Why slashing product prices is usually a terrible idea

As seen on Fortune.com

By: Geoff Colvin

Warren Buffett is an aggressive pricer. He mostly leaves the managers of Berkshire Hathaway’s portfolio companies alone, but when it comes to setting prices at companies including See’s Candies and the Buffalo News, he has often liked to be involved.

“The manager has just one business,” he once explained to Fortune. “His equation tells him that if he prices a little too low, it’s not that serious. But if he prices too high, he sees himself screwing up the only thing in his life.” Such excessive risk aversion leaves money on the table, Buffett figures, so he often pushes for higher prices. More often than not, he’s right.

Even in a historic downturn, Buffett’s instinct is worth keeping in mind. Many managers underestimate the power of pricing, and the unanimous advice from pricing experts in this troubled economy is to price with courage and creativity. In businesses where demand has plunged, slashing prices may be a terrible idea—and it may not be necessary at all.

In a few special cases—think hand sanitizer—the pandemic has turbocharged demand. Yet even here, managers need courage. It’s the courage to abstain from multiplying prices by five or 10 or 20, or whatever the market will bear. The winners will be those who think long-term, difficult as that is in a crisis.

For the vast majority of businesses—those facing strapped customers and shrunken demand—the No. 1 imperative is to avoid cutting prices if at all possible, what experts in the field call “maintaining price integrity.” In the B2B world, “you get a lot of pressure back from your customers to reduce price, which can manifest itself as hesitancy to move forward with the purchase,” says Ron Kermisch, a Bain consultant who leads the firm’s global pricing practice. “Companies too quickly move to price as the lever, without really understanding what’s driving the customer hesitancy.”

Creative managers can find many ways to allay customers’ concerns while maintaining price: for example, by extending payment terms, or by offering a shorter-term contract if the customer is worried about uncertainty, or by offering additional services such as help with integrating new software.

Even when financial concessions are unavoidable, maintaining the established price is crucial. In B2C commerce, several Four Seasons hotels are offering a third or fourth night free, the same strategy they followed in the last downturn; the customer gets more, but the room rate on the bill remains the same. Ritz-Carlton is offering some guests a daily “resort credit” of $100 to be applied toward meals, spa treatments, or other services, reducing the customer’s total cost without cutting the room rate.

But wait: Is anyone really fooled? If customers are being given more for a stated price, isn’t it obvious that the price has been cut? In fact, there is a difference, and it’s important. In pricing theory there’s something called the reference price, which is the lowest price customers ever paid for a product or service. They tend to remember it and compare all future prices against it. One-time add-ons to a product or service may be hard to remember or hard to value, but the reference price is clear. Reduce it, and customers will wonder why they should ever pay more.

That’s just the beginning of the damage that price cuts can do. They rarely pay for themselves. If you cut prices 20%, you have to sell 25% more units just to maintain revenue. In a severe downturn, how likely is that? And if a competitor matches your price cut, the pain will be much worse. The economics of every business are different, but McKinsey research has found that in a typical S&P 1500 company, a 5% price cut would have to spark a 19% volume increase just to pay for itself, and that hardly ever happens. Even if holding prices steady reduces sales and profits, price cuts may reduce them even more.

The long-term effects can be more harmful. Price cuts, even temporary ones, train customers to behave badly, always waiting for the next sale. Perhaps worse, they destroy brand equity.

The problem is especially acute in the luxury goods business, where a breathtaking price is a product feature and a key element of the brand identity. Conventional wisdom held that the industry had learned its lesson in the financial crisis of 2008–09, when some luxury items were offered for 70% off at Saks Fifth Avenue and other temples of upscale consumption. But it’s happening again. Valentino dresses are being discounted 50% at Valentino’s own website, for example, and 70% elsewhere; at Matchesfashion.com, a beaded Valentino gown has been reduced from $30,000 to a mere $9,000. Customers who paid full price may resolve never to make that mistake again. The same general phenomenon plays out in most product and service categories.

Having vowed to avoid price cuts no matter what, you may nonetheless find that in this downturn, which has been so traumatic for so many, you sometimes have no choice. Yet even then, you can mitigate the damage by asking for something in return. For example, recent Bain research finds that 81% of chief information officers who asked software vendors for payment relief received it—and 80% of those who received relief gave something back. Some agreed to extend their contract or to expand the scope of their contract in the future; others agreed to renew early. “Customers are willing to do that,” says Kermisch. “You need to show empathy as a provider, but they understand you’re running a business.”

And if you sell one of those white-hot pandemic products that are still in short supply? The advice is simple: Don’t gouge. Even if the market will bear it, your reputation might not. Attorneys general from Washington State to Washington D.C. have sued retailers or hit them with cease-and-desist orders for selling Clorox, hand sanitizer, and related products at exorbitant prices. Don’t let that happen to you. Forgo the quick profits and think long-term.

Pricing is an undervalued discipline. No one in the C-suite has “price” in their title. Research by the Simon Kucher & Partners consulting firm finds that “only 12% [of companies] believe they can boost profits by adjusting prices.” Pricing is worth far more attention than most managers give it—especially now, when you need every advantage you can get.