Value Distribution – Weight Scales

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.

Willingness to Pay and Reference Price

Take a look at this Yelp review

 went through a mess of salons to get some price ideas for mens haircut and I am sorry, I’ve been paying 10-15 dollars for a haircut for 22 years. I cannot and will not pay $80. That’s the price of a new video game! I called the salon and I got a price of $16 for mens! $1 more than my maximum?

ref-priceWhat do we see here? An illustration of the fact that,  as customers we do not walk around with a price we are willing to pay for every product and service. To a large extent this number is shaped by experience and what we have seen and trained to pay. That becomes our reference price.

Any price above the reference price – like the $16 vs. $15 – is seen as a pain or price increase that need to be reconciled. And you can see how this reviewer felt after paying $1 over his old reference price.

Reference price is not a fixed number, fortunately for all of us marketers. It is malleable – newer products, cost justifications, options, or extras - can be used to move it. If the customer is convinced they are seeing value for the extras they will happily move to the new higher reference price and will settle there until next movement. The same reviewer ends with,

I can truly say with a tremendous amount of confidence. I have found my PERMANENT salon.

Back to Willingness to Pay – the $80 price limit this reviewer quotes is his absolute reservation price. No amount of benefits, features, brand, customer service etc. can move this user to pay $80 for a haircut. His willingness to pay is somewhere close (tad below ) that number. You should know that this is just one customer and may be there are lot of them like him while there are many others who are more than willing to pay hundreds of dollars for a haircut (or the salon).

What do these two parameters mean to you as a marketer or entrepreneur?

First stop asking questions like,

“Would you pay $3.99 for my product?”

Because customers do not know.

Second do not be afraid of raising prices, as long as you understand the effect of reference price and execute this change correctly.

Finally, if your product used to be free and you are considering pay model do not assume no one will be willing to pay that price. You need to find those who value it enough, target them and move their reference price sufficiently to get the price that is fair share of your value add.

How do you manage your pricing?

See also: Multi-version pricing at salons.

Markup is just plain gross, not Gross Margin

An anonymous commenter on my previous post wrote,

maybe you need a refresher in the most basic tenets of finance and accounting because gross margin is a percentage, not an absolute dollar figure. you’re referring to GROSS PROFIT, but calling it gross margin.

First correction on this comment is – Gross Margin can be expressed as either absolute dollar value or as percentage. In most situations it is understood by context – especially by the practitioners. Gross Profit and Gross Margin are used interchangeably as well. See for example Apple’s earnings release

apple-gross-marginBut when Google Finance shows Apple’s financials they refer to it as Gross Profit.

Sometimes we see Gross Margin Percentage explicitly used to indicate percentage margin. Again practitioners are not confused by any of the terms even when two of them are used interchangeably.

What is Gross Margin? (or Gross Profit)

Expressed as dollar value it  revenue less cost of goods sold. Expressed as a percentage it is this difference divided by revenue.

The anonymous commenter (who seem to have inexplicably routed his IP traffic through, because I know MotleyFool is not afraid of making comments) added,

gross margin is the percentage that a company nets on the sale of a good after dividing it by its cost of goods sold.

That is not true. What this person is confusing with is  Markup. While Gross Margin (etc.) are financial accounting terms Markup is not. Its origins are in cost based pricing. You compute the cost to make a widget, add your preset margin you want to extract and call it the price.

Which you, my right tail readers, know is simply gross way to set prices. It would serve us all well if we banish the  “Mark Brothers” – Mark Up and Mark Down.

Another note on Gross Margin – it is a financial accounting term used for financial reporting purposes. The intended audience are investors and regulators. Since competitors can also see this companies do not want to signal their exact cost structure. So they  confound this number with a share of fixed cost allocation from manufacturing.

If you as a product manager or marketer going to worry about margin, worry about customer margin.

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).

Pricing Flash Storage in Tablets – Don’t Call This As Markup

The New York Times Bits blog laments about the giant markup Apple and Amazon charge on flash storage. Bits blog not only complains about the price vs. cost difference but also caught on to the price difference between Kindle and iPad for the same storage.

