How to price premium and standard versions of your product?

It is time to repeat the old statement that I believe Pigou said but adopted by me

If one price is good, two are better.

In general, when customers’ needs are different, how they value the product are different and most importantly how they value  certain benefits of a product are different,  two prices are indeed more profitable than single price.

There is a performing arts theater in the Bay Area that rents outs its venue. For those segments wanting to hire the venue for events there are two options. Both are rented in three hour chunks. Read the brief product features below and think about the price difference between the two.

Version 1: Main Theater

Features:

  1. Ideal for live performances
  2. Steinway  (Model D, 9 ‘) concert piano on stage
  3. Stage: 40 X 20 X 12
  4. Outstanding acoustics
  5. Seats 338 people
  6. Dressing room with private bathroom
  7. Portable P/A system with three microphones

The Steinway piano you see on stage has a usage fee of $150.

Version 2:

Features:

  1. Perfect for small recitals, meetings and presentations
  2. Steinway (Model B 7′) grand piano
  3. Stage: 23.5 X 17.5 X 12.5
  4. Intimate and ideal acoustics

The piano has a usage fee of $100.

Model B grand piano costs about one fourth the price of Model D concert piano.

Go ahead and compare these options as a product manager would and give an estimate of the price difference between the two.

Now think about these options as customers would and  give another estimate.

Since thinking in relative pricing is difficult let me give you the price for Recital Hall – it is $300 for three hours.

Do I have your answer?

My answer was 50% – 100% difference (I do not give single number estimate.)

The real answer it turns out is just $50. That is the Main Theater with all its benefits costs only $50 more than the $300 price for the Recital Hall. This is the same difference you saw between a $100,000 piano usage fee and $25,000 piano usage fee.

This is not so right pricing. While two prices are likely better than one price it is highly likely both prices are wrong – wrong in the sense of profit maximization.

Before I point out why it is wrong let me point out things that are done right

  1. The two different versions differ nicely on many key customer dimensions – number of people, ambience, image, piano option and end use (customer job to be done)
  2. The piano usage fee is additional – perfect unbundling since some may want it just for the scene while others may really want to use it.
  3. The concert piano option is available only with Main Theater – if you value it more you cannot choose the Recital Hall.

(Note: Think of these three pricing levers for your freemium webapp – can you unbundle the right feature? can you think of a feature that will not be available in lower priced version? …)

All these are great but the price difference is wrong for these reasons

  1. If the goal is to make it affordable to most then the lower priced version should be even lower. At just $50 difference it is not a huge discount compared to $350 version. Those who can afford $300, will most  likely upgrade to the Main Theater. This would leave to poor resource utilization and dismal monetization.
  2. If the goal is to maximize profit the Main Theater is priced too low compared to the Recital Hall. Just  by the sheer number of audience it can accommodate,  stage and other benefits this offers lot more value to customers hiring it for performances. The theater is leaving money on the table.

The way to fix this is not just take my 50-100% number but study the customer segments – find out the jobs they are hiring the two auditoriums for, how they value the different features and come up with a price. (Can you say conjoint analysis? Or lean startup conjoint using weight allocation method.)

It is highly likely we are seeing a case of cost based pricing – the venue amortizing its mortgage and other costs over the two options rather than pricing these based on customers and value.

In that case, if one price is not good, two are not going to fix it.

 

For marketing and de-marketing the first step is?

We have discussed enough about Greek yogurts, Coffee , Dry bar and Software. We even talked about Cronut. All those were cases of marketing. Now take a look at the following cases,

  1. A public school principal trying to keep a right “customer” mix in his school
  2. Public health officials trying to protect teen girls from skin cancer
  3. Conservationists trying to protect poor rhinos from being slaughtered for their horns

These cases are not that different from selling software or $40 blow dry. Instead of demand generation you are trying demand reduction.

The school principal does not want customers with expectations the curriculum cannot meet or those who won’t play a role in school’s growth.

