Chasing Loyalty at All Cost

[tweetmeme source=”pricingright”] When customers are not willing to buy branded products at premium prices, should the marketers  go after those customers with price cuts, discounts and promotions? Heinz, facing drop in sales and change in customer buying behavior, said it is doing exactly that:

Heinz warned analysts that it will likely have to lean heavily on promotions, discounts and advertising to stop the defection of consumers to cheaper, private-label brands. “This is a tough environment, there’s no doubt about it,” said Art Winkleblack, Heinz’s chief financial officer.

It is a surprise that Heinz that  reported increase in profits for the past four quarters is reverting to the conventional wisdom of maintaining loyalty. The expectation for any marketer holding on to customers through enticements is that:

1. These will stay loyal when the price eventually improves . But, data shows that buying loyalty leads to profit destruction in the long run.
2. Loyal customers are less price sensitive, based on a study which is a contradiction since marketers first have to buy loyalty with price cuts. There is no proof in the data that loyalty leads to price insensitivity.

In their 2002 book, Trading-Up, authors Silverstein and Fiske, talk about a behavioral shift in consumers – seeking New Luxury and willing to treat themselves to premium priced products. These are the customers who bought emotionally and justified rationally. Marketers chased these new breed of customers with price points that were high but attractive enough to this Trading-Up segment. (Note: If not for this segment, the prices would have been even higher. )When marketers got used to the volume and market share, they built capacity and made projections based on continued growth in the Trading-Up segment. But all that changed when the economy took a turn for the worse.

In the early days of the Great Recession, The Times profiled how customer’s buying behaviors started to change – from buying premium priced name brand food items to cheaper store brand items. A woman profiled in the story said she convinced her brand conscious husband he was getting A1 steak sauce by refilling empty A1 sauce bottles with store brand sauce.

Recession came as a shock, people losing jobs, seeing their friends and families lose their jobs and a fear for their own caused some to cut back on what used to be essentials. Economists call this the income effect. What the recession started was not just a blip but a behavior change that led  many customers to permanently trade down to cheaper private labels. Arguably these are the “Trading-Up” customers who sought New Luxury.

Instead of trying to hold on to these price sensitive customers  and buying their loyalty at all costs, marketers  must treat this as an opportunity to identify their truly brand loyal and price insensitive customers. When the price sensitive customers all take one step back, those who are left in the front row must be the brand loyal ones. Which means instead of discounting or dropping prices, marketers can actually  increase prices (See Starbucks case study).

What is your cost of loyalty?

Aligining Price With Value – Metering Vs. Versioning

In any  all you can eat pricing model, be it a lunch buffet or at&t iPhone subscription pricing, as long as the  total revenue  exceeds total costs, the business will make a profit  regardless of whether they lose money on any one customer.  There will always be a distribution of customers based on value they receive and price they pay

1. Some customers get more value than what they pay
2. Some don’t get as much value as they paid for

The problem occurs  when  the first segment uses a higher proportion of the service and risk completely starving the second segment.

AT&T says,

the heaviest data users, saying that 40 percent of AT&T’s data traffic came from just 3 percent of its smartphone customers

To provide appropriate level of service to the second segment AT&T needs to size their services so the big appetite of the first segment is served. Facing customer backlash from slowness, AT&T is trying to reduce data usage by the heavy iPhone users – this implies they are either working on introducing metered pricing or a multi-version pricing.

Either of these plans require that their subscribers understand the value they get from the current unlimited plan. If the customers do not know  how much value they have been receiving they will balk at any changes to current pricing. AT&T has a leg up on this, they have been itemizing  data plan usage minutes (page after page if you received paper bill) even though the plan is supposed to be unlimited. It is arguable how many customers look at paper bill but the auditing does provide a way for AT&T to make a case with its customers when they introduce new pricing plan.

For example,

“Dear customer, do you know, on the average, you used 100 minutes of data service for 1GBytes download in the past 12 months. That’s $50 in value per month and $30 more than what other customers like you receive. To better serve your needs and those of all our customers like yourself we are introducing a new pricing plan …”

Which one will it be? Will it be metering, charging per minute or megabyte of download of data usage? Will it be a set of new data plan versions offering a combination of minutes and download? Which has better chances of succeeding?

I do not believe it will be usage based pricing. It does not align with the current minutes plan and the  problem it introduces with customers constantly worrying about using the data service.  AT&T already has a track record in executing a successful multi version pricing plan for its wireline high speed service (see figure left). Modeled after this we should expect to see three to six different data plans at different price points, each offering a combination of minutes and download (GBytes).

