What’s next?

This is a guest post by Wim Rampen a data driven marketer who questions popular customer loyalty myths. Wim shares his thoughts in his blog and tweets at @WimRampen.

You should get your guest post submission in now. It takes only 100 words!

 


Pricing is about capturing a Company’s fair share of Customer’s value co-created. Aligning both, to further increase a company’s Customer equity, requires a shift from exchange to use & context based pricing strategies, imo.

Hence these three questions for you to answer in your specific style, that I so much enjoy:

1. What’s your point of view wrt pricing and optimizing profits over the Customer’s lifetime? And when/how should one (not) apply such strategies?
2. What’s your point of view on renewal pricing strategies?
3. What’s your point of view on dynamic (customer/context-based) pricing strategies (eg in subscription based business models)?

Recognizing upside of price unbundling – Southwest says bags may not fly free

baggage_fee_profitFor a while Southwest has stood steadfastly against charging for checked-in bags. They ran several advertising campaigns delineating this clear absence  of extra fees. They told us bags fly free. They told us how the bag fees add up to additional $100 per leg. All the while other Airlines were happily charging us for our bags.

Revenue from bag fees alone reached $769 millions in 2010 (the peak of SouthWest campaign against bag fees).  While most airlines face some level of customer backlash they successfully overcame complaints with better management of reference price. Emboldened by their success Airlines (all but Southwest)  “drained the pond” to expose all the hidden obstacles to value capture.  After scrutinizing every freebie thrown in with the ticket they moved from charging for extras to delivering products that deliver value and pricing for that value delivered.

The result? $6.1 billion in new revenues and with huge upside potential from other service enhancements. After all cost reductions have a lower limit, you can only cut so much but revenue upside from value creation has theoretically unlimited upside.

bags-fly-freeSouthwest stood by for the past seven years letting the revenue innovation pass by and not partaking in the fees growth. As I wrote before, it did not matter they were the only one not charging fees. Customers are trained to pay the fees everywhere and they are more than accepting of such fees. In 2008 I wrote differentiating on no-fees was not a good strategy for Southwest.  It could be argued fees are a fairness issue, shouldn’t passengers who do not checkin bags get a discount on their ticket price?

This week, five years later, we read they heard my message loud and clear.

Southwest CEO, Mr. Gary Kelly, said recently

 in one of his strongest hints to date that the policy could change, Mr. Kelly said that if fliers come to better understand and maybe even prefer “an a la carte approach…we’d be crazy not to provide our customers with what they want.”

Kudos to him for not holding on to a sub-optimal strategy just because they spent all these years supporting it. Not many have the courage to refine or toss out failed strategies, both due to sunk cost fallacy and fear of being seen inconsistent.

If the customers come to better understand value and are willing to pay price for it,  you too would be crazy not to provide that value at a price that lets you capture your fair share of value created.

What is your pricing strategy?

Evolution of Unbundled Pricing – From Service Reductions to Enhancements

Five years back, during the dark days of  the Great Recession, we saw the early stages of unbundled pricing. Specifically, airlines seeing considerable drop in passengers and hence revenue per passenger mile, increasing costs and increasing price competition needed a way to stay afloat.   The had excess capacity, exhausted their marketing spend, lost the ability to differentiate on the offering and were left with no real option to increase passenger miles flown.

So they chose the only choice available to them. Keep the ticket price competitive because customers were making decisions based only on price but separate out everything else that used to be included in the price of ticket and charge for it.

Whether unbundling the extras resulted in any cost savings is debatable. There was a case that each piece of checking baggage had a marginal cost of $15. It is however difficult to see how they can so precisely pin down cost one additional bag checked in. The primary effect of unbundling was not cost reduction but revenue generation.

feesCheckin bags? Need a drink? A pillow? Take out your credit card.

Some went even farther, charing for paper ticket, reserving through an operator, or picking seats.  Or more recently charging for printing boarding pass at the gate and carryon bags (Frontier).

Naturally customer backlash ensued. You may not remember it now but we all felt nickel and dimed paying for extras. That as I explained before was the reference price effect. We don’t feel that way anymore because fees have become the new norm and the reference price has moved from $0.

What started out as Nickel and Diming was nothing more than draining the stream to expose the submerged rocks blocking the value flow. There was no clear defensible reason other than convention why all the different extras were included in the price of ticket.  For one thing these added costs but as I said before more importantly they represented value capture opportunities. With all inclusive pricing Airlines could not figure out those opportunities.

Yes there was backlash and late night talk show jabs.  After all jokes are done the fees became a significant source of income (yes almost all of revenue flowed directly to profit to airlines. By the last measure airlines took in $6.1 billion in fees in 2012 and on track to double in 2013. What started out as an irritant to customers and a service restriction has become a significant revenue source.

These days airlines have changed their thinking process with regard to monetization. The default is not what additional services will help increase brand value, differentiation and ticket price but what new products we can introduce that will help add yet another revenue source.

It is all unbundling.

These days airlines see themselves as product managers – not the type you have in mind, the one worries about details, buttons, bevels – the kind that worries about what customers value and how they can deliver a product that captures that value.