The health officials are trying to teach the teen girls about detrimental side effects.

The conservationists are trying to eliminate the black market for rhino horns.

These three are doing de-marketing, trying demand reduction. And where does one start for de-marketing? The same place where one starts for marketing – customer segments and the job they are hiring the product for.

As The Economist writes about Rhino horn de-marketing,

The first step in “un-marketing” rhino horn is simple: find out who your buyers are and why they like the product. TRAFFIC, an organisation that monitors the illegal wildlife trade, has just conducted a survey to identify the most important buyers of rhino horn.

And the customer job  turns out to be,

It turns out that it is a luxury purchase by rich men in Vietnam: professional businessmen, celebrities and government officials.

In Vietnam horn is often bought for the sole purpose of being gifted to family, colleagues or people in authority. Buyers think that it affirms their social status—and that it is good for their health. They believe it possesses properties that detoxify the body and can therefore cure anything from a hangover to serious illness.

In business meetings, and other gatherings, rhino horn is sometimes ground to a powder, mixed with water and drunk. Rhino horn is made of keratin, like fingernails. Yummy!

How do they effectively do de-marketing?  In marketing one makes product pivots and positioning to make it the most suitable candidate for the customer job to be done. In de-marketing one does product pivots and positioning to make it the most unsuited product for the customer job to be done.

In case of rhino horns,

So how do you turn successful, well-educated men against a luxury good that conveys wealth and well-being?

Yet a better strategy may be to spread fear, uncertainty and doubt about the product. One idea being suggested is to inject rhino horn with poison that could make those that consume it seriously ill.

Anyone want to grind up and drink poisoned rhino horn?

Now if we can take this to saving sharks from connoisseurs or shark fin soup.

Freemium has not disrupted Segmentation

Is that enough buzzwords packed into single title? I bet I do not have to explain what is freemium or what is disruption, two of most overused words these days. Segmentation however is not new, in fact a very old concept, and yet it is not as popular and needs explanation.

Segmentation: I am not talking demographics based indirect segmentationhere but the right way of segmenting based on customer needs (or needs based segmentation). You are grouping together customers based on the similar jobs they are trying to get done. (see here and here for more details)

When you identify customer segment and the common job to be done, understand the alternatives, surface their willingness to pay for the job, and map the budget from which those customers will pay for that job, you have marketing and product strategy.

Four years ago, when Om Malik of GigaOm wrote, “How freemium can work for your business”, I called out the cognitives biases in looking only at successful businesses.

Two years ago I wrote Freemium has run its course in GigaOm (I am surprised he let me write after my Biases articles).

Fast forward to present day and let us look at one of the poster boys for the freemium model, Dropbox. We have seen numbers on how Dropbox can be profitable with just  3% of the user base converting to paying customers. Small percentage of a very large number is still a large number is the thinking.

Om Malik recently did a fantastic research report on their business and growth. In his report he found,

(Dropbox), according to sources close to the company, is rumored to be valued at more than $4 billion and is on its way to a billion dollars in revenue. It has about 200 million accounts and about 4 million of those are businesses.

The numbers speak loud and clear where their success is coming from -segmentation. While both consumers and businesses may have the same job to be done (easily sharing information in a safe and secure way) one segment values it more and has almost no alternatives compared to the other segment. And it also has a budge to pay for it.

dropbox-pricing

If we assumed businesses chose only the Pro edition at $99 a  year with just two users (over the business edition at minimum of $795/year) that comes to 5 million business customers. If we take 4 million number from Om Malik’s report that would imply businesses with average number of users of 2.5 (generating $250 a year).

In other words, we can explain almost all of Dropbox’s $1 billion a year revenue from its business customers – those with a job to be done that is hard to be filled by alternatives and have a budget to pay for the job.  You and I, consumers, do not have a budget we set aside for such services.

