why pricing is crucial
In our preparation journey to management consulting we all stumbled upon some sort of pricing framework, such as value-based pricing or price-based costing. However pricing is one of those areas where it can be very risky to employ a ready-made framework without an in-depth understanding of the customer dynamics. In all pricing scenarios the value at stake is generally very high as decisions reflect themselves straight into a company’s bottom line. In the paragraphs below we’ll show you a method to pinpoint the decisive factors in every pricing problem and identify the best decisions based on the client’s priorities (no ready-made frameworks here).
In all pricing decisions there are three critical data points we could use to come up with a potential price:
- Competitors’ prices: The idea is establishing prices based on how much competition charges. This implies the competitors exist and they sell a comparable product.
- Company’s costs: In order to make a product, the company has to incur a cost. Potentially this could be the starting point of pricing the pricing decisions. However, as we’ll learn, this should never be the case.
- Value added: Products usually aim to add value to customers, a generic concept which could come in terms of time, convenience, or money. However, for the purpose of pricing analyses, value should always be translated in economic terms. It is essential to bear in mind that different customer segments may attribute different values to a product, implying that the company could potentially charge different prices to different customers reflecting different value added in economic terms.
HOW TO PRICE A PRODUCT?
In order to understand in depth the thinking behind pricing, we’ll examine two cases and then derive general rules.
CASE #1: Duscraft, a fuel-efficient plane
Duscraft has just created a new airliner comparable in size to Boeing 737/Airbus 320 but with a significantly lower fuel consumption. Everything else, including maintenance costs is similar to its Boeing and Airbus competitors. Current prices for a Boeing 737 is 25m$ and for an Airbus 320 is 26m$. Considering that an aircraft usually lasts for 20 years and yearly fuel cost is 500,000$ for a Boeing 737, 400,000$ for an Airbus 320, and 300.000 for a Duscraft, how much should Duscraft charge for its aircraft?
CASE #2: Surinoco S-100, a mass-market phone
Surinoco is a Chinese supplier of while label mobile phone for the main European telecom operators. It has recently created its first branded phone, the S-100. The phone has similar characteristics to other mainstream mobile phones (whose price ranges from 60$ to 70$) and appeals to the lower end of the market. How would you think about pricing the S-100?
a FOUR-step approach to effective pricing
step#1: ESTIMATE THE CLIENT’S BEST ALTERNATIVE
Since we live in a market economy, we expect consumers to act rationally based on comparing our product with the ones of the competition. Therefore the starting point of our pricing decisions should be understanding what our client would choose if our product was NOT on the market. We identify the best alternative by estimating total costs the client has to incur by using different products. Here our focus should be the total cost of ownership (including acquisition price and running/maintenance costs), not only the acquisition price. Let’s see the application of this criteria to the above examples:
DuscraftTotal running costs (B-737): 500,000 x 20 + 25m = $35m Total running costs (A-320): 400,000 x 20 + 26m = $34m
Therefore the best alternative is the Airbus 320 as it has the lowest total running costs.
As you noticed we did not include maintenance costs, but for a reason: they are the same for all the three aircrafts and so adding them to all the 3 equations would not make a difference.
SurinocoTotal running costs (competition) = acquisition price: $~65
This assumes negligible running maintenance costs
STEP#2: ESTIMATE THE VALUE ADDED VS. THE BEST ALTERNATIVe
When pricing a product the main question is understanding how much value it adds to customers. The concept of value added is especially relevant for products that are somehow innovative and not commoditized. The key question is: does it add value compared to what? Additional value added should not be computed with respect to not using any product at all, but rather on using the best available alternative. For example, if we are dealing with a new fertilizer improving the quantity of a given crop, the value added would be given by the additional yield vs. the best existing fertilizer, not vs. not using any fertilizer at all. Once we estimate the value added, we should also estimate which share of this value we should charge to the customer. Let’s see the application of this criteria to the above examples:
DUSCRAFTValue added vs. best available alternative (A-320): (400,000-300,000)x20 = $2m
In this case there is no significant value added with respect to competitors, since the product is commoditized and aligned to competition
STEP#3: ESTIMATE THE SHARE OF VALUE ADDED to be REFLECTED IN PRICINg
Theoretically almost all the value added vs. the best alternative could potentially be charged back to the client as a higher price, i.e. if the client is a rational, utility maximizing individual she should be willing to pay the price for the best alternative option (STEP #1) plus a sum just marginally lower to the total value added (STEP #2), as shown in the Duscraft case below:
DUSCRAFTWillingness to pay: Best competitor's price [A320] ($26m) + value added ($2m) = ~$28m
This way the benefit from our new product would be almost entirely cashed in by the company. However, even if the client should rationally accept an agreement like this, it is unlikely that he will, for various reasons, such as:
- Switching costs to a new product
- “Risk” in adopting a new, relatively unknown, product
- Likely lower level of trust
For the above reasons, in order to incentivize the client to buy the new, innovative product, the company may decide on a more equal split of the value added, such as chargingBest competitors price [A320]: ($26m) + value added ($2m) x 50% = ~$27m
This way the value added would be effectively split equally between the company and the client, i.e. the total running cost for the client of using our plane would be 1m lower vs. using the best alternative (A320):Total running costs (A-320): 400,000 x 20 + 26m = $34m Total running costs (Duscraft): 300,000 x 20 + 27m = $33m
There is no formula for share split of the value added as it depends on a series of “soft” factors. It is however an essential concept to keep in mind.
