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Want to increase profits? It’s simple: Charge more.

I’m currently reading the book Smart Pricing by Jagmohan Raju and Z. John Zhang. Anything published by Wharton School Publishing has been thoroughly researched and applied in the real world of work—beyond the ivory tower of theory and abstraction often associated with academia.

In the book’s introduction, the authors present a simple concept: “A manager can pull only four levers to increase a firm’s profitability: sales, variable costs, fixed costs, and price.” If he spends more on advertising to gain market share, then he’s pulling the sales lever. By reducing hours to schedule and lowering payroll costs, he’s pulling the variable cost lever. If he’s able to negotiate better lease terms on space, vehicles, or equipment, then he’s pulling the fixed cost lever. The fourth lever, price, is pulled whenever prices are adjusted.

Though only four levers exist, there are some economic probabilities and consequences to consider that make the manager’s choice of levers more like a chess match. Conventional wisdom suggests that, in a soft economy, the most effective way to preserve profits is to reduce costs. With shrinking demand, increased competition, or both, most companies look to reduce their biggest expense: payroll. This results in the furloughs and layoffs we’ve been reading about (or experiencing personally) for the past several years…

Increasing sales is an attractive option but may be hindered by firms choosing to reduce their sales forces and/or marketing expenditures. And who really wants to tamper with pricing in such an uncertain economic environment?

I was surprised to read that the authors’ analysis found “that if a firm can cut its fixed costs by 1% without affecting its operations, its profitability can increase, on average, by 2.45%. Similarly, if a firm can increase its sales by 1% without changing its cost structure or price, the firm’s profitability can rise by 3.28%. The effect of lowering the variable cost by 1% is larger: Profitability can increase 6.52%. However, the effect of improving a firm’s price by 1% is the largest of all: 10.29%. Remarkably…this effectiveness ranking order holds for each of the eight industry groups using the standard industry classification (SIC) scheme.”

In my last blog post, I referenced a number of studies on the relationship between superior customer service and profitability. The latest study, by American Express and Echo Research, compiled research that revealed American consumers are willing to spend, on average, 9% more with companies that provide excellent customer service.

Do you see where this post is heading?

If companies took steps to improve the customer experience, then customer satisfaction would likely improve. Studies show that customers are willing to spend more with companies that provide superior customer service. And research finds that by adjusting the price lever and improving prices by only 1%, companies can increase profitability by 10.29%.

Companies with subpar customer service: It’s your move.

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This entry was posted on Friday, August 27th, 2010 at 11:08 am and is filed under Customer Service, Employee Engagement, Enthusiasm at Work!. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

  • http://iterativepath.wordpress.com Rags Srinivasan

    Steve
    The work done by Echo research is a poll – which can only find respondents attitude and not behavior. It is rife with many of respondent biases as well (e.g., people are inclined to say to a poll taker what they think the latter wants to hear). One cannot make willingness to pay or willingness to spend estimates from polls like these. we need more rigorous analytical methods that try to measure revealed preferences or test markets. So the 9% number is an overestimate at best.

    The Echo research looks at Geo segmentation but fails to take into account what the segmentation is within each Geo (e.g, Psychographic, needs based, product specific and buying behavior based segmentation). We need to know the segments to which customer service is important and deliver at a price they are willing to pay. We cannot deliver Nordstrom service at WalMart prices to all segments. Certain minimum level of service is like hygiene, required but we cannot say more of it is good.

    I disagree with this post’s conclusions and the overarching recommendation.

    Regards
    -rags

  • http://www.stevecurtin.com Steve

    Rags, it’s refreshing to see that someone other than my wife disagrees with me… I appreciate your willingness to share contrary views. It forces me to question some of my own assumptions. That said, I stand by this post. Even if the Echo Research conclusions were overstated, there’s a broad margin between a firm’s 1% increase in price and a consumer’s willingness to spend 9% more with companies that provide excellent service. I do believe the Echo Research findings (as well as those of the ACSI, J.D. Power & Associates, and PeopleMetrics presented in this post) are directionally accurate if not absolute. And while I don’t expect Nordstrom service at Walmart, there’s no reason why Walmart employees cannot deliver it. After all, what makes Nordstrom service legendary? Its returns policy (remember the snow tires?). Other than that, while you’re shopping in its stores, the only other service advantage is the salesperson’s tendency to smile, make eye contact, and add enthusiasm to his or her voice. Even Walmart is capable of matching Nordstrom’s service quality in these areas. When I think of my personal willingness to spend more with companies that have provided me with excellent service in the past, I immediately think of Tiffany & Co., Caesars Palace Las Vegas, and Hayward’s BBQ in Overland Park, KS. I am loyal to each of these companies and promise you that price scrutiny does not enter the equation when I purchase from them. Are their prices 9% higher than a competitor’s? Probably much more. Do I care? No. Am I rich? No. Am I willing to pay more for excellent service? Yes. And, I suspect, so are you.

  • http://iterativepath.wordpress.com Rags Srinivasan

    Steve
    The 1% price increase is a mathematical artifact, by plugging in the numbers in margin calculations. It is not a result derived from marketing research. (at the risk of being seen as plugging my link, here is an old post of mine on 1% fallacy http://iterativepath.wordpress.com/2010/06/06/the-1-price-increase-fallacy/ )

    We all love narratives and especially love those from Nordstrom, Trader Joes etc. But narrative fallacy biases towards focusing on extremes and ignore what is really possible for the rest of us.

    You make a good point about how you and I prefer better service and I agree. That brings us back to my previous comment, segmentation. Not all segments value the same and a marketer cannot be all things to all segments (or worse same thing to all segment). They have to make choices. What would have been useful is of Echo research surfaces some of these segmentation variables instead of stating averages.

    Wouldn’t it be lot more effective to know who really value experience and target them with versions at prices they are willing to pay?

    Regards

    -rags

  • http://www.stevecurtin.com Steve

    Rags, my previous employer, Marriott, had 17 different lodging brands when I retired from the company in 2006. Each brand had its own unique pricing strategy, competitive set, customer profile, etc. At that time, all 17 brands were spread across four different pricing tiers (i.e., economy, moderate, quality, and luxury) and segments (i.e., select service, full service, extended stay, and vacation ownership). To your point, Marriott could research the percentage premium a customer within a certain segment is willing to pay for excellent customer service. My hunch is that there would be less willingness to pay a premium for superior customer service by customers in the economy/select service segment (e.g., Fairfield Inn) versus the luxury/vacation ownership (e.g., The Ritz-Carlton Destination Club).
    Pricing is fascinating and I recognize that it’s more complex than simply adding an arbitrary percentage to an existing price. That approach can easily backfire – especially if nothing of consequence has been added to the value proposition as perceived by the customer. I recall reading last year that, according to Standard & Poor’s, 72% of Americans are willing to pay more for a differentiated brand. One area where brands can differentiate themselves from competitors is customer service quality. Zappos is a great recent example of this. They do not offer the cheapest prices on shoes, for example, but they do have a reputation for providing superior customer service.
    I wonder what portion of its sales price premium Zappos attributes to superior customer service? Maybe Tony Hsieh or Alfred Lin will chime in?
    Rags, thank you for your comments, for introducing me to your blog, and for investing so much energy into the science of pricing – which, when you consider the importance of value for price paid, is a critical component of overall customer satisfaction.