A must read pricing book with ‘Free’ in its title

There are two books on pricing with free in their titles.

One is by Chris Anderson and has the subtitle of, “How Today’s Smart Businesses Profit By Giving Something For Nothing.  I wonder how these companies do that, must be the volume. This is of course the new title for the paperback edition, the original subtitle was “The Future of a Radical Price”. I guess the future is here.

Rest assured I am not recommending you read this book.

The other book with free in its title is by Saul J. Berman, “Not for Free: Revenue Strategies for a New World”.  By new world Saul refers to the current business world that drank the kool-aid of previous book or obsessed with monetization model innovations.

And I recommend this book.

Saul isn’t as popular or a household name as Chris Anderson is, although a WSJ reported asked me, “who is Chris Anderson?”, when she was interviewing me on my GigaOm freemium article. This book has just 4 reviews on Amazon (all 5 stars, likely his colleagues?) compared to Chris’ book that has 170 reviews.

But don’t let what is popular and accepted by your peers let you decide the book to read or your pricing strategy.

Chris Anderson’s book talked about the abundance of computing power, abundance of bandwidth etc and how these forces led to a marginal cost of $0 which naturally means $0 price. Saul starts with those same trends disrupting business models and comes to a different conclusion – how important it is to have a differentiated revenue strategy in order to not let these forces drive your business to dust.

The first step in Saul’s revenue strategy roadmap? Segmentation (chapter 1 in the book):

 traditional segmentation approaches are at best correlative—they take an identifiable characteristic and match it with a likely behavior. Why be so indirect? Why not look directly for the behaviors relevant to your industry? Doing so can reveal when consumers are well served with an existing business model and when consumers would be open to new ways of doing things, especially for incumbents.

In other words start with the customer needs or the jobs they are hiring a product for and not whether they are in 25-35 demographics.

This alone is worth the price of the book. What are you waiting for? Go get now – Not For Free

Waging the right price war – The $65,000 Mistake

I believe “price war” may be a misnomer if both sides do not live to fight many rounds. We only see price battles or skirmishes that go for 1-2 rounds before one side throws in the towel or runs out of cash. There are two kinds of companies when it comes to price wars.

Category 1: There are just handful of companies that can wage incessant price war  by consistently keeping their prices low

Category 2: Even fewer that can withstand such low price attacks by their competitors.

Amazon.com and Walmart fall into the first category. Apple is in the second category.

In fact if the two players know that the other has the will, reserve and wherewithal to keep up the fight without ever letting up they most likely will choose not to enter price war in the first place. This is very much like nuclear deterrent  — mutually assured destruction.

BestBuy does not fall in either of the categories but was tempted to take on Wal-Mart with its iPhone 5 pricing. The result? BestBuy lost $65,000 in a single day.

Let alone the price war dynamics this is simply the wrong fight to pick. A tactical blunder.

First the product is not yours and the customer has many alternatives. Most are willing to pay full price at Apple stores. Customers do not think where they buy is important when it comes to iPhone (a qualifier is some insist they buy only after standing in line in front of Apple stores).

Second Walmart did not cut the price uniformly across all stores and did not make available unlimited quantities. Agreeing to match the price on such promotional tactic is simply wrong. It appears smart deal-seekers, instead of running from one Walmart store to another, simply walked into to neighborhood BestBuy and asked for the low price match. How convenient.

Finally, the low price was not attached to any other product sales and not designed as a loss leader that would help maximize customer margin.

And the result? Deal-seekers walked in, probably for the first time in many months, bought the $127 iPhone 5 and walked out without buying anything else. That is the $65,000 loss in a day.

Other readings:

See here for Waging Effective Price Wars.

See here for Effective Pricing

 

 

What effective pricing can do for your business

Take a look at this image courtesy of Planet Money

Revenue difference between MegaBloks and Lego

What you see are the annual revenue numbers for MegaBloks and Lego. Since Lego does not have (any more) exclusive rights to make the bricks, anyone can make them. And MegaBloks does. Its bricks are perfect replacement (as for as I know) for Lego bricks only cheaper.

How cheaper? 50% cheaper. Yet Lego makes 9 times more than what MegaBloks does in a year. Not only in revenue numbers Lego also beats MegaBloks on its margins as well

Gross Margin       70.5% Lego to  40% Mega (source below)

Operating Margin  30.1% Lego to 17.6% Mega.

A little bit of math will convince you Lego has no cost advantage. At 30% cost, even if it halved its price to match Mega’s prices, its margin will be 40%. In other words any (percentage) margin advantage Lego has comes purely from its pricing and not because of cost advantage.

What is going on here? In the words of Jeff Bezos, isn’t MegaBloks working hard to charge customers less and Lego working hard to charge more? Why aren’t customers overwhelmingly picking MegaBloks based purely on price?

If lower prices are designed to drive market share how come Mega has just 10% of market share despite being priced at 50% of Lego?

