When the value to the customer is not clear or hard to quantify it is difficult to go to market with the right price. Take the case of new market entry, while your customers in old  markets may connect well with your value message it is not the case in new markets where the  customers may  not have heard of your brands.

The problem is complicated when the new market is made up of low value, low willingness to pay  customers as in the case of Bottom of the Pyramid. Customers truly lack the resources and wherewithal to spend a whole lot on your products but do stand to get value from your products.

Introducing your product versions from your established and affluent markets into these emerging low WTP markets is fraught with perils. Wrong price will not only result in losing profits but you losing out completely to the local and regional brands.

I wrote about using relative price when the value message is not clear to your customers. The idea is to position your product and price it to capture a share of the budget spend in the particular area. A similar idea, with a variation, would work for bottom of the pyramid as well. Understand the total spend of the customer and what they spend on absolute essentials – then design and deliver a version at a price that is relative to these essentials and profitable to you.

Take the case of P&G, which is going after markets like villages in India and China. Here is what their approach is:

Products, too, have to be adjusted. Procter & Gamble has had to break down products like shampoos and soaps into smaller and less expensive sizes. In these countries, for instance, P.& G. makes sure that a small package of shampoo, enough for one or two uses, does not cost more than the price of an egg.

It is not enough that you compare your price against other direct substitutes and alternatives. You need to survey the whole range of customer spend and understand that you are competing for a share of the customer’s tiny wallet. If you did not understand your shampoo will be competing against eggs you will end up introducing a package at a price that is way beyond the reach of most customers. Note that this is not about cutting your price to meet the low WTP but versioning your product so that it is both priced attractively and can be delivered at a cost that is profitable to you.

Success at the bottom of the pyramid does not mean low prices – it is still delivering great value at the right price.

This a quote (long) from What Were They Thinking?: Unconventional Wisdom About Management by Jeffrey Pfeffer (2007), on commoditization of content

This raises the question of why one would buy a paper whose quality and uniqueness is declining because of inadequate investment in staff; why not just buy the paper from which the Chronicle gets a lot of its stories and which has invested in its own, unique news gathering and reporting? The point is that the more newspapers cut their quality, the less incentive there is for anyone to subscribe. So subscriptions fall, more cuts are made, and the death spiral continues, if not accelerates. The only thing that can possibly provide competitive advantage in a saturated media marketplace is the quality of the writing and the ideas. An undifferentiated, unoriginal product of low quality is not going to save any company in the newspaper, or for that matter any other, industry.

Prices of undifferentiated, unoriginal, non-unique, low quality content with unlimited supply will hurtle towards its marginal cost. In the case of digital content the marginal cost is $0. Facing commodotization, newspapers should not be lowering their price to $0 but stop producing such undifferentiated content.

The new media experts are right in saying newspapers cannot succeed by erecting pay walls for their online content – but only half right. If you are not adding unique value, you cannot capture value by erecting pay walls.

In any  all you can eat pricing model, be it a lunch buffet or at&t iPhone subscription pricing, as long as the  total revenue  exceeds total costs the business will be making profit  regardless of whether they lose money on any single customer.  There will always be a distribution of customers based on value they receive and price they pay

1. Some customers get more value than what they pay
2. Some don’t get as much value as they paid for

The problem occurs  when  the first segment uses a higher proportion of the service and risk completely starving the second segment.

AT&T says,

the heaviest data users, saying that 40 percent of AT&T’s data traffic came from just 3 percent of its smartphone customers

To provide appropriate level of service to the second segment AT&T needs to size their services so the big appetite of the first segment is served. Facing customer backlash from slowness, AT&T is trying to reduce data usage by the heavy iPhone users – this implies they are either working on introducing metered pricing or a multi-version pricing.

Either of these plans require that their subscribers understand the value they get from the current unlimited plan. If the customers do not know  how much value they have been receiving they will balk at any changes to current pricing. AT&T has a leg up on this, they have been itemizing  data plan usage minutes (page after page if you received paper bill) even though the plan is supposed to be unlimited. It is arguable how many customers look at paper bill but the auditing does provide a way for AT&T to make a case with its customers when they introduce new pricing plan.

