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 / Summer 2005 / Issue 39(originally published by Booz & Company)


The Right Mix for a Pricing Fix

The first alternative strategy, marginal cost pricing, offers a logical extension of open-book, full-cost pricing. It should be applied only in a long-term relationship for a small increment of capacity — and then only with absolutely clear communication of the rationale to the customer.

The open-book model ensures that the supplier’s base business has been priced for reasonable profits that can sustain the company. If a long-term customer seeks a low level of incremental work, the supplier can use marginal pricing and need not include fixed costs. Since the base business was priced at full cost, with an agreed-upon level of base volume, the long-term customer has already covered the supplier’s fixed costs. So a small amount of unplanned, incremental work can be rationally priced on a marginal basis. The unplanned business offers some incremental margin, but not an undue windfall to the supplier.

The second alternative method, opportunistic bidding, applies in short-term, transactional relationships where larger capacity increments are at stake. In such cases, yield management’s dynamic pricing algorithms do not apply. Consider a construction business for which a single pricing decision can have substantial impact on the supplier. Although such bids require a thorough understanding of cost, competitive dynamics tend to have a huge effect as well. In times of limited demand, construction companies lower margins in hopes of winning one of the few jobs available. But, when demand rises and capacity becomes tight, construction companies bid with higher margins. They know that other options probably exist if they overprice and lose the current one.

Such pricing clearly parallels the profit-maximizing logic of yield management. But, unlike yield management, opportunistic bidding does not demand sophisticated optimization models. Rather than setting a range of price points and dynamically adjusting them over time as uncertainty subsides, the company makes a one-shot pricing decision with a simple win/lose outcome. Pricing must be based on careful consideration, and a company should be wary of pricing so low that fixed costs are not covered — unless the likelihood of consuming the capacity more profitably is extremely low. Otherwise such bids could lead to the “winner’s curse”: the fate of a supplier skilled in landing undesirable, unprofitable jobs. (See “Reinhard Selten: The Thought Leader Interview,” by Matthias Hild and Tim Laseter, s+b, Summer 2005.)

Done right, opportunistic bidding has a real upside. Because the relationship is transactional rather than long-term, the supplier can extract premiums in times of high demand without fear of reprisal when demand subsides.

Mix and Match
Ultimately, most companies apply a mix of pricing approaches. For example, though airlines employ yield management techniques, they will contract for fixed fares between cities for a customer willing to commit to significant volumes. Similarly, a plastic parts supplier, like our cup-holder manufacturer, may employ open-book, full-cost pricing with a couple of long-term automotive customers that consume most of its capacity. But the same company may still use opportunistic bidding when serving small industrial companies that occasionally need plastic components.

The key is to anchor the business in an appropriate primary pricing methodology and build the capabilities necessary to implement it. If you have long-term relationships with a small number of customers, open-book, full-cost pricing probably applies best. This strategy, coupled with the ability to benchmark competitors and apply continuous improvement, helps minimize the likelihood of a re-sourcing decision by a major customer. The occasional application of marginal pricing for small, short-term needs demonstrates commitment to the relationship, which strengthens the sense of partnership, encouraging customer investment in joint improvement efforts. Taking advantage of long-term customers by adding pricing premiums in times of tight capacity — as in the yield management model — obviously contravenes the nature of an open-book partnership. Although occasional, judicious use of opportunistic pricing may be warranted, excessive use will surely strain close, long-term customer relationships.

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