“We’re a retailer trying to create a product line,” said Rick Elieson, American’s managing director of digital marketing.

After all a product is nothing but a value delivery vehicle.

Do customers value the flexibility of changing flights without having to pay change fee? American create a product branded Choice Essential—priced at $68  travelers can change reservation without a fee.

If one price is good, two are better. So American also has Choice Plus package, priced at $88 that lets you stand by for a different flight on the same day.

Travel a lot and want to save the hassle of paying for bags each time? United makes it easy for you with a product that lets you pay a flat $399 fee for the whole year.

Want to get better seats? You have economy plus product. You can also get yearly subscription for $499 without shelling out a fee each time.

In essence they have become a retailer or merchant. They are not anymore ripping out roofs in third class train cars (because there is no more roof), they are selling shades and umbrellas to the  customers in the roofless cars. They also are selling value added items to those in second class cars.

“We’ve moved from takeaways to enhancements,” says John F. Thomas of L.E.K. Consulting. “It’s all about personalizing the travel experience.” (Source)

That is what understanding your customers can do for you.

Do you enforce takeaways to limit your customer usage or enhancements to create and capture value?

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.

Capturing Customer Value Upfront

In my last article on Pricing Questions to Ask, one of the questions I listed was whether to capture value upfront or over a period. A subtlety I did not add was, “What if the customer lifetime (with your service) is limited?”. Let us see such a case here.

Match.com is running a promotion for its service, “If you do not find your special someone in six months, your next six months is free”. Simple and elegant plan that may on the surface seem to give away too much and yet captures the full lifetime value of a customer.

If a customer did find the special someone, there is no reason for them to pay for the next six months. If they did not, then they may still be less  likely to continue to pay for a service that is not meeting their expectations. The marginal utility of the service to a customer decreases as the time progresses and at some point the service adds no value to a customer. In other words, the lifetime of a customer is limited.

For any product or service with decreasing marginal utility that approaches zero, the pricing should capture all the value upfront and give away additional units at marginal cost.

For Match.com, the marginal cost of serving a customer is $0. So a pricing scheme that charges $60 for six months with additional six months free is better than a scheme that charges $60 for an yearly subscription.

There is one additional factor in the pricing of match.com, customer margin. The likelihood of  a customer staying on after six months, intuitively, is very low. But if they stayed on, there are opportunities to make incremental revenue in the form of selling other products and help build critical mass to attract new members. This  turns a cost activity into a revenue opportunity, squeezing  extra profit from the limited lifetime of a customer.

I think Match.com is practicing effective price management with a clear understanding of consumer behavior and lifetime value of customers.

How do you price your offering when the lifetime of a customer is limited?

The Value Waterfall

You have a great product – be it a software offering or a physical product and your economic value-add analysis shows that your product creates considerable value for the customer. But does your customer see it that way?  Since price represents your fair share of the value created, do you get a fair share if there is a gap between the true value created and the value realized by the customer?

What is stopping your customers from seeing the full product value?

In the context of Price Realization, I wrote about Price waterfall (first introduced in the book The Price Advantage). Price waterfall shows the price leakages that reduce your price realization. Another common, yet not so obvious, factor at work is the value leakage – the loss in value perceived by your customers. This is the  Value Waterfall. In pricing and cost-benefit analysis marketers focus on the costs incurred by them and the value created for the customers but not many consider the costs imposed on the customers in selecting and using their product. Value leaks are the costs incurred by the customer that leads to the following Value Waterfall:

There are five factors that decrease the perceived value of your product, creating the Value Waterfall:

  1. Credibility Discount:  While your calculations may be supported by analytical rigor, there are generalizations and assumptions that went into your estimate, not to mention some bias. Does your customer trust and believe your numbers? This is the credibility discount applied by your customer.
  2. Selection Cost: I wrote about the cognitive cost to customers in selecting a product. Be it evaluating all the options available in the market or evaluating the multiple versions you offer, there is a definite cost to the customer. The effect of these costs carries over from initial selection to product usage and hence decreases the product value.
  3. Cost of Doing Business: These are the costs to customers in adapting their buying process, business processes and operations, training their employees,  etc so they can start doing and continue to do business with you and use your product. For example, do you only deliver on Fridays? Do you fit within their procurement system? Does your billing cycle fit customer’s accounting needs? The net is another reduction applied to the product value.
  4. Risk Aversion Discount: What is the risk your customer is taking in going with your product? Are there social concerns – how will they be perceived by their friends, peers or their bosses? For instance, if you are selling bike helmet, will it make them look more dorky? If you are selling SaaS, are they worried about availability?
  5. Reference Price Difference: What does your customer consider as the substitute or alternative to your product? What is the price they pay for that? That is their reference price. If customers had always relied on cheap offering, despite its low value-add, they will be evaluating your product base on this reference price regardless of the true economic value from your product. Reference price has been proven to decrease customer’s willingness to pay for the value-add.

So despite starting with a large pie, the one you gets a share of is considerably reduced in size due to value leakage.

What can a marketer do about it?

How can you not only stop the value leakage but also turn each incident into a value addition?

Stay tuned for Value Staircase.