The Planet Money story says it is because of Lego’s attention to detail and because of their licensing deals for Starwars. But they miss the point. The answer, as in all pricing questions, begins with customers.

Think about the loyal customers who already have spent hundreds if not thousands building their Lego bricks collection and bought into the Lego brand and its messaging. Include the newbies who are getting inducted. Toss in those who are buying Lego as gift for someone else. Do you think any of these customers would make buying decisions based on price? What job do you think these customers are buying Lego for? I bet it is just not as a building blocks toy.

If such customers perceive value at its current prices and are willing to pay such prices there is no reason whatsoever for Lego to give its product away at lower prices. Pricing low because of cost, competition or in the hope of gaining market share is simply not effective pricing.

Lego’s effective pricing driven by customer segments helps it achieve 70% gross margin and 90% of the market.

Finally I should not dismiss MegaBloks or call its pricing bad. MegaBloks likely knows its target customers as well -a tiny fraction that is price sensitive but isn’t likely to grow. They likely found the optimal segment size and the price these customers are willing to pay that will help Mega deliver 17.6% operating margin (nothing to be sneezed at).

But if it really wants to put big numbers on the board it needs to get its own customers who are will hire it for its compelling value proposition and not because it is a cheaper substitute.

Price Setters and Price Takers Revisited

Let us recap.

If you can set the price and defend it against competition you are a price setter. Premium price or bargain price does not matter. As long as you can defend it because of your product’s (perceived) differentiation (among your target segment) or because of your cost advantage you are a price setter.

If your pricing is a reaction to an existing competitor then you are a price taker.

In the tablet space, big or mini, Apple and Amazon are price setters but Google is a price taker.

In my September article in GigaOm I analyzed the profit implications of iPad mini for Apple. Making a case against $199 lower-end iPad mini I wrote this about price setting:

If Apple is the price setter in the premium tablet category, Amazon is the price setter in the low end. Entering this segment would mean becoming the price taker or making an effort to become a price setter with a different price point.

By design, Apple has never been a price taker. In any market, the price setter gets to control its  own profit while a price taker is at the mercy of market forces. Trying to become a price setter when there already is one requires Apple to either go low or just a bit higher. Either way, Amazon has set the price anchoring. The most likely scenario is a $299 price point for the iPad Mini.

The real pricing came in at $329. In other words Apple chose not to be player in the low end market because it realized Amazon as the unshakeable price setter in that category and chose a segment where it can be the price setter.

Price Setters will thrive and go on to create significant value over long term.

Price Takers will be relegated to the footnotes of history.

Second Degree Price Discrimination and iPad Mini

There are enough news media reports, may be they all came from the  same source, about the imminent iPad Mini (a smaller and cheaper version of iPad to compete against Kindle Fire and Nexus). AllThingsD is convinced Apple has ordered 8-10 million units.

First there were “confirmed rumors” about invites going out on October 10th. Now they have retreated to another “confirmed rumor” about October 23rd event.

It is possible all these sources are true and Apple will go on to release a iPad Mini. But I find it still difficult to see a scenario where the lower priced iPad Mini can deliver incremental (net new) profit.

An analyst on CNBC said,

It could be big for investors, said Sterne Agee’s Shaw Wu.

“Like other products, lower price points tend to drive sales. An iPad Mini we think would likely drive incremental iPad buyers,” Wu said in a phone interview with TheStreet. “There’s going to be some cannibalism of iPad sales, but we think it makes a lot of sense.”

I am not sure if Wu followed Apple’s pricing strategy so far. Besides he seems to miss the point that lower price points also kill profits. Apple, however, never chased market share. Shaw Wu is not alone on this, there are many stock analysts and others who seem to think “some cannibalism is not bad”.

Exactly how bad is the cannibalism? Well for starters it is not about sales volume or revenue, it is about profits. Contribution margin on iPad is 42%-50%. That is, $210 to $250.  Given that we are hearing (from analysts) either $199 or $299 price point for iPad mini and that we know from Amazon that they are selling KIndle Fire at cost, it is highly likely contribution margin from iPad mini is in the range $10-$100.

I cannot see a scenario Apple selling anything at cost.

So for each unit of $499 iPad cannibalized, Apple has to sell 2 to 25 iPad minis. If we assume average, that is 13.5 iPad Mini for every iPad sales lost. Is that doable? Let us look at recent market research numbers on customer preference for iPad in the presence of cheaper iPad mini (second degree price discrimination)

35% of iPad owners surveyed by deal aggregator TechBargains.com say they’d trade in their old model for the smaller tablet

However, only 18% of all respondents in the TechBargains survey say they want the new gadget,

These are not good numbers. Presence of lower priced iPad, packed with value, will cause more than one third of current iPad customers to trade down. This can be compensated only if the 18% of the total addressable market for iPad mini (those who will not buy $499 iPad) is greater than 35% of iPad market.