Looking at the Surinoco case there is no added value vs. competition and therefore the only applicable reference point are competitors’ prices.
STEP #4: CHECK COSTS
Some companies in the past based their pricing on costs. Some still do it now, but this is pure nonsense. You should base prices on what customers are willing to pay, based on competitors’ prices and value added. So, what is the role of costs? They should be checked before launching a product, to ensure that the price estimated in STEPS 1 to 3 exceeds the cost. However, they should not be treated as the starting point, but as a final check in the decision of whether to commercialize a product.
Discover our articles on case interviews
Consulting interview questions (also called "case interview" questions) differ dramatically from traditional interview questions. In a traditional or behavioral interview, the interviewer will ask questions that tend to begin with "tell me about a time." For example: "Tell me about a time you had a conflict with a teammate and what you did to resolve that conflict."
Consulting interview questions, by contrast, begin by immersing you in a business scenario. They often begin with "our client." For example: "Our client is a $2 Billion distributor of office equipment whose profits have declined in the last four years. What should they do?"
When tackling consulting interview questions, your goal is not to draw from your background, experience, or opinions. Instead, you want to engage in an interactive problem-solving dialogue to provide a data-driven recommendation or solution to the question being asked.
You can perform better in consulting interview questions by having an upfront preview of what types of questions might be thrown your way. Below you'll find nine categories of questions and a few tips on areas worth exploring within each:
- New product
- New market
- Mergers & Acquisitions
- Should we undertake this particular initiative?
- Totally unique
Profitability cases directly tackle the amount of money a business is generating. For example:
- Our client is a manufacturer of ceramic mugs. Profits have declined over the last three years. They want us to diagnose the problem and come up with the solution.
- Our client is a distributor of propane and propane accessories. Their CEO was recently taken to task by a Wall Street analyst for having margins well below the industry standard. He wants us to help him figure out where the opportunities for margin expansion lie.
If you're tackling a profitability problem, don't be shy about going directly after the drivers of profitability -- revenue and cost. You can split revenue down further into quantities, prices, and product mix. Segment the revenues however helpful. Then be sure to examine both the fixed and variable costs.
Often looking at revenue first provides clues as to what may be driving the costs. If possible, some benchmark data -- either internally (against different stores, regions, plants, etc.) or externally (against competitors) can really help shed light on what might be going on inside the company.
Growth cases are all about a company getting bigger--usually in terms of dollars of revenue, but the measure might also be market share or number of customers. For example:
- Our client has promised Wall Street 5% revenue growth each year over the course of the next decade. We need to figure out how he's going to get there.
- Our client demands to know why they've been growing at 3% a year while the competition has been growing at 5%.
Mathematically, the only ways to grow revenues are to increase quantity sold or the price per unit sold. This mathematical thought process can add some useful structure to your approach, but don't let it curtail your creative thought process.
A company can grow by expanding or adding new forms of distribution channels (e.g. retail stores, online, catalogs, or affiliate partners). It can also introduce new products or tweak existing products to better satisfy their customers. They can also refresh their sales and marketing approaches. Finally, they can grow in giant steps by acquiring another whole company.
Consulting interview questions about pricing ask for the optimal price -- or way to determine the optimal price -- for a given product or service. For example:
- Our client has invented the food replicator from "Star Trek" that can instantly create any delicious meal you can conceive. They need to know how much to charge for it.
- Our client is readjusting their prices for their whole condiment product line. How should they think about tackling this problem?
When it comes to determining prices, there are three basic ways to frame your approach. The first is cost-based pricing. This tends to be how engineers think of pricing. You determine your cost per unit, then add a reasonable margin on top of that. This is an incomplete approach, but it does help give you some perspective on the minimum possible price.
The second is alternative-based pricing. With this approach, you look at how the alternatives (e.g. competitors or substitute) are priced and how your product stacks up against these alternatives.
