Pragmatic Pricing

In an earlier post we stated that as a general rule, price segmentation works by charging the majority of the customers a standard price and then giving a discount to people who can somehow prove they are price sensitive.  (Think students at the movie theater.)

Versioning is the exception.   When we use versioning, we develop a lowest cost base model and price this model at margins that are as low as we can tolerate to capture our most price sensitive customers.  Then we offer more-featured versions of the product at better prices and margins to profit from our less price sensitive customers.

Let’s run this through our rules for price segmentation.  Step 1 – segment the market.  This is a great method because we know there are people out there who are more sensitive and others who are less so.  Even if we can’t identify which is which, using this method they will self-select into their own category.

Step 2 – develop a pricing mechanism to charge different prices to the different segments.  In this case we build the bare-bones model for the really price sensitive customers, and a higher end product for those less price sensitive.  It works great.

The lowest cost base model attracts our price sensitive customers, but we have to have the attitude that if we didn’t have this model, the customer wouldn’t buy from us.  We want to make a little money on the sale.  Besides, this customer may buy some accessories from us as well, and of course our accessories have better margins.   

Two quick examples.  On eBay you can buy a new brand-name large screen TV for a price that is less than the cost for most resellers.  I talked with a director from eBay the other day about this and he described that these on-line stores were selling the TVs at their cost in the hopes of selling accessories, like stands or wall mounts.  Sounds a lot like our price segmentation.

A bike store in the midwest only builds custom bicycles.  They have a formula for how to price the frame, the parts, and the labor.  Every bike uses the exact same formula.  This is “fair” in their minds.  They described to me how a customer walked into the shop the other day and ordered top of the line everything.  I’m not sure they could build a more expensive bike.  The customer didn’t ask about price until the end.  Obviously this was not a price sensitive customer.  How could this bike shop earn more money from these type customers?  What about versioning a little more?  What if they changed their formula (i.e. markup) so that the higher end parts have a little higher markup?   My very rough calculation shows this small pricing move could put an additional $1,000 in their pockets.  That’s a lot for a bike shop owner.

Action:  What are you waiting for?  Figure out how you can use versioning in your business.

Price segmentation usually means selling the exact same product to two different people at different prices.  For example, two people sitting in coach class on a flight have purchased essentially the same service and experience, but usually pay different prices.  Another example is that students pay less to get into the movies.    

However, the most common method of price segmentation is all around us and is sometimes hard to recognize as what it is, price segmentation through product differentiation.  That is selling different levels of products to different people at dramatically different prices.

I went through the Burger King drive through the other day and ordered a Whopper for $2.39.   They asked if I’d like cheese and of course I said yes.  My Whopper with cheese was $2.69.  The cheese was 30 cents!  For a slice of CHEESE?

So how is this price segmentation?  People who are very price sensitive would never pay 30 cents for a slice of cheese.  But people who aren’t so price sensitive would.  This type of price segmentation is frequently called versioning.  As the name implies, we create different versions of a product for customers with different willingnesses to pay.  In this case we had two versions, a Whopper with cheese and one without.

I still remember shopping for my first brand new car about 20 years ago.  After I picked out the car, it was time to decide on the options.  Do you know that a radio for that car costs an extra $1,000.  I could buy a radio with speakers at an electronics store for less than $100.  What a ripoff.  (I ended up buying a radio later and installing it myself.)

The car dealers were simply using price segmentation.  They could still sell the bare bones car to someone like me to make a little profit.  But when someone who is less price sensitive (willing to pay more) they make even more profit by also selling the radio as well.

In contrast, these days, cars come with options “packages”, so it’s very difficult to determine if you’re paying too much, but it’s still versioning.

We can’t leave this topic without talking about airlines.  I recently looked up the price of a flight from San Francisco to LaGuardia in New York.  The coach seat was $310, the first class seat was $3,000.  WOW!  That’s price segmentation. Anybody wealthy enough to afford the first class ticket would probably purchase it just to be more comfortable for the 5 hour flight, but anyone who is price sensitive would definitely not.

