# Value Distribution – Weight Scales

Can you see the likely value distribution for features and the pricing is aligned to capture that value?

You really don’t believe Wifi is priced about \$70 more because of marginal cost, do you?

Do you know how to find how your customer segments value different features and hence how to charge for them?

Note: In the example above observant readers will notice brand is another variable that could influence the price difference.

# Price Realization Through Creative Packaging

This is how you do better price realization through creative packaging without upsetting customer reference price.

Customers are used to \$3.49 price they pay for similar almond bars but with less than half of protein. Nature Valley could have introduced the new protein bar at higher price to attract different customers. But they found it is better to appeal to their regular customers if they can get better price without unsetting their reference price of \$3.49.

The result is the creative packaging – maintaining same box dimensions and reducing the number of bars from 6 to 5 – a 16.7% savings in marginal cost that flows directly to profit.

Did you know there were only 5 bars in the Protein bar box? I didn’t until now.

And there is absolutely nothing wrong with better price realization through creative packaging.

# The Lego Pricing Puzzle

In a recent Wired blog post, physicist Rhett Allain asks

# Why Are LEGO Sets Expensive?

and answers his own question by stating,

I’m not sure I would say LEGO blocks are that expensive, but the statement is that they are expensive because they are so well made.

To his credit he immediately qualifies his claim by adding

Really, this has to at least be partially true.

Then professor Allain goes on to make his case based on size variances in Lego pieces and compares it with variances in other blocks used for “play constructions”. Finding no statistically significant difference with other plastic blocks he adds,

but the LEGO blocks appear to be created from harder plastic. Maybe this would lead them to maintain their size over a long period of time. (but no data)

Finally he builds a regression model of price of Lego sets  to number of pieces in each set.

In essence, Allain made up his mind that Lego is expensive because of the intricacies in manufacturing, its cost of materials and number of pieces. He then collects data that would support his claim but quickly discards them with alternative explanation when data doesn’t fit his claim.

But lost in all this are some published hard numbers from Lego. They have 70% gross margin and 30% operating margin. Note that I am using gross margin reported in financial statements that usually include other fixed cost allocations to confound the numbers. That is Lego’s real contribution margin (price less true marginal cost) could be higher than 70%.

Even if Lego were to cut is price in half they would make as much gross margin as MegaBloks that makes Lego compatible pieces. Intricacies in manufacturing and cost of hard plastic do not contribute to Lego’s costs (or prices as Allain claims). That is Lego does not incur any additional costs because, “they are so very well made”.

Lego is priced thusly because they identified customers who value its offering and are willing to pay the price premium despite the presence of cheaper alternatives. All the reasons about details of pieces and their size variance are post purchase rationalizations we tell ourselves to justify the price we paid.

Your costs are just that, your costs. Costs are not something you pass on to your customers (unless you use that as ploy to pass on price increases).

# On Free Kindle

It appears, at least to Farhad Manjoo, Kindle is going to be free. He writes in recent Slate colum,

I can’t tell you when this will happen. But it will happen. Mark my words: The Kindle will be free.

Let us not delve into how he arrived at such a certainty couched as a measured statement with uncertainties.  Let us take his word for it and look at what it would mean to Amazon’s profits. According to Manjoo, who seems to have a window into Amazon decision maker’s mind and their business strategy,

First, why? Well, that’s easy—because Amazon’s long-term goal is to make money from selling content and general merchandise, not by peddling its own devices.

The case in point is the low-end \$79 Kindle that will be free. So what kind of money should Amazon make by selling content and general merchandise by not peddling its device? Let us be aggressive and assume that this low-end Kindle is going to be great to sell general merchandise and not just content.

Again according to Manjoo, Amazon makes no profit on these devices or may be even losing money. Let us say they are indeed selling \$79 Kindles at their marginal cost.

Say by making the Kindle free, they sell 20 million of them.

Cost? \$1.58B for 20 million units. Just to stay where there are with current gross margin, they have to gain gross margin(not sales) of \$1.58B from content and merchandise sales.  To put that in perspective, Amazon’s 2011 gross margin is \$10.8B from sales of \$48B. At its 22.4% gross margin, this \$1.58B means \$7B in sales.

