Recognizing upside of price unbundling – Southwest says bags may not fly free

baggage_fee_profitFor a while Southwest has stood steadfastly against charging for checked-in bags. They ran several advertising campaigns delineating this clear absence  of extra fees. They told us bags fly free. They told us how the bag fees add up to additional $100 per leg. All the while other Airlines were happily charging us for our bags.

Revenue from bag fees alone reached $769 millions in 2010 (the peak of SouthWest campaign against bag fees).  While most airlines face some level of customer backlash they successfully overcame complaints with better management of reference price. Emboldened by their success Airlines (all but Southwest)  “drained the pond” to expose all the hidden obstacles to value capture.  After scrutinizing every freebie thrown in with the ticket they moved from charging for extras to delivering products that deliver value and pricing for that value delivered.

The result? $6.1 billion in new revenues and with huge upside potential from other service enhancements. After all cost reductions have a lower limit, you can only cut so much but revenue upside from value creation has theoretically unlimited upside.

bags-fly-freeSouthwest stood by for the past seven years letting the revenue innovation pass by and not partaking in the fees growth. As I wrote before, it did not matter they were the only one not charging fees. Customers are trained to pay the fees everywhere and they are more than accepting of such fees. In 2008 I wrote differentiating on no-fees was not a good strategy for Southwest.  It could be argued fees are a fairness issue, shouldn’t passengers who do not checkin bags get a discount on their ticket price?

This week, five years later, we read they heard my message loud and clear.

Southwest CEO, Mr. Gary Kelly, said recently

 in one of his strongest hints to date that the policy could change, Mr. Kelly said that if fliers come to better understand and maybe even prefer “an a la carte approach…we’d be crazy not to provide our customers with what they want.”

Kudos to him for not holding on to a sub-optimal strategy just because they spent all these years supporting it. Not many have the courage to refine or toss out failed strategies, both due to sunk cost fallacy and fear of being seen inconsistent.

If the customers come to better understand value and are willing to pay price for it,  you too would be crazy not to provide that value at a price that lets you capture your fair share of value created.

What is your pricing strategy?

Nexus 7 sales almost doubled, but from what levels?

Last quarter it appeared Google sold about million Nexus 7 (HT to Om Malik for doing the math first). Unlike Apple, Google does not break down the device sales. But Google is required to disclose all revenues and their sources (however cryptic) in its financial statements. So Om looked at the non-Ad revenue category (what Google classifies as “Other Revenues”) and attributed it to Nexus 7. Later I merely refined it taking into account growth trend in Other Revenues before Nexus 7.

Last quarter it appeared they sold one million Nexus 7 and at cost, bringing almost no operating profit from the Nexus  7 line. Using the same math here is what this quarter looks like, (source Google)

  1. Other Revenues went from $666M last quarter to $829M (the quarter before, Q2, it was $429M)
  2. That is a growth of $163M for this quarter and a total of $410M  from Q2
  3. If you account for the fact that Other Revenue was growing 5% even before Nexus 7 line, not all this growth came from Nexus 7. That knocks out $43 M (two quarters of 5% growth of $429M)
  4. So Other Revenues attributable to Nexus 7 comes to $206M last quarter (Q3) and $356M this quarter (Q4)
  5. At Average Selling Price of $210 (assumption) it translates to 1.7 million units

One million in first quarter to 1.7 million Nexus 7 in second quarter. It appears Nexus 7 sales almost doubled in the second quarter but that is from very low levels to begin with.

Compare that to Apple selling 12.5 million iPad mini in just its first quarter, not to mention the profits.

Please don’t embarrass us by having a business model for your startup – VCs

When I wrote the valuation model for Pinterest, many people wrote to me to point out that Pinterest stopped using SkimLinks and hence stopped making any revenue. Making revenue it turns out is not good for your startup (don’t quote this line out of context).

How do you value an investment? Any investment, be it a farm , shares of an established enterprise or a tech startup?

Simple answer is, you look for profits they generate now and how it is expected to grow.

