Confessions of the Pricing Man by Hermann Simon

The Book in Three Sentences

Ultimately, profit is the only valid metric for guiding a company and there are only three ways to influence profit: price, volume, and cost. Of these three factors, prices get the least attention, but have the greatest impact. The price a customer is willing to pay, and therefore the price a company can achieve, is always a reflection of the perceived value of the product or service in the customer’s eyes.

Confessions of the Pricing Man summary

This is my book summary of Confessions of the Pricing Man by Hermann Simon. My notes are informal and often contain quotes from the book as well as my own thoughts. This summary includes key lessons and important passages from the book.

• Never run a business in which you have no influence on the prices you charge.
• I don’t think much of a business that doesn’t make money.
• Prices determine how much money you make.
• Pricing is about how people divide up value.
• The value we perceive changes as the product ages.
• A business team may have many viable options, but can choose only one. These decisions involve so many factors and face so many market dynamics that black-and-white certainty is rare.
• Prices are the central hinges of a market economy. Think about it: every dollar of revenue and profit that a company generates is the direct or indirect result of a price decision.
• How much does one minute cost on your mobile phone plan? How much do you pay for 1 kWh of electricity? How much does your daily commute cost you? It is hard to answer these questions spontaneously, because for many goods and services, prices have many dimensions.
• There is always one “right” price or price structure and a multitude of “wrong” ones.
• The Russians have a saying which sums this up: “In every market there are two kinds of fools. One charges too much, the other charges too little.”
• People have asked me thousands of times to name the most important aspect of pricing. I answer with one word: “value.”
• The price a customer is willing to pay, and therefore the price a company can achieve, is always a reflection of the perceived value of the product or service in the customer’s eyes.
• When a company tries to figure out the price it can achieve, only the subjective (perceived) value of the customer matters. The objective value of the product or other measures of value, such as the Marxian theory that value is defined by the human labor time invested, do not matter intrinsically. They matter only to the degree that the customer thinks they matter and is willing to a pay a price in return.
• Expectations about how the value lasts will have a decisive influence on a customer’s willingness to pay for luxury goods, consumer durables, and cars.
• The process of price setting begins at the conception of the product idea. A company must think about prices as early and often as possible in the development process, not just after a product is ready to launch.
• As the French say, “ le prix s’oublie, la qualité reste.” Loosely translated, that means that the quality you bought endures long after you have forgotten the price.
• Better be cheated in the price than in the quality of goods.
• I learned that good advice is not expensive. It is quite affordable, if you can recognize its value.
• Offering true value is a necessary but by no means sufficient condition for success. Far too often I have heard managers claim that if you make a good product, it will sell itself.
• The only fundamental driver of willingness to pay is the perceived value in the eyes of the customer.
• Two of the most powerful intangible benefits we willingly pay for every day are convenience and peace of mind.
• Whenever possible, you should try to communicate value using hard data, especially in a business-to-business situation.
• In economic terms, the most important role price plays is in creating a balance between supply and demand.
• These assumptions about rationality and information first came into doubt through the work of Herbert A. Simon1 (Nobel Prize, 1978). In his view, people have only limited capacity to absorb and process information. For that reason, they do not strive to maximize their profit and their utility. Instead, they content themselves with a “satisfactory” outcome. He coined the term “satisficing” to describe this behavior.
• This reinforces a key lesson in this book: you need to know what your demand curve looks like, the more precisely, the better.
• Price is likely to serve as an indicator of quality when buyers are uncertain about a product’s underlying quality. This happens when they are confronted with a product that is entirely new to them or one which they rarely buy.
• In one test, study participants received a pain reliever at different prices. One group saw a tag with a high price, and the other group saw a low price. Without exception, the participants in the high-price group claimed that the pain reliever was very effective. In the low-price group, only half of the participants made that claim. In both cases, however, the pain reliever was actually a vitamin C placebo, which has no objective ability to relieve pain.
• When buyers know neither the price range of a product category nor have any special requirements (e.g., high quality, low price), they gravitate toward a price in the middle of the range.
