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.

Cost Allocation Obfuscation – eBook Pricing

Cost, especially fixed cost allocation, has nothing to do with pricing. Unless you are selling to the Government which allows you to quote only cost plus pricing. Government contractors are more than happy to do so because they not only include the variable cost of making a toilet seat but also add to it its share of all their fixed costs. So when you assign each toilet seat its share of building cost, executive salaries, etc etc you get $2000 as price tag.

Allocating each unit produced, its share of fixed cost is a financial accounting artifact – required by GAAP accounting rules. When convenient, like in obfuscating the true marginal cost to justify higher prices, some businesses are happy to adopt it.

Now publishers are adopting the same obfuscation to justify their eBook prices. Since they  are not selling the value of the book, they are facing challenges from customers expecting lower prices on eBook over hardcover books.

Michael Connelly’s recent legal thriller, “The Fifth Witness,” has more one-star reviews on Amazon than five-star reviews in part because some angry reviewers focused on the e-book’s $14.99 price.

Customers expect publishers to pass on cost savings from paper and printing charges in the form of lower prices. What are publishers resorting to? Obfuscation

Publishers argue it’s impossible to break out a profit per title that includes a percentage of all their costs because all books have unique one-time costs which are broken out over an unknown number of copies. It’s also hard to apply corporate overhead costs against the sales of individual titles.

They are hiding behind cost argument to say their “margin” per eBook is still low and hence it deserves prices that are comparable to hardcover.

If they are not willfully obfuscating, they are just plain ignorant in their cost allocation. Hard to believe.

All these because publishers are not addressing , “what job is the customer hiring a book for”. There is no attempt to sell the value. If the publishers are not differentiating on the content and the customers are not seeing difference between different titles (not their fault), both sides argue about the cost.

Does the customer get any less information value from a eBook than a hardcover book?

The real disruption of the publishing industry is yet to come. We will start seeing, substitutable, undifferentiated, and copious content sold as commodities for less than 99 cents and high value content sold at prices that capture a fair share of the value created for customers.

Until then, publishers, customers and all the media bloggers will focus on costs.

Xoom: Pricing is Wrong, Costing is Wrong or Playing for the Niche

Update 7/7/2011: Motorola cuts Xoom prices by $100.

In my last article, Why there is no 16GB Xoom, I raised two possibilities

  1. It costs them $600 to make Xoom
  2. Their costing is wrong – they incorrectly allocated a share of their fixed costs to every Xoom there by getting an inflated cost number compared to true marginal cost

Yesterday, iFixit did a tear down analysis of Xoom and found that the marginal cost is not much different from that of 32 GB iPad 3G.

So why is Xoom priced higher even though it is a new entrant with no track-record (like iPod touch, iPhone)? In an investor conference, Motoral CEO Mr. Jha said,

“Xoom deserves its higher price tag because of its quality and the free upgrade to 4G”

No product deserves higher price tag just because of its quality or because the marketer believes so.  Customers decide whether or the higher price tag is worth it.

Even if Motorola believe there is higher value to the customer and customers agree with that value proposition,  the reference price set by Apple brings down the price they can charge.

It is highy likely they got costing wrong. They may not be just looking at the cost to make each unit, like iFixit did, but including a share of their R&D, Marketing, other company overheads like executive salaries and other investments to each Xoom.

The next step in this slippery slope is to tack on a percentage margin and set a price, regardless of what the customers value, because all their products must meet an artificial percentage margin target.

There is yet another possibility. They are yielding the mass market to Apple and want to target only those customers who desperately need a tablet that is not an iPad and hence are willing to pay higher price for a non-iPad. It is not a recommended move when the market is just getting defined. There is no reason to slice a small niche within a niche especially when tablets threaten the PC market.

Net-Net, not having value based pricing, not having versions or pursuing a niche strategy are all bad moves.

We should expect significant price drop real soon, like after tomorrow.

Using Cost Argument For Price Increases – A Redux

The latest article in the, “Ask the Expert“, series featured a detailed and well researched article written exclusively for this blog by William Poundstone.  In that article, Mr. Poundstone answered the question whether businesses can use cost increase as an excuse to push through price increases. The article generated two very well reasoned responses. Here I will address the questions and qualifiers raised in the two responses.

Before I get to that, let me clarify one aspect that is most likely already clear to the regular readers.

Costs have nothing to do with pricing. Effective pricing is about finding what is relevant to each segment and targeting them with a version at a price they are willing to pay.

The question Mr. Poundstone answered was whether cost increase can be a good excuse for pushing price increase (not setting the original price). I have answered the same question in a previous post with similar response:

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 work, quoted by Cialdini, 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, any reason.

Now to the two responses.

  1. What about inflationary conditions? Leo Piccioli from Argentina raises the point about conditions where the monthly inflation rate is 2%. He writes

    Under an inflationary context (understanding it as a general increase in prices along the market, or, in other words a reduction in the value of money) “fairness” seems to be a bit easier: people know prices go up all the time and do not have the time to validate each increase (the cost of checking it out is higher than the benefit). Therefore, I would recommend constant small increases instead of periodic large ones.

    It is very true for such macro-economic conditions and across cultural boundaries the research I quoted and that quoted by Poundstone may not be relevant. Inflation is in the minds of the customers, it is their expectation that prices will go up. Presence of such expectation gives marketers the freedom to push through multiple periodic price increases without worry.

