What do you charge for a service that you just made up?

We all would like to believe there is nothing like our product or service. After all we are innovators and our vision is to change the way people do things. The investor pitch deck from a startup, Everest, sums up this attitude

Let us take all such claims at face value and treat every one of these products and services as new. Then we face the key monetization question
What do we charge for a service that we just made up?

To make this question more meaningful let us use a simple yet real life case study instead of talking about hypothetical product. The case study comes to us from NPR Planet Money, (Don’t read the full story yet, I will take you to the middle of the story to set up the case)

Two guys offer visa form printing services in front of the New York Chinese consulate.Visa applicants, turned away at the visa counter for filling they wrong forms, come to these guys who have computer and printer in a RV parked right outside the consulate. No such service existed before. They just made this up. How do you think they should price this innovative service?

As I wrote in the past, there are two places to start to answer the pricing question – even for something we’re building just now, Product or Customers. My recommended starting point is, Customers.

Even if the product is innovative and what you are building doesn’t exist yet, the needs are not.  The needs are why the customers are hiring your products for (Christensen). If needs indeed exist then they are currently addressed by different customers differently.

In general there are always different customer segments. For some  the needs may go unaddressed for others the needs may be addressed through alternatives, however sub-optimal they may be. There may not be a competitor product but there are always incumbents. In some sense, doing nothing is an alternative too (for Intuit’s TurboTax, they defined their incumbent as paper and pencil).

In the Chinese visa case the alternative is walking to the closest internet cafe and paying for printing or coming back another day (like those with low opportunity cost for their time).

You can’t serve all segments, at least not initially. You need to choose your segments, those that offer the best return with your limited resources. After all strategy is about making choices.

Say you choose the segment that used to walk to nearest internet cafe.  By choosing this segment you already know they are willing to pay for printing the forms at the internet cafe and they incur additional pain to make the round trip.

Your next step  is to position the product in the minds of the target segment. Positioning your product is not about how innovative it is but about what job you want them to hire it for and why your product is better than anything else that customers hire now. If you can’t position your product you can’t control its pricing.

Once you perfect the positioning, pricing is the next logical step. Hiring your product over the alternative adds incremental value to customers (like avoiding round-trip walk) and you price your service to capture your share of the value created.

How do you quantify the value created and how do you know your right share that customer will willingly part with? Some customers know, some don’t. It is up to you to do the value creation math and show it to them. Then you rely on quantitative methods, pricing experiments and signaling to find your fair share – the price customer is willing to pay without pain.

In general,  cases where you have repeat customers it is important to get the first pricing correct. Choose too low, you forgo profits. Choose two high and continue to drop prices, you lose credibility. That said, if you have done the Segmentation right, Targeting right and Positioning right, the pricing can’t be far from right.

Let us come back to the case study. They had no repeat customers. They chose to experiment. They charged $10, the same price charged by internet cafe and found the demand overwhelming. Next they went to $40 and found drop in sales. Now they charge $20.

Be it a software product,  magical delivery service or Visa form printing service – you need to worry about monetization. Otherwise why do it, however innovative the service is?

So what do you charge for a service that you just made up?


Readings:

  1. NPR Planet Money Story http://www.npr.org/blogs/money/2012/01/04/144636898/a-man-a-van-a-surprising-business-plan
  2. Segmentation
  3. Startups and Segmentation
  4. An entrepreneur will not always succeed in positioning his latest innovation the next “new thing.” http://www.chicagobooth.edu/capideas/oct09/5.aspx

Note 1: Note that the pricing for the service did not take into account the cost to rent the van, opportunity cost of the two guys operating it, or the cost of printing. Pricing comes before costing. If you cannot deliver the service profitably at the price customer is willing to pay you need to explore options.

Note 2: The price $10 set by internet cafe is the reference price in the minds of customers. Even if that price is wrong (cost based) you are stuck with it unless you can shift the reference.

How do you sell value? Show them!

Say you have a product that costs the customer almost twice as much as the alternative. How do you convince them to buy your product over the alternative?

Pricing starts with customer segmentation – the needs of different customer segments are different and the value they assign to products and solutions that address these needs are different.

If you treat all your customers as just one mega segment you will end up pricing your product based on the cheapest alternative available to most vs. value delivered to different segments.

Knowing the segment helps you not only price the product but show them the value.

Here is a case study done by US Department of Energy for LED bulbs. The initial price is almost twice as much as traditional lighting systems. While consumer segments most likely are not willing to pay twice the price for LED, business segments are. That is if you show them the value.

