Tag: Price

A Word About Pricing

I was going to write about the control of marketing risk this week but I am going to postpone that for a week.  Instead I want to talk about a pricing trap many businesses seem to fall into, commoditisation.

I was speaking to a local agricultural supplies firm during the week and noted that they didn’t have any prices on their business to business websites.

Their response was as follows:

“We don’t put prices on our business to business website because we have really complicated pricing structures and in any case, if we displayed our prices, our competitors would deliberately undercut them in an effort to drive us from the market.  Our competitors can withstand selling at below cost better than we can.”

UK law in relation to pricing, The Price Marking Order 2004, does not apply in the case of business to business transactions.  Sot there is no legal duty on a business who only sell to other businesses to display prices.  However, if a business is willing to sell goods to a consumer, a full VAT inclusive price indication must be displayed.  For goods sold loose from bulk, or for goods sold required to be sold with an indication of quantity; in ‘large’ retail premises; a unit price must also be shown.

The Business Protection from Misleading Marketing Regulations 2008 states that there must not be false or misleading statements in business to business transactions including in relation to price or the method of calculating price.

it is also worth remembering that under UK law, a price indication is not an offer to sell, it is an invitation to treat, or in Scotland, a willingness to enter into negotiation.  A price indication is therefore not a fixed determinant of final price and traders are free to discount or treat customers on an individual basis.

So if business to business traders are not required to show price indications, why was I surprised not to see them on the company trade website? (the company also had an e-commerce site where bot VAT inclusive and VAT exclusive prices were shown)

I suppose it was because, as a marketer, I am aware of what an important element of the marketing mix price is and how price transparency is an important factor in relation to building trust with your customers.

I am also aware that many firms have now abandoned complex special offers and discounting schemes and replaced them with simplified pricing structures and more fixed pricing strategies.  An example is Asda Walmart’s ‘everyday low prices’ policy and B & Q are currently advertising ‘new lower prices’ whilst reducing the number of special offers in store.

The comments by the company I visited about the possibility of a price really astonished me.  They were in direct contradiction to what I have been taught as a marketer and represented an outdated view of retail as one of selling commodities at the lowest price.

Levitt stated that there are no  such things as commodities, goods sold at the lowest price and where price is the only determinant of purchaser choice. As a result, there is no such thing as commodity marketing.

So:

  1.  Commodity markets are not a foregone conclusion
  2. Commoditisation is not outside a firm’s control
  3. If others are reducing prices you do not have to follow
  4. Continual price reduction is not an immutable law that you must follow
  5. Customer’s do not buy on price alone
  6. You are not serving your organisation, or its stakeholders, if you allow prices to continually slide – even in an effort to retain market share
  7. Lemmings are not the brightest animals
  8. If the market price, and the profit pool available, collapses on your watch, and you reduce prices to match that collapse, you are at fault.  You have got sucked in to an ever downward price spiral.

You have to look out for phrases such as, reducing prices, becoming more competitive and employing aggressive pricing strategies.  These may mean that you are actively pursuing a route to commoditisation and failing in your duty to maximise returns for stakeholders.  You may have entered a commodity slide where you move from a highly differentiated brand market to a commodity market where all competitors offer the same products at the same price.

As Paul Fifield states in his book Marketing Strategy, you are on a continuum from ‘Brand to bland’.

Think of markets which may have once been considered as commodity markets.  My mind immediately goes to utilities such as gas, electricity and water.  Are these products sold as commodities today?  Are all the companies operating in these markets offering the same pricing structures?  The answer in no.  Utility firms now offer customers a range of pricing options.  They market their products not only on the delivery of the goods, they bundle that delivery with a product halo of brand promises, customer service, maintenance products, insurances and guarantees.

If price is the only difference in your market offer, then that is the only thing affecting customer choice.

It is common for boards dominated by financiers to become overly focused on price.  They will argue that the firm must pursue a cost focus strategy to gain market share.  They ignore Porter’s other generic strategies of niche and differentiation.

The most recent example of a board following a small margin, lowest bid strategy is Carillion; and we all know where that strategy lead.  It is no accident that the CEO of Serco, one of Carillion’s main competitors keeps a toilet brush on his desk.  It is to remind him not to bid on any contract where the mark up was less than 6%, the standard margin for an office cleaning contract.