But that level of transparency and simplicity is a problem for venture capitalists investing in Silicon Valley’s startups. The New York Times Bits blog says why VCs don’t want the startups to show any viable business model let alone profits,

“It serves the interest of the investors who can come up with whatever valuation they want when there are no revenues,” explained Paul Kedrosky, a venture investor and entrepreneur. “Once there is no revenue, there is no science, and it all just becomes finger in the wind valuations.”

With any hint about business model one can come up reasonable valuation models for any business. Granted one has to make assumptions to get there but we can quantify the uncertainties in the assumptions and state our valuation in terms of probabilities which can be used to place bets (I mean investment).

That is not good because

they’re interested in pumping up enough hype and valuation to find a quick exit through an acquisition at an eye-popping premium.

How else can you justify $200 million valuation for Pinterest when its chances of making revenue that justifies such a valuation is less than 0.25 percent?

This seems to explain why VCs advice startups to give their product away for free and why VCs don’t advice startups about customer segments and filling an urgent need. As Stanford’s Pfeffer says,

These companies are simply being founded to be bought.

Not to fill an urgent need and to take their fair share of value created.

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Metered Price Discrimination, Customer Margin or in the Vernacular of Social Media – Freemium

Consider these real life pricing scenarios that you see everyday:

  1. Six Flags Discovery kingdom sells its annual season pass for $49.99. According to its website, “Buy your Season Pass for $49.99, just $5 more than a one-day admission.”  Now why would they give away an unlimited entry annual pass for “just $5 more than a one-day admission”.
  2. Movie theaters charge extremely high prices, 4 to 5 times what we usually pay outside, for popcorn.
  3. Gas stations sell gas almost at cost and sometimes they even lose money due to credit card interchange

What is common in all these pricing scenarios? All these businesses are practicing what the economists would call as,  “Metered Price Discrimination“, or what marketers describe as, “Customer Margin“. There is nothing new, it starts with, “price discrimination” – charging different customers different prices.  Customers differ in the value they get from a product/service and in how much they are willing to pay for it.

Let us start with a simple case where the only way to monetize a customer is the price they pay. Let us keep it really simple and assume all costs are sunk and the marginal cost to serve a customer is $0.

For each price point you set, there will be different number of customers willing to pay that price. That is your demand curve. Your job is to find the price that maximizes profit – if you increase the price you will lose some customers but gain more from the remaining ones,  if you decrease the price you will gain new customers but lose revenue.

Total profit ∏1 = p times N ; price is the only lever you can control

Now consider the case where there are many different ways to monetize the customer (let us still keep costs as $0). For example, amusement parks charge parking, sell you lunch etc. Then you have several different levers to control,

Total profit ∏2 = p times N + R1 * n1 + R2 * n2 + ….

where R1, R2 etc are average revenue from each additional service you sell or ways you monetize the customer and n1, n2 are the subset of customers that generate that revenue stream. It is trivial to see that n1, n2 etc are directly a function of N.

Your goal now is find the entry price p that maximizes total profit and not just the profit from price paid. For example, movie theaters may set the ticket price lower such that they bring in lot more people but make up for it from the subset who are willing to pay higher price for popcorn. Similarly gas stations attract more customers with lower gas price and sell high priced snacks and drinks in their stores.

This is Metered Price Discrimination – some customers get away with paying the low “entry fee” while others pay more by consuming additional services at different prices.

Now consider the special case where the entry fee, p =$0. You have what is described as “Future of pricing”, freemium. You give up on monetizing entry fee and focus only on profit from other revenue sources.

Total profit ∏3 =   R1 * n1 + R2 * n2 + ….

There is nothing new, radical or futuristic about it.

If you have done the analysis, know your customers and find that ∏3 is better than ∏2, then by all means set the price to $0. You need to know ex ante, what the different revenue streams are going to be and how many customers will generate that. You cannot go in with a free model assuming that once you get customers in you  can monetize them later.

If all you have is hope, or promises of a marketing guru quoting some extreme examples that show higher ∏3, you have have your work cut out for you.