The Power Of Smart Pricing

Companies are fine-tuning their price strategies--and it's paying off

How did Ford Motor Co. manage to earn $7.2 billion last year, more than any auto maker in history? The hot economy helped. But Ford couldn't have done it without a new pricing strategy that helped upgrade the mix of vehicles it sells. From 1995 to 1999, Ford's U.S. market share fell, from 25.7% to 23.8%. Ordinarily, that's cause for alarm. But behind those numbers was a 420,000-unit decrease in sales of low-margin vehicles, such as Escorts and Aspires, and a 600,000-unit increase in sales of high-margin vehicles, such as Crown Victorias and Explorers. Ford cut prices on its most profitable vehicles enough to spur demand but not so much that they ceased to have attractive margins. "This is probably the biggest driver of Ford's profitability," says Lloyd E. Hansen, Ford's controller for North America and global marketing.

Chalk up another victory for the power of smart pricing. While most companies have gotten savvy about cutting costs, few have figured out how much money they are giving up by using lunkheaded pricing strategies. Lacking detailed information about market demand and their own supply capabilities, companies routinely overprice some products and underprice others. Hansen admits that until about 1995, Ford was among the offenders. Its sales force was compensated on how many units it sold, regardless of their profit margins. So it tended to push the low-margin cheapos--because you could move more units with less spending of precious marketing dollars. Soviet central planners would have nodded in recognition.

The new strategy of smart pricing draws on microeconomics, buyer psychology, and the computing power to sift through lots of data on spending patterns. For example, Atlanta's Talus Solutions Inc., which developed yield-management software for airlines and hotels, is teaching its tricks to other businesses, ranging from United Parcel Service Inc. to apartment landlords to a major TV network. Clued-in companies are boosting profit margins--and dealing a blow to the idea that the Internet will inevitably drive down all prices toward marginal costs.

As one of the world's biggest companies, Ford is a good testing ground for the new pricing approach. Starting in 1995, it stepped up market research to find features that "the customer was willing to pay for but the industry was slow to deliver," such as more comfortable supercabs on trucks, says Hansen. Second, it set up its sales units as businesses and told them which vehicles and option packages made Ford the most money--so they would stop pushing the dogs. Third, with assistance from Talus, it rejiggered pricing to encourage customers to move up to better, higher-profit vehicles. In 1998, the first five U.S. sales regions that tried the new strategy collectively beat their profit targets by $1 billion, while the 13 that didn't missed their targets by about $250 million, says Hansen. Last year, all 18 regions were on board.

It's no coincidence that airlines were the first to get smart about pricing. As long ago as the late 1960s, travel agents were comparing their prices and placing orders on computer screens. The airlines eventually figured out that the key to making money was to segment customers by their willingness to pay. They squashed discount carriers People Express and Sir Freddie Laker's Skytrain by offering superlow fares with lots of restrictions for travelers on tight budgets. Today, the prices paid for seats on a flight are as unique as snowflakes. Hotel companies, starting with Marriott International Inc. in the 1980s, followed suit.

PERISHABLE. The lessons of airlines and hotels aren't entirely applicable to other industries because plane seats and hotel beds are perishable--if they go empty, the revenue opportunity is lost forever. So it makes sense to slash prices to top off capacity if it's possible to do so without dragging down the prices that other customers pay. Cars and steel aren't so perishable. Still, the capacity to make these goods is perishable. An underused factory or mill is a lost revenue opportunity. So it makes sense to cut prices to use up capacity if it's possible to do so while getting other customers to pay full price. That requires segmenting the market--geographically, for instance--so that full-price customers can't see the bargains that others are getting.

Conventional wisdom says that bargain-hunting software on the Web makes it far harder to charge different prices to different customers. "There's going to be a domino effect where these markets one at a time succumb to the competition," says Ethan S. Harris, a senior economist at Lehman Brothers Inc.

