Using Relative Price When Value Message Is Not Clear

Here are some questions I received from my colleagues and entrepreneurs who read my articles on pricing based on value.

Does pricing based on segmentation and value to segments apply only  for established enterprises?

Is value an irrelevant term for innovative new products  that aren’t just improvements over existing products and are truly different from anything that existed before?

Does pricing for  information goods (bits over atoms) require us toss out all our understanding of economics and look for a new one?

Pricing on value for the customer is tough when you are a startup with very low reference point to measure the true value. There are some direct value in using my product, and there are indirect benefits. How do you  measure/estimate all these?

These are valid questions, there are no pre-packaged answers for all.  But the basic premise of marketing remain unchanged even for startups and digital economy – segmentation and targeting.

Let me answer one of the questions – how to determine value to customer for new offerings – based on what I did in the past. The solution was a stopgap and served its purpose when the value to the customers was not clear. It was based on relative price – that is price relative to what customers pay for  products and services in the same class.

One of the clients had a product that was easy to explain but was difficult to define value to customers. The product was generic enough for customers of all sizes and verticals but it was clear not all of the customers had the same wherewithal to pay. Since the value was not clear neither was customer WTP and hence there was no demand curve. The product is bits not atoms and had no marginal cost. So it is fair to say this had all the complications raised by entrepreneurs.

What job is your customer hiring your product for: The first step I did is positioning the product – there are many definitions of positioning the one I mean here is creating a connection in the minds of the customer to a product/service they already know and use.  This is the hard part and the first one may not be the right one. One way to define this is by answering  “what job is the customer hiring your product for?” (Clayton Christensen). Position your products for those jobs. (Note that the usual marketing strategy is S-T-P, here it is P-S-T)

Segmentation: The second step is segmentation based on value. Since value is the undefined part here,  I looked at what is the total customer spend to solve those jobs. For instance if you are positioning your product for team collaboration, find out what different customers spend yearly on  alternatives they use. Dig deeper and find indirect costs  that are incurred due to inefficiencies of current solutions they use. Rank order the different segments based on their spend and other factors.

Targeting:  You cannot go after all segments. This is especially true for a startup with limited everything. The total opportunity size may look attractive but you need to identify those segments that are attractive in terms of opportunity size, ease of reach, other competitors serving those segments and  future potential. I chose the segment that  had the most annual spend and did not have a way to track the ROI on its spend.

Pricing to get a share of the budget: Then I priced it as a share of the average spend of the segment. For example for the team collaboration case if the  average annual spend by a customer was $1 million, I would have priced it as  0.1% to 0.5% for my offering.  As you notice, this has no relation to value but makes it easy for you to have a conversation with the customer by pricing it relative to what they pay for similar services. Your pitch could be, “for 0.1% of what you spend on X our product will help you achieve  results 1, 2 and 3”.

The net is I am not recommending this approach for everyone nor would I do it next time but this helps to illustrate the point that there are ways to price a new product when the value isn’t always clear. It was basically asking:

  1. Whose budget is this going to come from?
  2. What is the size of that budget?
  3. How can I get a tiny fraction of that budget?

What are your thoughts?

Relative Price

I was at Best Buy stores the other day and was looking at their cables. I was surprised to see HDMI cables being sold for $40-$80. Even a simple DVI to HDMI converter, which is useless without a cable, was priced at $30.  The same cables  from non-name brands are priced at fraction of the price online. In fact a quick search in the Internet shows stories since 2006 taking about  alleged “price gouging.

I do not believe price gouging exists in a free market where customers have options and are allowed to make their own choice.  But what explains the high price of these cables? It is the price  flat screen TVs.

The first reason is the relative price that is rooted in behavioral economics. To a consumer buying this TV (or having bought one), compared to the price the pay or TVs, the price of cables look cheap. Consumers tend to think of price they pay in terms of percentages and not absolutes. This is the relative price. For a crisper description see this.  $40 is a small percentage of $1000.

The second reason is the increase in reference price, which is the price a customer expects to pay based on their past experience. Having just paid $1000, customers are anchored to this price and are willing to pay $40-$80 on cables for these TVs.

Conveniently,  Best Buy only stocks cables $40 or more taking advantage of these factors at work. However, stocks cables of every possible price. In fact for the TVs Amazon says, “customers also bought $6 HDMI cables”. Here even though customers might be willing to pay high price for cables, the presence of cheaper options decreases  their reference price.

If you are a marketer, it is obvious what you should do with pricing. Price your complements as a percentage of the price of the primary component. Due to relative price and reference price effects, your customers will not mind paying high price for the complements.

If you are a buyer, be aware of relative price effects. The price you pay for accessories and complements should be looked at in isolation and not relative to the price of the primary component. In a consumer setup this can be handled by separating the two purchases in time. In a B2B set up, it can handled by having separate purchasing managers responsible for the primary component and secondary parts purchases.