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Name your price: is it possible to be customer-driven with pricing?

  • Type: Blog
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Retailers have talked about being customer centric for many years and, in a number of ways, retailers have seen a good degree of success in this regard.  A report just released by The Temkin Group listed grocery retailers as being amongst the most trusted companies in the country, with HEB being the most trusted of all.  Retailers like Publix consistently receive high marks from customers for providing great in-store customer service.  Retailers have also put a lot of effort into being customer-centric when it comes to their customer marketing campaigns.  But is it possible to be customer-driven when it comes to pricing?

In the first article in this series of pricing articles we discussed why pricing is a hot topic these days and provided a framework for thinking about pricing.  We also discussed three over-arching approaches to pricing: cost-driven pricing, market-driven pricing and customer-driven pricing.  In the second article we discussed cost-driven pricing in some detail and in the third article we discussed market-driven pricing.  In this fourth article we’ll discuss customer-driven pricing.

Don’t all customers want the lowest prices on everything?  The third potential approach to pricing is to take a customer-driven approach, but what exactly is customer-driven pricing? You can’t ask each individual customer what they would like to pay for every individual item, but, if you could, how do you think they would answer?  There’s probably a good chance that a portion of customers would say they'd like to pay zero dollars for all items!

But most customers are sufficiently knowledgeable about the way the commercial world operates to realize that retailers need to make a profit to stay in business, and, as such, the retailer needs to charge them something rather than nothing.  So what is the consumer psychology behind how much they’d be willing to pay for each item in a store?Don’t all customers want the lowest prices on everything?

Reasonable shoppers should say something like “I would like to pay a fair price that reflects the value of the item and that allows the retailer to provide the service that I’m looking for”.  To my mind, the words “fair” and “value” are the key parts of the previous statement and they remind me of a phrase that really resonated: “price only becomes an issue in the absence of value”.

So how do shoppers determine what is a fair price? Shoppers have a number of different criteria when they’re making a purchase decision and these criteria vary depending on the individual customer in question, which item is being purchased and the circumstances at the specific point in time. Take, for example, a bottle of water.  For a customer that is buying a 24 count of private label water price may be the main purchase criteria.  A particular customer may perceive very little differentiated value in bottled water so the key purchase decision criteria may quickly become the price.

Another customer may be purchasing an individual bottle of Evian. On a “per-ounce” basis a single bottle of Evian can be more expensive than one of the private label bottles of water contained within the 24 pack.  In this instance the customer clearly must have a different set of purchase criteria; if the decision was solely based upon price than their decision to purchase Evian would make no sense.

Would you pay $100 for a bottle of water? When shoppers find themselves in a different set of circumstances then their purchase decision criteria can also change. To give an extreme example, can you imagine a set of circumstances where you’d be willing to pay $100 for a bottle of water?  Most people when confronted with this question will often say “well, if I’d been lost in a desert for three days then I’d be happy to pay $100 for a bottle of water”.

Closer to home you can imagine situations where a shopper may have invited their in-laws or their boss over for dinner. In this case a shopper may choose to buy a more expensive cut of meat for dinner even though they could provide the same protein quotient at a lower cost per pound by purchasing a cheaper cut of meat.

Does the competitive situation impact consumer purchase criteria? Another set of circumstances that can lead to a change in consumer purchase criteria is competition density. If a shopper has a choice of various retailers within a very local geographic area then that can also impact the purchase decision criteria of shoppers but do all shoppers consider all retailers in the same light?

To talk about a real world example, think about the stereotypical customer that would shop at a Walmart versus a Whole Foods. Both are great retailers who have grown at a tremendous rate over their history and both have very different brand positions that attract shoppers with different purchase decision criteria.  When looking back at the Great Recession from 2008 to 2014, Whole Foods share price performed as well, if not better, than a number of other retailers, including Walmart, reflecting the fact that Whole Foods continued to grow sales strongly during this challenging economic time.Does the competitive situation impact consumer purchase criteria?

Which raises an interesting question: when the mainstream and trade media were full of stories about shoppers looking to save money on grocery staples how did Whole Foods manage to continue growing when their brand position is not mainly focused on low prices?

