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?

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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.

The Value Equation

For your customer the net value from using your product is total value created less the price they pay. The total value can come in the form of:

1. Incremental revenue
2. Decrease in costs
3. Relationship value

As long as the total value created is more than what they have to pay for it, i.e., net value created is positive, customers are happy to pay. (Let us set aside Reference Price effect here).

For a marketer the value created from making and selling a product is  revenue (function of price)  less costs. As long as this is profit it makes sense to serve the customers at the price.

But let us put these two together.

The total  value of the customer and marketer  is = Customer Value + Marketer Value. This is the size of the pie.

Customer Value =  Value Created   – Price

Marketer Value =  Price    – Cost

Which means Total Value =  Value Created  -   Cost

Surprising to see price not being part of the total value equation? This does not mean price is irrelevant, it is the line that determines marketer’s share of the value created. While price is important in customer’s decision making and marketer’s profitability, it is irrelevant to total value maximization. To maximize total value you either increase total value created or aggressively drive down costs.

A moment’s reflection will convince you that both these levers are under the control of the marketer. Bigger the pie, bigger is the share of marketer even at current proportional division. This leads us to define the role of innovation. A marketer’s efforts are better spent not on pricing innovations but on innovations that drive up value for their customers and innovations that drive out costs from their operations.

What is your value equation?

How do you define your innovation?

Free Radical

As a follow-up to Mr. Chris Anderson’s talk at Haas Alumni Luncheon and his description of continuously decreasing marginal cost I talked about opportunity costs and when it replaced the cost to produce/store/serve one additional unit.

Let us set aside the cost discussion and focus on price. Mr. Anderson’s new book’s sub-title is “The Future of a Radical Price”. Free service with Ad supported business model is not new and Mr. Anderson says that as well. What he says about free model is the emergence of a “freemium” model. What is “freemium”? Mr. Anderson explains this in a letter he wrote to The Economist,

The big shift since the crisis has been the rise of “freemium” (free+premium) models, where products and services are offered in free basic and paid premium versions. Think Flickr and Flicker Pro (more storage), virtually all online games and even your own site (some free and some paid content).

So many users pay nothing and get limited service and some pay to get a different class of service. I am not certain why this is radical or new. Let us consider following scenarios

1. Taxation on Paying Customers: The free users are irrelevant to provide service to the paid customers. In this case the business is simply throwing away money by serving the free customers. There is nothing new here. Paying customers subsidize the free customers – so paying a higher price to support the marketer’s higher cost structure. What is in it for these customers to support the freeloaders? If the business one day decides to jettison all free users, it is simply eliminating a cost function that has no associated revenue and giving value back to paying customers.
2. Up-sell: The business depends on converting a part of the free users to paid users over a period but otherwise it does not need the presence of free users to serve paid users. In this case it is no different from a business spending on marketing to bring in paid customers. Any one free user  by herself is not important but as a collection she is. This is similar to a mail campaign that has 1% conversion rate. Each mail you send out by itself is not important, but it is as part of the whole bunch you send out. So suddenly eliminating free customers is the equivalent of completely cutting off marketing spend. As long as the business can hold on to current paid customers and  has other ways to acquire new customers it can cut-off free users. In this case too the model is no different from what exists  in non digital businesses. Incidentally, whether or not there is a  cost to serve one single free user is irrelevant because the relevant cost to consider is the total cost to serve all free customers.
3. Value Distribution: The business needs the presence of free users to serve its paid users, in other words presence of the free customers adds value that is shared between the marketer, paying customers and the free customers. This is the classic two sided market, like eBay, in which one side creates value and hence is not charged and the other side consumed value and is charged for that. One again this is not radical. The presence of free customers is essential for the service and the paying customers who are not subsidizing free customers but compensating them for the value add.

Price is about capturing value created for customers, if the business chooses not to charge for that value-add then they do not have a working business model. Free is not a price, definitely not radical,  it is either failure to capture value, customer acquisition activity or  simply matching price with value added.

Pricing When Cost To Serve Is $0

What do amusement parks, airlines, hotels, baseball games, and  theaters  all have in common? Two things, first their capacity cannot be stored for future use and second the cost to serve one additional customer (marginal cost) is $0.  Once a plane takes off, all the empty seats in the plane expire, generating no revenue for the airline. How should a business price its service that falls in this category? Just because the marginal cost is $0 and the lost revenue opportunity should the excess capacity be sold at the lowest possible price?

There is a renewed focus (in the echo chamber of blogosphere), almost an obsession, with marginal costs and the fact that it is “spiraling to $0″ for digital goods. Wired magazine editor, Mr.Chris Anderson, has been talking and writing about this and has a book coming in July. Before we go further I would  like to reiterate that what it costs to produce a product/service does not matter in how it is priced and higher capacity utilization is not a valid reason for lowering prices.

The answer to the pricing question lie in:

1. Opportunity Costs: The cost to consider is not the marginal cost but the opportunity cost of admitting one additional customer – that is what is the lost revenue opportunity from selling one airline seat now at a lower price. Only airlines excel in implementing this pricing strategy that is based on yield management.
2. Value: That said, the business should look at the value created for the customer using the service. It is common sense that a business makes profit not just by creating value but by capturing some of it.  Note that the value created is different for different segments (technically it is different for each consumer but it is hard to quantify).
3. Reference Price: Businesses must consider the impact of low (or zero) price now on future profits due to the reference price effects. Once an airline sets a very low price or allows a customer to travel free because the cost is $0, then it risks setting a very low reference price in the minds of customers.  In the future, such customers will despise paying regular prices and may even be up in arms. The effect of reference price cannot be understated, despite the value added to consumers the reference price prevents the business from capturing a fair share of the value added.

Do you know your opportunity costs, value created and the reference price? Please use trackbacks to comment on this.