The final approach is the customer's maximum willingness to pay. Think about the ultimate underlying benefit created by the product (e.g. cost-savings, time-savings) and attempt to put a dollar amount on it. For example, if a product reduces the time a heart surgery takes by 10 minutes, and you can calculate the total hourly cost of running the operating team, 1/6th of that amount gives you an estimate of the value of that time saved.
Generally, the cost-based approach will give you a theoretical floor for the price (if you sold for any less, you'd be losing money), while the willingness to pay approach offers you a theoretical ceiling (no logical customer will ever pay any more than that). Getting the final price often depends on using qualitative factors to choose a reasonable figure somewhere between the two.
4) New product
New product cases deal with a fresh invention or idea for a company. For example:
- Our client has developed an iPhone case that looks like a cassette tape player. How should they proceed?
- Our client has stumbled into a chemical compound that permanently removes body hair from a given area. Should they launch it?
New product cases require you to take a look at a wide variety of issues. A basic understanding of the product, company, customers, competition, and go-to-market approach will be critical.
Some new product cases delve into the numbers associated with expected costs and prices. When these numbers materialize, interviewers often want you to calculate a breakeven volume (or the volume necessary to reach pre-determined business goals) and determine if such a volume is achievable.
5) New market
New market cases are similar to new product cases, except they tend to be broader and require a global perspective on a whole industry. For instance:
- Sharper Image is considering entering the personal computing market. What should they be thinking about?
- Chemco is considering entering the personal grooming space; is that a good idea?
When evaluating the attractiveness of a new market, Porter's Five Forces provides a great starting point to think through. The forces to consider are: threat of new competition, threat of substitutes, bargaining power of buyers (your customers), bargaining power of suppliers, and competitive intensity.
Knowing the general attractiveness of the market is a great first step. You'll also want to know if your client is a good fit for entering the market and what approach they'll use to enter that market.
6) Mergers and Acquisitions
M&A cases are all about the implications associated with rolling another company into an existing one. They might sound like:
- Our client is considering purchasing its 4th-largest competitor. Should they do it?
- SnackCo is looking to find $25 million of synergy from their recent acquisition of Snackers, Inc.
Before the merger, think through whether the target is a good fit and can be acquired at a good price that meets the business's objectives. Calculating synergies is all about identifying overlap opportunities.
On the cost side, determine how much each is spending on overlapping items.For instance, if both are purchasing potatoes, but one company is getting a 20% better price, apply that 20% savings to the amount of spend occurring at a less-favorable price. That approach will estimate how much one could save if the company were able to realize the per-unit pricing that the other company is getting.
On the revenue synergy side, it helps to think about cross-selling opportunities and expand the products sold to each company's customer list by including the new offerings made available through the merger.
Consulting interview questions about competition deal with beating out other industry contenders or responding to something they've done. For example:
- Our client's market share has dropped by 15% to 9% over the last decade. What's going on?
- Pepsi has slashed its prices by 30% across the board. How should Coke respond?
Competition cases can take many different twists and turns. It's ideal to understand the full implications associated with the competitive move and then use other case approaches as necessary.
If it's a declining market share scenario, it's ideal to understand potential changes in customer preferences and how well they're being met. If it's a price war scenario, it's key to understand how loyal the customers are and the relative cost base.
8 ) Should we undertake this particular initiative?
These consulting interview questions are really just other types of cases thinly-veiled. For example:
- Should we launch this marketing campaign?
- Should we launch this loyalty program?
Whenever you hear a "should," think, "based on what objectives?" First, get real clarity on the objectives. Asking about the goals of the loyalty program may quickly reveal that you're really trying to determine whether having a loyalty program will generate more profit than not having one. Then you're off to evaluating revenue and cost in each scenario.
9) Totally unique
Some consulting interview questions fall completely beyond categorization. For example:
- Our client is a chemical company concerned about the green movement. Will this environmental enthusiasm affect their bottom line?
- Our CEO is taking a 3-day trip next week. Here's a catalog. Pick out what two items she should take with her.
When you get a case that seems to fall way outside the bounds of a traditional consulting interview question, stay calm. All the normal case interview rules apply. You'll still want to clarify the objectives, hypothesis, provide a plan, be data-driven, and deliver a succinct recommendation. It just might sound a little different in the process.
Having a familiarity with these types of consulting interview questions will reduce the odds of getting caught off-guard when the moment strikes, and will help you to "ace the case". But don't spend too much time agonizing over the list. It's really not a good use of your efforts to try and memorize all of these.
Rather, the value comes from having done a quick preview to plant some seeds that sharpen your ability to identify relevant issues. Remember: the case interview is primarily a test of problem-solving -- not memorization.
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