Pricing Your Multi-Version Product

Note: This article gives basics of price discrimination, product versioning and consumer surplus that will help see the case I make on iPad2 sales.
[tweetmeme source=”pricingright”] How should a marketer set  prices for different versions? I wrote,

Set prices of your versions such that those who are able to and willing to pay higher prices will do so and are not tempted by the low priced version.

A slight variation of this statement was suggested by Chris Hopf,

Assort Value of your versions such that those who are able to and willing to pay higher prices will do so and are not tempted by the low priced version.

The difference is the value allocation but both statements are not only correct but also are complementary. To explain this we have to go to the very beginning of price discrimination – the Pigouvian economics.  For a marketer to adopt versioning strategy the following two conditions are necessary*:

1. Different customers must value the various versions differently. This means customers needs and the value they get by hiring a version must be different.
2. The products must not be commodities -products must add unique value to customers.

Together these two explain the value assortment argument. But it is not enough to just create value, a successful business model is not only about creating value but capturing a fair share of it. Pricing is the lever for value capture. This is what I said about setting prices for the versions.

Let us walk through an extreme case for simplicity. Let us say there are only two customers Bob and Alice. You, the marketer, create and sell shaving gel.

If both Bob and Alice value just the utility of the gel and hence do not value any other benefits there is no point in creating multiple versions, one for Bob and one for Alice. For instance, if Alice finds that she gets more from Barbasol, after all it is the same product as Pure Silk, then she  will pick Barbasol.

If Bob considers the gel just for its utility and has low willingness to pay (WTP) but Alice appreciates the scent and values how it works in the shower and hence has higher WTP then it makes perfect sense to create two version. The version for Bob is the simple Barbasol and the version for Alice is Pure Silk.

How would you price these two (given Bob does not value Pure Silk at all)?  You should price these two such that:

Value of Pure Silk to Alice  less  Price of Pure Silk

>

Value of Barbsol to Alice less Price of Barbasol

In other words, Alice, the high WTP customer, must get higher net value (consumer surplus) from Pure Silk than what she gets from Barbasol.  This means Alice will be nudged to self select herself to the Pure Silk version and not tempted by the Barbasol despite the lower price.

In reality there are lot more Alices, Bobs, Charlies, Davids, …

Some might  choose Pure Silk regardless of the price and at the other extreme some might always choose Barbasol. Some, if they didn’t know about lower priced Barbasol, would choose Pure Silk but when offered side by side would find higher value in Barbasol and choose it.

The general questions become  –

-What are the customer segments?

– What do they value?

-What are they willing to pay for that value?

-What is the size of each segment?

-What are the product versions and their prices that would maximize profits?

That is the core of strategic marketing.

Talk to me.

*Note: There are 3 conditions for practicing price discrimination (price harmonization) but the arbitrage is not relevant to versioning strategy.

Pricing BART Tickets

BART is facing $100 million budget shortfall and is looking to cut costs. One primary component is the salaries they pay to unionized train and station operators. There is a strike looming if the negotiations do not yield a solution before midnight Sunday August 16th.  I am not going to go into the negotiations, the salaries or whether or not either party is wrong. But I would like to point out the perils of focusing on only one component of profit equation – costs.

BART is a non profit but that does not mean they should focus only on the cost side of the profit equation. They have to focus on the revenue side which includes driving more traffic or driving higher revenue from higher prices. BART faced fall in customer traffic of 11%, and they are arguably reluctant to increase ticket prices as there is fear that this would cause further drop in traffic. The Public does not like ticket price increases as well.

What is missing here is

1. segmentation of the customer base and defining the economic value add to these segments, identify the price based on this value-add and reference price
2. identifying the demand schedule – how many people will stop using BART at different price points
3. what more can be done to monetize these commuters – from selling additional services to selling their attention

In short, BART is missing Effective Price Management.

I am going to address just one aspect here – segmentation. The easiest segmentation is based on  where-to-where and how often they use BART in a week. One such segment is daily commuters from East Bay stations who drive and park in their local station and commute to the stations in the city. Here is the economic value add to this segment.  Now that is considerable consumer surplus!

Lowering Prices To Generate Sales?

Here is another CEO who clearly believes lowering prices does not automatically guarantee  sales increase: Macy’s Terry J. Lundgren.  In his inteview with The Wall Street Journal, Mr. Lundgren  said,

WSJ: Do you think about lowering your average selling price or changing your product blend, as some of your competitors have done?

Mr. Lundgren: Here’s the challenge. We have [a men’s pants brand], and they typically go out the door between $29.50 and $32.50, with all the coupons and everything.

What Mr.Lundgren refers to as “out the door price” is the “pocket price“, the net price after all discounts. The net effect of the discounts and coupons is price leakage that erodes profit, clearly Mr. Lundgren is driving Macy’s to focus on its price waterfall.

