When it comes to target pricing, I am reminded of the following: What’s the correct price for a bottle of diet Coke?
Most folks will throw out a number. $1.50. $1.99. You should buy a six pack on sale and get it for under a buck, maybe even less!
But the correct answer is: it depends. There is huge variation in the average target price between channels due to sharp differences in buyer willingness to pay.
Target Pricing: The Power of Anchoring
We can define target price as the number which we are going to communicate to our sales team. It is often customized for a particular channel or customer segment, to reflect any differences in cost, competition, and customer circumstances. You need to be a lot more competitive on a truckload of product (when the customer has three other wholesalers on speed dial) than you do on a tiny little order that you need to deliver to a convenience stores.
The crucial problem which target pricing solves is that first number you throw out in a customer discussion really matters. It anchors the customer for the next round of discussions. Tell the customer the price is $1.50 and you’re never going to get them to agree to $1.99. Prices go down, not up. Even worse, it can serve as a reference price for your other products. The price you quote on a 4 pack of a consumer product implicitly helps set the reasonable price for every related item in your bundle. If 4 packs are $.50 per unit, you most like can’t quote the 15 pack bundles at $.75 per unit.
Returning to our diet Coke example, the correct answer depends greatly on the channel and circumstances where the retailer is trying to sell the item. Convenience stores, accustomed to working at higher margins and serving a customer with few other immediate options, would probably try to sell a bottle of diet Coke for between $1.50 and $1.99. A fancy hotel, airport store, or swank resort with no serious competition can probably get away with even higher prices – $2.50? $2.99? That same six pack in a grocery store is probably $3.99 – or $.67 cents per unit. A bulk pack of 24 bottles at Sam’s club can be purchased for about $12 right now, or $.50 per unit. So your reasonable span of pricing for Diet Coke ranges between $.50 and $2.99.
So where you pick that first price… in that huge range between $.50 and $2.99… really matters….
What Is Target Pricing?
A good target pricing process combines market intelligence from multiple sources to develop a point of view about how the sales team should price products for a particular audience. Inputs to this process should include: competitive intelligence, customer segmentation, profitability analysis, yield management.
A great target pricing scheme boils all of this down to simple guidance for a sales rep on the street, hiding the analytics behind a crisp clean process.
Setting Target Pricing – Competitive Intelligence
Good target pricing starts by developing a solid understanding of the customer, their needs, and what your distribution partners need to service the business profitability. This should be consolidated into a customer segmentation model which accurately captures critical underlying differences between sets of accounts, particularly with regards to customer value and willingness to pay. This needs to be translated into a price target for the selling team.
Where relevant, this segmentation should also reflect notable differences in channel partners and servicing models; these can have significant impacts on customer willingness to pay and represent an additional stakeholder in the discussion that manufacturers and re-distributors need to consider. Deals don’t work unless everyone makes money.
Careful attention should be paid to the following:
- Amount required to get the typical end user to switch providers
- If you work through distributors, what do you need to offer them to fulfill demand? What do you need to offer to actively generate demand?
- If you work through retailers, what are their margin expectations?
And I’m going to repeat it – since many people get this wrong. If your channel doesn’t make money from the deal, they won’t support you!
Target Profit Pricing / Target Return Pricing
The next step is to reach agreement with your management team and financial stakeholders about an appropriate profit level for the business. The degree of complexity involved in this process will vary by business.
If you want a simple approach to setting pricing guidance, you can use a single target profit margin or target selling price per unit across your entire base of business or by segment. This has the advantage of simplicity and is generally fairly easy to communicate and enforce. We need $X per unit; deals priced below this won’t be approved and will land the parties responsible in the hot seat. Simple enough to communicate and enforce.
More enlightened organizations will tolerate a little complexity when setting target pricing policy for the sake of three things:
- Capture incremental margin from channels with a higher cost to serve or known willingness to pay; everyone expects to have to reduce prices for Wal-Mart, but there is likely more room with small end user accounts.