One way for Apple to reduce the magnitude of this trade down is to what railways did in the past with their third class cars. For railways there was a big market of low price travelers (and they had excess capacity). They wanted to attract these low price travelers but did not want to lose the high contribution margin from those second class (or first class) travellers trading down to cheaper third class.  So to ensure those who can afford will continue to choose the second or first class the railways removed roof from their third class cars.

Apple could do something similar and cripple their iPad mini such that only the most cost sensitive segment will self-select to this version while the higher willingness to pay segment will continue to prefer the full iPad. But that is complicated by the presence of really good alternatives at these lower price points.

Even for those who would buy an iPad mini, there are many options at the $199-$299 price points.

The $199 price point is crowded with feature rich tablets and there are two others delivering great value at $269 and $299 price point. Not to mention the $399 iPad2 which offers better value than a $299 iPad mini.  Apple cannot cripple its iPad mini and expect to win against these value packed alternatives.

The cannibalization does not end with just iPad. It also extends to iPad Touch.

At $199 and $299 price points Apple will compete with its other product line – iPod Touch. Since the 7″-8″ tablet will deliver lot more value than iPod Touch for the same price more will switch from these high contribution margin units.

Considering Apple’s practice of effective pricing (note the fact that they did not introduce a $199 new iPod Touch) and effective use of product versions at multiple different price points I do not see Apple entering this field. Even if they did, it is only 10-30% chance this new product will result in net new profits.

 

Price Takers – Case of $199 Tablets

 Food Truck Race is a reality TV series on Food Network where contestants compete by selling food from their food trucks. Compared to other cooking contests, this series has very objective metrics- final sales dollars they are left with that decide who gets eliminated each week.

Contestants get seed money to buy first batch of raw materials but have to use part of revenue to buy more for producing more. You can see why just maximizing revenue is not the winning strategy but maximizing profit is. So they choose different products and pricing to maximize profits, mostly choosing premium products at premium prices.

While the contestants generally have freedom in designing their menus and setting prices, in one of the episodes they were told they had to price everything below a dollar. That is someone else just set the price for them.

The contestants became price takers whose only path to success consists of

  1. Sell lots of products to lots of customers to maximize revenue
  2. Cut costs – be it cutting a grilled cheese sandwich into four squares or using cheaper ingredients – to minimize costs
  3. Practice unbundled pricing by charging for every extra

That is it. No branding, no positioning or no product versioning. In summary these became the price takers to an external entity.

There are two kinds of businesses – those who take active control of their pricing and get to set their own prices and those who react to price set by others, be it an Food Network TV show host or another player in the market.

Food Trucks competing with price limit may sound unrealistic but that is exactly what is happening in the low end tablet space. There is one price setter, Amazon with its Kindle Fire that set the $199 price point. As Henry Ford wrote in his autobiography, Amazon chose the price first and did everything to deliver a product at that price. While Ford added the importance of making a profit on the sale Amazon is focused on other ways to drive profit like making incremental sales through the device.

But the fact remains, Amazon is the price setter in this space. Anyone else entering the mini tablet market are forced to take the price set by Amazon, like the Food Truck Race contestants did. Even the mighty Google that practices perfect pricing with its AdWords network saw itself in the role of price taker. The fact that it is a superior product to Kindle Fire did not matter in setting its price.

Again looking at Food Truck episode,

Lime Truck, now in dire straits since they’ve spent all of their seed money on premium ingredients they were going to sell for $11 dishes, has to rethink the strategy. Quinn is later seen at the supermarket crumpling in the aisle bemoaning that they have “lost all of (their) integrity.”

That is correct, with Amazon as price setter, Google was reduced to the role of price taker, forced to rethink their strategy and in that process abandoning any plan they might have had for different pricing. In the TV show it was impossible to go against the set price and in real life it is almost impossible unless one can change the target segment, reference and product positioning. By targeting the same segment with same value proposition and positioning Nexus 7 in the same way Amazon positions Kindle Fire, Google is forced to take Amazon’s price.

Life is not fun being a price taker!

Finally, what about Apple and its much rumored iPad mini designed to compete in the 7″ tablet space created by Amazon and now expanded by Google?

Here is what I wrote in my GigaOm piece,

Entering this segment would mean becoming the price taker or making an effort to become a price setter with a different price point.

By design, Apple has never been a price taker. In any market, the price setter gets to control its  own profit while a price taker is at the mercy of market forces. Trying to become a price setter when there already is one requires Apple to either go low or just a bit higher. Either way, Amazon has set the price anchoring. The most likely scenario is a $299 price point for the iPad Mini.

For a business that actively takes control of its pricing it is highly unlikely they would give up that control for a new device. Revisit the three steps I listed for price takers. Apple already sells millions of premium price iPad at low enough cost and unbundles almost everything. How much more volume should they get and how much more costs can they cut to make profit from iPad mini?

If Apple indeed introduce iPad mini, expect them to position it much different from how Fire and Nexus 7 are positioned and hence become price setter for this category.