The Art of Pricing: How to Find the Hidden Profits to Grow Your Business

Book by Mohammed Rafi

Chapter 1

Hidden Profits: Pricing for Profits and Growth

My friend David Straus has always been interested in cooking, not just as an avocation but as a career. He’s followed the tried-and-true career path of other successful chefs: attending culinary school and cooking at a variety of restaurants. Dave combined all of these experiences into a unique style of cooking and shares a trait that distinguishes the great from merely good chefs: he cooks to please his customers. So it wasn’t a surprise when he recently called to tell me that he was opening his own gourmet restaurant.

After catching up with each other, Dave shared a business problem that he was struggling with. “Rafi,” he said, “I don’t know what prices to set on my menu.” With a hint of exasperation, he went on to wonder aloud, “Should I price the prime strip steak with morel mushrooms at eighteen or thirty-one dollars? How will the thirteen-dollar difference affect the number of customers that patronize my restaurant?” His pricing decision was further complicated by conflicted feelings of “not wanting my restaurant filled with just a bunch of rich people; I want to serve a more diverse group of customers. But then again, I am in business to make a profit.”

What’s interesting about Dave Straus’s pricing dilemma is that it reflects a fundamental challenge faced by every business in the world—from small startups to Fortune 500 companies.

I’ve had the good fortune to work on pricing issues in aca-demia, government, and the private sector. As an academic, I wrote my Ph.D. dissertation, published new ideas in top research journals, and taught classes to budding managers on pricing. As an economist at the Federal Communications Commission, I worked on deregulating local and long-distance telephone rates as well as on public-policy issues that use price subsidies to make telecommunication services affordable to the poor. Today, I work with companies of all sizes in a wide range of industries on their pricing strategies. Throughout all these experiences, I’ve found that the root of pricing problems at most organizations is the same: they don’t think about pricing in the right way.

For most people, pricing is an unsettling exercise involving a mixture of compromise, fly-by-the-seat-of-the-pants analysis, guessing, marking up costs, following competitors, and doing things as they’ve always been done. What usually results is a price that “just works.” Eighteen- or thirty-one-dollar decisions compromise at $24.50. What’s the difference between using a price that “just works” and one derived from my pricing for profits and growth philosophy? A lot of hidden profits. The potential benefits of pricing extend far beyond making simple, black-and-white, $18 or $31 decisions.

Continuing my conversation with Dave, I pointed out that his desire to expand his clientele beyond rich diners actually touches on my central idea about pricing: some customers will value your product more than others will. For example, budget-minded young couples with a mortgage and kids who want to celebrate their anniversary with a fancy dinner can’t afford to pay as much as the well-to-do who delight in dining at the best restaurant in town. This simple realization—that customers place different values on the same products—empowers companies to price for profits and growth. The right way to think about pricing is as a series of strategies that serve (and capture different profit margins from) customers with different product valuations.

After an hour of discussing Dave’s business, goals, and potential customers, we designed a set of pricing strategies for the restaurant. They included early-bird specials; senior citizens’ discounts; regular menu prices; $200 annual “charter” memberships that provide a 25% discount on all meals for a year; discounted three-course meal bundles; a lower-priced bar menu; and premium-margined chef’s-table seating. Of course, the restaurant will make lower profits from those ordering early-bird specials compared to the margins gained from high rollers willing to pay for the privilege of sitting at the chef’s table and hobnobbing with the creative genius behind the meal. But this is exactly what pricing for profits and growth strives to accomplish. The right set of pricing strategies enables companies to serve (and profit from) as many customers as possible.

When I visited Dave six months later, he was beaming with pride at how well his restaurant was doing. He took particular delight in serving, through his early-bird pricing specials, those diners who normally could not afford to enjoy gourmet meals. As I looked around the packed dining room, I was happy for my friend. Dave had done a great job of pricing for profits and growth. Profits were being enhanced by options like chef’s-table seating, and the early-bird specials were growing his customer base. Think about all the hidden profits Dave would have missed out on had he viewed pricing as an $18 or $31 decision!

This book presents a pricing for profits and growth philosophy that’s relevant for any service or product, as well as for any type of business—domestic or global, large or small. The reason for its universal applicability is the simple fact that for every product in the world, there are at least two people who are willing to pay different prices. Think about your own customers. Aren’t there some “chef’s-table” customers who you know would continue to purchase if prices were raised? Similarly, aren’t there some “early-bird” shoppers who could be converted to customers if they were offered a lower price? If your company thinks about pricing primarily as an either/or, $18 or $31 type of decision, you are leaving a lot of money on the table. From this point on, pricing is not about setting numerical prices, it’s about creating a set of strategies to maximize your company’s profits. Just as important, these strate- gies are easy to create and can be implemented on Monday morning.