To answer this question it helps to think about the universe of all shoppers. If you look at all available shoppers, there are a portion of them that are, by their nature or circumstances, more inclined to make purchase decisions based mainly or solely on the basis of their perception of retailer’s prices; at the other end of the spectrum there are shoppers who will make most of their purchases based NOT mainly or solely on the basis of price; and then there are a large group of shoppers in the middle of the spectrum who will use a variety of purchase decision criteria that vary as a result of a number of factors.

As a result of this dispersion of purchase decision criteria across the spectrum of shoppers, some shoppers self-select into one type of retailer or another based upon the over-riding value proposition of the retailer.  This highlights the fact that retailers should not consider all customers to be the same and they should remember that individual customers may not remain the same over time and in different circumstances...especially when it comes to the role that price plays in decision purchase criteria.

How do retailers determine where to compete on the basis of price? What about the situation where shoppers have a choice between two mainstream retailers that are considered to be very similar; in this situation don’t shoppers directly compare prices because the two competing retailers are similar across all other areas of the holistic value proposition (both retailers offer similar quality, availability, convenience, service, etc.)?

In this situation price can play an important role in influencing shoppers’ decisions about where to shop and what to buy. As we discussed in the section on market-driven pricing, in repeated situations it has been found that there are a subset of items that disproportionately influence consumer price perception; it is essential that retailers are competitive on this subset of items but retailers need to ensure they understand from a customer perspective which items should be included in this subset of Key Value Items (KVIs).

Most retailers have an identified list of KVIs that they price aggressively against the competition. But if the items on the KVI list are not the items that shoppers purchase mainly or solely on the basis of price then the retailer could be competing on the wrong items.

What items should be on the retailer's list of KVIs? A frequent metric that is used to determine if an item is placed on the KVI list is sales of the item, with some retailers simply force ranking items based on total sales and then stating that the top 1000 products by sales are KVIs. Sales should be part of the overall equation but it is too simple a metric to be used as the sole KVI identification criteria.  There can be items that generate a lot of sales but are purchased mainly on the basis of quality so pricing is not a key purchase criteria for those items.

There can be other items that are purchased frequently and mainly on the basis of price but they won’t make it into the top 1000 by sales list – these items can also influence consumer price perception. And then there are frequently differences by customer segment; different customer segments within the store have different purchase decision criteria and as such you can easily have a different set of KVIs if you view the situation by segment versus overall.  Once a retailer has identified the right set of KVIs at a local level they then need to turn their attention to actually determining how to price these KVIs, which is not always straight-forward.

With all of these factors to consider, customer-driven pricing sounds like a complex undertaking but it starts with a simple premise. It is essential for a retailer to understand their brand position in the market and the needs of their core shoppers; they can then attempt to align their pricing strategy and, ultimately, their prices to deliver on their brand promise.  This then begs the question of how does a retailer determine this set of fair, customer-driven prices when an average store can have 40,000 items and the competitive set and customer set around each of several hundred or thousand stores is different?

How do retailers determine fair, customer-driven prices? It would be impractical to survey a significant number of customers within each store’s trade area and ask them what price they would like to pay on each item, so how does a retailer generate fair, customer-driven prices for all items across all stores. Surveys of shoppers have a role to play – they are a good input into the process of understanding consumer price perception and category roles but when it comes to identifying which of the 40,000 items in each store are purchased mainly on the basis of price a more scalable solution is required.Customer-driven pricing sounds like a complex undertaking but starts with a simple premise

Understanding the role of price in the purchase decision process. To really understand if price is playing a role in the purchase criteria it’s important to determine how shoppers react when the price of an item is increased or decreased. It’s also important to understand if customers will readily switch from buying one item to buying a comparable item if the relative price difference between the two items changes (note that this doesn’t require the price of the first item to change; a price change in the comparable item could cause a change in the volume that will be sold of the first item).

If we think back to our Evian bottled water example, customers are often very brand loyal to a product like Evian water and will not switch their purchase; but for the private label bottled water it would not be uncommon for customers to switch between a few different comparable bottled water brands (e.g. when a national brand of bottled water is on promotion).

