Using Cost Argument In Pricing

Pricing is about capturing a fair share of the value you add to your customers.  This method of pricing is called value based pricing. The opposite of this is called cost based pricing that is  internally focused and ignores  customers.  Your costs are irrelevant to pricing, as long as you are not selling below marginal cost and beyond break even point. After all if you are making a loss on every sale or on the whole operation then it makes no sense to be in that line business.

That said, a marketer can use costs signals to introduce price increases while assuaging customer concerns about fairness. I do want to stress that this is a pricing tactic and not a strategy. In their paper titled, Perceptions of Price Fairness, researchers Gielissen, Dutilh,and Graafland  validated their hypothesis,

Hypothesis 2: Options to pass on production costs are perceived to be fair.

When customers see the price increase is a result of cost increases, they are  willing to accept the new prices. Once the high prices become established, these become the new reference price and can remain sticky even when the original cause (production cost increase) is no longer valid.  We see that in the earnings results of CPG brands that used commodity price increase in 2008 to push through their price increases. Since they hit their peak in 2008, prices of food and utilities have come down but the CPG price increases remain.

Brands, despite their current pricing strategy, should implement tactics that take advantage of short-term market conditions. While we saw how P&G, Nestle, Cadbury, Heinz and Unilever taking  advantage of cost increases we also saw Lindt’s not using the increase in cocoa prices to increase its prices. The result is a 90% drop in their profits.

The net of this is, your costs are immaterial to your pricing strategy but short term price increases can be used as effective signals to fix faults in your pricing.

British Airways – Charging for Seat Selection

Suppose you are traveling on leisure with your family, how much do you value sitting together with your loved ones?

How much do you value having our teenagers sit as far away as possible? (or how much do your teenagers value that?

You are a business traveler planning to catch up on the marketing deck or your sleep – how much do you value not sitting close to kids or babies?

While most airlines do not ask these questions, British Airways started implementing a pricing plan for seat selection. If a service adds value to customers (note that the value-add is not the same for all) then the marketer must get a fair share of the value add. That is the first component of effective price management.

What British Airways is implementing is an unbundled pricing, separating  a service that has always been offered and seen as a monolith into its components and charging separately for each. As a proponent of effective price management, I fully support and applaud such a move. But British Airways customers are not amused:

“This is fundamentally dishonest.

“It isn’t about listening to customers at all. It’s about getting extra revenue.

“It looks like those willing to pay will be able to jump the queue and this will force up the price.”

Of course the comments above are not those of customers but those of a politician. Nevertheless BA should have anticipated this. Unbundling pricing is about identifying revenue opportunities, by finding what each segments value and realigning prices to better match the value provided with prices charged. But it is not enough to have strategy, the marketer needs to understand consumer behavior and have an execution plan that will reduce customer backlash and increase acceptance.

We have seen before USAir backtracking on its $1.99 in-flight soft-drinks fee. I have studied and written in detail about unbundled pricing. One common pattern I found with customer backlash is that it results from marketer’s failure to manage customer reference price. Customers do not like paying for something that used to be free even if this adds value to them because they had never paid for this service before. In a controlled experiment for Airline unbundled pricing, I found that improving customer reference price improves customer acceptance of new charges.

Recently SouthWest, that still steadfastly refuses to charge for extras, announced its plan to charge for priority boarding.  SouthWest does not pre-assigned seats, customers find their seats when they board.  SouthWest realized that there exists segments that are willing to pay for the convenience of boarding early and finding seats they like and hence introduced this service. Unlike BA, they did not face customer backlash because this is a new service they started offering.

What should BA have done? BA should have offered options, say one option is to charge a fee for the flexibility to reserve seats three days before the flight  otherwise making it first come first served. This is just one example and I am not giving detailed options here. In any case the idea is to improve reference price before charging for something that used to be “free”.

I would like to point out another idea on what could be causing customer backlash – fairness effect. Mr. Reed Holden, author of Pricing With Confidence, wrote about the extra fees and whether customers perceive them as fair or unfair:

Whether to a general population or to specific segments, when those fees are viewed as fair—they can be effective ways to call out the special features and services that customers can receive if they want to pay.   When fees are viewed as unfair by an increasing percentage of the population, however, they can cause increased switching and a declining population of loyal customers–something that has to be monitored over time.

However, I posit that in case of unbundled pricing whether or not a customer perceive the extras as fair or unfair is contained within the reference price.  I will write more on the last point at a later time.