For example,

“Dear customer, do you know, on the average, you used 100 minutes of data service for 1GBytes download in the past 12 months. That’s $50 in value per month and $30 more than what other customers like you receive. To better serve your needs and those of all our customers like yourself we are introducing a new pricing plan …”

Which one will it be? Will it be metering, charging per minute or megabyte of download of data usage? Will it be a set of new data plan versions offering a combination of minutes and download? Which has better chances of succeeding?

I do not believe it will be usage based pricing. It does not align with the current minutes plan and the  problem it introduces with customers constantly worrying about using the data service.  AT&T already has a track record in executing a successful multi version pricing plan for its wireline high speed service (see figure left). Modeled after this we should expect to see three to six different data plans at different price points, each offering a combination of minutes and download (GBytes).

Versioning is about offering multiple versions at different price points so the customers self select- in this case it also helps to better align the value customers have been receiving with the price they pay.

Cost based pricing is tacking on a % margin to the cost of the unit instead of pricing your product/service based on the value it adds to your customers. Let me try to explain how ridiculous cost based pricing is by taking it to the extreme.

Suppose you ran a coffee shop that sold just one SKU (as I said I am taking this to the extreme to prove the point). As your customers buy their cup of coffee they see a row of jars in front of them. Each neatly labeled with

1. a short definition of what it is for
2. a dollar value

There is a jar for

• mortgage
• insurance
• delivery
• coffee beans
• milk
• utilities
• bathroom cleaners
• interest
• depreciation on coffee machine
• salary for employee 1 &2
• childcare (for your child while you work)
• profit

Each jar is also marked with a respective dollar amount.

You ask your customers to drop exact amount marked on every one of those jars.

Every time the price of coffee beans, milk etc goes up you re-lable your jars.

What do you think your customers will do?

Ask your self what your customer is paying for? Did they walk into your store to get their daily caffeine fix or to help you offset your costs?

Do you practice effective price management?

Reasoning and decision making biases are not new – they have been extensively studied and reported.  Committing the same biases are not new either – for academics and new media specialists alike. It should come as no surprise to see the same mistakes committed by very smart  thought leaders like Mr. Anderson and Mr. Om Malik when they write about how Freemium  would help startups and other businesses alike.  I have written previously about biases committed by Anderson in his book Free, now let me discuss Mr. Om Malik’s case for freemium.

To be clear, Mr. Malik’s post is titled  How Freemium Can Work for Your Startup , in which he discusses three startups, EverNote, RememberTheMilk and DropBox and on their ability to generate revenue with a freemium model. Based on these an on a NYTimes article on EverNote Mr. Malik offers 10 commandments of a successful freemium app. Let us look at the biases and flaws in the overall case for freemium and flaws in one  specific “commandment”. His rest of the commandments are actually quite good and applies to any business model a startup chooses.

1. Survivorship Bias: – Mr. Malik looks only at those that “succeeded” (by his definition I understand, generating some revenue, not necessarily profit). What about all other startups that failed despite? Did he closely look at all those that failed to say that these did not have the same characteristics as the three he declares to be successful? This is not new, we have seen this flaw before in the business best seller Good to Great by Jim Collins (who later followed through with Why the Mighty Fall).
2. Availability Bias: Mr. Malik’s post came after his query to his readers for services that they find indispensable.  So we can hypothesize that his argument is based on information that is available to him and vivid in his memory.
3. Ignoring Other Options: EverNote may be making $79,000 per month from a fraction of the free users who upgrade to paid service,  but could they have generated equal or more revenue  through other marketing options available to them including offering only paid versions? I do not have data to say either way, neither does Mr. Malik offer any to support that Freemium was the best of the available options to EverNote. After evaluating all options if freemium still offers the best chance to succeed, then by all means do it but not without exploring other options.
4. Can the business wait? In a follow up post, Mr. Malik writes,
   

   I used Evernote as an example of a freemium application that’s successfully converting its free users to paid ones. Indeed, the more people use an application like Evernote, the more likely they’ll be to pay for a premium version of it.