Versioning is about offering multiple versions at different price points so the customers self select- in this case it also helps to better align the value customers have been receiving with the price they pay.

How is This For Cost Based Pricing?

[tweetmeme source=”pricingright”] Cost based pricing is tacking on a % margin to the cost of the unit instead of pricing your product/service based on the value it adds to your customers. Costs does not matter to your customers and nor should it matter to pricing your product. Costs matter only to the extent that it makes no economic sense to sell a product below its marginal cost. I am dismayed to see the extent to which people go to compute costs, allocating a share of every cost incurred to every unit sold.

Let me try to explain how ridiculous cost based pricing is by taking it to the extreme.

Suppose you ran a coffee shop that sold just one SKU (as I said I am taking this to the extreme to prove the point). As your customers buy their cup of coffee they see a row of jars in front of them. Each neatly labeled with

1. a short definition of what it is for
2. a dollar value

There is a jar for

• mortgage
• insurance
• delivery
• coffee beans
• milk
• utilities
• bathroom cleaners
• interest
• depreciation on coffee machine
• salary for employee 1 &2
• childcare (for your child while you work)
• profit

Each jar is also marked with a respective dollar amount.

You ask your customers to drop exact amount marked on every one of those jars.

Every time the price of coffee beans, milk etc goes up you re-lable your jars.

What do you think your customers will do?

Ask your self what your customer is paying for? Did they walk into your store to get their daily caffeine fix, experience the great ambiance you provide or to help you offset your costs?

Do you practice effective price management?

Pricing Digital Goods – (Hint: Not Free)

The problem with digital goods is it is easy to get confused by its economics, the marginal cost is $0, selling a unit to customer does not make it unavailable to another and there are challenges in restricting use. This has led to supposedly new branch of economics, “economics of free and abundance”, led by Mr. Chris Anderson and has built a large following.

I have written several articles on the need to sell the value and not focus on the marginal cost. In the digital world matching price to value is more difficult than it is in physical world.  Economist Brad DeLong from UC Berkeley (my alma mater) writes in his 1999 paper titled, Speculative Microeconomics for Tomorrow’s economy,

In many information-based sectors of the next economy, the purchase of a good will no longer be transparent. The invisible hand theory assumes that purchasers know what they want and what they are buying so that they can effectively take advantage of competition and comparison-shop. If purchasers need first to figure out what they want and what they are buying, there is no good reason to assume that their willingness to pay corresponds to its true value to them.

When customers do not exactly know what they want and the value they get, the marketer will find it hard to make a value proposition and charge a price that captures that value. Difficult does not make it a good reason to give up on charging for digital goods and give it away for free.

In a Nov 1998 article in Harvard Business Review, economists Hal Varian  (also from Berkeley now at Google) and Carl Shapiro wrote (Harvard Business Review, 00178012, Nov/Dec98, Vol. 76, Issue 6)

But there is a practical way to set different prices for basically the same information without incurring high costs or offending customers. You do it by offering the information in different versions designed to appeal to different types of customers. With this strategy, which we call versioning, customers in effect segment themselves. The version they choose reveals the value they place on the information and the price they’re willing to pay for it.

It takes us back to what Ted Levitt said about customers buying holes and later what Clayton Christensen said about, “what job is your customer hiring your product for?”. The difficulty in value calculation comes from focusing on the “drill” and not on the “hole”. If marketers focus on what the customers really want and what job they are hiring the digital information for it becomes easier to tease out the value to customers and how it differs across segments. Then the marketer can target the segments with specific versions and position it appropriately to capture a share of the the value through effective pricing.

Proposals to give away your offering (Mr. Chris Anderson in Free/Freemium) or let the customer decide what they want to pay may capture your imagination but as Hal Varian (who was described by Mr. Chris Anderson as someone who taught him more about economics than any of his professors) said in 1998 (full ten years before these new models):

Success in selling digital goods does not require a whole new way of thinking about business. Rather, it requires the same kind of smart managing and smart marketing that have always set apart the best companies. The real power of versioning is that it enables you to apply tried-and-true product-management techniques-segmentation, differentiation, positioning-in a way that takes into account both the unusual economics of information production and the endless malleability of digital data.

The road to profitability in any market goes through STP! That’s Segmentation – Targeting – Positioning. The rule does not change whether you are selling physical or digital goods.

