Getting Fair Share of Value vs. Offsetting Lost Revenue: Ad Free Hulu #Pricing

hulu-logoQuestion at the outset: Hulu introduced a new commercial free version of its subscription service for $11.99/month. Is the new pricing based on the share of value to customers or the need to offset lost Ad revenue?

For those cutting chords (figuratively speaking) – removing cable TV option and satellite TV – Hulu has been the go to option to catchup on TV shows. For $7.99 a month subscription fee Hulu offers its customers current and full season episodes of most popular TV shows (some network exceptions apply based on their content licensing agreement). Seems better option to customers than paying cable TV bill or struggling with Over The-Air Antenna.

What viewers get for the price is unlimited and on-demand streaming of TV shows. Just like a TV show is interrupted by commercials (even in the pay-Cable ones) viewers see commercials. Sometimes these are the same that aired with the show and other times different ones inserted. But the experience is the same – 30 minute sitcoms and 60 minute murder mysteries filled with 10%-20% commercials.

Some of those paying customers are not too happy to be interrupted by the commercials – limited or not. Clearly demand for such Ad free TV shows exists, Netflix and Amazon are quite successful even though they do not offer current episodes like Hulu does. Seeing this pressing customer need to be not interrupted Hulu is introducing a No Commercials version at a price of $11.99 per month.

hulu-versions

The price difference is $4 for no interruptions. I have always said many times before, “If one price is good, two are better“. So isn’t this better for Hulu and its customers? The answer is a qualified yes.

We need to consider the reasoning and logic behind the $4 price difference for no interruptions. Is that based on customer research and value they assign to for interruption free TV shows (hopefully done using some kind of conjoint analysis)? Or is the pricing done to offset the lost revenue from Ad sales from the premium version?

It is possible Hulu is using one of two revenue metrics

  1. Average Revenue Per User (ARPU)- measured as a sum of subscription fee of $7.99 and Ad revenue from the average user
  2. Total revenue measured as sum of all subscription revenue and sum of all Ad revenue

In case 1 it may see the need to keep ARPU the same and may simply came up with a price point of $11.99 which is likely its ARPU.

In case 2 it may see the erosion in Ad revenue, model possible uptake and come up with per user uplift in pricing needed.

Both cases are wrong as they start with Hulu’s costs over value to customers. In fact there is evidence to point out cost based pricing is how Hulu set its price of $11.99 according to this news article:

Hulu and its owners don’t want to encourage large numbers of existing subscribers to shift to the new ad-free service

That is they are using case 2 above and modeled in small enough uptake of new version and shaping that expected customer behavior with a higher price tag.

universal_express_logoIt is perfectly normal and acceptable effective pricing practice to shape customer behavior with higher price point. For instance amusement parks set a high price for Fast Pass and other similar options to skip lines to reduce uptake. After all if the price is low enough and many take it the lines at FastPass will degrade value to customers.

But using higher price point just to support a model assumption on Ad revenue loss without measuring customer value is simply not effective pricing.

When it comes to pricing your first version or the second version the right place to start is with customers, not your costs and revenue goals. If one price is good, two are better if both are based on customer value and not costs.

How do you set pricing?

Is Customer Loyalty A Predictor Of Profitability?

[tweetmeme source=”pricingright”] Much has been said and written about the need for customer loyalty. The need to focus and attain customer loyalty is intuitively clear to all marketers. Some of the key arguments for customer loyalty include

  1. Reduced Customer Acquisition costs – Since it costs $X to acquire new customers, any customer you hold on to saved you $X. For example, it takes mobile providers $350 to acquire new customers and there are similar metrics for most products.
  2. The Loyalty Effect: Longer a customer stays longer they keep paying you. There was a book by the same name that claimed up to 75% increase in lifetime value of a customer if they stayed longer.
  3. Cross-Sell & Up-Sell: Since you keep your customers and come to know more about them it creates additional revenue opportunities through cross-sell and up-sell opportunities.
  4. Price Tolerance: Loyal customers keep buying from you because they are delighted by your product and are less sensitive to prices.  Some even claim that loyal customers do not even bother to use coupons and promotions, thereby saving you money.
  5. Decreasing Cost to Serve: The more you understand your customer’s usage behavior and needs fewer the mistakes in servicing them and hence lower the cost to serve them.
  6. Bump From Word of Mouth: Loyal customers are also your best marketers, they are happy to write online reviews and promote your products to all their friends and web communities. This means they generate additional incremental revenue.

All these factors seem plausible and the “gut feel” says these must be true.  If even a subset of these six factors are a work, customer loyalty must be a very good predictor of sales growth and profitability.