Anyone who sets prices can benefit from this book. That includes nonprofits (e.g., a local university alumni club), government services (e.g., public transportation), and regulated industries (e.g., local telephone services). These entities all strive to provide as much service as possible given a constraint. The constraint could be the organization’s nonprofit status, fixed subsidy level, or set rate of return. No matter what, some people will value the product or service more than others will. This simple fact means that the strategies in this book are applicable to every entity that sets prices. In fact, these organizations have already started expanding the way they think about pricing beyond $18 or $31 decisions. Still dubious? Here are some examples. Older alumni, often seeking business connections, are charged more to join university alumni clubs than are freshly minted grads. Washington, D.C.’s Metro subway sets commuter prices based on time of day and distance traveled. Telephone companies charge Fortune 500 companies more for a local line connection than they do low-income customers who need a phone in case of an emergency. These organizations realize, just like Dave Straus discovered, that the right set of pricing strategies allows them to serve as many people as possible. In addition, since some customers are paying more than others, profits are increased. These new revenues can subsidize more customers or enhance services.

Hidden Profits

In today’s business environment, everyone—CEOs, managers, salespeople, ambitious new hires—is under the gun to show results and grow profits. Wall Street and your boss demand a better bottom line every year, primarily from new products and new initiatives. While obviously important, these efforts are risky and costly. Most of us have a moment of doubt when we agree to meet ambitious new profit targets based on the launch of a new product or service. Pledges are made that sacrifices today will result in better profits tomorrow. Further compounding the stress is the generally long “plant-to-harvest” period before a growth investment bears profits or is written off as a bad idea.

While you must keep adding new products to avoid stagnation, what if you had a strategy that would help you hedge your bets? In addition to new products and initiatives, there are creative ways to grow by finding the hidden profits residing in your current products and services. The pricing mind-set and tools in this book are the business strategy equivalent of the Antiques Roadshow television show. In this PBS program, the hopeful line up to have their yard-sale bargains and family heirlooms appraised. While most of the items have more sentimental than financial value, the real excitement comes when the appraiser excitedly announces that Aunt Jenny’s tarnished necklace is actually a $25,000 Tiffany rarity! Families leap for joy when they discover the value that has been hidden in their attics. Your products contain a similar untapped potential to increase profits. The only difference is that in the Antiques Roadshow, the potential for a windfall is hit or miss. In contrast, I believe that the ability to easily increase profits exists in virtually every business product or service. A good example is the way Lloyd Hansen uncovered three billion dollars in hidden profits at Ford.

Lloyd Hansen rapidly ascended through the management ranks at Ford. After enjoying the thrill of helping turn around Ford’s profit performance in Asia Pacific and other markets, he was particularly frustrated in his new position as controller of the Ford and Lincoln Mercury divisions. He felt the divisions’ financial performance had stalled despite aggressive cost-cutting. As controller, he was searching for the next big thing, the idea that could boost Ford’s profits and, in turn, maintain the momentum of his career. He was convinced that cost- cutting was not the entire answer. Although important, another round of cost-cutting simply would not get the job done. The anxiety of finding a new source of profit was increasingly waking him up in the middle of the night. During our interview he recalled, from the comfort of his oversized top-floor office at Ford’s headquarters in Dearborn, Michigan, “It was a time of uncertainty and stress.” Little did he know, but Lloyd Hansen was about to discover and implement one of the most profitable business strategies in the history of Ford.

As Hansen doggedly searched for new avenues of profit, he returned to the question of whether Ford was pricing its products correctly. Intrigued, he ran an analysis of the effects on Ford’s bottom line from an additional 1% of net profit margin. He could not believe the results: culling an additional penny of profit from each revenue dollar would increase Ford’s net income by 33% and cash flow by 45%, and, if sustained over time, could increase Ford’s market value by 45% (market value usually closely follows changes in cash flows)!1 Excited by the potential opportunity, especially in a business that is “profit-challenged,” Hansen went on a mission to overhaul Ford’s pricing strategy.

For many executives, pricing is the one area of their business strategy in which they feel uncomfortable and vulnerable. The problem lies in the way that they think about pricing—it’s too complex. For them, pricing involves constructing a demand curve, finding the optimal price, and then managing the anxiety of wondering whether their price is indeed optimal. While Hansen shared the same apprehensions, he began wondering if there was more to pricing than just deciding what number should be listed on the invoice. Hansen embarked on broadening the view Ford took concerning pricing. Setting the actual numerical price was going to be a small, yet integral, component of his new vision of pricing.

Hansen quickly discovered that the strategies in his expanded vision of pricing yielded fabulous profits. While the strategies were straightforward, his biggest obstacle was in convincing managers handicapped by a “that’s the way that we’ve always done it” mentality. But once they saw the results, they quickly became believers in his new pricing perspective. Hansen focused on the following four initiatives.