationary times your customers’ alternatives are likely impacted by inflation but the impact could be very different. Value pricing in inflationary times, then, is reassessing your price against the current value of your customers’ alternatives.
So, there are two key questions. How does inflation impact the value you deliver? And, how do you best implement the revised pricing?
Value Pricing Review
Before we answer these questions, let’s review the basics of value pricing. The maximum price you can charge is the price of your customer’s NBA plus (or minus) the incremental value your customer will receive from your offering relative to that alternative. The value equation provides your maximum price.
Price <= Price(NBA) + (Value(you deliver) – Value(NBA))
We always stress that it is important not to limit your thinking on the customer’s NBA. Directly competitive products are certainly alternatives, but so are substitutes for your offering such as alternative materials, formulations, technologies, etc. You also need to consider the customers’ ability to use less of your offering, or not use it at all. For example, when fertilizer prices are higher (all else being equal), farmers will use less fertilizer.
How does inflation impact your ability to value price?
All of your customer’s alternatives can move in times of inflation, so it’s important to reassess your value. Directly competitive products likely have similar economics and will move in highly correlated ways. But substitutes may move in markedly different ways in magnitude and potentially even direction.
This reminds me of my freshman college economics class, and the importance of evaluating all tradeoffs. The story my professor told was on the tradeoff between choices of alcoholic beverages (obviously he was playing to his audience). If the price of beer were to go up because of a shortage of hops, then some beer drinkers may change from choosing between different brands of beer, to buying a different forms of alcohol altogether, like gin. I am fine with either beer or gin, so I am not sure it is much of a tradeoff. Can your customers switch to alternative ways to meet their underlying needs if you raise prices too much?
So where do the increases in your cost show up in the value equation? THEY DON’T. Your cost is never part of the value equation. Seeing cost increases due to inflation is simply a signal that marketplace costs, and likely product values, are changing and that it may be time to revisit your pricing. Cost and margin should only surface when deciding whether the returns are sufficient to continue participating in this business.
For consideration: If raising prices because of raw material inflation is NOT value pricing, why does it persist? Four hypotheses:
- It usually works (1) – competitors likely have similar cost pressures and so the price of the next best alternative is (or will) likely go up as well
- It usually works (2) – almost everything is inelastic in the short-term, so small changes in price will likely not result in customer completely re-evaluating their supplier decisions, especially when their business faces other pressing problems (like supply chain issues and trying to raise prices to their customers)
- It is inwardly focused – like all cost-based pricing, it starts with the internal perspective that we need to maintain margins or still hit our financial goals… but like all cost-based pricing that makes it easy, but doesn’t make it right (see previous blog on why cost-based pricing persists)
- It is easy to sell – being able to point to raw material price increases often gives a sales force the extra courage to implement a price increase and not discount away the gains
How do you best implement revised pricing?
Make no mistake, we support raising pricing when you can – when your price goes up and volume stays the same, it always looks good in a spreadsheet (and on your bottom line). That doesn’t mean that it will work that way in the real world. Our experience is that how you implement a price increase plays a big role in its impact, both short-term and long-term.
Broadly speaking, there are three mechanisms for managing pricing in inflationary times: simply revising all-in prices, indexing prices, or adding a surcharge separate from the price. Each has its place.
Revised all-in prices are most appropriate when the impacts of inflation are smaller and/or less volatile, and when your relative value moves in more complex ways vs competitors and substitutes. A benefit of this approach is that it naturally keeps the focus on value.
Indexed pricing is most natural when one or a few key inputs (raw materials, feedstocks, additives) account for the majority of the product value and when indices for those few inputs are easily established. A significant drawback of indexed pricing is that the indices do not account for any changes in relative value; it’s possible that indices on autopilot could drive your price too high relative to your value resulting in lost volume or could leave your price too low vs alternatives (resulting in lost value capture). And while it is possible to maintain a value price with indexed pricing, another drawback is that it naturally tends to shift the focus to cost.
Surcharges work well when inflation impacts are significant and more volatile and when indexed pricing is not preferred. Surcharges provide good transparency for the inflationary elements while preserving a separate value price, and they are sometimes easier to sell when they impact something that is already a separate line item, like freight. The same drawback as noted with indexed pricing applies here with surcharges; leaving surcharges on autopilot can result in over-pricing (lost volume) or underpricing (lost value capture).
What are the common pitfalls in value pricing during inflationary times?
In addition to understanding the mechanisms for implementing price changes related to inflation, effectively implementing value pricing updates means guarding against some common pitfalls.
