Price Smarter on the Net

Two very different approaches to pricing—neither optimal—have dominated the sale of goods and services through the Internet. Many start-ups have offered untenably low prices in the rush to capture first-mover advantage. Many incumbents, by contrast, have simply transferred their off-line prices onto the Internet. In some cases, they believe their brand strength inoculates them from the need to price competitively; in other cases, they feel pressure to establish an on-line presence but aren’t prepared for the complexities—or potential cannibalization—of multichannel pricing. Transparency and efficiency go both ways. Just as it’s easy for customers to compare prices on the Internet, so is it easy for companies to track customers’ behavior and adjust prices accordingly. Both approaches cause companies to miss a big opportunity. The Internet allows companies to price with far more precision than they can off-line and to create enormous value in the process. Transparency and efficiency, after all, go both ways. Just as it’s easy for customers to compare prices on the Internet, so is it easy for companies to track customers’ behavior and adjust prices accordingly. But organizations must act quickly and rethink their on-line policies before habit and customer expectations make changes difficult, if not disastrous. The Reality of E-Pricing In the absence of hard data, intuition and supposition are still driving many companies’ Internet pricing strategies. Some observers insist, for example, that the Internet will be the great equalizer, driving prices down to the lowest level possible, and that customers will take advantage of the Web’s transparency by opting exclusively for the lowest prices. In the end, they argue, price will be the most important factor differentiating products and services for on-line consumers, outweighing quality, service, and reputation. And, indeed, when asked, on-line consumers regularly say that far and away the most important factor motivating them to buy on-line is lower prices. But their behavior tells a different story. A recent study of consumer click-through behavior here at McKinsey & Company has found that most on-line buyers actually shop around very little: 89 % of on-line book buyers purchase from the first site they visit; so do 84 % of those buying toys, 81 % buying music, and 76 % buying electronics. Fewer than 10 % of Internet users in a separate study of North American consumers turned out to be aggressive bargain hunters. The rest tended to return to the same sites time and again when making online purchases. Nor is price the main consideration for corporate buyers. Businesses buy online primarily to lower the total cost of ownership, but price is often a relatively small component of ownership cost. For example, we found that only 30 % of B2B purchasing managers identified lower prices as the key benefit to buying online. Most said the main advantages come from lowering transaction and search costs—reducing paperwork, for example—and from automating purchasing information to track inventory and make better purchasing decisions. Only 14 % of those buyers said they expected to reap lower prices at the expense of suppliers’ profit margins. On the contrary, they explicitly recognized that both buyers and suppliers should benefit from reduced transaction costs. Business-to-business buyers (unlike individual customers) actually do what they say they do in the surveys. Reverse auctions—which are designed to push prices down—are not especially popular, despite all the press they get. Only 15 % of the companies that make purchases over the Internet have even tried them. Only 2 % of business-to-business buyers prefer reverse auctions to other approaches, and only 3 % intend to continue using them in the next year. Interestingly, half of the companies buying through reverse auctions do not choose the low bidder, and 87 % of those stay with their current supplier despite the higher price. Profiting from E-Pricing Flexibility Of course, even if price is not the most important factor, it does matter; on-line suppliers can’t raise prices indiscriminately. Poorly justified price changes can be perceived as capricious—or, worse, deceptive—which can cause long-term damage to a company’s price proposition. Ultimately, however, the fundamental value of the Internet lies not in lowering prices but in optimizing them. It gives companies greater precision in setting and announcing prices, more flexibility in changing prices, and better information, which can lead to improved customer segmentation. (See the exhibit “Three Approaches to Improving Pricing.”) Let’s look at each of these in turn. Three Approaches to Improving Pricing Companies can use the Internet to make pricing more precise, to be more adaptable in responding to fluctuations in supply and demand, and to segment customers more effectively. Precision. All products have a “pricing indifference band,” a range of possible prices within which price changes have little or no impact on customers’ purchase decisions. These can range as wide as 17 percentage points for branded consumer health-and-beauty products to 10 % for engineered industrial components to as narrow as 2 % for some financial products. Being at the top rather than the middle or the bottom of this band can have a huge impact on profits. For example, a typical financial services company moving from the middle to the top of a 2 % indifference band in setting interest rates for personal loans would increase operating profits by 11 % for those products. Determining the borders of these indifference bands in the physical world is difficult, expensive, and time-consuming. Traditional price-sensitivity research can cost up to $ 300,000 for each product category and take anywhere from six to ten weeks to complete. It’s no wonder that only about 25 % of North American companies have conducted such research. Adjusting price changes according to market response keeps companies broadly within their appropriate price range but can’t help them pinpoint the precise floor and ceiling. On the Internet, however, prices can be tested continually in real time, and customers’ responses can be instantly received. If, for example, an e-business wants to determine the sales impact of a 3 % price increase, it might test the response by quoting the higher price to every 50th visitor to its site and comparing the purchase rates. These tests can also help a company predict volume fluctuations resulting from price changes that fall outside the indifference band. This kind of testing can have dramatic results. For example, in an on-line price test conducted by the software-services company Zilliant, an electronics company reduced four products’ prices by 7 % . Sales volume for three of those products increased by 