But there are plenty of examples of prices in the Internet era, even prices on the Net itself, that aren't showing any signs of being driven toward marginal cost. A study last year by Erik Brynjolfsson and Michael D. Smith at Massachusetts Institute of Technology found that while Inc. charges less than bricks-and-mortar stores for books and compact disks, its prices remain substantially--and durably--higher than those of online discounters. Although discounter charged less than 99% of the time, its share of the traffic was just 2.2%. Tired of fighting a losing battle, Cendant Corp. shut down last year and sold its name to Inc. Brynjolfsson speculates that the Internet may heighten the importance of trust and brand awareness, both of which has garnered in spades.

If, a seller of pure commodities, can avoid price wars, it should be even easier for companies selling things that are less commodity-like. Steel, for instance. New York-based e-Steel Corp., a Web site for steel transactions, offers a feature by which buyers can broadcast requests to every participating steelmaker. But few use it, preferring to receive bids only from the few mills they're interested in doing business with--even if that means cutting themselves off from some low bids. That suits high-end steelmakers just fine. Dofasco Inc. of Hamilton, Ont., one of North America's most profitable steel companies, says the vast majority of its steel is made to order. It uses as a forum for hammering out specs with customers, not bidding for business. "An auction site is of zero interest to us," says Dofasco spokesman Gord Forstner.

One tenet of the new revenue management is that prices should vary constantly with changes in supply and demand. For instance, Archstone Communities Trust, an Englewood (Colo.) operator of apartment complexes, is using Talus Solutions software to set rental rates. If the market is weak, Archstone might offer a prospective tenant a low rent for just a month, instead of locking in that low rate for a full year. Higher rates would be offered for 3-month or 12-month leases.

BACKFIRE. In some industries, though, too much price variance can backfire. M. Douglas Ivester, the former Coca-Cola Co. chairman, found that out last year when he floated the idea of changing the prices of soda in vending machines depending on the weather. Technically, it would have been a snap. But customers howled at the thought of being gouged on hot days. And marketers warned that Coke would damage its brand by focusing on price. The company quickly poured cold soda on the idea.

Varying the price constantly works best in situations where there's no bond between the buyer and the seller. In the stock market, for instance, you don't know and don't care who sold the shares you're buying. But in many transactions, relationships do matter. Asking About Prices, a 1998 book by Princeton University economist Alan S. Blinder and others, concluded from interviews with 200 companies that a big reason for "sticky" prices is that sellers fear antagonizing customers with frequent price changes.

A less controversial pricing strategy is to offer customers a unique bundle of products and services so that you meet their needs precisely. That makes it harder for them to make price comparisons. "The idea is to remove yourself from the world of univariate comparisons," says Stuart I. Feldman, director of IBM's Institute for Advanced Commerce in Hawthorne, N.Y. It's the latest idea in software, which is vulnerable to price wars because the cost of producing more copies is near zero. Application service providers are "renting" their software and support by the month instead of selling an unlimited-use license. "The guys who have really figured this out, I hate to say it, are the porn industry, with pay-per-view," says James H. Geisman, president of Marketshare Inc., a Wayland (Mass.) business-development consultancy.

CLUELESS RIVALS. Smart pricing strategies aren't entirely good for buyers. While some prices fall, others rise. A top executive at a New York-based TV network declines to talk about how he's using revenue-management tools to raise and lower rates for airtime, for fear of antagonizing media buyers. Reuben Swartz, director of e-pricing at Trilogy Software Inc., an Austin (Tex.)-based supplier of electronic-commerce software, projects that smart pricing will increase profits in industries by shaking out the unsophisticated discounters. Predicts Swartz: "It's going to be bigger winners and bigger losers, faster."

Another sign smart pricing could hurt consumers is that companies that have mastered it are eager to let their competitors know. Why? Because they don't want clueless rivals to misunderstand their intentions when they cut a price surgically--and respond by slashing prices across the board. "I agree 100% that revenue management works best when as many companies as possible in an industry are using it," says Archstone Chairman and Chief Executive R. Scot Sellers. "The risk is that one or two irrational competitors...will pull down overall industry profitability."

Sellers argues that targeted pricing based on supply and demand "is a very good thing for the informed and active consumer." His reasoning: "You get paid for doing your research." That's true. But the biggest winners will be the companies that master the new techniques and keep their heads above the rising tide of commoditization.

See Peter Coy's video discussion of revenue management at