For the first time in at least a decade, inflation has become an urgent short-term consideration for almost all companies around the world.
No one knows how long the current wave of inflation will last, but a poll of economists in the summer of 2021 hinted that the current trend could last for years. More recently, the U.S. Federal Reserve implied that the current wave of inflation may not be as “transitory” as originally suspected.
So, how should managers respond?
The classic response to inflation is to select one of three unattractive options. Managers can upset their customers by raising prices, upset their investors by cutting margins, or upset practically everyone by cutting corners in order to cut costs. Faced with this trilemma, most managers ultimately resort to raising their prices, then look for clever ways to mitigate the subsequent drama.
What they overlook, however, is that those three options are shortsighted tactical relics of earlier eras. In the 1970s, when “stagflation” gripped major economies, managers lacked the technology, the data, and in many cases the notion to do anything bolder or more strategic. When inflation hit during the Great Recession of 2008-09, managers still saw themselves constrained within the same old trilemma.
Inflation in 2022 is a different story. Managers now enjoy a level of market visibility and agility that their predecessors could have hardly imagined even one generation ago. Managers have much better data and more sophisticated tools to analyze and turn this data into a useful information to support decisions. It’s an ideal time for them to treat inflation as a strategic opportunity rather than a tactical challenge, and to choose from a better set of options. Instead of worrying about how much more to charge their customers, they should devote their resources to figuring out how and why they should be charging them.
Managers should consider these three strategic options, especially if inflation persists: recalibrate and clean up the product portfolio, reposition the brand, or replace the price model. These options are not mutually exclusive, so managers could also pursue a combination of them.
In my experience, most companies have already had internal discussions about pursuing at least one of these options, because they bring benefits that have nothing to do with inflation. Some companies may even have preliminary plans in place. These companies, in particular, should view inflation as an exciting opportunity to seize rather than as an uncomfortable problem to solve.
Option 1: Recalibrate and Clean Up the Portfolio
Companies have several ways to implement this option. They can bundle or unbundle existing products, either to create new value propositions or to expose customers to lower price points for the disaggregated goods and services they want to buy. They can draw on insights from behavioral economics to change price gaps in order to steer customers toward more profitable offerings. Depending on what they have in their R&D pipelines or how flexible their production capacity is, they can also introduce less-expensive alternatives or, counterintuitively, introduce higher-end products that make the existing product line appear more affordable.
When thinking about inflation, managers tend to overemphasize price sensitivity as the key factor in determining how customers will respond to any changes they see. But they should keep in mind that customers are also quantity sensitive and quality sensitive.
If customers are more price sensitive than quantity sensitive — as research shows they are — they are less liable to notice a price increase in the form of a smaller quantity at a constant price. Several consumer packaged goods companies tried that strategy when inflation pressures increased during the Great Recession.
Quality sensitivity comes down to the features that customers could live without or accept at a lower level. If a product or service has several such features, managers can consider whether removing or adjusting them create opportunities for new versions with fewer features at a lower price point. The converse also holds true. Slight changes in quality can unlock much greater willingness to pay without a significant increase in costs, allowing the company to establish new offerings at the higher end of the market.
Option 2: Reposition the Brand
At any given time, most offerings are either overpriced or underpriced — in some cases significantly — relative to the value they deliver. A wave of inflation offers managers an opportunity to correct these misalignments in their product positioning.
Let’s start with overpriced products. When a company is investing large amounts in marketing to maintain or prop up a value proposition that is becoming increasingly tenuous, a price cut can make sense. That can happen when an offering is losing its competitive edge or was priced too high from the outset. Inflation makes it riskier to maintain that position. The company can solve this problem by reducing the marketing expenditures and lowering the price at the same time to support a more realistic positioning. Depending on the magnitude of those changes, the moves could even lead to higher profits.
The more common situation, however, is that a product is underpriced relative to the value that customers derive. In that case, the uncertainty surrounding inflation, combined with customers’ expectations that they might need to pay more, provides an opportunity to change communication and position a product in a higher price tier. That opportunity is especially promising when the company has relied on low prices as a source of competitive advantage. Persistent underpricing turns price into an oxidizing agent that tarnishes the offering’s image, and inflation offers a chance for companies to correct the misperceptions.
Option 3: Replace the Price model
Intrigued by the success of subscriptions and “my-product-as-a-service” models, many companies have already considered adopting new price models. The immediate need to respond to inflation gives them a compelling reason to implement these plans now and avoid needing to settle for the lesser of three evils in the classic trilemma.
Over the last decade, companies in a wide range of industries, from software to education to health care and industrial production, have demonstrated that changing the way they charge their customers brings numerous advantages. When you replace your prices instead of raising them, you can:
Move the customers’ eye level to a lower price point.
A price per month, per mile, or per other unit of consumption is usually much lower, more transparent, and much more manageable for customers than an outright purchase price. Such prices also align better with how customers create and derive value. They pay when they consume or create something, not when they buy products or stockpile them.
Avoid firing customers.
One drawback to the “raise your prices” answer to inflation is that you might lose customers who can’t bear the higher costs. But is it worth losing any customers when they might not be “bad” customers (whatever that means), but victims of an outdated transactional model that restricts their ability to try and use your product? Access, consumption, and outcome-based price models allow more customers to buy and use what they need from you, when they need it, rather than tying up their money in expensive assets or foregoing the inputs they need to develop better products at their own speed and scale.
New pricing models often sacrifice the upfront revenue impact of big-ticket sales, but they generally make up for that with higher recurring revenue over a customer’s lifetime. Investors tend to find these revenue streams more attractive because they are predictable and because they spread risk over a wider basis of customers.
That final point is what makes new price models a strategic decision rather than tactical response. In 2013, Adobe switched from selling its customers perpetual licenses via plastic discs in boxes to selling them software access via a monthly subscription to its Creative Cloud. During the adjustment period, the company absorbed slight declines in revenue and profit, but has achieved strong growth ever since. Buoyed by the advantages of this new price model, Adobe has seen its market capitalization soar from $22.5 billion when it announced the new model to over $310 billion in November 2021.
Some new pricing models are bolder than subscriptions. The Australian mining services company Orica sets prices based on the quality of the outcomes it achieves for customers, not for the services performed or the amount of materials used. The electric vehicle manufacturer Tesla is now testing insurance models based on “real-time driving behavior.” Launched in Texas in October 2021, the program calls for drivers to make “monthly payments based on your driving behavior instead of traditional factors like credit, age, gender, claim history and driving records used by other insurance provider.”
Such revenue model changes were less common when the last wave of inflation hit in 2008-09 and were a practical impossibility in the stagflation days of the 1970s. That’s why changing to a new price model might not immediately spring to mind when companies search for solutions right now. But with today’s data resources and analytical power, there is no reason why you shouldn’t explore an attractive strategic response to inflation rather than trying to choose among tactical price increases, margin hits, or reductions in quality. If companies don’t want to make a wholesale change to a new model, they can allow the new and old models to exist together and allow customers to self-select.
Credit byHarvard Business Review