   Mr. Malik recomends patience as a virtue, waiting for customers to fall in love and find the service indispensable not to mention switching a hassle. Customers, enamored by the free service will try it and start using it and this may take a long time before they upgrade to the paid version. Can businesses know or model this conversation rate? Without this, it is incorrect to assume that this conversion will happen and will do so before your startup runs out of cash. Customers can stay on free version longer than your startup can stay solvent (hat tip to Keynes).

5. Free is Free marketing? One of the 10 commandments is
   

   Free is free marketing. Instead of advertising, the service should sell itself.

   How true is this statement? Where is the data? Does free sell better than marketing/advertising? I have some data,  a paper published in Marketing Science Aug 2009 studied the impact of marketing actions like exhibits, print ads, PR. Of these marketing actions, all but PR and Exhibits yielded better long run sales than free as the marketing action.  Another problem is when there are many similar free services available to the customers – what will be your share of mind and wallet?

To repeat, if after evaluating all options  freemium still offers the best chance to succeed and maximize your profit, then by all means do it but this is not a generic solution as it is touted to be. Do not accept, without challenging, statements like “freemium works” or “it worked for 3 and hence it will for every startup”.

“For example is not proof”

Yes there may be a market and a considerable number of customers who are willing to pay for certain products and services. Is the existence of the market a good enough reason to make the investment?

This is a quote from The Times story on entrepreneurs who started small businesses like coffee shop. One of them, Ms. Adler, who runs a bakery said,

More people may be on a tighter budget these days, but if you need your daily caffeine fix, you probably won’t give this up

Ms. Adler may be right. Economy or not there will a group of customers who need their daily caffeine fix and are willing to pay for it.  But, how many of those customers will choose your stores, how often and why? If you see the opportunity, how many others also see it?

The size of the pie may be big, assuming the pie exists, but what will you get to own for yourself?

“0.5% reduction in mobile subscriber churn rate can increase revenue by 74%” – No really, but don’t stop reading, let us talk realistically about customer loyalty, customer lifetime value and  effect of loyalty on your profit.

Let us take AT&T as an example. It has a current monthly churn rate of 1.17%, the lowest among top 3. Churn rate is the % of current subscribers leaving the service provider. This translates to 14% yearly churn rate. Conversely, AT&T’s customer loyalty is 86%. So lifetime of an average customer with AT&T is  1/14% = 7.14 years.

Let us assume all customers bring in same revenue for simplicity (even though this is wrong)  of $x/year. So customer lifetime value is 7.14x. Let us say AT&T spends $200 to acquire a customer and the monthly bill is $50. The Lifetime Value of the customer (ignoring PV calculation) is$4084.

If AT&T can reduce their monthly churn by 0.5% -  0.5% reduction in churn makes the churn rate 0.67%/month, 8.04%/year, 12.4 years, that is 5.26 years more than previous state and hence 74% increase in revenue. If only AT&T can decrease its monthly churn by 0.5%, it can increase its revenue by 74%.

QED?

Let us pick apart this spurious reasoning and sleight of hand:

1. Anytime you increase average lifetime of customers you increase revenues proportionately. There is nothing magic here. So stating, ” increasing loyalty, when everything else like prices is held constant, increases revenue ” is self evident truth and not an insight.
2. I said reduction of 0.5% monthly churn rate. In reality this is reduction from 1.17% to  0.67% – this is confusing two different percentage scales. In reality this is 43% reduction in monthly churn.
3. What is it going to cost me to reduce churn by 43%? What is the new infrastructure investment needed? What is the opportunity cost of this investment? What is the incremental profit from this investment? Is this going to require “buying loyalty” with price cuts and promotions? Even if you gain or buy loyalty, is that stable and sustainable? If AT&T is going to spend money on this, will Verizon and Sprint stay still? Can the money be better spent in acquiring new customers?

