Warren Buffett, billionaire CEO of Berkshire Hathaway BRK.B +%, once said, “The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business.” Buffett of course, is talking about his favorite types of companies, those with strong enough brands and business models to have a “moat” around them, allowing them to better control product pricing.
Yet according to the Professional Pricing Society, fewer than 5% of Fortune 500 companies have a full-time function dedicated to pricing. If this is in fact the case, most companies have little to no idea whether they can raise their prices without losing business to a competitor.
Investors that have spent any time delving into retail pricing know there are numerous approaches. According to MIT Sloan, pricing approaches across industries, countries and companies usually fall into one of three buckets:
- Cost-based pricing
- Competition-based pricing
- Customer value-based pricing
The Price You Get vs. the Price You Set
The ultimate goal of any company is to achieve an average unit retail (AUR) price as close as possible to the initial price that they set for the product.
Of the three pricing strategies mentioned, the one that offers the best path to realizing an AUR closest to the price you set is customer value-based pricing.
Referred to as value-based pricing (VBP), the approach uses data on the perceived customer value of the product as the main factor for determining the final selling price. Rather than trying to figure out how you can raise prices in a competitive environment, VBP asks how you can create additional customer value and increase customer willingness to pay, despite strong competition.
Two examples of companies following this approach (in part) are Under Armour UA -1.25% and Apple AAPL -2.86%. Both of these companies have strong brands and have enjoyed significant pricing power and the resultant high margins. However, I believe that both companies still are missing out on the full promise of value-based pricing.
Under Armour has successfully communicated the value and differentiation of its products through technology and marketing. While Under Armour certainly faces competition, consumers appreciate the quality of the products and are willing to pay premium prices. An example of this was the pricing of their Highlight Football Cleat. Last year it sold for $110; this year it is selling for $130. While Under Armour is succeeding in capturing the additional value of the shoe this year, wouldn’t it have been better to have known the product’s price elasticity last year in order to have set the initial price at $130?
Apple Store (Photo credit: Wikipedia)
Apple employs value-based pricing throughout its product line-up. However, even Apple is not immune to price resistance when it exceeds the boundaries of consumer expectations. When it first launched the iPhone, it was priced at $599. Apple realized the price was too high and dropped it to $399, offering store credit to early adopters. Like Under Armour, Apple eventually found the “right price,” but it could have avoided a PR nightmare had it known the true customer value before it launched the product.
MIT Sloan states that customer value-based pricing approaches are driven by a deep understanding of customer needs, of customer valuation and of forward-looking price elasticity. Getting consumers to engage in a meaningful way with a brand enables companies to understand in advance how people value a product versus simply guessing.
Today, the walls between brands and consumers are all but gone. Unfortunately, most companies still seem to be far away from using value-based pricing because they are not actively seeking the types of data that can help them understand consumer valuation. As Mr. Buffett stated, this can give you the power to understand where you can raise your prices and not lose customers.
As retailers are constantly trying to maximize profits, investors would be wise to understand the various pricing approaches employed by their potential portfolio companies. Ask yourself, how vulnerable are the companies in your portfolio to price competition? Are they in a position to achieve the highest AUR possible?