No doubt there will be other factors at play over and above changes in price that will have an impact on the volume purchased but with the right analytical approach it’s possible to obtain an understanding of the impact of price across all items at the individual store level. In fact, it is possible to go one level lower and understand the impact by customer or segment within each individual store.  Factoring shopper response to changes in price into the identification of category roles and KVIs takes the retailer a whole lot closer to ensuring that they are on the path towards determining fair, customer-driven prices and taking a customer-driven approach to price strategy.

What about promotional pricing? It would be remiss at this stage to not recognize the role that promotions play in impacting consumer demand. Using the right analytical approaches it’s also possible to understand which categories/brands/items are most important to shoppers from a regular price perspective as well as from a promotion price perspective.  Some items respond strongly to changes in regular prices and others respond more strongly to changes due to promotional pricing.  This understanding can help a retailer determine if they should be more of an EDLP retailer or more of a Hi/Lo retailer…or something in-between.

Do I need a customer identifier to pursue customer-driven pricing? Given that we’ve been discussing customer-driven prices I feel it is worth taking a moment to discuss whether a retailer needs a customer identifier in order to pursue customer-driven pricing. It is sometimes assumed that a retailer must have a reliable customer identifier (like a loyalty card) if they are to pursue customer-driven pricing.  This could not be further from the truth.

A retailer can take some incredibly significant strides along the path to customer-driven pricing without any customer identifier. Operating at the store/sku/week level enables a retailer to understand customer response to prices at a very granular level – the price responses reflect the group of customers that shop at each local store and tailoring prices at this level is oftentimes a leap ahead of current pricing practices.A retailer can take some incredibly significant strides along the path to customer-driven pricing without any customer identifier.

A customer identifier can help if a retailer is looking to disproportionately invest in lower prices on specific items in order to enhance price perception with their most loyal customers. We’ve all seen headlines about a retailer investing hundreds of millions of dollars in lower prices, but it then usually falls to a pricing or category team to determine exactly which items should receive these investments in lower prices.

In this case being able to understand how different customers or segments respond to lower prices could lead the retailer to select one item over another. For example, item A may generate a 15% increase in volume for a 10% price decrease whereas item B may experience a 12% increase in volume for the same decrease.  But if most of the volume increase for item A comes from cherry-picker customers whereas most of item B’s volume increase comes from loyal customers then the retailer may choose to lower the price of item B rather than item A.

It does have to be said that if a retailer wants to take the extra step of tailoring prices to their most loyal customers or to pursuing price personalization then a customer identifier is required but we’ll address this topic some more in a later article in the series.

Is customer-driven pricing a silver bullet? When I think about retailers being successful in a sustainable manner I often come back to an age-old mantra:

"The retailers that best satisfy the needs of customers will win"

If you believe the previous mantra then it follows that retailers should be as customer-centric as possible across as many components of their holistic value proposition as possible, including with pricing. When I talk to category and pricing teams they will often agree with the concept of customer-driven pricing but when confronted with day-to-day operational realities they often fall back into adopting a cost-driven or a market-driven approach.

Isn’t it too difficult to execute customer-driven pricing? Anyone that has spent any time working with category teams will find these operational realities to be understandable. While I don’t believe that retailers should let "the perfect be the enemy of the good" and attempt to be purists when it comes to customer-driven pricing I also don’t believe that they should accept defeat in pursuing a more customer-driven pricing approach.

From a strategic pricing perspective retailers need to ensure they are determining a large portion of their prices by employing customer-driven pricing. In between setting prices using a strategic, customer-driven approach retailers can cut their category teams a little slack and allow them to manage and maintain prices using some intelligent aspects of cost-driven and market-driven pricing.  But they should always ensure they return to the right path by re-asserting customer-driven pricing at strategic points throughout the year.

All of this may sound a little complex and we’ll address how to manage those complexities in a subsequent article but for now we’re going to turn our attention to another topic. Earlier in this article we raised the topic of EDLP and Hi/Lo, so lets take a look at where these two traditional pricing strategies fit in with the cost-driven, market-driven and customer-driven approaches.

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