Can you afford to set your pricing wrong?

“My only regret was how we introduced pricing in the beginning, because how did we introduce pricing? Thirty dollars and you get all you can eat,”

This is what ATT wireless CEO Mr. Randall Stephenson said about their iPhone history.

It is likely that the price and the unlimited data plan made sense in 2007 when 95% of the people consumed far less mobile content. ATT was fighting for subscribers in a market that was close to saturation. Only way to show growth was by causing churn away from competitors. They chose a price such that it brought in large number of customers with only a small percentage of them being outliers in consumption.

All you can eat was not all bad when there was not much to eat, everyone eats differently, and the amount one can eat had an upper-bound. But all that changed when the very device (iPhone) they were after resulted in explosion of content to consume and rate of consumption.

ATT was forced to rethink pricing to better align price with value delivered. But the initial low price and offering set a strong reference price that was hard to overcome.

Hats off to Mr. Stephenson for seeing their initial folly and admitting it. He sees the importance of getting initial pricing right.

What about your free webapp? How difficult is it going to be to move from free to fee?
ATT has the resources to recover from its pricing mistakes. Can you afford to make mistakes?

 

Answer to Pricing Puzzle – Pricing Lactaid Milk at Trader Joe’s and Target

This will be a nice reference price question to test for behavioral economists like the beer on the beach question by Daniel Kahneman. My hypothesis, you will find either no difference or higher price quoted for Target.

Run a split test with,

I am going to Target to get some stuff. I will get your Lactaid milk there. How much are you willing to pay?

OR

I am going to Trader Joe’s to get some stuff. I will get your Lactaid milk there. How much are you willing to pay?

But I digress.

For those who are not aware, Lactaid is the brand of lactose reduced milk ( reduced using lactase enzyme). It is generally priced twice at much as regular milk. Instead of buying Lactaid, one could buy regular milk and lactase and mix it themselves. But what Lactaid offers is convenience and for the limited segment that wants milk despite their intolrenance and values convenience. So a higher price makes sense.

Lactaid is a national CPG brand, available in most stores. So why is it priced higher at Trader Joe’s?

Another argument is cost based. Target, a bigger retailer, has pricing power with suppliers. Since it can negotiate a lower price it can charge lower price to its customers. True but the cause and effect are reversed. Target wants to serve lot more customers that have lower willingness to pay. Once they decided the price they work with suppliers to bring the cost down. Not the other way. Think about prices of other products (granted not same brand). Does the cost argument holds?

One line of argument is, it is not just the product, it is the store experience. The price of store experience is built into the milk. Partly true. Then you must run the behavioral experiment I stated in the beginning.

The answer, as in most pricing cases, starts with the customer.

A Trader Joe’s customer goes there for different reasons than they go to Target (likely same customers but they hire the stores for different reasons). They go to Trader Joe’s for its unique product mix, experience etc. but definitely not for getting Lactaid milk.  If I remember correctly that is the only major CPG brand I have seen at Trader Joe’s. Most of the product mix is  made of store brands or smaller regional brands.

Those customers seeking to buy Lactaid at Trader Joe’s is looking for convenience. They are at the milk aisle for the rest of the family and want to complete their milk shopping list by avoiding one more trip to another store or its milk aisle.

There are likely not many such customers (most  likely TJ’s customers are Target customers as well). So for that limited segment that values convenience and needs a specific product, the willingness to pay is higher.

Since they can charge this higher price they are likely willing to pay higher price to suppliers to stock the milk in their shelves.

No customers. No products.

Price always comes first then costs. And for pricing, customers and their needs come first, then everything else.

Explaining why it costs even more at Whole Foods is left as an exercise to the reader.

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.

What do you charge for a service that you just made up?

We all would like to believe there is nothing like our product or service. After all we are innovators and our vision is to change the way people do things. The investor pitch deck from a startup, Everest, sums up this attitude

Let us take all such claims at face value and treat every one of these products and services as new. Then we face the key monetization question
What do we charge for a service that we just made up?

To make this question more meaningful let us use a simple yet real life case study instead of talking about hypothetical product. The case study comes to us from NPR Planet Money, (Don’t read the full story yet, I will take you to the middle of the story to set up the case)

Two guys offer visa form printing services in front of the New York Chinese consulate.Visa applicants, turned away at the visa counter for filling they wrong forms, come to these guys who have computer and printer in a RV parked right outside the consulate. No such service existed before. They just made this up. How do you think they should price this innovative service?

As I wrote in the past, there are two places to start to answer the pricing question – even for something we’re building just now, Product or Customers. My recommended starting point is, Customers.

Even if the product is innovative and what you are building doesn’t exist yet, the needs are not.  The needs are why the customers are hiring your products for (Christensen). If needs indeed exist then they are currently addressed by different customers differently.

In general there are always different customer segments. For some  the needs may go unaddressed for others the needs may be addressed through alternatives, however sub-optimal they may be. There may not be a competitor product but there are always incumbents. In some sense, doing nothing is an alternative too (for Intuit’s TurboTax, they defined their incumbent as paper and pencil).

In the Chinese visa case the alternative is walking to the closest internet cafe and paying for printing or coming back another day (like those with low opportunity cost for their time).

You can’t serve all segments, at least not initially. You need to choose your segments, those that offer the best return with your limited resources. After all strategy is about making choices.

Say you choose the segment that used to walk to nearest internet cafe.  By choosing this segment you already know they are willing to pay for printing the forms at the internet cafe and they incur additional pain to make the round trip.

Your next step  is to position the product in the minds of the target segment. Positioning your product is not about how innovative it is but about what job you want them to hire it for and why your product is better than anything else that customers hire now. If you can’t position your product you can’t control its pricing.

