Certainly the business environment we're experiencing supports the ability to raise prices. Yet many price increase announcements are poorly executed and set the stage for future price sensitivity and demands for price concessions.
The way to better manage pricing changes is to separate the value component from the cost component. But successful implementation requires integrity, discipline and fairness.
An improving economy creates a problem
Looking back at the forecasts for 2004, there's an almost tangible feeling of relief: for some companies, the widely predicted economic recovery is beginning to materialize. Along with the recovery, many firms are now trying to grow profits through price increases. One trade journal editor recently told me that they've had to stop printing price-increase announcements—they're receiving an average of 67 daily.
Yes, the current business environment supports the ability to raise prices. And that's where the challenge emerges: many of the price increase announcements are being poorly executed. The majority of announcements cite higher costs as the reason for increasing prices. The problem with this approach is that it sets the stage for future price sensitivity and demands for price concessions.
Across most industries, product and operating costs (e.g., raw materials, energy, and freight) are rapidly increasing. If companies are to achieve profit growth, they will need to recover these costs.
But while these cost increases have been sudden and dramatic, it's uncertain how long they will last. For example, the cost of a barrel of oil is in record territory, but this level will unlikely continue forever.
The problem with cost-based price announcements occurs when costs begin to go back down and customers want a "pay back." They argue that "you got me as costs ran up, so you must pay me back as costs moderate." Cost-based price increases also encourage customers to track cost components.
And most importantly, cost-based price increases confuse the value component of price with cost components, causing customers to lose track of what's really valuable.
Separate value from cost
Implementing a pricing policy that separates the value component from the cost component is a better way to manage pricing changes. This allows customers to see the cost component but purposely keeps costs separate from value delivery.
The process starts with understanding the economic impact you have on each customer's business (how you decrease customer's costs and increase customer's revenue and profit) and the competitive alternatives each customer has.
Before any discussion of price with customers, make sure they understand your value delivery; and position your prices as fair and reasonable given that value. Of course, this means you must have done your homework—you must understand how both you and your competitors financially impact your customer's business.
When separating the value from cost components, it is important to communicate clearly and openly with customers. It is frequently not the price increase itself that creates customer discontent—it's the perception that some other customer is paying less. Managers can reduce this discontent by implementing pricing policies based on the following:
- Integrity—The price that a customer is asked to pay is proportional to the value that the customer receives. Price points must pass the red face test: price differences between customers can be explained—without embarrassment—by differences in value delivery to various customers.
- Discipline—No special deals or rebates are negotiated with customers. If customers insist on lower prices, they always receive lower value.
- Fairness—Customers understand there is consistency in pricing policy implementation; no other customer gets a better deal for the same value.
A significant portion of each customer interaction—sales, technical support, management, customer service, etc.—should be devoted to reinforcing your value communication. ("This is why you buy from us.") This constant reminder of your value delivery is aimed at reducing customer price sensitivity and getting rewarded for your value.
Use surcharges to cover costs
However, suppliers must still find ways to recover their unprecedented cost increases. One way to recover cost increases without setting the stage for future price concessions is to separate the cost components into a surcharge. (We have worked with companies to establish as many as three surcharges—for raw materials, energy and freight.)
Cost-driven surcharges can move up or down based on publicly available indexes. For example, we have used Producer Price indexes available from the Federal Government to index surcharges. The PP indexes are available for many industry sectors (three and four digit SIC sectors) and have the benefit of being updated monthly.
The advantage of implementing surcharges is that they are inherently fair. All customers pay the cost surcharges. Furthermore, customers know that when the publicly available index goes down, surcharges will also be reduced. And customers can confirm periodic changes in the surcharge based on publicly available data.
Use this disciplined approach
In summary, the price charged to customers should have two components: a price component based on the value delivered to customers, and a cost component based on a trusted public index. When you use this approach, customers are less likely to confuse the two components.
In addition, the value component tends to be the same over longer time periods, while the cost component—expressed in the surcharges—changes as often as monthly. We are not suggesting indexing the total price, as this mixes value and cost and has the potential to confuse customers.
Of course, discipline is required in applying the two component price structures. The value component of the pricing formula must be consistently applied and proportional to value delivered—there are no deals or special concessions. Further, the surcharges must be consistently applied across the customer base—no waivers for "strategic" customers.
The current business environment is rich with opportunities to implement price increases, but companies must remember that price increases based solely on increasing costs will sow the seeds of discontent and lead to requests for future price concessions.
Moving to a two-component price structure, using surcharges to separate value from cost, will alleviate this problem and ultimately drive greater profits and loyalty in your customer base.
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