We should be able to validate the following models

Sales Growth =   Constant  +   ß1 * (Customer Loyalty)

Profitability =  Constant  + ß2 * (Customer Loyalty)

(ß1 and ß2 are the weights of  customer loyalty )

In a study published in circa 2000 in the Total Quality Management journal, researchers studied precisely these two models for a large set of products and services. The result?

Loyalty is a poor predictor of both sales growth and profitability. Their R-square values are 6% for profitability and 2% for sales growth. (For services the number goes to 14.7% and 7.8% respectively). That means only a tiny fraction of the changes in sales growth and profitability are explained by changes in customer loyalty.

Loyalty has positive impact on sales growth but more strikingly, for products, the impact on profitability is negative, which means higher the loyalty lower the profitability. This means any attempt to “buy loyalty” with price cuts does bring you loyalty but at lower profitability.

The net is, what seems too obvious isn’t so. This is not to categorically dismiss need for loyalty but the positive effects of loyalty are clearly overrated. If their effects are so low then there is a high opportunity cost to improving them. You cannot put all the  wood behind the loyalty arrow!

Sidebar:

Correlation means two variables are associated and the extent of association si expressed as correlation coefficient. It ranges from -1 (low,high)  to +1 (high,high). A value of 0 means no correlation.

Predictability, R-square, means one variable is a predictor of other. It is measured as a square of correlation coefficient. So two variables that have a correlation coefficient of 0.8 have a predictability of only 0.64. R-square is usually expressed in %, so 64% means 64% of changes in dependent variable are explained by changes in predictor variable. That said, correlation does not mean causation. There are other factors to consider including but not limited to statistical significance of weights of variables, omitted variable bias, etc

Pay What You Can Is Not Price Discrimination

Update 1/2/2014: I am saddened to hear Sensorielle is now closed.

This has been my favorite pricing case study for the past ten months or so – Sensorielle spa in the city I love, Boulder, went to a Pay-what-you-can pricing model. The spa’s owner, Ms. Petteway made it clear that this is not “pay what you want” but a scheme to allow those loyal customers who were hurt by down economy to come back and pay only what they could afford.

A few months back I wrote about the partial results published by:

Ms.Petteway published results from her experience in the Boulder Net LinkedIn discussion board. She talks about how  few customers interpret the pricing plan as “pay what I want” and ask for high-end services even though they pay less than the posted prices. For any rational customer (Homo Economicus) whose goal is to maximize their utility, it makes sense to pay the minimum they can get away with.

I said then Pay-what-you-can  scheme despite its close resemblance to first order price discrimination is not really price discrimination. It does not stand on solid data ground or analysis and leaves the future profit uncertain. Better results could be achieved with segmentation and targeting.

Will this pricing scheme help the spa identify willingness to pay of different customers? No, because the reference price is set by the list price and is pushed down by the option for “pay-what-you-can”. There are other ways to get customers to reveal their true willingess to pay (see my article on Pricing for garage sale).

I do not have access to any sales data nor have I had this conversation with Ms.Petteway but I hypothesize that they found this pricing scheme yielded lower profit than previous years.  The spa is not standing still and is making  more pricing changes  for the coming year:

  1. The Pay-what-you-can is limited to just two days of the week. This is something they should have done to start with and that would have been a great way to sort customers based on their WTP.  This would also help reduce cost of operations for those days by staffing with junior staff and not offering their high margin services. I also would recommend offering no reservations or charge for reservation separately (unbundled pricing) for these pay-what-you-can days.
  2. They are increasing prices of some and decreasing prices of some. If they based it on customer survey then it makes perfect sense. When re-pricing  two version of the same service I would have recommended that they don’t reduce the price for both.
  3. Note how the text reads for price decrease and price increase. They say “price reduced” and “price changed” respectively. That is not a strategy but the right messaging – do not ever say price increase.

Small businesses can blame the economy and be swept by the recessionary wave or they can take control on their marketing strategy to drive higher profits. Lack of specific marketing skills is not an excuse anymore. Kudos to Ms.Petteway for experimenting with pricing and her willingness to adapt as she gained more data about consumer behavior.

Should Publishers Allow Kindle Text-To-Speech

With Amazon Kindle there is a feature that has not been available before, Text-To-Speech. Publishers are not happy about this feature.One of the Kindle eBook publisher, Random House, has turned off Text-To-Speech for all its eBooks. Opinions on this are divided. Kindle readers are most likely to think that they had already paid for the book and hence they should get the Text-To-Speech feature. Amazon would like this as well as a value added feature for its $300 device. Should Kindle Text-To-Speech be allowed? Are publishers just being unreasonable? For these we should look at what we pay for a book.

Suppose you bought a hardcover book from a local bookstore. You pay just the price of the book and  read it when and where you want and as many times as you want. You can annotate, bookmark, refer back or even tear off pages you like and archive it.

