Right before the release of my book, Pricing Strategy, the husband of my boss asked me to tell him what pricing strategy is all about, and he said “make it simple, I don’t want the details.”  I knew he was serious. And I knew he was smart. With my boss, who is also the Chair of the DePaul Marketing Department sitting right next to him, I knew this was a “make-it-or-break-it” moment. After researching and writing for years, how was I to explain the entire body of thought on pricing in 15 seconds or less? I took a sip of my beverage then dove into with full blunt force:

“There are three key questions that must be asked for every pricing problem. Each must be asked from the customer’s perspective, not your own. Number 1:  What is the alternative? Number 2:  Are you better or worse? And Number 3:  Why should I care?”

To my relief, the marketing department chair smiled.

It has been a little over a year since I first boiled pricing strategy down to these three questions. Since then, I’ve seen this mantra resonate strongly with others. So now, I think it’s time we explore it.

The Customer’s Perspective

The starting directive is to take the customer’s perspective, not your own.

This directive comes from the marketing concept of the firm. According to the marketing concept, a firm exists to create value for its customers, value which it exchanges through the pricing mechanism for cash. If the firm can’t create value for its customers, it can’t survive. If a business does create value for its customers, it can.

This viewpoint is supported by Peter Drucker, Theodore Levitt, Gary Hamel, Ronald Baker and many others who work in the fields of business and pricing strategy. These leaders advocate working from the customer’s perspective back, to define the price and ultimately the product.

This directive is in direct contrast with medieval pricing where costs are calculated, margins added, and then salespeople are told to convince customers to buy. Instead, in using this customer perspective, the needs of a target market are defined, their willingness-to-pay to fulfill these needs determines the price, and the product is then designed to hit that price at a profitable cost. The firms that still use medieval pricing then find themselves in a nightmare of missed sales quotas and discount-led margin erosion.  Those firms that use this customer perspective find themselves engineering products and prices that customers will gladly pay and the firm will gladly profit.

What’s the Alternative?

No product is launched into a vacuum. Every product faces competition, even if that competition is “do nothing.” This competing alternative will be used as a reference point by your customers in evaluating the merits of the product. Therefore, the price of the competing alternative forms the starting point for pricing your product and answering the first question:  “What’s the alternative?”

If the product faces direct competition from a highly similar product, the price should be very similar. If the product faces no direct competition, then the price of the nearest substitute, which enables the customer to achieve the same or similar set of goals, should be used as the starting point for identifying the price.

And you cannot escape this question by claiming that your product is a “new-to-the-world” product.  Products are purchased because customers believe it will help them fulfill their goals.  Any means that customers use to achieve the goals your product is designed to help them meet should be considered your competing product.

Are You Better or Worse?

If you enable customers to reach their goals better than the competing alternative, you can price your product higher. If your product is worse than its competing alternative, you should price your product lower. That is what pricing to value is. Hence the second question is “Are you better or worse?”

The point of product differentiation is contained in this question. The price of a product relative to its competitors should reflect the sum value of the positive differentiating factors, less the sum value of the negative differentiating factors. By adding more positive differentiating factors to a product, the firm is increasing its pricing power.

If your customers think all competing products are the same, then I am sorry to say that your pricing strategy is reduced to matching your competitor’s price, since for all intents and purposes you are selling a commodity product. But don’t give up hope. Even the marketing of commodities can be differentiated, and hence some pricing power can be uncovered.

Why Should I Care?

This last question is purposely stated in an emotional manner, because purchasing is an emotional customer decision. The third question is written to remind us of the importance of the customer’s perspective, to ensure that whatever differentiating factors are used to define the pricing strategy are relevant to the market, and to bring a little psychology into the mix.

The first two questions – “What’s the alternative?” and “Are you better or worse?” – are logical. They rely on driving pricing strategy to fit a rational economic viewpoint of the world:  Customers are value-maximizing creatures who will purchase the best product after subtracting the price of acquisition. This homoeconomicus viewpoint will get your pricing in the right ball park most of the time, but sometimes it’s wide of the mark.

Customers, who in both consumer and business markets are humans, are not completely rational. Our perception of what is the right price to pay for a product is subject to what academics like to call cognitive errors. These cognitive errors arise from deep-seated psychological, neuroeconomical, behavioral, environmental and perhaps even evolutionary forces.

In terms of pricing, it is important to ensure that the emotional perception of your price is in line with the logical perception of your value. If the price is logically right but emotionally wrong, it is likely the emotions will override the logic, and your customers won’t purchase. Fortunately, the perception of the product’s value, and therefore the right price, is somewhat under the firm’s influence. Firms can use this to help their customers care deeply about the positive points of differentiation and little about the negative points, thus enabling the firm to capture higher prices.

Setting Pricing Strategy

So if you know little about pricing or need to quickly divine a pricing strategy, just ask these three questions, and ask them from the customer’s perspective.

1. What is the alternative?
2. Are you better or worse?
3. And why should I care?