Purchasing and Negotiation Training

Robert Menard, Certified Purchasing Professional, Certified Professional Purchasing Consultant

Editor’s note: This is Part 1 of a two part series; it presents the first four of eight popular pricing strategies.  Part II presents the second four. 

The Cost/Price Myth says that Price is related to Cost.  Make anyone who says that prove it.  As Ronald Reagan liked to say, “Trust, but cut the cards”.  This should be part of every negotiation.  Whenever someone says, “Higher Price means greater value,” or “You get what you pay for,” think of mandatory Price Analysis.   

Ask ten people how a price is established and nine will say that the supplier takes its cost and adds a percentage for profit.  That percentage may vary, depending on market conditions, and other factors, but basically Price is considered to be computed as some multiple of cost.  We will use 10% for simplicity.  If the supplier’s cost is about $0.90-$0.91 per unit, then a 10 % profit means that the Price should be $1.00 each.  

There is a good reason why buyers have been trained by sellers to think in this cost plus percentage mode.  The seller has a ready answer to the buyer’s price reduction demand.  “Look”, the salesman can offer flatly, “I cannot possibly reduce the Price because I have so little on it now!” 

 The origins and evolution of prices is usually not quite as simple as the cost plus percentage chestnut might suggest.  One of our first tasks in negotiation is to ascertain how Price is established.  This process is called Price Analysis.  The following list comprises the eight most popular strategies for pricing of products andservices.  We will examine each for their negotiation value.  

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Eight Popular Pricing Strategies 

• Cost plus a mark up
• Survival
• Target
• Traffic
• Revenue Management
• Yield Management
• Perceived Value
• Optimization

 Cost plus a mark up 

This is the by far the most predominant of pricing strategies and for good reason.  Many products and services have been around for a while and may have lost unique character.  Expiration of patents and emergence of competitive and/or replacement products are two illustrative reasons.  Any mature product or service in a mature market probably falls into this category.  Portland cement, high heel shoes, thermo set plastics, laundry detergent and automobiles are common examples with which we can easily identify.  In these markets, the bloom has long fallen from the rose in terms newness, mystery, and applicability.  Stated in another fashion, these products and services no longer lend themselves to exotic forms of pricing.  The buyer has extensive experience and knowledge of the product and market and thus the range of Price is relatively constrained.  

As a product or service matures over time, market equilibrium sets in and the price truly becomes related to the cost as margins become regular and costs are managed better and buyers and sellers settle into a comfortable cost plus percentage mode. 

Survival 

Many are familiar with this pricing strategy that results directly from competition, usually in the form of a lower cost supplier, in the market place.  A good example is Southwest Airlines.  They have made low cost reliable air transportation their hallmark.  No frills, usually timely, and certainly a challenge to their competitors, they caused huge ripples in the market when they expanded nationally in the 90’s.  

Southwest’s low cost structure translated directly to lower priced air fares, which upset the pricing systems of competitor airlines.  Fare prices of the larger national competitors fell to meet Southwest’s market challenge and had no relationship to the costs.  Rather it was a matter of survival.  If Southwest could capture market share with low prices, then they might be able to capitalize on connecting flights and that would seriously threaten survival of the hub and spoke airlines. 

This pricing strategy can be dangerous for buyer as well as seller, particularly if the price is driven too low.  The supplier might not stay in business, and the buyer might induce Robinson-Patman (link) problems in the purchase of goods.  

Target 

Target pricing might not be obvious to the buyer who may even think that it is something she has done to deserve preferential treatment.  More likely, the buyer has nothing to do with the supplier’s pricing.  The pricing depends upon a strategic decision by the supplier to capture a market segment. 

 Suppose that you are a school book publisher.  Your ideal customer is a school district that buys 1,000,000 books annually.  Assume further that you want to neutralize certain aggressive competitors who have been nipping on your heels, cutting into your customer base. 

 An effective strategy for corralling the best prospects while icing competitors may be to target certain customers who appeal to your strengths, produce the greatest return for the least investment (cost) and who can bring you other customers as a result of your low priced sales initiatives.  Meanwhile, the seller is mining every opportunity to generate future business from similar customers.  The seller approaches similar customers with verifiable success stories of how you, a very similar customer, has been well served and thus should join you as another preferred customer.  The seller’s motivation could be customer size, industry, location or other factors.  The point to keep in mind is that this is a common pricing strategy and one that needs to be identified by the buyer as a negotiating tool.  

Traffic 

We have all heard about “what the traffic will bear” as a pricing strategy.  That usually means that the seller is gambling that the market is good and therefore the law of supply and demand swings in its favor.  This strategy is merely a variation of the cost plus percentage mode as a ‘normal’ markup is augmented by a premium to reflect market conditions.  The science of economics predicts this swing, of course, but as with so many factors in negotiation, economics may not tell the whole story.  Might the supplier have other motivations?  What about the salesperson in front of you who wins the contest for a trip to Hawaii if she makes this next sale to you.  Supply and demand, margin, and even pride all fade in the glow of making this sale. 

 Once in my home neighborhood, we had a door to door newspaper subscription hawker who was offering coupons at a local restaurant if we would subscribe to the paper.  It did not matter if we actually paid for the paper after the test free period as long as he got credit for writing the subscription and we did it now.  Feeling suspicious, I phoned the paper.  A helpful but naïve fellow explained that the two local competing papers were being audited.  Higher subscription counts bring higher advertising rates.  So my subscription Price, whether I continued or not, had nothing to do with the paper’s costs.  Sometimes, this Traffic strategy is not all that it seems.

Part II discusses the four pricing strategies of Revenue Management, Yield Management, Perceived Value, and Optimization