For instance, you and I may not mind changing light-bulbs every year because our opportunity cost is $0. But for businesses there are real costs associated with maintenance. Every bulb change avoided is not only savings in bulb cost but savings in maintenance costs.  If you add these all up, despite the high initial cost, the LED systems  deliver 9% in total cost savings over the lifetime.

That is how you sell value!

Cost Allocation Obfuscation – eBook Pricing

Cost, especially fixed cost allocation, has nothing to do with pricing. Unless you are selling to the Government which allows you to quote only cost plus pricing. Government contractors are more than happy to do so because they not only include the variable cost of making a toilet seat but also add to it its share of all their fixed costs. So when you assign each toilet seat its share of building cost, executive salaries, etc etc you get $2000 as price tag.

Allocating each unit produced, its share of fixed cost is a financial accounting artifact – required by GAAP accounting rules. When convenient, like in obfuscating the true marginal cost to justify higher prices, some businesses are happy to adopt it.

Now publishers are adopting the same obfuscation to justify their eBook prices. Since they  are not selling the value of the book, they are facing challenges from customers expecting lower prices on eBook over hardcover books.

Michael Connelly’s recent legal thriller, “The Fifth Witness,” has more one-star reviews on Amazon than five-star reviews in part because some angry reviewers focused on the e-book’s $14.99 price.

Customers expect publishers to pass on cost savings from paper and printing charges in the form of lower prices. What are publishers resorting to? Obfuscation

Publishers argue it’s impossible to break out a profit per title that includes a percentage of all their costs because all books have unique one-time costs which are broken out over an unknown number of copies. It’s also hard to apply corporate overhead costs against the sales of individual titles.

They are hiding behind cost argument to say their “margin” per eBook is still low and hence it deserves prices that are comparable to hardcover.

If they are not willfully obfuscating, they are just plain ignorant in their cost allocation. Hard to believe.

All these because publishers are not addressing , “what job is the customer hiring a book for”. There is no attempt to sell the value. If the publishers are not differentiating on the content and the customers are not seeing difference between different titles (not their fault), both sides argue about the cost.

Does the customer get any less information value from a eBook than a hardcover book?

The real disruption of the publishing industry is yet to come. We will start seeing, substitutable, undifferentiated, and copious content sold as commodities for less than 99 cents and high value content sold at prices that capture a fair share of the value created for customers.

Until then, publishers, customers and all the media bloggers will focus on costs.

If you think Organic Produce is priced higher because of costs

Image from Foodsubs.com

Suppose I told you that a box of 80 conventionally grown D’anjou Pears are priced at $33 at Seattle. What do you think will be the price of box of 80 same variety of pears but grown certified organic?

Higher? It is a good guess. Safe to say, in Seattle, it will be higher than conventionally grown variety.

How much higher?  $4-$8 more? Good guess. It costs $6.90 more for a total price of $39.50

Why are organics priced more? One argument is, the yield is low when you cannot use fertilizers and it costs lot more. While true, it is not relevant.

But let us let the reasoning stand for now.

Let us go all the way from Seattle to New York and buy a box of 80 conventionally grown D’anjou pears. What will be the price in New York?

I will not ask you to guess for this. The price is $35, $2 more than Seattle.

Why are comparable pears priced higher in New York? One could argue that it costs lot more to ship to New York and the rents are higher in New York. Again, true but not relevant.

Again, let us let this reasoning stand for now.

What do you think is the price of same 80 count of organic pear in New York?

If the two cost reasonings are true, it should be $6.90 more than price of conventionally grown?

Wrong.

In New York, the organics are priced at $58.10, a whopping $23.10 more than conventionally grown.

Do organics really incur additional costs when sold in New York?

Organics are priced higher because there exist segments that are willing to pay higher price for the value difference (be it real or perceived value, rational or emotional).

Costs are not the reason for the higher price, but the higher price that organics can fetch are the reason someone is willing to incur the costs to produce them.

The big price jump in New York is because customers there value the organics lot more and are willing to pay much higher price. Not due to costs. If you think East coast costs for organics are inexplicably higher, in nearby Boston, a market similar to New York, the organics are priced at $42.50, $10.50 more than conventionally grown.

In pricing, Customers – their needs, interests, aspirations- come first. Cost is a factor for deciding whether or not you can profitably serve the needs of the customer, not for setting price.