Once you perfect the positioning, pricing is the next logical step. Hiring your product over the alternative adds incremental value to customers (like avoiding round-trip walk) and you price your service to capture your share of the value created.

How do you quantify the value created and how do you know your right share that customer will willingly part with? Some customers know, some don’t. It is up to you to do the value creation math and show it to them. Then you rely on quantitative methods, pricing experiments and signaling to find your fair share – the price customer is willing to pay without pain.

In general,  cases where you have repeat customers it is important to get the first pricing correct. Choose too low, you forgo profits. Choose two high and continue to drop prices, you lose credibility. That said, if you have done the Segmentation right, Targeting right and Positioning right, the pricing can’t be far from right.

Let us come back to the case study. They had no repeat customers. They chose to experiment. They charged $10, the same price charged by internet cafe and found the demand overwhelming. Next they went to $40 and found drop in sales. Now they charge $20.

Be it a software product,  magical delivery service or Visa form printing service – you need to worry about monetization. Otherwise why do it, however innovative the service is?

So what do you charge for a service that you just made up?


Readings:

  1. NPR Planet Money Story http://www.npr.org/blogs/money/2012/01/04/144636898/a-man-a-van-a-surprising-business-plan
  2. Segmentation
  3. Startups and Segmentation
  4. An entrepreneur will not always succeed in positioning his latest innovation the next “new thing.” http://www.chicagobooth.edu/capideas/oct09/5.aspx

Note 1: Note that the pricing for the service did not take into account the cost to rent the van, opportunity cost of the two guys operating it, or the cost of printing. Pricing comes before costing. If you cannot deliver the service profitably at the price customer is willing to pay you need to explore options.

Note 2: The price $10 set by internet cafe is the reference price in the minds of customers. Even if that price is wrong (cost based) you are stuck with it unless you can shift the reference.

How do you sell value? Show them!

Say you have a product that costs the customer almost twice as much as the alternative. How do you convince them to buy your product over the alternative?

Pricing starts with customer segmentation – the needs of different customer segments are different and the value they assign to products and solutions that address these needs are different.

If you treat all your customers as just one mega segment you will end up pricing your product based on the cheapest alternative available to most vs. value delivered to different segments.

Knowing the segment helps you not only price the product but show them the value.

Here is a case study done by US Department of Energy for LED bulbs. The initial price is almost twice as much as traditional lighting systems. While consumer segments most likely are not willing to pay twice the price for LED, business segments are. That is if you show them the value.

For instance, you and I may not mind changing light-bulbs every year because our opportunity cost is $0. But for businesses there are real costs associated with maintenance. Every bulb change avoided is not only savings in bulb cost but savings in maintenance costs.  If you add these all up, despite the high initial cost, the LED systems  deliver 9% in total cost savings over the lifetime.

That is how you sell value!

Fixing Past Pricing Sins by Price Unbundling

Price unbundling is back in the news after its big splash during the recessionary times of 2008.  Most people do not use the phrase “price unbundling” or “unbundled pricing” in their everyday vernacular nor do they use it label the trend. Customers and newsmedia call it, “nickel and diming” or “squeezing the customer for extras”. Before we go further definitions are in order.

Unbundling is not the opposite of Bundling nor as the name implies undoing a bundle. Marketers deliberately introduce bundles for several reasons, I discussed a few of them here. Primary reason is customer perception of value. Take a sample case of two products A and B and two customers P1 and P2. Bundling of A and B delivers better profit when P1 and P2′s value perception of A and B are reversed. Before the bundling A and B were valued albeit differently by customers. Unbundling is not the case of reversing the decision the previous decision to bundle A and B.

Unbundling is breaking down a product or service that was perceived as a monolith and charging for parts that used to be included. Marketers did not start with two or more products that each had a customer demand, value and price.

A required condition for unbundling is the component that is being unbundled must be truly optional – selling left and right shoe separately is not unbundling.

So why didn’t the marketers start out by pricing separately for the included components?

  1. Either the components were not separately consumed. Likely no one wants to eat airline food without traveling in one as well.
  2. Even if they could be, the marketer had a different source of revenue that delivered higher profit than charging for the extra.This is the case of bank debit cards, banks were able to charge the merchants an interchange fee. It was easier for banks to drive up debit card  adoption and usage by including it for free as part of the “whole” because each transaction  brought revenue from the merchants.

All is well with these free extras if their current cost, market, demand and ecosystem dynamics remain unchanged. But what if

  1. The product price is inflexible due to regulations, competition or other reasons. For instance they can’t increase the price without drop in demand that will adversely affect profit.
  2. The other source of revenue dried up as in the case of debit cards. The new regulations severely cut the merchant fee and banks are stuck with a service they adds value to customers but nothing to the banks.
We should not lose sight of the fact that these extras do add value to customers and are truly optional (as I stated above). Since the marketers chose not to do value signal and not to charge for it, the reference price for these extras are stuck at $0 in the minds of customers.
It was their past sins – giving away more than what the customer wanted or rewarding one side with value gained through other sources – that leads marketers to unbundling.
When the marketers, airlines and banks, try to charge for this value-add without focusing on the customer reference price they face extreme backlash. Any price higher than the reference price will be seen the customer as unfair. It is especially hard when the reference price is $0.
So how can a marketer roll out unbundling without customer backlash?
  1. Maintain reference price of components even when they are included with the whole. Take the case of amazon free shipping for purchases over $25. Amazon always lists the shipping cost and then subtracts it.
  2. If they neglected to do this step the next best option is to improve the reference price before charging for it. There are many ways, one of them is to use options and another is to use cost signaling.
It is easier to not commit the original sin of including lot more than the customer wants and even if you did maintain the reference price.