1. Focusing too narrowly on competitive pricing and/or inflationary costs
During inflationary times, what previously may not have been a realistic alternative (e.g. substitute) may have become your customer’s best option, changing the NBA benchmark price and your incremental value. It’s critical to keep your eye on your direct competitors AND on the broader set of alternatives. Not detecting your customers’ ability to substitute would lead to mistakenly high prices.
There is a flipside as well. It can be the case that inflation has put more distance between you and substitutes by increasing the incremental value of your offering. In this case, if you are a price leader, there is an opportunity to lead pricing north. Again, this hinges on an understanding of value broadly across both direct competitors and other alternatives/substitutes.
2. Failing to make prices stick
Remember, the value equation only gives you the maximum price you can charge. Even if you know this quantity exactly, there is some artwork in how much you can capture. As you try to deploy value pricing, the market and even your own organization can conspire against you. When roll out new pricing, it is important to consider the extent to which inflation has changed the factors that determined how much of the value you can capture, especially competitor pricing behavior and your ongoing ability to differentiate.
It’s also critically important to ensure that your own company’s behavior doesn’t limit the ability to capture the new value price. The most common culprit is discounting. As an example, a client who did a great job of properly assessing and setting value price captured very little of that price because the sales force was incented on total dollars of sales and had latitude to discount. Adding insult to injury was the quarter-end push for revenue that also drove incremental freight and handling costs on top of the discounting.
3. Improperly communicating reasons for price change
When updating prices to address inflationary impacts, it’s important to convey that the price changes are based on value economics (not whimsical) while not giving away any cost information that could be used against you. The approach to communicating will vary depending on the mechanism used.
With an all-in price change, communication should focus on how inflation impacts the differential value vs. competitors and substitutes. It can and should touch on specific inflationary drivers and how inflation impacts the value of those alternatives. It should also avoid tight linkage to specific inflationary cost impacts for your products. If inflationary impacts are very similar for you and your competitors, then emphasizing competitive price movement can help avoid the cost focus.
With index pricing and surcharges, the inflationary drivers are laid bare. Using published indices helps to avoid disclosure of any costing. When customers desire to validate modeling (i.e. by translating indices to surcharges based on composition of product impacted by inflationary drivers), it’s possible to validate without disclosure by using third party auditing.
4. Inadvertently setting up longer term price reductions
Setting up unintended longer term price reductions can be an issue with any of the pricing mechanisms but is more often an issue with indexed prices and surcharges. Setting the expectation that your price is tied to some index necessarily means that when that index comes down your price will come down as well. Be sure to test the limits of the index to assess the range of outcomes.
Even with this diligence, you still may need to reduce price over time. If your relative value drops because competitors strengthen their offerings, it will be necessary to reduce your prices. But this is an action based on value change and is not a mistake in your framework or modeling.
5. Creating perverse incentives
No matter what your intentions are with pricing, your customers and the market will always act in their own best interest. It is far too easy to unintentionally set up a system that allows customers to game it to your disadvantage.
An example of this is a client that made packaging film from petroleum-based material. During the spike in oil prices in 2008, they implemented an oil surcharge that updated quarterly. In the fall of 2008, the price of oil fell from a peak of $140 per barrel to around $60 within a quarter. In Q4, their customers knew that their price would drop significantly beginning in Q1, so rationally, they delayed their orders – the company went nearly six weeks without a single new order!
That alone is bad enough, but the situation was exacerbated because their product was usually made to order. Their high capital cost meant that the client kept their production lines running and so they produced stock based on their best guesses at thickness, width, etc. Unfortunately, their best guesses didn’t match the slew of orders that arrived in Q1 when the prices dropped. They were immediately behind in fulfilling the new orders and took nearly a year to work through the mismatched inventory they had accumulated.
Summary
In the end, it’s important to remember what we call the “iron law of the marketplace:” customers will not pay more than the value they receive. Period. And the value customers receive has nothing to do with your cost to deliver your offering. Inflation doesn’t change that fact, but inflation can have significant, even disruptive effects, on the economics of the customer’s alternatives. So, periods of inflation should trigger reevaluation of the cost economics of your customer.
Raising prices just because your costs have gone up is still cost-based pricing. But if prices are going up for other alternatives, this may present opportunities, and if you haven’t done so for a while, it may be a great time to re-ground your understanding of what value really means to your customers.
How can Amphora Consulting help?
Value pricing is challenging. Keeping value pricing current in inflationary times is even more challenging and requires diligence in evaluation and implementation. Amphora has expertise in:
- Value pricing and assessment of pricing ability
- Sales and customer communications
- Economic modeling of the likely impact of surcharges
- Implementation of pricing mechanisms