  2. What about the cost of the messaging to justify price increases? John Balz who writes the NudegBlog, posted an article responding to Poundstone’s article:

    The basic point is that rather than having companies coordinate separate communication about commodity prices at moments of price hikes, wouldn’t a better strategy be to integrate market commodity costs into a communication strategy more generally?

    Yes there are costs to a marketer in running these campaigns but a constant and steady message on costs has the danger of converting the pricing into cost driven one and letting the customers demand a price that is only marginally more than cost. For the extreme example, see my Coffee shop example,  do customers come into a coffee shop to offset your different costs or get their daily caffeine fix.
    Or take the case of Apple’s 3G iPad and compare that to of Kindle 3G. Both have the same radio parts but the price of 3G iPad is $130 more than iPad Wifi while Kindle 3G is only $50 more than Kindle Wifi. Clearly, Apple is pricing based on value to customer.

The net is, pricing has nothing to do with cost and we should not be talking about it at all. When the original price is wrong or misaligned, cost increases can be used as an excuse for better price realization without much customer backlash. Otherwise, let us not bother our customers with the cost of sending our children to daycare so we can deliver the product to them.

Moving to Customer Driven Product Development and Pricing


Does this sound familiar?

  1. Long list of features that are thought to be cool and must-haves. Most of them compiled by looking at other products in the market and  by generalizing from an individual’s personal pain-points and wish list.
  2. All these esoteric features hastily force-fitted into benefits – because marketing is about benefits and not features.
  3. Search for customers – and if the first set of customers don’t like it, try another and another

If this is the product development flow then it inherently drives a marketer to commit the mistake of cost based pricing.  Since product development starts with features, pricing starts with cost — cost of components, cost of R&D etc. Then a marketer tacks on an artificial margin that is treated as sacrosanct and determines the price.  Then they search for customers with needs and  are willing to pay that magical price. Economic value add to the customer does not picture in this process. As the marketers find fewer customers willing to pay that price they resort to price cutting and eventually to complaining that customers decide on price not on “features”.

(Sidebar: The extreme case of this is what is happening with all things digital for which the marginal cost (cost to produce, store and distribute one additional unit ) is $0.)

Which funnel is yours?

Now consider this, take a look at the funnel on the right:

  1. Identify the needs and wants of different customer segments, select those that offer the greatest opportunities and you have unique competitive advantage in serving.
  2. Create a credible value proposition. Determine the product positioning to credibly answer the question, “what jobs are your customers hiring your products for?” and what benefits are key to get those jobs?
  3. Design the minimal product that delivers  those benefits at the lowest possible cost.

Starting with the customer segments and their needs leads a marketer to the correct way of pricing – value based pricing. Asking what jobs customers are trying to solve enables the marketer to create a credible value proposition. Calculating economic value add to customers reveals what the customers must be willing to pay for the product. Then it is applying innovation to design the product with the minimal feature set  that can be produced at a profitable cost.

When you start with customers and value the marginal cost becomes not the prime determinant of pricing but just a gating factor below which the products cannot be sold.

Which funnel is yours?

The Percentage Margin Trap

One of the income statement metrics that stock analysts obsessively focus on is operating margin expressed as a percentage.  Stocks get punished when the operating margin drops or did not meet the goals. So businesses align their marketing and operations to focus on this improving operating margin. To an extent operating margin expressed as a percentage shows the profitability of the operations but the obsessive focus on percentage leads to two errors:

  1. Information loss – specifically the absolute profit earned. ( I am going to ignore here  a more rigorous number, operating cash flow and treat earnings as all cash.) Given two stocks of identical companies in the same market, one with an operating margin of 10% and the other 12%, both with a stated 5 year goal of 4% improvement, can we tell which stock is a better prospect? What about their absolute income level and growth prospects?
  2. Causation Confusion – percentage margin is incorrectly treated as the driver of overall profit. Higher the operating margin, higher the profit. Margins do not drive your profits it is the other way.

Operating margin percentage is a computed number not an intrinsic metric that needs to be actively managed and definitely not a driver for your marketing decisions like pricing the products. Let us take the case of Mattel just because it was in the news recently.

Recently Mattel anounced blow out earnings, with 86% increase in profits with only a single digit increase in sales.  This is extraordinary but there is a concern on what they are focusing on. The WSJ news story’s title reads “Earnings Up 86% As Margins, Barbie Sales Jump“. Margins did not drive the profits up. Profits went up because of price improvement on their Barbie line. In its earnings call Mattel CEO, Mr. Robert Eckert, made the following statement

“We will price our products consistent with our goals of long-term operating margin of 15% to 20%,”

Determining the price to sell based on the stated operating margin goals is cost based pricing.  Pricing the products to  meet a derived metric is like putting the cart before the horse. Price is not driven by a businesses need for meeting its operating margin targets  set by stock analysts but by the customer’s willingness to pay. Based that price the business must either try to make the products at costs that are profitable (price driven costing) or choose not to compete in the market. I want to believe that Mr. Eckert meant here choosing only those products that can help Mattel meet its margin goals and not set prices regardless of the customers.

What drives shareholder value is absolute profits. Not percentages. As Ford said about costs, operating margin is always a computed number.

What drives products prices is value to customers and their willingness to pay, not stock analysts.

What sets prices and drives profitability is effective price management not meeting operating margins.