Data Source: http://newfarm.rodaleinstitute.org/opx/product.php?prid=19

Using Cost Argument For Price Increases – A Redux

The latest article in the, “Ask the Expert“, series featured a detailed and well researched article written exclusively for this blog by William Poundstone.  In that article, Mr. Poundstone answered the question whether businesses can use cost increase as an excuse to push through price increases. The article generated two very well reasoned responses. Here I will address the questions and qualifiers raised in the two responses.

Before I get to that, let me clarify one aspect that is most likely already clear to the regular readers.

Costs have nothing to do with pricing. Effective pricing is about finding what is relevant to each segment and targeting them with a version at a price they are willing to pay.

The question Mr. Poundstone answered was whether cost increase can be a good excuse for pushing price increase (not setting the original price). I have answered the same question in a previous post with similar response:

if the price increase were justified with a reason, a greater number of customers will accept it. In their paper titled,Perceptions of Price Fairness, researchers Gielissen, Dutilh,and Graafland  validated the hypothesis that price increases justified with cost arguments were perceived to be fair by customers.

Ellen Langer’s work, quoted by Cialdini, point to another possible reason for customer acceptance of higher prices – it is not the justification itself but the mere presence of one.  This opens up opportunities for both B2C and B2B marketers to re-price their offering or capture greater value without turning away customers – just give a reason, any reason.

Now to the two responses.

  1. What about inflationary conditions? Leo Piccioli from Argentina raises the point about conditions where the monthly inflation rate is 2%. He writes

    Under an inflationary context (understanding it as a general increase in prices along the market, or, in other words a reduction in the value of money) “fairness” seems to be a bit easier: people know prices go up all the time and do not have the time to validate each increase (the cost of checking it out is higher than the benefit). Therefore, I would recommend constant small increases instead of periodic large ones.

    It is very true for such macro-economic conditions and across cultural boundaries the research I quoted and that quoted by Poundstone may not be relevant. Inflation is in the minds of the customers, it is their expectation that prices will go up. Presence of such expectation gives marketers the freedom to push through multiple periodic price increases without worry.

  2. What about the cost of the messaging to justify price increases? John Balz who writes the NudegBlog, posted an article responding to Poundstone’s article:

    The basic point is that rather than having companies coordinate separate communication about commodity prices at moments of price hikes, wouldn’t a better strategy be to integrate market commodity costs into a communication strategy more generally?

    Yes there are costs to a marketer in running these campaigns but a constant and steady message on costs has the danger of converting the pricing into cost driven one and letting the customers demand a price that is only marginally more than cost. For the extreme example, see my Coffee shop example,  do customers come into a coffee shop to offset your different costs or get their daily caffeine fix.
    Or take the case of Apple’s 3G iPad and compare that to of Kindle 3G. Both have the same radio parts but the price of 3G iPad is $130 more than iPad Wifi while Kindle 3G is only $50 more than Kindle Wifi. Clearly, Apple is pricing based on value to customer.

The net is, pricing has nothing to do with cost and we should not be talking about it at all. When the original price is wrong or misaligned, cost increases can be used as an excuse for better price realization without much customer backlash. Otherwise, let us not bother our customers with the cost of sending our children to daycare so we can deliver the product to them.

Ask the Expert – Episode 1 – How do you know you are practicing Value Based Pricing?

This is the first in the new pricing series I wrote about last week. In this article, Reed Holden, renowned pricing expert and author of two pricing books, answers one of the three key pricing questions I posed him. Mr.Holden asks the product managers to do their homework, on their market, customer preferences, how to sell and most importantly ask and answer the question: “How the customer makes money?”

What is one visible and tangible task a business practicing value-based pricing will do that others don’t do?
Understand, in depth, the value of the product or service to the customer relative to good competitors.  That value should be based on the specific financial benefit to the customer organization and include cost reductions, increased efficiencies and improved sales and profitability.  It should be based on a solid understanding of the customer business model and how the product and services impacts that model.


[My annotation] Understanding the customer business model is so elementary yet most ignore in practice. It is important to know this not only when you first start selling but also essential to be tuned to its evolution. For one thing a customer with failing business model may not buy anymore from you and the other a changed business model may make your offering irrelevant.  A business focused on its own cost for its pricing is clearly focused on its own business model rather than its customers.

If you do not know how your customers make money, you are not practicing value based pricing.

Other readings:

  1. Treating different customers differently
  2. Pricing Strategy is all about the segment