It just happened you were not able to read it yourself, so you hire someone to read it to you. (Hold on to your question “why did this person not buy audio book?”).Everyday for an hour this person comes to your place and reads the book until it is done.When something was not clear or you wanted to listen again you ask them to go back and re-read the those sections. Anytime you like a section you ask them to bookmark it and also add a Post-It note with your comments on it. You also ask them to flip back to previous chapters and selectively re-read. When this person is done they leave the book with you, which you can thumb through to refer bookmarked sections. You pay about  $X/hour for this service.

One day this person says she cannot come in person to read for next few sessions but can read it over phone to you. You get all the benefits of the previous case except that you do not have the book with you, have to take your own notes and it is done over phone. You would expect to pay less than $X/hour for telephone reading.

Sometime later the same person says that they cannot make the appointed time but will record their reading and send it to you. You can tell this person beforehand your specific needs, reading speed, annotations etc. You lose many of the benefits of previous cases but gain the convenience of hearing it anytime and anywhere you want.

On the other hand you simply can buy the audio book, that is mass produced and lose personalization and customizations you had with your own reader. But you do not pay a separate fee for someone else to read the book, you pay one price for the audio format.

This brings us to what I call the three C’s of  what you pay for the book:

Price of a book  = Content   + Consumption  + Convenience

Content: Is the information content of the book, be it ideas or the story. These days even the most popular books are discounted heavily. Unless you are buying an esoteric topic or a college text book, the price paid for content is almost the same and negligible for most books.

Consumption: This is how you consume the book and what you pay for the method of consumption. This is determined by the formats the book is sold, for example, printed book, eBook, audio book. The price component for consumption varies by the format.

Convenience: This is the trade-offs between benefits and deficiencies of the different methods of consumption. With each format you gain some and lose some.

You can see that Consumption and Convenience are interrelated and we can simply call these two as Convenience.

Since content is all normalized  we can say that what you pay for a book is  for convenience.That is each format has a different value proposition and it is different for each customer segment. If all  a reader pays for is convenience then the publisher should be able to charge you separately for each method of consumption. This is the reason you see hardcovers, soft covers, eBooks and audio books all sold separately.

Coming back to Kindle’s Text-To-Speech, this offers the ability to add a new method of consumption that offers some of the benefits of the new method but without paying  it.  This is the root of the conflict between Amazon and publishers. To me it makes perfect business sense that the publishers do not like what they see as value destruction (by giving it away for free). Actually the additional value is all captured by Amazon in the price of the device.

A better reslolution for this argument is that this Text-To-Speech feature must be unbundled and  priced separately so that the publishers can capture some of the value they add. Amazon can either pass on this additional charge to its customers or decide to eat the cost since they capture considerable value by selling the device.

The Long and the Short of Lifetime Value of Customer

Zappos takes pride in describing itself as a great customer service business that happens to sell shoes. I had to return a pair of shoes. As it had been said very eloquently by many, it was the easiest task I have ever done online. Zappos knows they have not lost me and that I sure will buy more shoes from them.

On the other hand, I went to the local UPS store to drop off the package. I asked the friendly associate to tape my box and affix my printed UPS shipping label. He did, but charged me $1 for a strip of tape. He explained that he makes no money from people dropping off packages and in my case he lost money because he spent time and material and hence had to recover that cost.

It was not a big deal to pay a dollar. But …

Do businesses need to make money off of every customer interaction? The problem with most businesses, especially those run in franchise model with very low operating margin, is that they look for every opportunity to amortize the costs.

They look at customer interactions as transactional and not as a relationship.

The transactional model assumes every customer will visit your store exactly once (at least for the next few years). So the goal is to get the customer to pay. Even a small act you do for the customer needs to be charged.

The relationship model treats the customer visit as one of many opportunities to build a relationship with them. There is no concern about making money from every visit.

A customer who has bought other services in the past is not going to be happy for getting charged for every small thing. A new customer will form an opinion that will drive them away from the store for future services. The store should use every customer visit as an opportunity to build a stronger and better relationship.

The UPS stores are independently owned and operated by local business people. The franchisee, a local entrepreneur, pays a fixed fee and a percentage of revenues to UPS and takes as profit whatever is left after covering costs. Harvard Business School professors Campbell and Datar say in their working paper, “franchising imposes undiversified risks on the store manager and can create hold-up problems where franchisees may under invest in their stores”. This may lead them to measures that are needed to stay afloat but does not help the brand.

We can’t blame the franchisees for trying to stay afloat but customer experience is tied to the main brand. A customer will then relate the same experience to every UPS store and its offering rather than treat it as one off experience with an individual. UPS should incent the franchisees to build better relationships, and help reduce overhead costs by providing simple supplies to the stores to create better experience. This holds true for any business, franchised or not, big or small.

The high lifetime value of the customers in the relationship model requires businesses to look beyond profit from every visit and deliver above and beyond what is required.