If they were to increase the average number of users per business to 4,  even with no change in 4 million number, their run rate will jump to, $1.6 billion. If they were to target businesses with more than 5 users (and there are many if you look at US Census site), their revenue rate will rise very quickly to $5 and $8 billion.

That is Dropbox’s $1 billion run rate and its valuation are supported not by its freemium but by its segmentation strategy. Freemium may have captured everyone’s attention but it is segmentation strategy that is driving Dropbox’s success.

 

Those who know segment and the rest chase market share

How many gurus and bloggers write – the single most important task for a business is to gain market share? If only a business has all the share there is, even if they received a tiny profit from each customer  that will a;; add up to really handsome profit. In fact some go on to recommend businesses that are making handsome profit  now must give up that profit and gain market share so they can make future profit.

Take a look at second largest market out there – India. Let us say you are selling premium motorcycles. Should your goal be to price it such that 1.1 billion people will buy just your product?

Here is what the market looks like there

Segment 1: Millions of people in India still don’t have the means to buy an entry-level motorcycle that costs about 40,000 rupees ($640).

Segment 2: A recent survey by Credit Suisse estimated that India has 182,000 millionaires. That is 24,000 more than it had in 2012.

Making 10% gross margin on $640 motorcycle and making 40% gross margin on $20,000 premium motorcycle means businesses have to sell hundreds of millions of cheaper unit just to get the same profit selling premium units to 100,000 customers.Think about the cost of capital, distribution network, service network and all the other fixed costs needed to server hundred million customers.

That is  static segmentation just based on affordability and wherewithal to pay. If you look at the market based on “need based segmentation”, you will find

Segment-1: That hires the motorcycle to move from point A to point B

Segment-2: That hires the motorcycle for recreation

Won’t Segment-1 want to hire the  motorcycle for recreation? Sure they would but from what budget will they paying for? What are the alternatives available to them at that budget? A business’ strategy is to decide which segment they want to serve and what customer job they want to position their product for. Because segmentation and positioning determines price and hence profit.

The goal of business is not gain 100% market share but make profit in the most efficient and least capital intensive way. You do not have to serve every segment and every customer job.

If all businesses are going to be disrupted in the future shouldn’t a business maximize its profit till then and not spread out too thin that it gets disrupted from all directions?

 

The most beautiful price fence

Fence a3

Fences are never beautiful. May be the picket fences are. But when designed to keep two sides from moving easily from one side to the other they are not usually described as beautiful. Price fences are as bad as say a fence between two countries. But they do serve the same purpose – to keep the two sides apart. Here is how a research article from 2009 defines price fencing,

market segments should be kept separate to prevent demand spillover from high priced segments to low priced segments and the associated revenue loss. Tools to restrict customer migration across segments are referred to as ‘fences’

 Price fences are key components of segmentation and revenue management. They are designed such that those who can afford and willing to pay higher prices are not tempted by the lower priced versions.

Let us take an extreme example from the early days of railroad transportation. Railroads are a high fixed cost business and the marginal cost of adding one more passenger was practically zero. They could have set the ticket price really low to fill every seat but that would be not capturing value from those willing to pay higher prices.

So they offered classes of service – small number of super premium first class service, moderately priced second class service and really low priced third class service. To prevent those who can afford second class service from being tempted by the low price of the third class service railroad operators removed roofs from the third class cars.

That price fence was not beautiful.

But here is some really beautiful price fence – comes from your favorite brand that excels in product design, Apple.

mbp-price-fence-2

It is three different price points with right mix of features so carefully selected to let those who can and willing to pay higher prices from choosing the cheaper version. You may not see how impervious the fence is as you admire the beauty of the MacBook Pro. Let us dig deeper.

Between the $1,299 and $1,499 versions the differences are only in the RAM and flash capacity. Say you like the $1,299 version but just need more flash capacity. They are designed such that those with higher willingness to pay will choose the $1,499 version and pay the $200 extra.

