How to use indexed pricing as the economy recovers from the pandemic
Steven Forth is a Managing Partner at Ibbaka. See his Skill Profile on Ibbaka Talent.
“The future is already here — it's just not very evenly distributed.”
William Gibson
Many of us are busy this summer planning for the emergence of the economy from the Covid 19 pandemic. In some places, the post-Covid economy is already a reality. In others, the pandemic continues to rage, piling up deaths and economic damage. Our markets are not all going to recover at once. Some may never recover. Others sputter along for years, with the recovery coming in fits and starts. As pricing leaders, how do we respond for this reality, one in which we face many different realities?
As pricing leaders, how to we respond for this reality, one in which we face many different realities?
Many people, such as Tim O’Reilly from O’Reilly Publishing, have suggested that we use scenario planning to prepare for the post pandemic future. See Welcome to the 21st Century How To Plan For The Post-Covid Future. Others think that scenario planning is too time consuming and also too formal a process for a world that is changing so rapidly and where things are uneven. (This position was taken by several partners and customers that we spoke with over the past week.) At Ibbaka we have been applying scenario planning to both pricing and talent management strategies (see Post Covid 19 we will all need to be strategic pricers -scenario planning is the key to understanding shifting patterns in willingness to pay), but we recognize that many people need a more flexible and responsive tactic as they prepare pricing for the post-Covid economy. Fortunately, there is a well established approach you can take, indexed pricing.
What is indexed pricing?
In essence, indexed pricing connects the price you charge to one or more external economic indicators. Take the price you would have normally charged, and multiply it by a variable based on an external measure. If the variable is greater than one, you will charge a premium; if smaller than one, you are offering a discount.
Historically, indexed pricing has usually been based on input costs. The most common example is a variable-rate mortgage. The payments go up and down depending on the prevailing interest rates (often the prime rate). The prime rate is thought to reflect the bank’s cost of capital, and this approach to pricing is generally perceived to be fair.
There are many other examples. Some pricing models are indexed to input costs, such as energy or raw materials, or even prevailing labor rates. Many contracts include an adjustment for inflation, where the price goes up (rarely down though that could change in the future) along with the rate of inflation. The inflation rate varies from year to year and is expected to be less than one percent in 2020 (see Projected annual inflation rate in the United States from 2010 to 2021).
In these cases, the index is either based on the seller’s input costs or on general economic trends. To respond to the post-Covid economy, we need to get customer focussed and more granular.
How can I apply indexed pricing?
The approach we are advocating is to tie pricing to the performance of your customer’s industry in the geography where the operate. If the industry in the geography is depressed, then the index will be smaller than one, and the customer will get a discount. As the industry recovers, the discount automatically goes away. This is a customer-in approach and turns conventional indexed pricing on its head. This approach is much better aligned with value-based pricing than is indexing input costs.
Aside: In many cases indexing on input costs can have perverse effects. For example, when both the seller and buyer have their profitability impacted in the same way by the input, which is the case for many raw materials and energy, then the index can create a double hit that leads to a downward spiral.
Seller: My costs have gone up so I am going to charge you more.
Buyer: My other costs have gone up so I can afford to pay you less.
Both: That is your problem.
We need to make sure we do not fall into this dynamic.
So why not just give a Covid 19 discount, as some companies are doing? There are a few things wrong with this approach.
It uses a machete when a scalpel is needed - broad price cuts go to companies that are hurting and to companies that are thriving.
There is a risk of resetting the reference price - discounts tend to stick. New customers will think of the discounted price as the standard price no matter what you say.
It is not obvious when these discounts should end (we have seen several companies that originally had them ending in June, have now extended them to September, and may well have to push them out into 2021.
Indexing prices to the performance of the customer’s industry gets around this.
Indexes can be based on the customer’s industry. Airlines and restaurants would get a discount. Makers of video conferencing would not.
By connecting the price to your customer’s industry you signal that you are in it with them. This is also a first, small, step towards outcome-based (performance-based) pricing.
As an industry recovers, prices automatically come back to normal.
Here is an example. A company we know well provides scheduling software for contingent workers (gig workers) in the event space. The crews that set up shows at those large stadiums are one of their key markets. There are not a lot of events happening right now. The company is looking at moving into other markets that use contingent workers and have new scheduling challenges in response to Covid 19, but it also wants to use this time to lock in more and more large event production companies. These companies are not going to benefit from the software until events start happening. So the price will be indexed to stadium events (this data is easily and publicly available from trusted third parties for most markets).
“Easily and publicly available from trusted third parties” - this is the key. The index needs to be based on a public number that is updated frequently. So the first step is to identify this number for your key markets.
The complete process for pricing looks something like this.
Segment your customer base (including your potential customers) by how well their sector or industry is performing. You may need to do this by geography.
Identify the external economic indicator that tracks performance in the relevant sectors (there may be several and creating a composite of lagging and leading indicators can work, but don’t get too clever).
Use the indicator to index your price. You may want to build a price increase into the model so that prices get adjusted higher as the economy recovers.
Offer this to customer’s on an opt-in basis. If you have many small customers you can explain and execute on through your website. If you have fewer larger companies, have direct conversations and consider doing this as part of a webinar for the industry.
The goal is to signal concern for your customers, willingness to be flexible, while avoiding resetting the reference price and , possibly, building in a price increase.
How does indexed pricing track willingness to pay (WTP)?
Willingness to pay (WTP) is sometimes seen as the best pricing metric. In the current situation, willingness to pay has become ability to pay for many of your customers. Indexed pricing is a good way to connect willingness to pay and ability to pay. It is also an opportunity to move beyond willingness to pay, which does not really help you understand your customer’s business, to true value-based pricing, which is based on understanding the economic, emotional and community value you provide to your customers.
Value is always relative to the alternative. Look for ways that indexed pricing can sharpen your value differentiation. You can do this by careful customer segmentation. Research the economic indicators that are the real predictors of your customer’s success. Align your value propositions around these. Use indexed pricing as a scalpel to provide targeted value to your customers.
For the contingent worker scheduling platform described above, this means indexing on different indicators for different types of customer. Contingent worker scheduling is important to event producers, but it is also a challenge for restaurants (which will need a different indicator), for healthcare providers (which now need to avoid having people work at multiple facilities, and even agricultural workers. Value-based pricing is most effective when you can define market segments in terms of how you are creating value.
See other posts in our how How to price … series
How to price for SaaS transformation
How to price new functionality
How to monetize customer success
How to use indexed pricing as the economy recovers from the pandemic
How to price your learning resources
When to price predictive analytics
How to hire a pricing consultant
Pricing professional services is a challenge for SaaS companies