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The 1% Windfall

Most companies spend hundreds of thousands of dollars and invest countless hours in research and development, distribution, and marketing strategies to bring a product to market. But when it comes to setting a price for their product, many companies drop the ball. Most managers aren’t comfortable setting prices, and a lot of times critical pricing decisions are made by using the method of “this is the way we’ve always done it” or it’s “just like the competition’s” (Mohammed 23). Rafi Mohammed, author of The 1% windfall, feels that this strategy causes companies to shortchange themselves everyday.

Illustrating the power of pricing, a study of the Global 1,200 found that if companies raised pricing by just 1% their average operating profits would increase by 11%. By following several guidelines, companies can create a comprehensive pricing strategy for any product or service. Better pricing is more than simply raising prices. Instead, Mohammed contends the key is to offer customers a variety of pricing options. This in turn is a win-win strategy providing profits to companies and choices for consumers.

The first part of Mohammad’s book introduces value-based pricing, which is the foundation of pricing for profits and growth. Setting prices for a product based on its value to consumers is a new concept for most companies. An example of thinking like a customer would be street vendors, who increase the price of umbrellas as soon as it looks like it’s going to rain. This illustrates that pricing is about capturing value, not marking up costs or focusing on margins.

Rafi proposes that “the key to better pricing is to set value-based prices” (Mohammed 5). He states that there are two methods to setting value-based pricing: one-on-one pricing, which is when a company sells one product to one customer, and multi-customer pricing, which is when a company sells more than one product to many different customers. There is a limited number of one-on-one pricing situations. For example, selling a house, selling a used car, or setting a price for a custom-job customer.

An example of one-on-one pricing that Mohammed uses is that of a beach house for rent. Imagine you own a beach house that you rent to vacationers by the week. Your neighbor also has a beach house that is identical to yours, but your house has a swimming pool, while your neighbors does not. A potential renter is trying to decide which house to use for a vacation. Mohammed offers a list of steps to take to determine the highest weekly price at which you can close the deal.

He explains that there are many components you need to take into consideration, such as using your neighbor’s house as a starting point for your price. In this case, your neighbor’s house is set at $2,000 per week. From your experience, you determine that a vacationer will pay a 20% premium above the next best alternative. As a result, you price your house at $2,400 per week. Mohammed also shows that we need to take into consideration the price of your neighbor’s house. If it is too high or too low, determine the real value of the house and use that as a pricing point to which you would add the 20% premium.

The challenge of the multi-customer pricing is to find the price that is the most profitable and provides the maximum margin per products sold. The difficulty of this is that every customer values a products’ unique characteristic differently. This translates into a different willingness to pay. Some customers (families) are willing to pay more than others (sightseers) for a pool at their rental beach house. The roots of these differences rely in the way that these customers subjectively and objectively determine value.

Since taste is a personal thing, subjective value varies from consumer to consumer. For example, “no formula can decipher why one man wears blue ties while another prefers yellow ones. This heterogeneity in taste is also apparent in furniture style choices. Many people take pride in their French country antiques, whereas some are into art deco and others are comfortable with shabby chic. Personal taste is a key reason why customers have different valuations for products and services” (Mohammed 12).

Objective value reflects a more understandable rationale as to why some customers prefer one product to another. People with large yards generally place a higher value on John Deere riding mowers over those with smaller lawns. Similarly, more expensive Energy Star certified fluorescent light bulbs last up to 10 times longer and are more energy-efficient compared to regular light bulbs. So why doesn’t everyone buy these bulbs? Some people decide not to buy them because they don’t use their lamps very much. The lower usage results in a longer payback period for the upfront cost at the time of purchase. Customers are unique in determining what they feel the value of a product to be. Because of these differences, some consumers are willing to pay more than others. This concept is critical for setting a value-based price for a product that is sold to more than one customer.

In addition to setting value-based prices to meet the needs of potential customers, businesses can offer different versions of a product or different pricing levels for different distributors. Called pick-a-plan, companies can offer their customers different options to purchase a product. Examples include short-term leases, the option to trade in an old product for a new one, or a value bundle that includes add-ons or accessories for the product. A few minor changes to a product can also attract new customers or entice existing buyers to trade up to products that earn higher profits.
Businesses can offer higher and lower priced product versions. Versioning tactics are classified into three groups: the first product may have premium attributes, the second a stripped down basic product, and the third might be a unique customer need product.

Businesses can also employ differential pricing tactics by offering higher and lower prices. Lower prices can be offered to warehouse stores, as student discounts through a $10 off coupon, and to those willing to wait six months after a new model is released. Higher prices can be set for luxury retailers, and for customers who want the latest version of a product on the day of its release.

Pricing has far more range than the conventional “raise it or lower it” usage. There are four fundamental pricing strategies: value-based pricing, pick-a-plan, versioning, and differential pricing. Mohammed feels that better pricing generates short term and long term profits. Since historically companies haven’t focused on pricing there are usually significant opportunities for growth. These opportunities generally don’t require large investments and can start generating new profits almost immediately. Better pricing also creates a foundation that will produce future profits and growth. In addition, a strong pricing foundation will continue to generate profits even as market conditions change and new products are developed.

Mohammed feels that the benefits from employing value-based pricing can potentially surpass the 1% windfall. Small changes in price can potentially lead to a much larger windfall. He has shown that adopting a 1% increase in price allows some companies to experience even more growth in percentage of profit. “The 1% windfall” reveals how modest incremental changes to an everyday business practice of pricing can yield significant rewards for businesses willing to follow these strategies. “The epiphany to better pricing is to understand – actually, to embrace – the same insight that companies use to create strategies and profit in other areas of their business: a wide variety of customers are interested in buying their product, and these customers differ from each other. These differences are what make pricing a creative business strategy instead of a search for one ‘perfect’ price” (Mohammed 27).