• The less a buyer knows objectively about the quality of the products and prices in an assortment, the stronger the pull of the “magic of the middle” will be.
• One of the cleverest tricks to boost sales is to create the perception of scarcity.
• We have observed time and again that the introduction of additional alternatives can significantly increase sales and shift demand toward higher priced products.
• A price threshold is a price point which triggers a pronounced change in sales whenever it is crossed.
• The most important argument for the existence of odd prices is that customers perceive the digits in a price with decreasing intensity as they read from left to right. The first digit in a price has the strongest influence on perception; that is, a price of $9.99 comes across as $9 plus something rather than $10.
• My own findings show that it makes no sense to set prices at $9.90 or $9.95. If you want to remain below a price threshold, then you should set your price as close to the threshold as possible, which means $9.99 in this case.
• The pain we feel from a loss is greater than the happiness we feel from a gain, even if the magnitude of the loss and gain themselves is equal.
• It is particularly advisable for people with limited financial means to use cash payments as a control mechanism.
• When we receive our monthly statement and see that long list of transactions, the effect of any individual transaction gets watered down. This also hurts less.
• The standard way of expressing a price—for example $16.70—causes a pronounced response in the brain’s pain center. The response is weaker, however, when the respondent only sees 16.70 and the dollar sign is omitted. Apparently the brain does not immediately perceive that number to be a price. The activation of the pain center is even weaker for a round number, such as 17.
• A high margin results only in high profit if you achieve a sufficient gap between price and costs. That is not a trivial observation.
• Even when a company does achieve high margins, it still needs to sell enough units to make a high profit.
• Premium pricing means offering higher value and demanding a premium price in return.
• Gillette practices premium pricing of the best kind: creating value through innovation, communicating that value, and then extracting it with premium price
• Superior value is a must: Premium pricing will work over time only if a company offers superior value to customer.
• Innovation is the foundation: In general, innovation provides the foundation for a successful, sustainable premium price position. This applies to groundbreaking innovations as well as continual improvements, such as Miele ’s under the motto “Forever Better.”
• Consistent, high quality is a must: This prerequisite comes up time and again. Successful premium suppliers maintain high and very consistent quality levels. Their service must also meet the same requirements.
• Premium pricers have strong brands: One function of these strong brands is to transform a technological advantage—which is often temporary—into a long-lasting image advantage.
• Premium pricers invest heavily in communication: They know that they have to make the value and advantages of their products perceptible and understandable to consumers. Remember: only perceived value counts.
• Premium pricers shy away from special offers: They are hesitant to offer promotions and special offers. If the promotions they offer are too frequent or too steep, these instruments can endanger the premium price position.
• The key secret to the art of pricing luxury goods is mastering “limited editions.” The supplier must strictly abide by its own limit; otherwise it risks losing its credibility and reputation. The limited number of units determines the scarcity and thus the value of the luxury good.
• Watches manufactured in Switzerland represent just 2 % of the world’s annual watch production. Yet on the back of this tiny volume, the Swiss watches altogether account for an incredible 53 % of the global watch market on a value basis.36 The difference between their volume-based market share (2 %) and their value-based market share (53 %) is dramatic.
• When a customer pays a very high price for a product, he or she expects that the product will hold its value.
• Their research revealed two success guidelines, which they referred to as “better before cheaper” and “revenue before cost.”
• These interesting findings imply that the share of companies which are successful with a premium price strategy is greater than the share of companies which have achieved sustained success with low-price strategies.
• “Very rarely is cost leadership a driver of superior profitability .”
• After 40 years in the pricing game I am convinced that only very few companies will achieve long-term success with a low-price strategy.
• Profit is ultimately the only valid metric for guiding your company. The rationale is simple: profit is the only metric which takes both the revenue side and the cost side of a business into account.
• “Profit is a condition of survival. It is the cost of the future, the cost of staying in business.”
• Price setting requires a thorough understanding of two things: how your customers perceive your value and the profit level you need to sustain or improve that value.
• The reality in almost all companies is that goal setting is not an “either-or” exercise. Balance is paramount. The central problem is that most companies are not balanced.
• This means that every business has only three profit drivers: price, volume, and cost.