Knowing Your True Marginal Cost

From big businesses to home based businesses there is an uncontrollable desire to allocate a share of the total cost to every unit of product sold. It is actually surprising that some of the small businesses do elaborate calculations just so they can allocate a share of the mortgage, insurance, delivery vehicle etc. This is from the NYTimes story on the new entrepreneurial craze – Cupcake stores:

For each cupcake she sells, Ms. Lovely figures she spends 60 cents on ingredients, 57 cents on mortgage payments and utilities, 48 cents on labor, 18 cents on packaging and merchant fees, 16 cents on loan repayment, 24 cents for marketing, 18 cents for miscellaneous expenses and 4 cents for insurance. That totals $2.45, leaving a potential profit of 55 cents on each $3 cupcake.

It is not difficult to see that Ms.Lovely’s elaborate calculations are based on volume sold, so any changes in number of cupcakes sold will affect her cost allocations.  Only the ingredients and labor costs are true marginal costs (you could argue even those don’t count as MC).  For a cupcake priced at $3, that gives a contribution margin of  $1.92 which all add up to defray the fixed costs of mortgage, insurance taxes etc.

So when volume drops and the margin drops below 55 cents will Ms.Lovely increase price of her cupcakes? Will the market pay for it? The problem with cost driven decision making is it ignores the customers.

Padding marginal costs with cost allocation combined with the percentage margin obsession will lead to incorrect pricing that is unrelated to what the market is willing to pay and lost profits or even the end of your business.

Here is five step process for cupcake cost economics:

1. First find out how many cupcakes you can sell different prices, then find the price that maximizes your profit given the true marginal cost for a cupcake.
2. The difference between price and the marginal cost is what each cupcake contributes to defray your fixed cost and eventually contributes to your profit. This is called the contribution margin.
3. The number of cupcakes you need to sell so that the total contribution margin can cover fixed costs is your breakeven volume.
4. Don’t look at % margin on each cupcake, this is irrelevant to your business decision. Not every cupcake you sell needs to contribute to profit, only those that you sell beyond the break even point contribute to profit. Trying to allocate fixed cost and profit to every cupcake leads to bad decisions.
5. If you cannot sell the cupcake for more than its marginal cost, there is no business case. If the total contribution margin   cannot cover the fixed costs, there is no business case.

We are increasing prices because …

[tweetmeme source=”pricingright”] I saw a notice posted on the external doors of an ice rink that said,

Please close the doors behind you otherwise the rink will fog up

I did not stand around to measure how many followed the advice and whether this number was better than what it would have been if the sign had simply asked “Please close the door behind you”.  But other people have done such studies.

In the book Influence: The Psychology of Persuasion (Collins Business Essentials) author Robert B. Cialdini narrates the work done by Harvard Social Psychologist Ellen Langer on the power of the word “because”.

People simply like to have reasons for what they do.

It does not matter how relevant or meaningful the reason is. The word “because” made the difference in people accepting your request. This isn’t to say that giving reasons for requests works universally but  it does help to reduce resistance.

Take the case of price increases. When a marketer pushes through price increases without extending any reason customers resist those increases and perceive the price increase as unfair. But if the price increase were justified with a reason, a greater number of customers will accept it. In their paper titled, Perceptions of Price Fairness, researchers Gielissen, Dutilh,and Graafland  validated the hypothesis that price increases justified with cost arguments were perceived to be fair by customers.

Ellen Langer’s and Cialdini’s work point to another possible reason for customer acceptance of higher prices – it is not the justification itself but the mere presence of one.  This opens up opportunities for both B2C and B2B marketers to re-price their offering or capture greater value without turning away customers – just give a reason.

We see that in the earnings results of CPG brands that used commodity price increase in 2008 to push through their price increases.

Another case is for two-part pricing – asking customers to pay an upfront fee and then a per unit price.  Examples are mobile phone activation fee or registration fee charged by services. These upfront fees are nothing but pure profit for the marketer and find customer acceptance when justified with reasons, however trivial, like  processing fee or registration fee.  For B2B case, a marketer can charge additional upfront price with reasons like customizations or order processing.

Just give a reason! – “We are increasing prices otherwise we will go out of business”

I should note that this is a pricing tactic and not a strategy – if your strategy is wrong, any number of fine tuning tactics, even with reasons, are not going to help.

Footnote: It is a good idea to A/B test your reasons even though Cialdini and Langer say the specific reason is immaterial.