Pragmatic Pricing

The other day, in a group of about 25 “normal people” (i.e. non-pricers), one of them went on a rant about how the airlines are trying to nickel and dime us to death.  In particular, this person was especially upset about the new fees for checked luggage, and now even some carry-ons.  Being a pricing expert, I calmly explained how this was more fair because people who use the services pay for them and people who don’t use them can pay less.  Not a single person agreed with me.  They all HATED it. 

What is happening?

This is a consequence of a couple things. Recall that unfair means an unexpected change that is not in our favor.  This change was certainly unexpected, and the way it was presented it was not in our favor.

The airlines did the equivalent of raise prices.  They took away services without an obvious price decrease.  The decreased services were noticeable, any associated price decreases were not.  Hence, we think this is unfair.

The airlines could have had normal price increases and then offered discounts for passengers without luggage.  This would have made the passengers happier, but the one airline who did this would suffer.  Most people buy airline tickets comparing the prices that show up on Expedia (or similar) and Expedia doesn’t list all of the fees.  If an airline charges higher prices with a discount for no baggage, the higher price shows up on Expedia.  Another airline that charges lower normal prices with a fee for baggage has their lower price show up on Expedia.  Obviously the airline with the lower normal price will win more business.  Consumers are not using the baggage fee as part of their purchase decision.

Remember when the airlines debundled food in coach?  They used to serve us a meal, now they try to sell us one.   This didn’t create the same outrage, but I remember people complaining about it.  Once we got used to it, the bad feelings went away.  The same will happen with the baggage fees.  In a year or so, people will forget what it used to be like.

We make so many purchases, some bundled, but most unbundled.  It seems very interesting to me that the act of unbundling a service can cause so much heartache.

What lesson can you learn?  You have to carefully communicate changes in pricing.  What if the airlines announced their new policy like this:  “Checking and caring for your luggage the way it deserves is expensive to us, and many of you don’t use that service.  We will stop bundling baggage service with our flights so those of you who don’t need it don’t have to pay for it.  We are lowering the price of all tickets by $50 and offering our baggage service at the rate of $50 per checked bag.”

The outrage may have been reduced.

The battery in my car died the other day.  After unsuccessfully attempting to replace it myself (why are cars so hard to work on these days?) I called around to find a shop that had the right battery. 

On the phone they quoted a flat rate for the job, which included the battery and the labor.  They must have created the price “on the fly” by adding the price they would charge for the battery and their estimated cost of labor to change a battery (maybe for my car).  The fact that they quoted a flat rate made me feel much more comfortable than a price for the battery and then an hourly rate for labor.  If they had quoted an hourly rate I wouldn’t know how much the bill would be until it was time to pay, and then it would be too late to do anything.

When I arrived and was waiting to be served, I was looking at their displays.  They were advertising three levels of oil change service, $29.95, $49.95, and $99.95.  Since my car was due for an oil change, I ordered the middle one (of course).  Then I started thinking, they would not have gotten my oil change if they priced based on an hourly rate.  It was the flat rate that made me comfortable.

When does it make sense to charge “time and materials” vs. “flat-rate”?

This question is relevant in so many different situations.  These certainly include auto and other repair shops, along with consulting projects, building projects, and anything custom like logo design.

The flat rate price lets the buyer know the maximum he will be liable for, which is very comforting.  It assures the buyer that he will not get ripped off with padded hours.  It implies that the selling firm is experienced enough to know what it will take to get the job done.  Flat rate pricing is also insurance to the buyer, in case their job is more difficult than most.  Most people would prefer to purchase on a flat rate.

Yet sometimes, time and material is the only way to quote.  A plumber doesn’t know how long it will take to unclog your drain until he shows up and tries (unfortunately I know this is true.)  Yet a plumber can and usually does quote a flat rate to a contractor building a new home because it is more predictable.