Versioning is not new.  Here is a quote from a 19th century economist on the railway travel business.  “It is not because of the few thousand francs which have to be spent to put a roof over the third-class carriages or to upholster the third-class seats that some company or other has open carriages with wooden benches.  What the company is trying to do is to prevent the passengers who pay the second class fare from traveling third class; it hits the poor, not because it wants to hurt them, but to frighten the rich.”  Jules Dupuit, 1849 Did you catch that?  Third class rail travel was hard benches WITHOUT A ROOF.  I’m sure the airlines are trying to think of a way …

More on versioning in a later blog.

Action:  What products do you currently sell with different versions?  Are you charging enough for the highest level?  Are you charging too much for the lowest level?

Chris Anderson’s book “Free:  The Future of a Radical Price” was insightful and thought provoking.  His basic premise, from a supply and demand point of view is:

• Supply – Costs are going down dramatically.  The marginal cost of delivering information is very close to zero.
• Demand – Consumers behave radically differently for a free product than for even a very small price.

The demand side is what I’d like to discuss today.  Free has many different meanings.  Buy one get one free is very different from a free sample.  A free sample is Genuinely Free, while buy one get one free is really only a 50% off offer.  Genuinely Free is just that, something you can get without having to open your wallet, but more importantly it’s something you get without having to give anything (time, energy or attention) in exchange.

Free is possibly the most powerful word used in marketing, but it is used in so many different contexts.   There are free trials, free TV and radio if you watch the commercials, free “lite” versions of software, free blogs, free email and many more.  Not all of these are Genuinely Free.  If we want the windfall of free, we need to offer products as close as possible to Genuinely Free.

I can think of four reasons a person or company would offer a product or service Genuinely Free.

1. Altruism – This person or company simply wants to help others.
2. Trial – Free samples will allow someone to try your product in the hopes they will purchase it later.
3. Exposure – Writing blogs and giving away valuable information is typically done simply to build a reputation for the writer.  The hope is that when the readers need something related, they know where to go.
4. Build a network – Some businesses are more valuable to the customers when there are more users.  For example sites like LinkedIn and FaceBook require millions of users for them to be successful.  By offering a lot of value for free, they can build their network.  They can make money by charging for more services.  (They also sell advertising which is addressed below.)

In each of these cases, the focus was on the giver.  Why is this person giving something away?  Because they get something in return.  (In the case of altruism they get good feelings knowing they helped others.)  The great thing about each of these is that although the giver gets something, the receiver doesn’t have to give anything.  Thus, Genuinely Free.

Although many firms offer products for “free”, they aren’t really free.

Advertising based business models are pretty close to free.  The customer is exposed to advertising in exchange for receiving entertainment or information on TV, radio or the Internet.

Free 30 day trials of software seem free, but they really aren’t.  The user must invest the time and energy to become proficient at a software package which will be taken away in 30 days if they don’t buy it.  This is different from a lite version of software which is Genuinely Free.  If you go to the iTunes App store you will find thousands of Genuinely Free applications.  The providers of these applications are hoping you will upgrade to their full version.  Giving away the lite version costs them very little.

Free is a powerful word.  Unfortunately it is sometimes deceiving.  There is nothing free when you have to buy one to get one free.  Consumers are savvy and quickly see through these tricks.  If you want the impact of free, make it Genuinely Free.

Action:  Can you think of something you can give away for free?  Genuinely Free?  Which of the four reasons listed above can you use to justify your Genuinely Free offering?

Coca Cola brilliantly created a unique price segmentation method and then completely botched the execution.

As you can read in this 2005 New York Times article, Coke created vending machines so that on hot days, a can of Coke costs more than on cold days.  This was superb price segmentation.  We can see why when we look at the 2 steps of price segmentation.

1.  Segment the market – People are willing to spend more for a can of cold Coke on a hot day than they are on a cold day.  Notice that the segmentation doesn’t have to be different people.  In this case the same person’s willingness to pay changes with the weather.

2.  Create a pricing mechanism.  They created smart vending machines.  These machines could sense the outside temperature and adjust the prices accordingly.  Simple and perfect.

So how did they completely ruin this wonderful idea?  The first sentence in the article reads “Remember the plan to charge more for a Coke on a hot day?”  That’s the problem.  They charged more for a Coke on a hot day.  People thought they were being gouged.  How dare Coke take advantage of the heat to extract more money from me.

