Willingness to Pay and Reference Price

Take a look at this Yelp review

 went through a mess of salons to get some price ideas for mens haircut and I am sorry, I’ve been paying 10-15 dollars for a haircut for 22 years. I cannot and will not pay $80. That’s the price of a new video game! I called the salon and I got a price of $16 for mens! $1 more than my maximum?

ref-priceWhat do we see here? An illustration of the fact that,  as customers we do not walk around with a price we are willing to pay for every product and service. To a large extent this number is shaped by experience and what we have seen and trained to pay. That becomes our reference price.

Any price above the reference price – like the $16 vs. $15 – is seen as a pain or price increase that need to be reconciled. And you can see how this reviewer felt after paying $1 over his old reference price.

Reference price is not a fixed number, fortunately for all of us marketers. It is malleable – newer products, cost justifications, options, or extras – can be used to move it. If the customer is convinced they are seeing value for the extras they will happily move to the new higher reference price and will settle there until next movement. The same reviewer ends with,

I can truly say with a tremendous amount of confidence. I have found my PERMANENT salon.

Back to Willingness to Pay – the $80 price limit this reviewer quotes is his absolute reservation price. No amount of benefits, features, brand, customer service etc. can move this user to pay $80 for a haircut. His willingness to pay is somewhere close (tad below ) that number. You should know that this is just one customer and may be there are lot of them like him while there are many others who are more than willing to pay hundreds of dollars for a haircut (or the salon).

What do these two parameters mean to you as a marketer or entrepreneur?

First stop asking questions like,

“Would you pay $3.99 for my product?”

Because customers do not know.

Second do not be afraid of raising prices, as long as you understand the effect of reference price and execute this change correctly.

Finally, if your product used to be free and you are considering pay model do not assume no one will be willing to pay that price. You need to find those who value it enough, target them and move their reference price sufficiently to get the price that is fair share of your value add.

How do you manage your pricing?

See also: Multi-version pricing at salons.

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?

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?

Small Business – Big On Price Management

Effective Price Management – Nestle is doing it, P&G is doing it, Victoria Secret is doing it and these are definitely not small businesses. Now, smart small businesses, despite facing recession and decreasing customer demands, are adopting effective price management.  Here are two businesses featured in WSJ Insights Entrepreneur Roundtable and their pricing strategy and tactics:

Versioning: If one price is good, two prices are better. Versioning is about understanding that your customer segments and delivering them a version that adds value at a price point they are willing to pay and profitable to you. Bud Konheim, founder and CEO of Nicole Kim, says:

In July of 2007, I saw what was going on and I had a choice: lower the prices and compete that way, or go back to the philosophy that we have, which is design, design, design. You know, competing by price, the winner gets zero. We didn’t want to do that. But we are known for special-occasion dresses, so I introduced a new category called Daytime Dresses, which was a cover for making lower-price stuff. So I had two of these things going, a lower price and a higher price.

Using cost signals for price increases: This is a pricing tactic that helps address fairness concerns when a marketer wants to increase prices. Lida Orzeck, CEO of Hanky Panky Ltd, says

On June 1, 2004, we raised the price to $18; I think maybe it was $17 earlier. And then five years had passed and near the end of ’08, we had a plan to increase the price. We let everybody know and explained why—all of our prices have gone up, for materials, labor and so on.

Further reading:

  1. five steps to effective price management for small businesses,
  2. Price increases when demand shrinks
  3. Bottled water prices

Effective Price Management

Adaptive Price Management

When the downturn started in 2008 and retail sales started dropping, the department stores started dropping prices from fear of being left with inventories. There were big sales, with 50% to 70% drop in prices even in high end retailers like Saks. There was one exception, Abercrombie & Fitch, which steadfastly refused to drop prices.

They knew they were not a product for the mass market and there was a small segment they served. For a long time that segment was not worried about price. They were more concerned about the brand and the long term effects of sales on their brand and future pricing power. They were worried about setting low reference price in the minds of their customers and did not want to train their customers to wait for sales. There was more to lose from price decrease than to gain.

However, things got worse for Abercrombie & Fitch. Their operating margin shrank from 20% to barely 4% in less than a year. Their sales fell 30%. Whatever happened to Effective Price Management  that recommends pricing for profit and protecting  price premium to deliver higher profit.

They  correctly following and religiously implementing two of the three components of Effective price management:

  1. Pricing based on value add to segments
  2. Pricing based on incremental analysis

Unfortunately there are two problems that led to profit erosion.

First  problem is effective price management requires the marketer to manage all three components and selectively choose one or two and implement just those. When a marketer optimizes a subset they end up missing the true optimal solution.They were focused on margins from individual items and not on maximizing total margin from the customer. They ignored the third component of effective price management – Focus on customer margin not product margin.

Second problem is the model is not static – you do not decide  your segment, their value proposition, their demand curve once and forget about it. The segments, their taste, value proposition and willigness to pay all change and change drastically due to external events. The New York Times  reports on a market research that found just this shift:

Aéropostale and Wal-Mart, the discount chain, are among teenagers’ go-to stores this season, while more expensive stores — like Hollister and Abercrombie & Fitch — are not, according to a survey of students ages 12 to 17 by Majestic Research.

“Rather than get one top at a Hollister, they can get two or three at Aéropostale,” said Brian J. Tunick, a retail analyst at J. P. Morgan Securities.

When this shift happens then all the previous models on segmentation, targeting and incremental analysis on sales drop and lost profit must all be reevaluated. When the model does not evolve and remains static, it results in decisions that does not deliver under changed conditions.

Effective price management is not about picking and choosing a subset of the three components but implementing all three with right balance to maximize profits. It cannot be done in a, “set it and forget it mode”,  it is a dynamic model that requires continuous tuning to adapt to changing inputs.  Failure to do so will result in sub-optimal results regardless of how optimized the partial model is or how accurate and complete the initial model is.