Without answering these questions, it is pointless for me or any management guru to say to you to focus on customer loyalty and it is irresponsible for a decision maker to accept these pseudo-facts without challenging them.

Businesses, small and big are almost obsessively focused on allocating a portion of every cost incurred to every unit produced. The distinction between sunk costs and  marginal cost is lost on them. Costs that are incurred regardless of volume produced are spread over units produced. For example, a Cupcake business allocates a portion of the mortgage, insurance and other fixed charges to each cupcake.

The problem is complicated by the way these businesses set pricing, they simply tack on an artificial margin to come up with unit price

Cost Based Pricing: Unit Price = Unit Cost * (1+ % Unit Margin ) (WRONG!)

There is no logic behind the % Unit margin, it is either based on what competitors are reporting or a magic number someone comes up with. An arbitrary number that has no meaning and no indicator of absolute profit becomes the number everyone in the organization works towards. No effort is spared to protect  (and increase)  % Unit Margin leading to drop in absolute profit.

The net result is the business has no way of knowing what the market demand is and how the market will react if they were to change prices. Due to their fixation on protecting he % margin they end up selling at the wrong price and losing out on the absolute profit. Since the unit cost is wrong to start with the % margin leads to higher prices. In addition, in this method of cost allocation, any increase in volume will reduce unit cost and any decrease in volume will increae unit costs (because fixed costs are spread over more units).

Increasing market share requires them to produce more unit and it also helps with reducing unit cost. So they produce more, flood the market and end up discounting heavily, destroying the very margin they were trying to protect.

Businesses are reluctant to give up market share in favor of profit because producing less “eats into % margin”. When business have high market share and operating at near full capacity, the unit cost is at its lowest. Due to the incorrect cost allocation, higher market share is wrongly associated with higher % margin. So businesses spend all energy in defending market share.

If the demand shifts down (due to recession), businesses are reluctant to  reduce volume produced because the decrease in volume increases unit cost and hence “eats into % margin”.

This is the same reason businesses are reluctant to increase prices because any price increase leads to lower volume which affects unit cost and % margin.

What starts as cost allocation mistake leads businesses down the wrong path of protecting market share and % margin.

Here are some questions I received from my colleagues and entrepreneurs who read my articles on pricing based on value.

Does pricing based on segmentation and value to segments apply only  for established enterprises?

Is value an irrelevant term for innovative new products  that aren’t just improvements over existing products and are truly different from anything that existed before?

Does pricing for  information goods (bits over atoms) require us toss out all our understanding of economics and look for a new one?

Pricing on value for the customer is tough when you are a startup with very low reference point to measure the true value. There are some direct value in using my product, and there are indirect benefits. How do you  measure/estimate all these?

These are valid questions, there are no pre-packaged answers for all.  But the basic premise of marketing remain unchanged even for startups and digital economy – segmentation and targeting.

Let me answer one of the questions – how to determine value to customer for new offerings – based on what I did in the past. The solution was a stopgap and served its purpose when the value to the customers was not clear. It was based on relative price – that is price relative to what customers pay for  products and services in the same class.

One of the clients had a product that was easy to explain but was difficult to define value to customers. The product was generic enough for customers of all sizes and verticals but it was clear not all of the customers had the same wherewithal to pay. Since the value was not clear neither was customer WTP and hence there was no demand curve. The product is bits not atoms and had no marginal cost. So it is fair to say this had all the complications raised by entrepreneurs.

What job is your customer hiring your product for: The first step I did is positioning the product – there are many definitions of positioning the one I mean here is creating a connection in the minds of the customer to a product/service they already know and use.  This is the hard part and the first one may not be the right one. One way to define this is by answering  “what job is the customer hiring your product for?” (Clayton Christensen). Position your products for those jobs. (Note that the usual marketing strategy is S-T-P, here it is P-S-T)

Segmentation: The second step is segmentation based on value. Since value is the undefined part here,  I looked at what is the total customer spend to solve those jobs. For instance if you are positioning your product for team collaboration, find out what different customers spend yearly on  alternatives they use. Dig deeper and find indirect costs  that are incurred due to inefficiencies of current solutions they use. Rank order the different segments based on their spend and other factors.