5 % to 20 % —not enough to make up for the cost of the price reduction. However, with the fourth product—a high-end model—sales more than doubled. The company analyzed the data and learned that most of that increase came from high schools and universities. The price reduction, it seemed, had uncovered a whole new segment of latent demand. Armed with this knowledge, the company created a special Web site to cater to these buyers and offer them special prices not available to other groups. What’s more, the company has also rethought its approach to selling the product to the educational market off-line. Companies testing prices on-line must take great care not to alienate customers. Recently, Amazon.com angered customers and triggered a wave of bad publicity when in a price test it offered DVD buyers discounts of either 30 % , 35 % , or 40 % off the manufacturer’s suggested retail price. When the test was discovered, a vocal portion of those who had been quoted the smaller discount were upset. At every stage, from designing the test through handling responses to complaints or inquiries, companies should remember that the purpose of such testing is to gather information, not revenue. Some companies, when they test a price higher than one previously published, refund the difference as soon as the purchase order is complete by adjusting the invoice or sending a follow-up e-mail. Companies can also test customers’ responses not only to different levels of discounts but also to different approaches to discounting. They can find out if customers respond better to a limited-quantity offer or to a percentage discount, for example. FairMarket, which sets up business-to-business auctions and develops automated-pricing technology, has found that customers buy more quickly and accept higher prices on clearance items when they see a price reduction than when they’re told that only a limited quantity is remaining. Testing of this kind is a low-risk way to develop very practical rules of thumb for pricing. Such tests in a bricks-and-mortar store would be extremely expensive and complex, and they wouldn’t yield as much in-depth understanding. Adaptability. Changing prices in the physical world takes time. Business-to-business markets may need several months to a year to communicate changes to distributors, to print and send out new price lists, and to reprogram their computers. In consumer markets, pricing is a little more flexible, but changes are still costly and time-consuming to carry out. In stores, for example, signs often need to be revised manually every time a price changes. On-line pricing is far more adaptable, allowing companies to make adjustments in a fraction of the time and to profit from even small fluctuations in market conditions, customer demand, and competitors’ behavior. Think of the ticketing business, for example. Traditionally, prices on preprinted tickets are set far in advance, and there’s no opportunity to recalibrate later. Tickets.com, by contrast, adjusts concert ticket prices based on supply and demand—and has generated as much as 45 % more revenue per event as a result. Our research suggests that customers don’t fight those price adjustments. In fact, Internet sales can often push prices higher, especially when demand fluctuates sharply. Prices for hot products—from video games to luxury cars to concert tickets—are 17 % to 45 % higher on-line than off because the Web increases the chances of finding a buyer willing to pay a higher price. Taking advantage of this flexibility can improve profits considerably: one consumer electronics company extended the period that a product sold at full price by two weeks, increasing its profits by 17 % . Prices for hot products are 17 % to 45 % higher on-line than off because the Web increases the chances of finding a buyer willing to pay a higher price. Products in low demand can also command higher prices on-line because of the Internet’s ability to expand the buyer base. Aucnet attracts four to five times as many buyers as traditional wholesale car auctions, and FairMarket has been very successful in helping electronics and apparel companies dispose of excess inventory and obsolete products more quickly and profitably. This pricing flexibility creates an imperative for companies to accurately assess and respond to the overall balance between supply and demand in their industry. For example, when capacity utilization, order lead times, or industrywide inventory levels indicate that products are in great demand across the board, prices might be temporarily raised. Conversely, when overall demand lags, a company might experiment with lower prices, auctions, or targeted short-term promotions. It is estimated that one electronics supplier realized a $ 25 million profit by adjusting prices faster than other players during a temporary industrywide shortage of key components. The ability to react quickly and decisively is crucial. Segmentation. It’s commonly understood that because different consumers value a product’s benefits differently, some are willing to pay more for it than others. But in the off-line world, it’s difficult and clumsy to offer different customer segments different prices, particularly in the retail market. A visitor entering a store is usually a statistical mystery. Sales staff have no idea what that customer has bought in the past, what combination of price and benefits would trigger a purchase, whether that person generally buys items at full price or only on sale, or if he needs an incentive to go beyond browsing. The mystery is cleared up on the Internet. On-line companies can segment their customers quickly using many sources of information—everything from clickstream data about the current on-line session to customers’ buying histories tracked by cookies created on their own computers. Once a company has identified an on-line customer segment, it can offer a segment-specific price or promotion immediately. Ford, for example, expects information about its on-line customers to significantly improve the yield from the nearly $ 10 billion it spends annually on promotional pricing. Efforts like discount financing and cash-back programs have historically been offered to all customers on a broad range of models over a specific period of time. But the Internet will enable Ford to finely target the promotions at just those models that would most benefit and to just those customers who would actually respond. The Internet also allows companies to identify customers who are happy to pay a premium. For example, an online electronic components company uses customers’ buying histories to determine if someone is a “core” customer—one that buys a majority of its components from the company—or a “fill-in” customer—one that buys the majority of its components from a competitor and comes to