Kindle: 16 gigabytes for $300 and 32GB for $370; to enjoy 16 extra gigabytes of storage, a customer pays $70 more. For its smaller 7-inch tablets, Amazon charges $50 more for an extra 16 gigabytes.

iPad: You can get a 16GB model for $500, a 32GB model for $600 or a 64GB one for $700. That’s $100 extra for that first 16GB bump, then a relatively cheap $100 to get from there to 64GB.

At the outset let me point out I have lamented on the same topic as well but mostly admired it and only lamented it a bit as a consumer. Let me point out how the flash storage prices vary even within Apple’s different product lines,

Apple Pricing

Yes both Kindle and iPad are able to extract lot more consumer surplus with their flash pricing. That is because they figured out their customers value the additional capacity lot more and are willing to pay the additional $100 (or $70) for doubling capacity. This is not markup and the fact that flash costs 50 cents per gigabyte should not matter.

Using words like markup comes from cost based pricing (add up all the costs then mark it up to get the price, hence markup), as is shown by this text in the same Bits blog post,

Of course, when you buy a new gadget, you’re not just paying for a slab of components. The maker of the product is trying to get you to cover the cost of research and development, manufacturing and advertising, and still rake in some profit.

Note how sure the author is – “Of course, you understand the price you pay is …”.

Let me do my own convincing and point out that – of course  customers are not concerned about your costs. They are not paying the price to defray your costs. Besides R&D, Manufacturing and Advertising costs are sunk and are not attributed on a per unit basis.

Customers pay for what they value and marketers charge for that value. If marketers figured out a way to deliver the value at  the lowest possible price it does not mean they have to pass on the savings as lower prices unless they are forced (by market forces) to do so.

Call this effective pricing and don’t call it as markup.

As a customer do I lament alongside Bits blog? I do. But as a product guy I admire their pricing.

For extra credit see my articles on

  1. Nexus 7 flash pricing
  2. Second degree price discrimination infographic
  3. Why Apple does not include earphones with iPad?

How can I offer $140 shirt for only $39.50?

I received an Ad insert for Charles Tyrwhitt shirts with Saturday’s WSJ. Yes, as a matter of fact I still get the real paper newspaper, but we digress.

The Ad offered all kinds of dress shirts for a single price of $39.50 (normally $140 to $160). The Ad, speaking in the voice of the shirt company founder, then poses the question you see in the post title and answers it for us.

As expected the answer starts with cost, “because our buyers are great, we deal direct and no middlemen”

You can see at play some of the behavioral pricing tactics – price anchoring  with stated high price and signaling great value with marked down prices. Besides the  tactics the explanation does not answer the original question. In fact that is not the right question at all.

If the cost argument is accurate, then the question a customer should ask is,

How is it a shirt that likely costs less than $39.50 to make is normally priced at $140-$160?

As a regular reader of this blog and a fellow practitioner of value based pricing you may be tempted to answer this pricing question  with,

“because there exist a customer segment that is willing to pay that price for whatever job they are hiring the shirt for”

Unfortunately it is not the case with apparel pricing.  Pricing is not as sophisticated as you believe it is. It is steadfastly stuck in the land of cost based pricing with standard markups.

The data for this comes from an article in WSJ that analyzes pricing of $155 polo shirts. Almost the same, down to the sub-category level and price point.

The article does a marvelous job of marginal cost analysis. Most articles on cost analysis commit cost allocation error – allocating a share of all fixed costs to every unit made. This analysis gives us a true marginal cost of $29.57 for a polo shirt. We won’t be far off to assume that Tyrwhitt shirts have the same cost structure.

Then we see how they arrive at $155 price tag,

Using standard industry markups, the MacLanes set the wholesale price for the women’s polo at $65 and the retail price at $155. (Retailers in the U.S. mark up wholesale prices of ready-to-wear by roughly 2.2 to 2.5 times.)

Here are your answers for both the original wrong question and the right question.

How can a producer offer a $140 shirt for only $39.50?
Because it likely  costs them less than $39.50 to make one so they can still make  profit per unit and the $140 price is based on wholesale and retail markups.

How is it a shirt that likely costs less than $39.50 to make is normally priced at $140-$160?
Because of the antiquated way of setting wholesale and retail prices of apparels.

It is one thing to charge four  or forty times the marginal cost based on customer willingness to pay (Apple) but to charge four times the marginal cost based on standard markups  is …