Where a board is overly fixated on price, you enter the self-fulfilling prophecy of commoditisation.  You are on the downward slide to the dreary and depressing end of the market.

Marketing scientists have carried out extensive research into consumer attitudes to price.  This research confirms the segmentation model expressed by Professor Malcolm Macdonald in his seven farmers model developed for ICI Agrichemicals.

What the research shows is:

  1.  In developed markets, 90% of customers prefer to buy on non-price value issues.
  2.  In developed markets, 10% of customers will buy on price because they care little about the product category.
  3. In undeveloped markets, a large proportion of customers (about half) would like to buy on the basis of non-price value issues.
  4. In undeveloped markets, a proportion of customers appear to want to buy the cheapest option but their latent needs have not been identified, explored or met, by suppliers.
  5. In undeveloped markets, about 10% of customers will buy on the basis of price because they care little about the product category.

So in both developed and undeveloped markets, only around 10% of customers are driven by price.

In Macdonald’s seven farmers segmentation, his customer profile of a price driven customer, Arthur, made up about 7% of the market for agricultural fertiliser.

If you are operating solely on the basis that you sell a commodity in a commodity market, your focus is that you must be able to produce at the lowest cost.  If you only aspire to be the lowest cost producer; or you assume that you are the lowest cost producer; your chances of success are nil.

In commodity markets, only the producer with the lowest cost base will survive.

It is a mistake to assume that you operate in a commodity market or that your consumers are only interested in price.  You have the whole marketing mix at your disposal and you do not need to follow the market like a lemming.

It is also a mistake to assume that your competitors will always look to undercut you on price and that they are willing to start a trade war.

Selling at below the market floor price:

  1.  Breaches a board’s duty to maximise returns for stakeholders.
  2. Will affect all players in the market, not just one firm you are trying to drive out of business.  Such actions may lead to retribution from competitors that the aggressively pricing firm cannot withstand.

Most importantly, aggressive pricing strategies can be negated through the other elements of the marketing mix such as product, promotion, place, physical evidence, process and people.

 

 

 

Carillion: Script for an Outsourcer’s Tears

The news headlines over the last week were dominated by the collapse of Carillion, the civil engineering and public service outsourcing firm.

Carillion began as a civil engineering and construction firm but diversified into public service provision.  It held major contracts with local authorities and national governments.  It was involved in major PFI projects to build schools and hospitals.  It built roads and was a major contractor in the HS2 high-speed rail project.  It ran prisons and provided school and hospital catering.

The collapse of Carillion also opens a wider debate into the way public services are outsourced and the business practices of outsourcing firms.

So what went wrong with Carillion?

The answer was that the firm’s directors pursued an extremely risky growth strategy and they forgot the principles of contract bidding.  Getting the contract for cash flow was more important than ensuring sufficient profit margin.

A few years ago, Carillion was a star of the stock market.  It’s share price was high and the company was offering attractive dividends.  However, not everyone in the city was convinced of Carillion’s merits and several hedge funds bet against the firm.  Carillion’s collapse has proven those fund managers right as successive profit warnings were issued and the share price collapsed.

The hedge fund managers betting against Carillion saw the firm for what it was, a form of outsourcing Ponzi scheme.

A Ponzi scheme is named after the American fraudster Charles Ponzi and it is a form of ‘long con’.  It is an adaptation of a pyramid scheme.  A Ponzi scheme is a form of investment vehicle which offers incredibly attractive returns.  Investors may be told that their money will be doubled in a relatively short time.  The scheme then relies on the exponential attraction of new investors.  Money gathered from new investors is used to pay the returns to existing investors.  However, as exponential growth in investor numbers is required, soon there simply aren’t enough new investors to keep the fund going and to pay the investors the promised income.  Unlike a traditional pyramid scheme, which tend to collapse very quickly, a Ponzi scheme can stave off collapse by getting existing investors to put in more money.  But the truth is that it is inevitable a Ponzi scheme will collapse.

The last instance of a Ponzi scheme was the investment fund managed by Bernie Madoff.  This scheme lasted for several years and attracted a number of high-profile celebrity investors.  For many years, Madoff was seen as a financial wizard.  His investment products were seen as highly successful.  However, When the fund ran out of money it collapsed leaving a number of its high profile clients significantly out-of-pocket.