• Prices get the least attention, but have the greatest impact.
• The obsessive pursuit of the wrong goals—customer counts, revenue, and market share —leads even the sharpest managers to neglect the effects that discounts and promotions have on profits.
• Price is the only marketing instrument you can employ with no upfront investment. This makes it an especially powerful marketing tool for small business or start-ups with tight financial resources.
• Sellers have some leeway in setting prices. This leeway can be substantial if the product is innovative or even unique.
• “Pricing is guesswork. It is usually assumed that marketers use scientific methods to determine the price of their products. Nothing could be further from the truth. In almost every case, the process of decision is one of guesswork.”
• All paths to profit begin with price.
• This is an important insight. It means that it is not the end of the world if you don’t have the optimal price figured out down to the last decimal place. It is more important to be in the right vicinity.
• If your product delivers 20 % more value than the competitors’ products, you should collect 10 % of that difference in price. If you demand more—or demand it all—the customer actually never gets to enjoy the difference in value. If your value difference is 20 % and your price difference is 20 %, the customer comes out of the deal empty-handed despite the greater value you provide. You offset the entire advantage for the customer by setting the product’s price too high
• Past market data has very limited relevance for predicting future behavior
• George Stigler, who won the Nobel Prize in economics in 1982, claims that price leadership is the best solution for companies in a highly competitive oligopoly
• We can see from these comparative graphs that one uniform price —even when set optimally—exhausts only part of the available profit potential in the market.
• A prerequisite for optimal price differentiation is detailed knowledge about the buyers’ willingness to pay
• When a seller packages several products together and charges a total price less than the sum of the individual product prices, it is called price bundling. Bundling is a very effective way to differentiate prices.
• Sellers should choose incremental discounts whenever possible. For buyers the opposite advice applies. They should ask for full-volume discounts. In other words both buyers and sellers should focus not only on the percentage of discount they receive, but also the structure of the discount.
• “Big Data,” the analysis of large amounts of data about transactions on an individual basis, opens up fantastic new opportunities for person-specific price differentiation. Interesting here is the question of whether consumers should occasionally order a very inexpensive product, in order to convey a high level of price sensitivity to the seller. This could trigger advertisements for special offers and attractive prices—a new kind of cat-and-mouse game.
• Individuals at different times have different levels of willingness to pay
• Using a penetration strategy is recommended for experience goods. These are products which require a consumer to gain some experience with them in order to understand their true value. A low price at launch motivates more customers to give the product a try, and can create a multiplier effect if customers have a positive experience and start to comment on or even evangelize about the product.
• Apple supplemented its skimming strategy with continuous innovation and an expansion of its product line. This process is sometimes called “versioning,” the ongoing introduction of new versions. Each new version offers superior performance compared to the previous generation, which allows Apple to keep the prices for its devices relatively constant.
• The high art of pricing lies in intelligent price differentiation
• In the case of nonlinear pricing, one must know the marginal utilities for each additional unit. Without knowledge of willingness to pay as a function of time, location, or other criteria which will serve as the basis for differentiation, managers are stumbling around in the dark.
• Reaping the rewards of price differentiation is a “micro” task and not a “macro” one. It requires a microscopic perspective, not a rough or back-of-the-envelope calculation. Gut feeling, no matter how much experience may back it up, hits its limits on questions of price differentiation.
• One must understand willingness to pay at the individual level as narrowly as possible, in order to take advantage of it through a differentiated price structure
• Successful price differentiation requires the ability to separate customers effectively according to their willingness to pay
• Fencing is effective when the value difference between the two price categories is sufficiently large and the seller can control access. That means that the highest price category needs to offer correspondingly high value, and the value in the lowest price category is kept intentionally low.
• The French engineer Jules Dupuit noted this necessity way back in 1849. At that time, the lowest class passenger rail cars did not have a roof. “It is not because of the few thousand Francs which would have to be spent to put a roof over the third class seats,” Dupuit explained. “What the company is trying to do is to prevent the passenger who can pay the second class fare from traveling third class; it hits the poor, not because it wants to hurt them, but to frighten the rich.
