Profit Leverage in Pricing Tempts Us to Raise Prices
Most of us are very familiar with the famous McKinsey study, which showed an average company can improve profits by 11% by raising prices by 1%, all else equal. But it is clear that pricing can have tremendous leverage on profitability. Relatively small price changes translate to significant profit increases. This assumes, of course, that we’re not losing any business by raising those prices by 1%.
And so, it would seem that if we need a quick burst of profits, the easiest path might be to get that 1% price increase. It’s a sexy idea. Lots of leverage in price! Look at all the unnecessary discounts we’ve given. Surely we can find 1%, just by correcting all the bad pricing we’ve done in the past!
Let’s charge forward! Let’s find all the underperformers! Let’s raise their prices! Let’s get that 11% increase in profits!
After all, profits are the basis for company valuation. So, an 11% increase in profits means an 11% increase in company value, right? Well … maybe not … let’s rethink that.
How Pricing and Profits Connect to Company Value
Assuming everything they taught me in MBA school was correct, the value of a company should be the risk-adjusted present value of all future profits. If I raise profits, I should be raising company value … unless I am potentially adding risk to the future profits, thereby causing a necessary increase to the discount rate used to value the future profits.
It’s possible that I may increase profits and, in doing so, actually hurt the value of the company.
Why?
Because most of the time, raising a customer’s prices adds risk to the customer relationship. Even if the customer continues to buy from me for now, I could be adding risk that turns into a churn event tomorrow. And if I plan on continuously raising customers’ prices year after year, I should assume that I am pushing customer relationship risks to the limit and ultimately beyond.
What Causes Customer Churn?
Studies show that when customers defect, less than 20% of the time it is due to price. About two-thirds of the time, it is due to a service failure of some sort or a failure to appropriately handle a service failure.
But let’s step back and think about this. If I have two customers that experience the same service failure, but one is currently paying a price that is cushioned well below the customers maximum willingness to pay, while the other customer is paying a price that is very close to the customer’s maximum willingness to pay, is one customer more at risk of churn than the other? Yes. Absolutely Yes.
This is where value comes in.
What is Value?
My favorite definition of “value” comes from Merriam-Webster Dictionary:
value (n): worth, usefulness, or importance in comparison with something else.
In this sense, you might say the value the customer receives from a transaction is the incremental “worth” or “usefulness” of having whatever they bought in comparison to the money they paid you. If the amount of money they paid you was significantly below their maximum willingness to pay, we could say they got a high amount of value from the transaction. If instead, the amount of money they paid was almost the same as their maximum willingness to pay, then they got little or no value from the transaction.
Sucking the Value Out of the Customer Relationship
Raising Prices toward a customer’s maximum willingness to pay, therefore, reduces the amount of value that customers get from the transaction, and ultimately the entire customer relationship. In fact, if all you do is raise prices without giving the customer something of additional value, you are just sucking the value out of the customer relationship. Customer relationships can be valuable assets, but only if those customers see value in the doing business with you.
When you reduce the overall value that customers get out of the relationship, you put that relationship at risk. You devalue the customer-relationship asset.
Over the course of most customer relationships, there are likely to be ups and downs. There may be unintended or even accidental service failures. In these situations, customers that get significant value from the relationship are more likely to forgive the failure than customers who are already at the edge of their patience. This is why sucking value out of your customer transactions can be dangerous and risky.
Relationship Equity
Relationship equity refers to the good will built up between a company and its customers, as a result of high value transactions and good experiences the customer has received in the course of doing business. Relationship equity solidifies the prospect of future sales, as customers have built up an expectation of fair treatment and high value from the company.
Conversely, companies that mistreat their customers or offer no excess value typically have little or no relationship equity with their customers. And this can lead to higher than normal churn rates, even if they don’t manifest themselves as a direct result of any specific price increase.
Sharing Excess Value with your Customers Improves Customer Equity
In Economics, the difference between a customer’s willingness to pay and the price is called consumer surplus. This is the excess value in a sales transaction. Sharing that excess value creates win-win relationships, where both parties benefit from the transaction. Sucking all the excess value out of the transaction by pricing very close to the customer’s maximum willingness to pay is win-lose—the extra value you take is directly proportional to the extra value the customer loses.
Unfortunately, most companies don’t see the damage this can cause to customer relationships because it often does not immediately show up on financial statements. Sometimes it shows up later in the form of an elevated churn rate or a lack of sales growth.
Summing Up
Just because you can raise a price doesn’t mean you should. Customer churn is typically a longer-term result from taking value away from customers and increasing customer risk. Customer relationship equity is more important than near-term profits because it determines the value of future customer profits. Unless you only care about the short term, you should always consider the potential negative effects on customer relationship equity before you decide to raise customer prices.
While price increases are sometimes needed as a one-time correction for abnormally low prices, it’s probably not a good idea to plan to use price increases, year-after-year, as a primary way to grow profits. You’ll probably get more out of investments to increase growth and minimize churn.
Just remember—business is all about the present and the future. And for companies that want to grow, the emphasis should be placed on the future.
What You Can Do
If you are concerned with growing the value of your company, you may want to take inventory on your own customer relationships and see if there are opportunities to increase customer relationship equity. Here are some questions you can review:
Are you currently measuring customer churn? If so, are your customer churn rates where you think they should be? If not, it may be good to look into why so many customers are leaving?
Do you often use solutions or techniques to raise prices of customers who regularly buy from you? If so, could that be putting strain on some customer relationships?
Is your company constantly looking for ways to provide value to your customers without charging more for it? If so, are you communicating to let your customers know how they can benefit from the new value you are creating for them?
Have you considered if there may be a need to reduce the prices of some of your products and services, which may be priced too high relative to the market, in order to reduce customer relationship risk?
Do you have access to tools that can make it easy to measure how customer relationship risk translates to the overall value of your company—the risk adjusted present value of all future profits? If so, do you ensure that you are appropriately accounting for growth, churn, and risk in the determination of your pricing strategies and decisions?
If you step back and focus on your whole business, including the effects of your pricing decisions beyond the short-term-focused metrics of profit and margin percentage, it is easier to see the impact of raising prices on your business. Sometimes the strategy of raising prices is necessary. Sometimes it can be quite harmful. The key question is: How does your pricing affect the value your customers receive from doing business with you?
After all, win-win-thinking companies win when their customers win. Are your customers set up to win?
About the Author: Jeff Robinson brings the perspective of two-decades working with companies across industries to help them improve their pricing practices and results. He has designed, marketed, and implemented pricing solutions used by hundreds of companies, whose combined revenues total more than one trillion dollars. Having earned a bachelor’s degree in economics, combined with an MBA in marketing and finance, he has brought new perspectives to the world of pricing, often challenging prevailing notions or widely accepted strategies. Combining his formal education with over 20 years’ experience, he has recently authored the up-coming book, Price for Growth, A Step-by-Step Approach to Massively Impact the Value of Your Company by Leveraging Focused Pricing Strategies, expected to be release in 2021. Today, he is leading the development of a new company, Revolution Pricing, focused on helping companies create and select appropriate pricing strategies for maximizing the value of their own companies.
About Revolution Pricing: Revolution Pricing is a company founded to help companies create and select appropriate pricing strategies for maximizing the value of their company value by focusing on the right metrics, building goodwill with their customers, and reducing the risk of future profits. Unlike most companies that offer pricing solutions, Revolution Pricing focuses on longer term benefits largely driven by metric other than near-term profit dollars. We believe the path to success requires education and understanding prior to implementing “optimization” tools to insure any such tools accomplish the right desired objectives. For more information, visit RevolutionPricing.com