You want the lowest priced version and try to customize your MBP with higher flash capacity. But guess what? There is no option available to increase just the flash capacity of your MBP. You can increase your RAM from 4GB to 8GB (the same level as the two versions on the right) for $100 more but cannot do that for flash  capacity. It is not hard for you to see that if RAM difference is priced at $100 the disk difference should also be priced and offered at $100.

Do not think this is a technical challenge. It is not, and it is offered as an option for another MacBook Pro – the non Retina version.

flash-upgradeThe MacBook Pro without Retina ships with hard-drive (the spinning platters kind) and if you want to customize it with SSD you would pay $200 more for 128GB and $400 more for $256GB. That is they want those customers to pay $200 for the same 128GB to 256GB upgrade.  So offering  just flash upgrade for Retina version  (for $100 as we saw above) would pose challenge to that $200 extra they charge for non-retina MacBook Pro version.

To state in simple terms, Apple’s price fences are not some isolated chain links but an integrated system of impenetrable walls that are passable only if you are willing to pay the same price where ever you decide to cross the fence.

They want $200 additional price  and they make sure they do it with price fences.

And go ahead and try to tell me that is not the most beautiful price fence you have seen.

 

Now I get it why Crocodile skin handbags deserve their price tag. Come on!

Rich Crocodile with Funny Money and Cash Currency

(Photo credit: epSos.de)

When you run a business magazine it is expected you would do more than surface scratching on business topics. But that is too much to expect these days. At the very least such business magazines should refrain from stories that are seemingly well-researched but completely miss the point.  Recent example is the article in Bloomberg’s Business of Fashion section.

It tells us, complete with quotes from crocodile farmers and analysts, why those handbags sell for 30 times the price of those made of cow hides.

… no crocodile is easy or cheap to raise, and it takes years to breed them.

“If I’d known how hard this business was before I’d got into it, I may not be here today,

And so on and so forth about the high cost of raising crocodile and harvesting their skins.

The article while touches upon on market size and demand side completely fails to grasp the concept of customer segmentation and why these customers buy a crocodile skin handbag.  Whoever these customers are, it is safe to say they are not buying these bags for simply carrying their stuff.  This is not a utilitarian buy.This is a conspicuous consumption to help them flaunt their exclusivity.

It comes to understanding what job are these segments hiring the crocodile skin handbags for.

And for that they are willing to pay a high price tag for that purpose.  These customers could care less about how difficult it is to raise crocodiles or how deadly their bites are. If the handbag cannot deliver such exclusivity they will hire another product.

On the flip side, if raising crocodiles becomes so simple and the market is flooded with their skins, these segments will find the crocodile skin handbags fail to the job they hire them for and will move on to better candidates.

If luxury marketers understand this job to be done and customer willingness to pay they are willing to make investments and take risks to build the product. They will do so as long as the return on risk far outweighs the cost of a few bites.  Shed no crocodile tears for those complain how hard it is to produce the product, they are either using it to justify high prices or  shouldn’t be in the business in the first place.

When you look at the simplified value chain here is how it looks like:

Customers ← Marketers ← Middlemen ← Farmers

Ultimately the customer decides what price are they willing to pay for a product they are hiring for a certain job. Marketer has influence over this price. But it is still the customer who forks over the money. If there are no customers there won’t be marketers either.

Marketer’s role is to understand customer needs (job to be done) and deliver them a product that does the job far better than the alternatives. They get paid for that job. They make profit by finding ways to do it far cheaper than the price customers are willing to pay.

Middlemen are the suppliers, distributors, resellers etc. Once again they are in this crocodile skin value chain only because they believe they can make a profit.

Same goes for farmers. Since the costs are high and the risks are high not many will rear crocodiles. But those who do that do so because they found a way to make a profit.

That is the value chain with customer at the top. And they do not care about the travails of those at the other end of the chain nor are they willing to pay higher prices to offset someone else’s costs.

May be now you know why some willing to risk crocodile bites.