• Effective fencing requires adequate gaps in value across the price categories.
• It is not the maximum price differentiation that is optimal, but rather the extent that strikes the best balance between value and costs.
• It will become more and more difficult to implement differentiated prices for identical products and services. Customers are simply too well informed and when in doubt they can buy the product elsewhere at a lower price.
• All multidimensional price structures contain some form of price differentiation, because the fixed price gets allocated across different volume levels. An advantage of these systems is that a company makes the same price offer to all customers, but each customer pays a different amount according to his or her own actual usage.
• The goal of a freemium model is to use the free price to attract the largest number of potential customers. The company hopes that if the user becomes comfortable with the basic functionality, he or she will have a growing interest in paying for a version which is more powerful, and more advanced, or offers additional functionality. Freemium fits very well to experience goods, whose full value only becomes apparent when customers have had a chance to use the good.
• The largest hurdle in freemium models is getting customers over this initial price barrier, or getting them to cross the “penny gap
• The largest hurdle in freemium models is getting customers over this initial price barrier, or getting them to cross the “penny gap .” The challenge for the publishers is to draw customers away from the “free” culture and to establish their digital content as a paid experience.
• A systematic optimization of price and product using a freemium model typically increases revenues by about 20 %, according to Simon-Kucher & Partners ’ experience.
• The music group Radiohead released its album In Rainbows online in 2007 with a “pay what you want” model. The album was downloaded over one million times, with 40 % of the “buyers” paying an average price of $6 apiece.
• In short: businesses should avoid “pay what you want ” systems.
• Instead of perpetuating these revenue-based plans, I strongly recommend that companies switch to profit-oriented incentive plans. In making that switch, companies do not need to sacrifice simplicity or confidentiality. One simple approach is to link the commission or incentive to the level of discount. The lower the discounts a salesperson grants, the higher his or her commission.
• Surcharges are an appropriate way to take advantage of higher willingness to pay in peak periods. A passenger railroad could introduce surcharges for travel on Friday afternoons or on Sunday evenings. These surcharges would have two effects: they would increase the company’s profits and also damp demand, which lowers the chances that trains will be overbooked or overfilled in those peak travel times. Price cuts in off-peak periods often have little effect, but price increases in peak periods can have a significant effect. We see these kinds of asymmetries in time-based price differentiation in a number of industries.
• Often the value of a product depends on how quickly it becomes available or how quickly a customer can access it.
• Under normal circumstances, managers tend to show a preference for a “lower prices, constant volume” alternative, but this tendency becomes more pronounced in a time of crisis. The effort to keep sales and capacity utilization up, and keep people at work, takes precedence. But in a time of crisis, that can be precisely the wrong approach.
• The same principle applies to renting, not just to purchases. In general, it is more advantageous for a lessor to offer a new tenant several months of free rent instead of a discounted price per square foot.
• The biggest challenge facing pricing in the modern world is overcapacity
• As long as this root cause remains unaddressed or unresolved, any changes companies make are just doctoring with symptoms rather than finding lasting cures. The path to rational, reasonable, profitable prices often requires the elimination of excess capacity.
• I summarize my insights into price wars very simply: there are smart industries and there are self-destructive industries. What is the difference? The smart ones avoid price wars, and the self-destructive ones get stuck in them. The smart ones are profitable; the self-destructive ones incur losses or destroy profits. The problem is that it only takes one self-destructive competitor to render an entire industry self-destructive. That’s why it is better to have smart competitors.
• I advised him to repeat the “profit” mantra every day, as often as possible. He of course will hear the message every time he says it, but others hear it only once or twice and won’t get tired of it.
• Pursue price leadership through a consistent communication campaign emphasizing the importance of price and value.
• “Good pricing has three prerequisites: create value, quantify value, and communicate value,” I said in summary. “That is when you get the price you deserve, the price you need for a profitable business. And, last but not least, avoid price wars.
• Profit maximization is the only sensible goal for pricing.
• Pricing belongs on the CEO ’s desk.

Confessions of the Pricing Man by Hermann Simon

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