The Need for Aggressively Driving Down Costs

In the Oct 2009 issue of Harvard Business Review there is an article co-authored by GE’s CEO Mr. Jeff Immelt and Tuck Business School professor Mr. Vijay Govindarajan. The article’s theme is “reverse innovation” – it talks about how GE (and some other global businesses) are introducing in US, innovations that were originally developed for lean markets. [tweetmeme source=”pricingright”] Countries like India and China have a vast population that has low willingness to pay mostly because of their extremely low wherewithal to pay. So instead of introducing stripped down versions of products that were primarily developed for US (wealthy customers) market GE is creating these products ground up for India and China. The authors provide as examples GE’s $1000 electrocardiogram device and a portable, PC-based ultrasound machine that sells for as little as $15,000.

Is this new or revolutionary? Since the innovation flow is reversed this is indeed new for most businesses but this in its essence represents a gap in business strategy – something all businesses should have been practicing whether or they are global, local or glocal. I am not referring to reverse innovation, I am referring to aggressively driving out costs from the system.

Henry Ford wrote in his book My Life  and Work,

Our policy is to reduce the price, extend the operations, and improve
the article. You will notice that the reduction of price comes first. We
have never considered any costs as fixed. Therefore we first reduce the
price to a point where we believe more sales will result. Then we go
ahead and try to make the price. We do not bother about the costs. The
new price forces the costs down.

Businesses like GE find it important to develop $1000 EKG for markets like India because that is what the customers are willing to pay. In the US markets there have been no real drivers for such innovations (until now) –  either the customers had higher willingness to pay or did not care because someone else was paying for it. In the specific case of medical equipments, the hospitals did not care about the high price tag because their customers did not care. Since the  hospitals could charge a high usage fee (that are mostly paid by insurers who then get it back in the form of high premiums from their customers) they did not actively force their suppliers to drive out costs from the system. So there was no incentive for any player in the value chain to focus on costs.

Had this been a different system where the patients pay out of pocket and/or have lower willingness to pay for use of such medical equipments then we would have seen each player actively squeezing out the costs to “make the price”. As Ford wrote, “the new lower price would have forced the costs down”. This is exactly what is happening now with down economy and high health care costs. So the low cost innovations that worked for markets with low price points are flowing back to markets that previously had high price points.

The lesson to takeaway from GE’s experience is not that we all should look for innovations in low willingness to pay markets to introduce them in high willingness to pay markets (although it is not a bad lesson) but know that a business should always be aggressively focused on  driving down costs be it through innovation or any other means.

In my article on Value Equation, I wrote the that a marketer has two levers to pull in maximizing their profits:

  1. Increase total value add to the customers
  2. Reduce the cost to create that value

Since pricing is a share of the net value added, improving anyone or both of the components will result in better profits even if the initial pricing were wrong.

Whatever new label you slap on this innovation flow – there is nothing new to the importance of driving down cost from the system.

Rebranding Price Discrimination – Breaking the Bad Rep

[tweetmeme source="pricingright"]

Economists are not good marketers otherwise they would not have named the greatest profit maximization scheme to date as Price Discrimination. The word discrimination evokes so much negative feelings that it is hard to justify price discrimination is legal, ethical and  fair. If general discrimination is treating different people differently based on demographic or psychographic characteristics, price discrimination is charging different people different prices based on value they get and their willingness to pay.

Since finding each customers’ true willingness to pay is impossible  the next best options are:

  1. Equating customer’s wherewithal to pay  to their willingness to pay – for example giving student and senior citizen discounts. It is the same product but based on verifiable external criteria different customers are charged different prices. While this is termed third degree price discrimination, marketers who implement this have a better term for this – “discount” for one class and a “surcharge” for another.
  2. Delivering multiple different versions (products that vary in different dimensions) at different price points and letting customers self-select themselves to the right version. This is the second degree price discrimination and after rebranding it is called versioning.

Still the practice of charging different customers different prices still causes considerable outcry in the news media and in the social media. Most price discrimination schemes end up using demographic variables which further aggravates the situation. It is hard to even classify good and bad price discrimination. In fact, price discrimination makes it possible for certain customers to avail themselves of products and services that would not have been possible with a single price. For example, this is a story from NYTimes on pharma companies selling branded generics at lower prices:

As a result, some drug makers are pursuing a two-tiered strategy in developing markets: selling their own lines of more expensive name-brand products to the more affluent, as well as offering midpriced branded generic lines that include prescription and over-the-counter medicines for the broader market.

“We are able to create different tiers of products at prices they haven’t previously seen with our stamp of approval,” said Andrew P. Witty, the chief executive of GlaxoSmithKline.

What we need, I think, is a new brand for Price Discrimination, to move way from its current negative connotation and the negative press around it.

Here is my recommendation:

Price Harmonization: Has a nice positive ring (harmony) to it and is cryptic enough that it conveys nothing about the true intention of the marketer. Harmony does not have to mean homogeneity, it just has to mean “compatible, consistence, coincide in their characteristics”. You can look at it as making price compatible with customer willingness to pay.

Finally, a marketer practicing price harmonization appear to be doing something nobler than one practicing price discrimination.

Do you practice Price Harmonization?

Other similar pricing terms: Price Realization.

Pay What You Can Is Not Price Discrimination

Update 1/2/2014: I am saddened to hear Sensorielle is now closed.

This has been my favorite pricing case study for the past ten months or so – Sensorielle spa in the city I love, Boulder, went to a Pay-what-you-can pricing model. The spa’s owner, Ms. Petteway made it clear that this is not “pay what you want” but a scheme to allow those loyal customers who were hurt by down economy to come back and pay only what they could afford.

A few months back I wrote about the partial results published by:

Ms.Petteway published results from her experience in the Boulder Net LinkedIn discussion board. She talks about how  few customers interpret the pricing plan as “pay what I want” and ask for high-end services even though they pay less than the posted prices. For any rational customer (Homo Economicus) whose goal is to maximize their utility, it makes sense to pay the minimum they can get away with.

I said then Pay-what-you-can  scheme despite its close resemblance to first order price discrimination is not really price discrimination. It does not stand on solid data ground or analysis and leaves the future profit uncertain. Better results could be achieved with segmentation and targeting.

Will this pricing scheme help the spa identify willingness to pay of different customers? No, because the reference price is set by the list price and is pushed down by the option for “pay-what-you-can”. There are other ways to get customers to reveal their true willingess to pay (see my article on Pricing for garage sale).

I do not have access to any sales data nor have I had this conversation with Ms.Petteway but I hypothesize that they found this pricing scheme yielded lower profit than previous years.  The spa is not standing still and is making  more pricing changes  for the coming year:

  1. The Pay-what-you-can is limited to just two days of the week. This is something they should have done to start with and that would have been a great way to sort customers based on their WTP.  This would also help reduce cost of operations for those days by staffing with junior staff and not offering their high margin services. I also would recommend offering no reservations or charge for reservation separately (unbundled pricing) for these pay-what-you-can days.
  2. They are increasing prices of some and decreasing prices of some. If they based it on customer survey then it makes perfect sense. When re-pricing  two version of the same service I would have recommended that they don’t reduce the price for both.
  3. Note how the text reads for price decrease and price increase. They say “price reduced” and “price changed” respectively. That is not a strategy but the right messaging – do not ever say price increase.

Small businesses can blame the economy and be swept by the recessionary wave or they can take control on their marketing strategy to drive higher profits. Lack of specific marketing skills is not an excuse anymore. Kudos to Ms.Petteway for experimenting with pricing and her willingness to adapt as she gained more data about consumer behavior.