And this \$7B  sales will all have to be incremental new sales, sales that are made possible only because of the free Kindles. Sales that would have any way happened, because customers do shop even without free Kindle, cannot be counted towards these numbers.

On a per Kindle basis that means every free Kindle user must spend additional \$350, above and beyond what they are already spending with Amazon. How likely is that scenario? Say amazon now has 100 million shoppers, its current revenue of \$47B means, each shopper spends an average of \$470 per year. Can a free kindle somehow add \$175 per year (assuming device lifetime of 2 years) to this \$470?

Now this is just the simplest of the math. You can see how unfavorable it gets when you add in lost profit from those who buy other Kindle models and Kindle Fire switching to free version.

On the flip side, say if Amazon were able to sell 5 million of the \$79 Kindles. As per our marginal cost assumption they are no costs. If Amazon were able to generate the same \$175/y in incremental sales from these 5 million customers that is \$875 million in new sales and \$196 million in new profit – not just the profit they had to make stay at same place but something that actually moves the needle.

Why wouldn’t they do that? If somehow a free Kindle buyer could be coaxed to spend \$350 more why is not possible with the one that bought Kindle for \$79?

I don’t have the window into Amazon’s strategic mind or the data they are looking at.May be you should ask Manjoo.  Amazon has said before, “economics don’t work for a free Kindle”. That appears as a bluff to Manjoo.

What appears like a bluff to us outsiders may really be the result of strategy guys doing their job – evaluating all possible paths ahead of them and making choices with constraints.

That is the difference between writing something based on one’s wishful thinking and having to make decisions that affects shareholder value.

# On Pricing Low

Here is a comment on an old article of mine titled, Enough with the marginal cost argument,

Rags, there may be a pony in here somewhere, but I’m having trouble finding it.

In competitive markets with many substitutes, marginal cost is a the key to pricing. You may not like it, but it’s true. The start up costs may impact new players, but if the startup costs are already sunk, they are irrelevant. A rational player will grow market share by cutting prices until marginal cost is met. If you tried to compete with YouTube by charging to make up for your startup costs, you’d lose, right?

Now here is what the same commenter had to say in his own blog about low prices (of course I cannot be sure about the identify of the person who commented on my blog, looking at the phrases it is highly likely the two are the same)

If you build your business around being the lowest-cost provider, that’s all you’ve got. Everything you do has to be a race in that direction, because if you veer toward anything else (service, workforce, impact, design, etc.) then a competitor with a more single-minded focus will sell your commodity cheaper than you.

Cheapest price is the refuge for the marketer with no ideas left or no guts to implement the ideas she has.

I like his second version of the pricing principle. May be he had a change of mind? It is far better to find a segment that values your product and deliver them a version at a price they are willing to pay than try to capture market share with a commodity product at or near marginal cost.

Marginal cost is relevant only to set the floor and not the price you should charge. You don’t have to like it, but it s true.

# Answer to Pricing Puzzle – Why do children’s museums charge lower price for children?

First note that the marginal cost for the museum to allow one more child (or a family) is \$0. That is irrelevant to pricing regardless of what some guru says about future of pricing.

This is a case of metered price discrimination combined with partitioned pricing. Do not look at this as two separate price points for parent and children. This is just one total price. The museums want to charge a fixed price per family. If you assume a simple case of  one parent per child combination, the museums want them to pay one total price for their entry.

Some parents may find the total price too high and may not use the museum but others will.

Once they decided the total price for parent-child pair it becomes a question of how to partition it between parent and child.

1. They could simply not partition, setting one price for the pair. That would result in the customer (the parent) assigning all the price to just one and see value mismatch. Research on combined vs. partitioned pricing suggest the single price will not be received well with the customers.
2. Charge all the price to parent or child and call the other one as free. This has the same effect as previous case.
3. They could share the total price evenly and set same price for both adult and child. But that goes against the reference price in the minds of the customers on priced they pay for children. Same reason they cannot assign higher share to the child.

Hence we have the case we see everywhere despite value delivered to the customer, parents tickets are priced higher than the that of children’s.

A case of partitioned pricing.