this company only in emergencies, when the competitor does not have the desired component in stock. Through its segmented on-line pricing, this supplier regularly charges fill-in customers as much as 20 % more than it charges core customers. And the fill-in customers gladly pay that premium for the assured supply in emergency situations. Making an On-Line Pricing Strategy Work How does a company develop and execute an on-line pricing strategy that fully exploits the opportunities afforded by improved pricing precision, adaptability, and segmentation? We’ve identified three important steps. Identify degrees of freedom consistent with strategy and brand. Companies must choose e-pricing approaches that do not inadvertently conflict with key strategic objectives, core business principles, or brand image. For instance, on-line price sensitivity research might suggest that lowering the price for a new product would increase sales profitably, but the price cut wouldn’t make sense if a company was trying to position the item as a premium product over the long term. Similarly, a retailer might not be comfortable pursuing a strategy in which widely different prices were offered to different consumers if that was perceived to violate an image of consistency and trustworthiness. But a bank might decide to offer substantially different prices to different customer segments on-line because consumers understand and accept that more profitable, more loyal, more wealthy customers justifiably receive better interest rates on loans. Build appropriate technological capabilities. Pursuing the right technology for optimal e-pricing does not necessarily require huge systems investments. Rudimentary tracking and testing initiatives can form a strong foundation for more sophisticated systems, if required later on. Other inexpensive tools include price-tracking software to monitor competitors’ prices and on-line surveys to track overall customer price perception. Ideally, companies should use an array of techniques to inform their pricing strategies by monitoring and responding to the behavior of customers, markets, and competitors. They can: Test pricing precision, adaptability, and segmentation on-line. Many companies have considered these three modes of e-pricing conservatively because they’re locked into an off-line mind-set in which mistakes take a long time to correct. The Internet invites a more dynamic approach in which it’s easy to conduct limited tests of alternative prices and pricing structures. These tests can indicate not only at what level to set prices but also which other variables will need to change and how often. A financial services company, for example, may realize tremendous value by changing interest rates hourly, a tactic that would require a highly automated price analysis system. But an industrial manufacturer may find that moving from annual to bimonthly price changes is sufficient. That approach would obviously require less-sophisticated systems to track the peaks and valleys of supply and demand. Develop early indicators of customer price perception. The Internet grants companies a unique opportunity to get a better handle on customers’ price perceptions and pricing indifference bands. One consumer electronics retailer, for example, used a simple on-line survey to help decide how to respond to a proliferation of competitors offering the same products at or below cost. To the managers’ surprise, only 5 % of respondents cited lower prices as their primary reason for buying from a competitor. That insight led to the decision not to engage in a price war—a move that proved correct. Within months, several pure-play rivals had either gone out of business or announced price increases. Regular surveys can give managers early signals of potential problems or opportunities. Companies can also track the “book-to-look” ratio as an indicator of customer perception. It’s possible to monitor customers’ behavior all along the purchasing process, comparing how many people visit a site with how many view and configure a product, check the price, or make a purchase. If the ratio rises above a set threshold, the time may be right for a price increase; alternatively, if it falls, it may be time for a targeted, short-term price promotion. Identify supply and demand imbalances. To take full advantage of the Internet’s flexibility, companies need to spot the shifts in supply and demand that could trigger profitable price changes. Many companies already collect this information for operational purposes, but it’s rarely passed along to the pricing group quickly enough to be useful. There is a need for greater coordination to allow pricing and marketing managers to identify these opportunities. Create an entrepreneurial pricing group. Few pricing organizations are set up to exploit the full potential of e-pricing. This is especially true of incumbent players that have only started to sell on-line; their on-line and off-line pricing strategies usually look exactly the same. Start-up e-businesses often suffer from a related problem for a different reason—they have never developed any sort of pricing capabilities in the first place. To improve on-line pricing, companies need to replace traditional pricing groups with a new, entrepreneurial pricing organization that is more strategic. (See the exhibit “Old Versus New Pricing Organizations.”) It probably should sit at a higher level of the organization than pricing groups generally do, too, so that it has the authority to experiment constantly, to change prices, and to adapt quickly to shifting circumstances. This group will be more analytical, more streamlined, faster, and more flexible. It will be staffed by people who are comfortable with the latest analytical tools and technologies. They will become expert at feeding the information they gather back to the company’s off-line channels so that those, too, can become more responsive. We don’t know of any pricing organization that does all these things correctly today—but we do know of a few companies that are beginning to move in the right direction. Old Versus New Pricing Organizations In traditional companies, pricing decisions are made intuitively and globally. But the Internet allows—and requires—companies to price with greater precision, speed, and flexibility. As pure Internet plays and traditional companies’ e-ventures struggle to become profitable, improved pricing represents a large and as-yet-untapped opportunity. By taking full advantage of the unique possibilities afforded by the Internet to set prices with precision, adapt to changing circumstances quickly, and segment customers accurately, companies can get their pricing right. It’s one of the ultimate keys to e-business success.

Price Smarter on the Net

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