You operate a business-to-business (B2B) enterprise, an essential link in the supply chain that transforms raw materials into products that serve the end consumer. And you make money the old fashioned way: by charging your cost, plus a reasonable margin.
But what if you could increase profitability by as much as 52 percent simply by adjusting this pricing strategy?
That’s the promise of a new paper by Jonathan Zhang, an assistant professor of marketing at the University of Washington Foster School of Business. The B2B pricing model developed by Zhang and co-authors Oded Netzer and Asim Ansari demonstrates that switching to a dynamic pricing strategy—informed by data on customer behavior and adjusted over time—can both increase profitability and maintain customer relationships.
“We’re advocating for the adoption of a smarter pricing paradigm that is focused on customer behaviors, and not on cost,” says Zhang. “Through increasingly sophisticated CRM systems in the current days of Big Data, we know a lot more about customers than ever before—their buying behaviors, their sensitivity to price and external factors, their business relationships with you.”
“So why not leverage this information to customize pricing for each customer, and adjust it over time to make sure that these relationships yield optimum profitability and still remain healthy?”
Pricing apples and oranges
Most businesses follow the fundamental pricing strategy of cost-plus. That is, charging buyers the cost of producing or purchasing and marketing a product or service, then adding on a reasonable margin to allow for a measure of profit.
This strategy is the accepted—and expected—standard in business-to-consumer (B2C) markets, where prices are usually standardized, publicly posted, and readily comparable. Most deviations from this doctrinal pricing strategy have been met with ringing criticism. Take, for example, the failed Amazon.com experiment in pricing discrimination based on customer demographics that resulted in an apology by CEO Jeff Bezos and a vow to never again try such an unorthodox pricing scheme.
But B2B is different. Prices are not public, and they are negotiable. And because products are often customized, B2B sellers have a lot more flexibility—and reasons—to charge different prices to different customers.
In addition, the relationships between seller and buyer typically last longer and are stronger, often reaching the level of symbiotic partnership. And the cost of changing these partnerships is very high. “You rely on me to supply products or materials or services on time and at a reasonable price, and I rely on you to be a stable customer for many years,” says Zhang.
In such a relationship, Zhang finds that pricing can and should be approached differently.
Know your customer
To construct their model, the researchers examined the customer relationships of a middle-man supplier of manufactured materials selling to small- and medium-sized industrial companies.
Mining deep stores of data captured over time, they were able to distinguish two types of buying behaviors: relaxed and vigilant.
Customers with “relaxed” behaviors buy in a simplified way. They are not price sensitive, they don’t negotiate and they don’t shop around (in fact, they often order before knowing the price, and get invoiced afterward). These customers tend to have longer relationships with the supplier, and trust the supplier not to send them a high bill.
Customers with “vigilant” behaviors are price sensitive. They always ask for price quote before they buy, they negotiate and sometimes decide to buy elsewhere. They tend to be newer customers who have yet to establish a relationship of trust with the seller.
These behavioral states, however, are not constant. And pricing can be a powerful tool to shift customers between them over time. For instance, a customer that has received a price that is lower than what it paid before will be more likely to be in the relaxed state. On the other hand, even a relaxed customer will become more vigilant upon finding that a bill is higher than what it paid previously.
Price it right
Since the nature of a B2B buyer’s relationship to a seller is not fixed, Zhang cautions that such relationships must be continually monitored to reach optimal pricing at a given moment.
Optimal being the highest price the customer is willing to pay. To reach this, Zhang’s model accounts for such variables as the nature of relationship, past buying behavior, sensitivity to price changes, and tolerance of external forces (such as spikes in commodity prices, among others).
To distill a complicated model to its essence: the relationship drives the price, and price helps manage the relationship. This does not happen in a cost-plus pricing scheme.
“If you have set a 20 percent margin but the customer is willing to pay 25 percent, then you’re leaving 5 percent on the table,” says Zhang. “And if another customer is only willing to pay 15 percent, then you’re leaving 15 percent on the table because you’re not getting their business at all.”
Back instinct with science
Magnifying this “money on the table” is the sheer amount of money we’re talking about.
B2C may command the media’s attention, but B2B is the real engine of the economy. A 2010 report by McKinsey & Company found that B2B commerce constitutes approximately 80 percent of the volume of transactions in the global economy (including 72 percent in North America).
In this very common context, differential pricing, backed by data-driven knowledge of a firm’s customers, can present a significant boost to profitability, according to Zhang. And even pricing changes on the most obvious data available can make a big difference on the bottom line.
“Our model is state-of-the-art; we don’t expect anyone to run it entirely,” says Zhang. “But even simple record keeping can indicate how a customer buys and whether it is relaxed or vigilant at a given time. If you keep track of this, and use the conceptual insights from our research, a simple regression will still get you to significant gains in profitability while maintaining the long-term customer relationship.
“Smart managers have always known this is important. But now we can back that instinct with science.”
“Dynamic Targeted Pricing in B2B Relationships” is the winner of the 2009 Shanker-Spiegel Dissertation Award and is forthcoming in Marketing Science.