It seems that everything points toward trying your best to quote a flat rate whenever possible.  Another reason to quote a flat rate is price segmentation.  If you publish an hourly rate, then you are unable to get customers who differ in their willingness to pay to actually pay different amounts, unless you unethically fudge the hours worked.  However, if you are quoting flat rates, you can easily find ways to segment prices.

One big downside to quoting flat rates is the risk that your costs will be much higher on that job than you estimated.  Hopefully on most of your jobs your costs are less than or equal to your estimates, so on average you make good profit.  Then on the occasional job that is more difficult, you lose a little, but you made it up on all the other jobs.

This is especially a big problem for very large projects.  It even has a name, The Winner’s Curse.  For example, imagine 10 contractors bidding to build a new office complex.  Each one has the exact same costs and profit needs.  The only difference is the person that estimates the cost of the job.  Some people will err high and others will err low.  The company that estimates their costs to be the lowest is most likely to price lower, will win the job and may lose money because they estimated their costs too low.  This is why they call it the Winner’s curse.

The bottom line is – try to quote flat rate prices.  Your customers prefer them and you have more pricing flexibility.  Of course you are taking the risk, but you should be able to charge a little more since your flat rate includes “insurance.”

How do you price to maximize the lifetime value of a customer? What an interesting question.  In its simplest form, the issue comes down to customer capture and customer retention.

What does it take to capture a new customer?  Of course when we price a product we only have a probability of winning each deal.  The lower we price the product the higher the probability that we win.  If this is a one-time purchase, meaning that selling this one doesn’t make it more likely to sell the next one to the same customer, then we would simply choose the profit maximizing price using the models as we always do.

However, if we believe that capturing a customer makes it more likely to sell another unit later to the same customer, then it is in our benefit to lower our price so we can win more customers up front.  We often see special rates to new subscribers for satellite TV service, or cellular phone service.  These are services where they can determine if you are a new customer or not.  And once they have you, they really lock you in (for 2 years).  We also see prices as low as free to capture new customers.  For example, free samples of products or free trial periods of software.  The more likely you are to sell another unit to the same customer, the lower you will set your customer capture price.

Our customer retention price works the same way, only it is slightly higher.  We are assuming now that we have some “loyalty”, meaning the customer is predisposed to purchase our product over our competitors.  That is why we gave the discount on the customer capture price.  This means that we could get away with charging a higher price than we would if the customer were making a first-time decision.  After all, we should be able to capture some of that loyalty.   When we set this customer retention price, some customers will buy and some won’t.  We may be tempted to select the profit maximizing price for this decision.  But note that we are in a similar position as we were when setting the customer capture price.  If we win a customer, we have a higher probability of winning him again.  This gives us extra incentive to lose fewer customers, motivating us to price lower than our profit maximizing price.  This price of course is going to be higher than the customer capture price, but not as high as it would be if we knew this is the last this customer will purchase from us (or give us loyalty).

What if you could segment loyal customers from those that make stand-alone decisions every time?  The above logic implies that you may want to give your loyal customers lower prices, because that keeps them coming back.  Restaurants like Subway that offer a buy 10 get 1 free card are doing exactly that.  They offer their loyal customers a 10% discount (actually 9% but who’s counting?) while the non-loyal customers pay full price.

The real answer though is it depends.  It is very possible that the loyalty is so high that you may be able to charge an exorbitant price to most of your repeat customers while losing only a few.  In this case you would charge them more than a non-loyal customer if possible. Yet I can only think of three conditions where you could get away with this:  1.  the customer is ignorant of other rates and just keeps on writing the check;  2. the customer is somehow locked into the deal, like a cell phone contract;  and 3. the customer faces some very high switching costs (similar to 2).  In the absence of one of those three conditions, you should set your loyal customer price lower than (or equal to) your non-loyal customer price.

Summary – Without going through any complex math, our logic produced the following generalizations.  For customers who are more likely to make a repeat purchase, charge a lower price to capture more of them initially.  For their repeat purchases, charge more than the capture price, but less than what you would charge a non-loyal customer.