Sometimes pricing is just wrong

Take a moment and think about this pricing scenario. What do you think the pricing for slim-fit shirts should be compared to regular-fit shirts of same brand, material and design?

Logical answer would be slim-fit shirts should be priced higher than regular-fit because there exists a smaller set of customers who prefers the look of slim-fit and value it enough to pay more for it. After all, demographically there are not many that would fit (and look) stylish in slim-fit and for those who want to look good with a slim-fit there is value that can be captured as higher price.

This would appear to be a perfect case of second degree price discrimination. Present two different versions at two different price points and let the customers self-select. It is fair too because all customers have the option to choose either one.

Except that is not how shirt makers think about pricing or set pricing. Here is how shirt makers set pricing

First they add up all the costs – including hours spent and fixed cost (overheads) allocation. The use “standard industry markups” to set wholesale price. Finally double it to get retail price. (And mark it down to generate sales)

It is as simple (or simplistic) as that. Cost based pricing with price markups and not based on customer value and willingness to pay.

Hence if you see same pricing for slim-fit and regular-fit it is not just a matter of missing out price discrimination it is a matter of setting the price wrong to begin with.

If you see different pricing it is highly likely that shirt makers chose to allocate different overheads – likely more to slim-fit because of smaller volume – than because they recognized opportunity for price discrimination.

Sometimes things are not as smart as you would like to believe.

On Pricing Low

Here is a comment on an old article of mine titled, Enough with the marginal cost argument,

Rags, there may be a pony in here somewhere, but I’m having trouble finding it.

In competitive markets with many substitutes, marginal cost is a the key to pricing. You may not like it, but it’s true. The start up costs may impact new players, but if the startup costs are already sunk, they are irrelevant. A rational player will grow market share by cutting prices until marginal cost is met. If you tried to compete with YouTube by charging to make up for your startup costs, you’d lose, right?

Now here is what the same commenter had to say in his own blog about low prices (of course I cannot be sure about the identify of the person who commented on my blog, looking at the phrases it is highly likely the two are the same)

If you build your business around being the lowest-cost provider, that’s all you’ve got. Everything you do has to be a race in that direction, because if you veer toward anything else (service, workforce, impact, design, etc.) then a competitor with a more single-minded focus will sell your commodity cheaper than you.

Cheapest price is the refuge for the marketer with no ideas left or no guts to implement the ideas she has.

I like his second version of the pricing principle. May be he had a change of mind? It is far better to find a segment that values your product and deliver them a version at a price they are willing to pay than try to capture market share with a commodity product at or near marginal cost.

Marginal cost is relevant only to set the floor and not the price you should charge. You don’t have to like it, but it s true.

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.

Suppose You Made Pricing Decisions Based On Your Marginal Cost

Let us suppose you made pricing decisions based on your marginal cost. One of the examples quoted in Mr. Chris Anderson’s series on “free” is digital music. Mr. Anderson says, since the cost to produce, store, distribute digital music is $0 (or approaches $0) it makes sense to give it away and find other ways to make money, like concert tours and other paraphernalia. Let us take the marginal cost argument to the extreme and apply to the concert itself.

The marginal cost to admit one additional person into the concert arena is, you guessed it, $0. Once you decide to put on a concert, pay for marketing, stage, security etc it does not cost anything additional to allow one more person for  free into the concert arena. So why not do that?  Because the marginal cost is relevant only up to the point whether or not you can breakeven on your initial investment and is always irrelevant to your pricing decision as long as you do not charge below your marginal cost.

Before you put on a concert , you add up all your costs of what it would take to do it. Then you look at what is your “average price” below which you cannot breakeven and hence makes no sense to do your concert. This is the floor for the average price. Then you determine the multiple customer segments and their willingness to pay for the tickets and design a multi-version pricing scheme that appeals to those segments. You design your pricing and product mix such that those with higher willingess to pay will self-select themselves to the higher priced version (because of closer seat etc). Then you determine the total profit  and see if this is net positive over the total cost of your concert. At no point you are deciding based on the marginal cost.

Why is this any different when you cho0se to distribute your music digitally?  I am not saying do not make your digital music free, by all means do it if that is the best among all available options in terms of total profits delivered. Make your business decisions because you have done the analysis and evaluated all options and not based on “everyone else is doing it” or “free is the law”.

But the problem with writing a book that says, make it free when it drives maximum profit through other means, charge for it when that delivers maximum profit,  is you are seen as hedging your bets. As Professor Dan Ariely points out, people trust confidence more than expertise. Prof. Ariely says, “We’re Swayed by Confidence More than Expertise“. You can sell more books with confident assertions.

Because though confidence and accuracy sometimes go hand-in-hand, they don’t necessarily do so. And when we want confident advisors, some will exaggerate to give us what we want.  Maybe this is why so many pundits on TV for example exaggerate their certainty?