Targeting:  You cannot go after all segments. This is especially true for a startup with limited everything. The total opportunity size may look attractive but you need to identify those segments that are attractive in terms of opportunity size, ease of reach, other competitors serving those segments and  future potential. I chose the segment that  had the most annual spend and did not have a way to track the ROI on its spend.

Pricing to get a share of the budget: Then I priced it as a share of the average spend of the segment. For example for the team collaboration case if the  average annual spend by a customer was $1 million, I would have priced it as  0.1% to 0.5% for my offering.  As you notice, this has no relation to value but makes it easy for you to have a conversation with the customer by pricing it relative to what they pay for similar services. Your pitch could be, “for 0.1% of what you spend on X our product will help you achieve  results 1, 2 and 3″.

The net is I am not recommending this approach for everyone nor would I do it next time but this helps to illustrate the point that there are ways to price a new product when the value isn’t always clear. It was basically asking:

1. Whose budget is this going to come from?
2. What is the size of that budget?
3. How can I get a tiny fraction of that budget?

What are your thoughts?

The problem with digital goods is it is easy to get confused by its economics, the marginal cost is $0, selling a unit to customer does not make it unavailable to another and there are challenges in restricting use. This has led to supposedly new branch of economics, “economics of free and abundance”, led by Mr. Chris Anderson and has built a large following.

I have written several articles on the need to sell the value and not focus on the marginal cost. In the digital world matching price to value is more difficult than it is in physical world.  Economist Brad DeLong from UC Berkeley (my alma mater) writes in his 1999 paper titled, Speculative Microeconomics for Tomorrow’s economy,

In many information-based sectors of the next economy, the purchase of a good will no longer be transparent. The invisible hand theory assumes that purchasers know what they want and what they are buying so that they can effectively take advantage of competition and comparison-shop. If purchasers need first to figure out what they want and what they are buying, there is no good reason to assume that their willingness to pay corresponds to its true value to them.

When customers do not exactly know what they want and the value they get, the marketer will find it hard to make a value proposition and charge a price that captures that value. Difficult does not make it a good reason to give up on charging for digital goods and give it away for free.

In a Nov 1998 article in Harvard Business Review, economists Hal Varian  (also from Berkeley now at Google) and Carl Shapiro wrote (Harvard Business Review, 00178012, Nov/Dec98, Vol. 76, Issue 6)

But there is a practical way to set different prices for basically the same information without incurring high costs or offending customers. You do it by offering the information in different versions designed to appeal to different types of customers. With this strategy, which we call versioning, customers in effect segment themselves. The version they choose reveals the value they place on the information and the price they’re willing to pay for it.

It takes us back to what Ted Levitt said about customers buying holes and later what Clayton Christensen said about, “what job is your customer hiring your product for?”. The difficulty in value calculation comes from focusing on the “drill” and not on the “hole”. If marketers focus on what the customers really want and what job they are hiring the digital information for it becomes easier to tease out the value to customers and how it differs across segments. Then the marketer can target the segments with specific versions and position it appropriately to capture a share of the the value through effective pricing.

Fads like freemium, freeconomics and economics of abundance can help to sell books or speaking engagements but as Hal Varian (who was described by Mr. Chris Anderson as someone who taught him more about economics than any of his professors) said in 1998 (full ten years before the fads):

Success in selling digital goods does not require a whole new way of thinking about business. Rather, it requires the same kind of smart managing and smart marketing that have always set apart the best companies. The real power of versioning is that it enables you to apply tried-and-true product-management techniques-segmentation, differentiation, positioning-in a way that takes into account both the unusual economics of information production and the endless malleability of digital data.

Probably Mr. Anderson missed this class.

The road to profitability in any market goes through STP! That’s Segmentation – Targeting – Positioning. The rule does not change whether you are selling physical or digital goods.