Mr.Lundgren’s management serve as the best case study so for on the three components of effective price management:

Knowing the value add to segments:

Our purchasers are women. She’s spending the same amounts but just shopping with a great deal of discretion. Value is the word, even if it’s at regular price. The intrinsic value of what she’s buying is very important.

Incremental analysis: How much should sales rise to compensate for loss in profit from price cuts? (Lundgren is on the direction but he is comparing top-line while he should be doing incremental math on lost profit. There is also numbers error as pointed out by the commenter.)

So we were getting tremendous sell-through at low price points and no margins. And I am not making my pants sales for last year, because my average sale dropped by 30%. It’s really hard to make the math work. I have to have 30% more transactions on this product to break even.

Customer Margin: Understanding that loss leaders are effective only if they help generate incremental profit from customers who are attracted to the stores by low prices of loss leaders.

We and the manufacturer together agreed to mark them (pants) down to $21.99 or something like that. Selling like hotcakes. Every other pants around them stopped selling.

Does your business practice effective price management?

Cloudy With a Chance of Free Business Model

There is a children book called Cloudy With A  Chance of Meatballs which is  a great story about a town where food was in abundance, because it rained food three times a day. It rained breakfast, lunch and dinner. In this scenario, there is such thing called free lunch. In fact the town hired sanitation crew just to cleanup the excess food from the streets and keep them clear. I bet no one in the town went hungry and there was no need to save food for the rainy day (pun intended). There is a page in the book that shows a restaurant with people eating inside. One notable aspect about that restaurant is there was no roof. Waiters simply caught “the rain” and served their customers. The marginal cost of food is zero for the restaurant.

That brings us to free as a business model that Mr. Chris Anderson talks about. Mr. Anderson says how free is the future for digital goods and services because their marginal cost approaches $0.  The meatballs book  applies Mr. Anderson’s argument about marginal cost to physical goods. Abundance of one component simply makes it irrelevant in pricing because a marketer cannot make a value proposition based on that component. The business model shifts to other components that deliver value.

1. Since the marginal cost of food is zero, should the restaurant serve its customers for free?: No. The marginal cost is irrelevant. The restaurant should charge the customers for the convenience  (someone else catching the raining and serving) and experience. The fact that marginal cost is $0 for food only changes the product/service that is being sold.
2. If the restaurant simply serves the rain that people can do it for themselves, why would anyone go to any restaurant?: Same answer as above.
3. How would one restaurant differentiate itself from others?: Better service, live entertainment,  complements like wine that is not part of the rain.
4. What role do chefs have to play in such a town? If the food from the rain is bland or flavorless then chefs role could be to improve its flavor. They could also specialize in plating the dishes in an attractive manner.

Pricing is about capturing a share of that delivered value. Since  “free” does not capture value it cannot be a business model.

Small Business Pricing – 5 Steps To Effective Price Management

Linda runs a sewing business that does works like alterations and hemming.  Unlike most small business owners, Linda writes a blog that is about “Sewing for profit” in which she shares her ideas and practices to help others like her to run an alterations business.

In the down economy when people postpone purchases, alterations should be good business. But the barriers to entry are low, there are many individuals and businesses offering this service and the market alters (pun intended) with the economy. There are also challenges in reaching the right customer segments. All these make this a highly competitive market with challenges in communicating differentiation and price list becomes the main piece of any messaging.

Linda is thinking about pricing and wrote about it recently. A very well written article that considers factors like opportunity cost of the business owner’s time, competitive analysis and a pricing model for someone starting new in this business. Linda recommends a pricing that is based on the time it takes the individual to do the work and based on pricing from other competitors in the area.

If I were to suggest changes, it is avoiding what Mr. James Mason described as the 8 deadly pricing sins and practicing what I described in Effective Price Management. Pricing a product or service based on what it takes to produce and deliver it is cost based pricing. The risk is that in any undifferentiated market there will always be someone willing to price it lower and quickly prices will spiral down.

What can a small business, like an alterations or any such business, can do to practice effective price management in a highly competitive environment? Here are five steps to get there:

1. Recognize that cost to produce is not relevant to your customers. Your costs are relevant only to see if you can run a profitable business given the addresable market and prices you can charge.
2. Recognize that price is not differentiation. Competing on price does not let you have a conversation about the value you add.
3. Identify the different customer segments and the economic value to them from your service.In the case of alterations the segmentation is based on usage scenarios, sometimes a customer would want to get their work pants altered and other times their expensive evening wear. The economic value is different for each case. Practice a pricing model that is based on this value add.
4. What is “ownable”? When many other competitors are in the same market, what sets you apart from the rest? Is that defensible and unique and no one else can claim the same? In other words is that “ownable”? Identify that and make the marketing conversations about this and not lower prices. On the last point, salons excel in offering multiple prices based for the same service based on who does the work.
5. Offer multiple versions of your product/service, be it based on material that is worked on, raw materials you use, convenience or based on person who is doing the work in your business.