Pragmatic Pricing

A couple weeks ago I taught a pricing class to about 40 professional marketing people.  We started out discussing Value Based Pricing and how it’s more profitable than cost plus pricing.  We then went on to discuss when costs matter and how to use them in pricing, which is almost never. Great discussion followed and it was obvious they intellectually understood the concepts.

A couple hours later one of the students applied a version of cost-plus pricing to their portfolio.  I had to remind him that costs don’t really matter.  Then another student did it.  Then another student.  I started feigning dejection each time someone mentioned costs, and of course they laughed.  By the end of two days of this, the students were finally internalizing the concept.  Whenever they said the word “cost”, they would say it thoughfully, timidly, verifying they were using it correctly.

That’s when I realized, cost plus pricing is deeply ingrained in us.  As shoppers we expect companies to use cost plus pricing. It feels fair.  It feels secure.  As business people, it is very hard to disavow cost plus.  So, let’s try again.

There are 3 rules that govern how costs should effect pricing (if you’re using value based pricing). Read them and go ahead and disagree. Then think hard about them. Just like the students, you need to get them out of your system.

The 3 rules

1. Fixed costs NEVER apply to pricing. Use projected fixed costs to determine whether or not to enter that business, not to set prices. Past fixed costs are sunk costs and are mostly irrelevant.

2. Variable costs do NOT apply to setting prices in negotiated markets.  (Negotiated markets are like automobiles, where each customer negotiates their best price.)  Instead, use your variable costs to help determine your floor.  What’s the lowest you are willing to accept if you have to go down that low.

3. Variable costs DO matter when setting TIOLI prices.  (TIOLI or Take It Or Leave It pricing is where you set one price and many customers decide whether or not to purchase, like in a grocery.)  In most cases as you raise price you win less business.  You need to estimate your demand and profitability at both price points.  Since your profitability depends on your variable costs, then obviously these costs matter.

These are not complicated, but they do seem hard to internalize.  Send your objections or questions to me.  I’ll do my best to address them.  If you want to be as profitable as possible, heed the following management advice:  Disagree, then commit.

Mark Stiving, Ph.D. – Pricing expert, speaker, author

Photo by Herederos de Rowan

Does price segmentation make you uncomfortable?  Do you feel like you’re cheating the customers who pay higher prices? 

Here’s one way to look at price segmentation.  You are taking from the rich and giving to the poor.   You are following the Marxist philosophy, “From each according to ability, to each according to need.”  You are redistributing wealth.

As an avowed capitalist these concepts are hard for me to type, but the interesting thing is in most situations for price segmentation we really are acting Marxist.  And in many ways, it makes us feel good.

Let’s start with an easy example.  Airlines make huge margin when they sell first class seats.  Why can’t they be more profitable?  It’s because all of us normal travelers are beating them down on price.  If it wasn’t for first class and business class, either airlines would go out of business or we would all be paying higher fares.  You see, the first and business class travelers are subsidizing our seats.  They can afford it or they wouldn’t pay those prices.  We can’t.  They pay more, we pay less, the airlines barely stay in business.  Sounds like Marxism.

This could be one of the best examples.  On May 12, 2000 the New York Times opened an article with “Five pharmaceutical companies offered today to negotiate steep cuts in the price of AIDS drugs for Africa and other poor regions afflicted by the disease.”  They go on to describe how one treatment, that has a worldwide ASP (average selling price) of $16 would sell for only $2 in Africa.  This is an 87.5% discount. This should have saved or prolonged many lives in Africa.

From a segmentation point of view, poor Africans can’t afford the full fee while most rich Americans can.  But what about the Americans?  If they can’t afford it they can’t buy it?  This is true, that some Americans may have not been able to afford it, and that is truly sad.  However, if the drug companies didn’t have the rich American market to sell into, they couldn’t justify developing the drug.  The rich American market is what motivated the drug companies to attack the problem.

But it still doesn’t seem fair.  The development costs are all sunk costs.  They’ve already been spent.  Why not just make them sell in America at $2 like they do in Africa?  Surely that covers the cost to manufacture the product.  Here’s the problem.  If we do that, the drug companies won’t develop drugs for the next huge epidemic.  They won’t even work to improve the current drugs.  The rich American market motivates drug companies to invest in R&D.

Price segmentation isn’t perfect Marxism by any means, but from many perspectives it achieves similar goals.  From each according to ability, to each according to need.  This sounds a lot like pricing to Willingness to Pay.

Mark Stiving, Ph.D. – Pricing expert, speaker, author

Photo by loop_oh

You know the traditional 3 C’s of pricing: Cost, Customer, Competitor.  We can think of these as the environmental factors that drive optimal pricing, but as pricing people we have little control over them. 

Several months ago we proposed a 4th C, corporate strategy.  This met the same criteria as the original 3 C’s.

The other day it became apparent we need a 5th C, capacity constraints.

I was working with a client who, as a consultant, charges by the hour and has regular weekly work hours at each of her customers.  For example, she would spend the day with the same customer 8 hours every Monday, a different customer 4 hours Tuesday afternoons, etc.  As we discussed her pricing situation, it became apparent that she should be charging higher prices to NEW customers when she already has an almost full calendar.  When her calendar is more empty, she is more in need in clients and less able to lose the opportunity.  Then she should charge less to make certain she fills her time.

After stepping back and thinking about her situation, she should charge different prices based on how close she is to full capacity.  Wait, airlines do this as well.  The more full an airplane is, the more expensive the seats.  Hotel rates go way up when demand increases.  (I heard that a room at a Best Western in Indianapolis over Super Bowl weekend was over $1,000.)  Some spas only offer their most expensive services during their busy hours.  It’s all around us.

Think about your business.  Are there times when you are capacity constrained?  Can you find a way to increase prices during those periods.  One way is to be selective of your customers during those times.  Typically you will want to continue to serve your regular, loyal customers without price increases, but there is nothing to keep you from raising prices on new customers.  Who knows, they may remain customers at higher prices, even after the capacity constraints have eased.

Mark Stiving, Ph.D. – Pricing expert, speaker, author

Photo by Sarah Elizabeth Simpson

If people were rational, well, economic theory would work.  Buyers would make purchase decisions based solely on the value of the acquisition relative to the price.  But we know people aren’t rational in many ways, including price. 

For example, if people were rational, why would so many prices end in 99 cents?  (Because we are lazy subtractors.)

Why would people assume a product is higher quality just from the price?  Shouldn’t they know the quality first and then decide if it is worth the price?

Why do people get so upset when they see “unjustified” price increases?

We can manipulate consumers choices by offering good, better, best product offerings.

We can confuse them with too many choices.

We can get them excited about and move them to action with a sale.

They will pay more (or less) for the exact same object depending simply on what they expect to pay.

Pricing is psychological.  Consumers are much more effected (make more irrational decisions) than companies, but companies do it as well.  Corporations have buyers, and these buyers are normal people with the same emotions as the rest of us.  They have been trained to be more rational, but in the end they are people.

If you are a B2C company, you absolutely must pay attention to the psychology of pricing.  It is not an option.  If you’re B2B, you should be able to focus more on delivering real value for the price, and justifying it with rational arguments.  Even so, don’t be surprised when your customers exhibit irrational behavior based on pricing psychology.

Mark Stiving, Ph.D. – Pricing expert, speaker, author

Photo by Thomas Thomas