It’s the question that will not die: What is the best way to maximize profits over the long term? Executives of small and medium-sized companies deal with the conundrum every day — and too frequently, their decisions are ad hoc and only loosely considered. Yet there are ways to resolve the vexing problem of pricing without agonizing on a case-by-case basis. We favor a practical framework that considers two crucial factors: the “current relationship” with the customer, and the “capacity increment” required by the order. The current relationship could be anything from a single transaction to a critical, long-term partnership. The order’s capacity increment could represent a large proportion of the company’s total capacity, or a small one.
Without even constructing a 2x2 matrix, it’s easy to see that this simple framework suggests four distinct pricing strategies:
For large chunks of capacity in a long-term partnership relationship, a supplier should apply open-book, full-cost pricing.
For small-capacity increments in transactional relationships, yield management offers greater profit.
For a small-capacity increment in a long-term relationship (a relatively rare combination), a supplier should employ marginal cost pricing.
Although it has become less common for a supplier to sell large increments of capacity in a transactional relationship, traditional opportunistic bidding remains the preferred pricing model in such circumstances.
Short or Long
You’ll notice that this framework deliberately avoids the more typical debate: Should pricing seek to recover and build profits on top of long-term fixed costs, as many business leaders believe, or should it seek marginal contributions above short-term variable costs, as many economists argue? It thus sidesteps the thorny question of which costs are truly fixed versus which are variable — and when the short term becomes long.
Real life rarely presents precise answers. For example, a company generally can break a fixed lease and pay a penalty. But this option can consume an uncertain amount of time, imposing equivalently uncertain costs, so the precise time over which lease costs are truly fixed remains elusive. “Free capacity” is a similarly unclear concept. Even when capacity utilization is below target, there remains some chance that new orders might arrive and consume the excess.
Inherent uncertainty makes it impossible to provide precise benchmarks for distinguishing short-term, variable costs from long-term, fixed costs. A pricing philosophy based on this distinction isn’t terribly useful for real-life decision making.
A more productive framing of the pricing issue asks the following: Under what conditions should a supplier ignore fixed costs? Here, the answer involves a less subjective measure of time: the form of customer relationship. In transactional customer relationships — someone needs something from you now, and you may never see that customer again — pricing decisions can be made for each order individually, without concern about setting a precedent. In long-term relationships, however, the pricing of individual orders sets expectations for subsequent orders and must be reasonably predictable.