- Recognizing base business vs. opportunistic business and setting margin guidance to “smooth the ride” while “seizing opportunities”. This can take the form of locking in large low-margin customer with long term contracts to build a base of demand to absorb fixed costs and using yield management pricing principles to get the most of your remaining discretionary capacity.
- Support strategic growth and capacity utilization goals; perhaps we need volume on a particular product line or need scale in a specific market.
From Target Price to Target Cost:
Once you understand the channel requirements and your management objectives, you’re in a position to use target costing and cost analysis for pricing decisions. The channel will provide you with guidance on where your price needs to be. You need to look at your cost structure to understand how efficiently you can meet that ask, while also meeting your financial objectives.
This may be communicated to your organization as a target cost formula. Given a specific target price, the manufacturing and logistics cost for a product needs to be held below $X. Manufacturers who serve retailers with specific “hot” price points, such as $1 / $5 / $10 often use some version of this logic to manage product design, using target cost pricing to identify how much room they have to deliver a product that still meets a retailer’s margin objectives.
The inverse applied as well, in the wholesale trade. Many wholesalers who deal in closeout merchandise work with target pricing formulas. This is generally intended as improvements over simple cost plus pricing, intended to capture logistics and holding costs. One specific example is requiring a specific profit per pallet of product handled, to ensure the distributor recovers the cost of handling the product and delivering it to a customer.
What Are The Advantages of Target Costing?
The target costing approach provides a transparent way to keep your manufacturing, buying, and logistics teams focused on controlling the cost of a product. It provides clear guidance.
When combined with a good target pricing model, the entire organization is focused on working together to maximize your margins. The sales team is focused on finding customers who are comfortable buying within your target price range. Operations is focused on controlling costs down to a level that ensures you are earning a fair return on your time.
Target Profit Pricing Example
Simply take the end user retail, adjust it for any distribution costs and channel margin requirements, then compare this price with the profitability guidance you’ve developed with your management team. So if you need a $5 retail – and the channel needs 30%, the channel needs a cost of at least $3.50. Working the math, you determine that anything over $3.25 will provide an acceptable return on the machine time. Green light to proceed – you offer $3.50.
This can also be a source of value feedback for product and offer development. Once you know the target cost for a channel / offer, you can look at options for “right-sizing” the cost and features of your product to match the customer’s willingness to pay.
You can also use this to estimate the impact of adding “scale” to your operation. So if you were able to reduce pricing 20%, what kind of lift in volume could you expect? And would that be enough to kick your manufacturing plan to a much higher level of efficiency? This can create a virtuous cycle from a competitive strategy perspective, as the largest player in a market winds up with a significant cost advantage over new entrants.
Setting Target Pricing – The Power of Simple
My brothers in sales have some feedback to the pricing community: Keep it simple, Keep it consistent, Keep it explainable.
When setting target pricing, it is important to remember that someone needs to ultimately be able to explain all of this to a customer – who may have pieces (but not all ) of the relevant information on market conditions from competitors. Good pricing guidance is delivered to sales in a manner that is extremely easy to understand and doesn’t interfere with the conversation. This is an area where a lot of statistical pricing systems fall short. When the details of the target pricing guidance are hidden behind “proprietary” statistical algorithms, you will have challenges getting broad sales support.
The best guidance systems are intuitive, built up from market feedback provided by the selling team. Differences in target price between accounts should be explained using crisp, clear principles – while these can certainly be derived from statistical data, they should be simplified for sales use. Minor losses in precision can often be recouped 10 fold in support if you are able to get sales to buy into the vision of how pricing should be quoted.
Consider the topic we started with – anchoring. The first price you mention is the most important. When the target pricing guidance is simple enough that your team can quickly and accurately lead with the right price for the situation, your sales team can drive customer conversations from a position of strength and confidence. This anchors the customer’s pricing at a higher level and builds customer agreement about the value of your relationship.
And that helps close more sales…. (at higher margins, of course, we’re still pricing people!)