Here there is a parallel with Carillion.  For years the stock market saw the firm as a success.  Only when its need for exponential contract growth could not be met, did its collapse became evident.

Carillion’s business model was to gain as many infrastructure projects and public service contracts as possible.  This meant it was often the low bidder.  The business model didn’t properly account for the price element of the marketing mix.

The first error in Carillion’s pricing strategy was not to properly account for project over runs and unforeseen costs.

It is normal practice for such issues to be properly accounted for in project bids.  As long as projects went ahead with no issues, Carillion could meet its cost expectations.  However, as the company grew it offered low bids on projects which were subject to long delays.  The company also did not account for delays in payment.  This resulted in the firm building up large debts as it had to borrow to cover running costs.

The CEO of another outsourcing firm, Serco, has a toilet brush sitting on his desk.  The brush is a reminder that his firm should not bid on any public service contract where the profit margin is less than 6%.  This is the minimum mark up on the services of an office cleaner.  Carillion were regularly bidding on contracts where the profit margin was far lower than 6%.  If anything went wrong with those projects, Carillion was left out-of-pocket.  And things went wrong.

By under-bidding on contracts, Carillion’s reputation was also damaged.  When I worked in a local authority, many colleagues held the view that Carillion were a ‘bit crap’.

Carillion got to the stage that any income it made was going to pay off its bank borrowings.  The company also had a significant pension black hole.  It is estimated that Carillion had £29 million in bank deposits but that the company’s debt and pension fund shortfall was £3.1 billion.

As a Ponzi scheme runs out of potential investors, there simply weren’t enough new infrastructure and public service contracts in the market for Carillion to meet its debt repayments.  The banks pulled the plug.

Some of the blame for Carillion’s collapse must be laid at the door of the company’s non-executive directors.  It is their job to act as a critical friend to the business; warning management that policies and strategies were dangerous and presented unacceptable risks.  It seems that Carillion’s non-executive directors were ignored by management or that they did not take proper cognisance of their functional role.  Clearly, the management of Carillion were allowed to carry on with a high risk business strategy that was doomed to fail.

So what lessons are there for SMEs from the Carillion collapse.  The first is that if you are in a contract bidding process, always build in a cost factor for delays and late payment (overrun costs).

Secondly, know you’re market and what is acceptable in terms of margin: don’t be fooled into the belief that it is always the low bidder who gets the contract.  If necessary, use a ‘more for more’ strategy which bundles in additional service features for relatively low-cost additions.  The secret to a ‘more for more’ strategy is to bundle in features which are greatly valued by your prospective customer but which cost little additional cost to your firm.

For example, a landscaping firm I know recently bid for a grounds maintenance contract.  The contract went to a competitor. There was little difference in price between the two bids but the competitor offered detailed seasonal planting schemes on top of the grounds maintenance work.  These schemes cost next to nothing to prepare but it offered additional services which were valued by the client.

Finally, when bidding for a contract do not use simple cost-plus accounting to set your price.  Instead combine the bid price with the probability of achieving the contract.  An example:

A builder is bidding on a contract to build an extension to a house.  The cost of the extension is £10,000.  The trader knows that if they offer to complete the job at cost, there is a 100% probability of getting the contract.  If a 3% profit margin (£300) is applied, the probability of getting the job is 90%.  If a 6% profit margin (£600) is applied, the probability of achieving the contract falls to 80%.  If a 15% margin is applied (£1500), the probability of success falls to 18%.  A 20% margin (£2000) means that there is zero probability of the contract being awarded to the firm.

So:

£0 multiplied by 1 = a notional margin of £0

£300 multiplied by 0.9 = a notional margin of £270

£600 multiplied by 0.8 = a notional margin of £480

£1500 multiplied by 0.18 = a notional margin of £270

£2000 multiplied by 0 = a notional margin of £0

So in the above simplistic example the best combination of profit and probability of bid success is to offer a contract price which includes a 6% profit margin and an 80% probability of bid success.

The standard graph of notional margin sees a gradual fall in the probability of a contract being awarded as the margin increases.  However, eventually there will be a sharp fall in the probability of a contract being awarded as the cost exceeds the expectations of the market.