What they should have done is charge less for a Coke on a cold day.  Functionally and practically, this is the exact same thing as charging more on a hot day.  The BIG difference is the perception of the customer.  If Coke is giving me a discount to motivate me to buy on a cold day, that’s a great thing.  Thank you Coke.

How could they have done this?  Not only should all of their public relations emphasized the discount, the front of the vending machines could have had an LED display that showed “Outside temperature is only 45 degrees.  Please accept a 10 cent discount.”  Everybody loves a discount.

Recall from a previous blog that almost all price segmentation should be done by setting a standard price (the highest price) and then offering discounts from there.  This case is no exception.  Because Coke ignored this little detail, they were ridiculed, lost a little brand equity, and were not able to implement this price segmentation.

Action:  Memorize and internalize this fact.  People love discounts.  People hate surcharges.  If you are going to charge different prices for the exact same thing (which you should), always make your standard price the highest and offer discounts from there.  Have you started price segmentation yet?  Are you using discounts?

Coupons are a fun example of price segmentation.  Let’s look at their usage through the lens of our price segmentation glasses.

As you may recall, price segmentation requires 2 steps:  1. segment the market and 2. create a pricing mechanism.

1. Segment the market

Coupons segment the market into two groups:  people willing to invest time and energy to get a lower price and people who are not willing to put in the effort.

This segmentation is not black and white.  Very few people always use coupons, and most of us would be willing to use a coupon if it was worth enough.  For example, most of us do not use coupons to save a dollar off of Welch’s Grape Juice, but I would wager that most of us would be willing to use a coupon for 50% off of a brand new car.

The two segments are those think the effort is worth the value of the coupon and those that don’t.  Another way to think about this is people who value money more than time vs. people who value time more than money.

2. Create a pricing mechanism

In this case the coupons are our pricing mechanism.  Most of us pay the normal price, but those who are willing to put in more time and effort to use a coupon get a discount.

Screenshot from Coupons.com

Right now on the Internet are hundreds of sites that offer coupons you can use.  Do you use them?  If not, why not?  Probably because most of us are not that price sensitive.  Think about who uses those sites … people who are price sensitive, people who are willing to put in the effort to get a better deal.

IMPORTANT:  As a general rule, price segmentation works by charging the majority of the customers a standard price and then giving a discount to people who can somehow prove they are price sensitive.  Step 2 pricing mechanisms are methods we use to allow people to prove they are price sensitive.  In this case, using a coupon is proof of price sensitivity.  In the previous example we looked at, students showed an ID at the movie theater as proof they were price sensitive (theater owners determined that on average students are more price sensitive than the rest of us.)

To summarize, coupons are a pricing mechanism we use so people who are very price sensitive can pay a lower price, and these people prove they are price sensitive by investing time and energy to use the coupon.

Action:  Does it make sense in your business to offer coupons?  Will people who are very price sensitive use them while the majority of your customers will not?

ps – Coupons are also used for reasons besides price segmentation.  A common goal of coupons is motivating new customers to try your product.  The purpose of this commentary was not to evaluate coupons, but to show how coupons are used in price segmentation.

Value is a a commonly used word, but has three different meanings in the world of pricing.  Whenever we hear that word used by a customer, we need to know what they mean.  The first two meanings of value closely relate with the concepts from “Will I? Which one?“, the two decisions consumers make when deliberating on a purchase.  These two meanings consider the value of a product before considering the price.  The third meaning, reference value, is the value after considering the price as part of the package.  Let’s look at these three meanings using examples.

1. “Will I?” value:  How much do you value air?  Air is essential to breathing, and breathing is essential to life.  Although it’s free, you would probably pay everything you have for air if you had to.  Air is infinitely valuable.  For a less severe example, how much do you value driving to work?  You could walk, you could ride a bike, you could take a taxi?  This type of value best fits in the “Will I?” customer decision.  Will I buy a car?  Not which car will I buy?  Another way to think about this is how much value will you get out of buying a product in the product category.
2. “Which one?” value:  If you are deciding between a Ford Taurus and a Toyota Camry, and the Ford Taurus costs $30,000, then how much would you be willing to pay for the Camry?  In other words, how much do you VALUE the Camry?  This is an example of the “Which one?” consumer decision.  How much do you value one product over another?  This value is how much are you willing to pay for a product, knowing the price of your next best alternative?  This is also the meaning implied in the phrase Value Based Pricing.
3. Reference value:  The final use in pricing contexts is the value of the combination of product and price.  For example after you purchase your new Taurus, you say to your neighbor, “this was a great value” meaning you got a great deal.   Similarly you might also say that you didn’t buy the Camry because it wasn’t a good value.  This third meaning of value relates closely to what you expected to pay for the product.  What you expected to pay is also called your reference price.  So a great value is when the price is much lower than your reference price.

Action:  Do a search in the Wall Street Journal or New York Times on the word value.  Which of these three meanings is implied by the usage?  When your customers use the word value, you want to quickly determine their implied meaning so you can provide the proper response.  Do this exercise to practice that skill.

Please read Value Based Buying prior to reading this post.

Value Based Pricing (VBP) is about setting a price to capture the value that a potential customer receives.  If you understand the post on Value Based Buying, then it will be simple to understand why Value Based Pricing makes sense.

Here are the steps:

1. Identify your customer’s second best option.  If your customer won’t buy your product or service, then what would he or she choose?
2. Determine the price of the second best option.
3. List all of the ways that your offering is better than the second best option.  Estimate how much you think these differences are worth to your customers?
4. List all of the ways that the second best offering is better than yours.  Be very honest here.  How much do you think these are worth to your customers?
5. Your calculate price is the price of the second best option (item 2 above) plus the value of your advantages (item 3) minus the value of second best option’s advantages (item 4).

Price = Item 2 + Item 3 – Item 4

All customers are different, so which one do you think about when doing this analysis?  Choose a customer that purchased from you and do this analysis.  Then choose a customer who didn’t buy from you (harder to find to talk with) and do this analysis again.  Customers who buy from you and those who don’t value your offering differently.  This is especially true for your advantages and disadvantages.  As a marketer your target market should be the customers who value your advantages.  Hence, you should price for those customers.

IMPORTANT:  This does not give you the “Right” answer.  This gets you close.  This let’s you see how your customers are making decisions, and creates a calculated price so you can see if it makes sense.  Eventually, you have to tweak this price up or down based on your judgment and experience.  If you are trying to reach a broader market, you may want to reduce the price.  However, a better strategy may be price segmentation, which we will discuss more later.

Don’t skip this step.  Even if it gives you the same price range you are currently using, it forces you to think about your customer’s decisions process.  This is valuable to you.

Action:  Use the 5 steps above to calculate your VBP for one of your most important products.  Use the information you gathered earlier when talking with your clients.

Value Based PRICING is the most highly recommended pricing technique by consultants and academics.  The basic concept is setting a price to capture the majority of what your customers are willing to pay.  Before we explain Value Based Pricing, let’s look at Value Based BUYING (VBB).  VBB is how your customers make their decisions when they deliberate about which product to purchase.

Imagine you are at the grocery and you want to buy a can of green beans.  Two cans catch your eye, Safeway Select is a store brand and Del Monte is a National Brand.  Safeway Select costs $1.49 and Del Monte costs $1.69.  How do you choose?  You ask yourself, is the Del Monte can worth 20 cents more?

Is it worth it?   To answer this, you think of everything that is different between the two cans.  You may have had better experiences with Del Monte brand.  One may have less salt.  One may be cut differently.  One may have a prettier label.  It’s completely up to you as to what you think is important.  After you’ve determined the important differences, you place a value on them and then decide if the Del Monte brand is worth 20 cents more than Safeway Select.

Of course you don’t actually do this math.  But that is how your mind makes the decision.  You ask yourself and answer the question, is the Del Monte can worth 20 cents more than the Safeway Select can?

Notice there is no right or wrong answer.  People are different and value things differently.  Some people will prefer Del Monte and others will prefer Safeway Select.  This fact is important when we turn this around in the next blog to discuss Value Based Pricing.

Action:  You’ve been asking your customers what they would have bought if not yours.  Their answers tell you who your toughest competitors are.  Choose one of these competitors and do the Value Based Buying math for yourself.  How much is your product or service?  How much is your competitor’s?  What are all of the differences?  (Don’t be biased.  Be sure to list the areas where your competitor is better.)  How would you value these differences?  How do you think your customers value these differences?