Pricing Week 6
PRICING
Starting this week we learn how to capture value from our customers. The first concept is of coursepricing. While pricing is highly context dependent, I will give you some basic notions in pricing that youcan employ in many industries.
This week we build our understanding of pricing on two readings:
The Value Pricing Framework (https://udel.instructure.com/courses/1699152/files/118085475?wrap=1) from the book How to PriceEffectively, written by Utpal Dholakia (https://business.rice.edu/person/utpal-dholakia) . Utpal is a professor of marketing at RiceUniversity and is my coauthor on multiple papers (https://scholar.google.com/citations?user=_ZCs5k8AAAAJ&hl=en&oi=ao) andfriend for many years. He has graciously shared the relevant chapter from his book with our class.
The other reading is Atlantic Computer case (in the course packet on HBR (https://hbsp.harvard.edu/student/) ).
In the rest of this page I will summarize the value pricing framework. However, please read the chapter for more examples, and especiallyfor the example about Costco.
The Va lue P r i c i ng F ramework
The value pricing framework is a flexible approach to making and evaluating pricing decisions that can be applied to any industry. Itincludes the following components:
1. Inputs . There are four inputs: company’s relevant costs (for pricing), customers’ economic valuation of the benefits provided by theproduct, reference prices (those customers already possess, and those provided by the company), and the value proposition thatdictates how the three other factors will be weighted in pricing
2. Decisions . There are two pricing decisions to make: either set a new price or change an existing price. Embedded in thesedecisions are structural decisions: offer the product a-la-cart, as a bundle, or both; set one- or two-part price (fixed and variable); sella perpetual license or subscription, etc.). As part of these decisions we also get to realize the price, which means that the price wesell at is different from the price we set using the value pricing framework (due to incentives we give customers in the form ofdiscount, markdowns, freebies, etc.)
3. Measures . Four measures determine the success of the organization’s pricing: sales revenue, profit margin, customer satisfaction,and employee satisfaction. Instead of maximizing any one measure, an effective pricing strategy tries to balance the four measures.The key is to maintain or increase unit sales and revenue while enjoying a healthy profit margin, having a base of customers that issatisfied with the company's prices and pricing policies, and proud, confident, and knowledgeable employees
The measures of success then feed back to the pricing inputs, resulting in a cyclical process. I will elaborate on each of these componentsbelow.
I npu t s
In this section, I will elaborate on the four inputs. Please click each expander tab for a detailed explanation of each.
Costs
For the company to be sustainable, its average prices must be greater than its average costs. Thus, costs establish the floor or lowerbound for the price. Not all costs are relevant to pricing though. Think about a failed development for a product. Should these costs bemounted on a successful product? Doing that may increase the price of the successful product substantially. Once the relevant costs
are adequately understood, and a long-term viable pricing structure is put in place that is designed to cover average costs, managershave the flexibility to design creative short-term pricing offers to attract new customers or expand reach in existing customers.
Here is a simple example: your friend is considering becoming an Uber/Lyft (or both!) driver. Let’s help your friend make a decision byunderstanding their relevant costs.
The job requirements are a fairly new car, a driver’s license, a clean driving record, and a smartphone.
Uber Driver Expenses
Fairly new and reliable car Late-model Ford Fusion, $375/month
Car insurance Comprehensive coverage, $80/month
Smart phone Android phone and service plan, $65/month
Gas and vehicle wear/tear Estimated for Ford Fusion at $0.48/mile
W h i c h o f t h e s e c o s t s s h o u l d y o u r f r i e n d c o n s i d e r ?
Once you've considered this question, click the button below to reveal the answer.
C l i c k t o r e v e a l t h e a n s w e r .
Customer Value of Benefits
This is essentially a mapping of product features to benefits and benefits to willingness to pay, which means that customer value is theceiling or upper bound for the price. The following two examples show how customer value can be completely unrelated to costs:
1. Sports fans are happy to pay a hefty premium for receiving priority for playoff tickets, a feature that costs a professional sportsteam virtually nothing to offer.
2. In early versions of Amazon's Kindle reading device, the text-to-speech feature was added at significant cost. However, fewcustomers used this feature, leading Amazon to drop it.
Let’s consider an example based on a model of prices and quality.
Imagine a LED light bulb that is priced at $3. It is sold by an unfamiliar brand name. The bulb is 60W equivalent (consumingapproximately 9 watts of electricity) and has a tested life of 20,000 hours. Is that a good deal? In other words, what is the bulb’svalue?
To assess that, consumers must use all their knowledge about prices and bulb life. They will create subjective prices and values,perhaps similar to the following chart, where prices are on the left and performance is on the right. The crossed arrows represent howa thoughtful customer understands the value of the product. However, a lazy customer might infer quality from price rather thaninferring it independently (as in this case, in which $3 is actually a really good price for 20,000 bulb hours).
W h a t d i d w e l e a r n f r o m t h i s e x a m p l e ?
1. Instead of trying to understand how much consumers are willing to pay for a product, we need to understand their subjectiveprice ranges and what they mean. Here for example, $1 is cheap, $2-3 is reasonable, $4 is expensive, and $5 is very expensive.
2. We should map the objective quality measures (hours in this case) to subjective quality measures.
However, remember, high prices are often indicative of quality (suggesting the arrow in the middle of the chart should actually be flat:from expensive to excellent!).
A final note about consumer value: it changes based on circumstances. In an insightful piece in the New York Times,(https://www.google.com/url?q=https://www.nytimes.com/2015/10/11/business/mutfund/take-surge-pricing-to-the-limit-then-go-further.html&sa=D&source=editors&ust=1617047332820000&usg=AOvVaw0A2ZWX59xS-TqKtom6FYqr) I read this (and many other coolexamples):
Think of how much you could actually charge for a public restroom. The one at Madison Square Park costs 25 cents.Imagine how much more you could charge on St. Patrick’s Day, when crowds throng the streets and beverages areconsumed. No city would run a deficit under my bladder-surge pricing plan.
Reference Prices
When assessing whether a price is a “good price” or not, customers evaluate it relative to other prices. These reference prices includeprices that the customer is familiar with such as the product's old price, and the prices encountered during the purchase process suchas those of key competitors, or even prices of unrelated products. Reference prices provide a “reasonable range” and if the companyprices in that range then consumers are more likely to focus on benefits than on price.
In an interesting NY Times article (https://www.nytimes.com/2022/02/26/technology/amazon-price-swings-shopping.html?) the authorsuggested that recently customers find it hard to form reference prices since online retailers change prices so frequently. This is arelatively new phenomenon so it remains to be seen how it will affect demand. If you wonder why Amazon and the likes do that, the
answer is twofold: yield management (i.e., when demandincreases so does the price) and they want customers tokeep coming back to the site/app to check the prices.
Company's Value Proposi�on
The value proposition provides a declaration of intent or a statement that introduces a company's brand to consumers by telling themwhat the company stands for, how it operates, and why it deserves their business. In its most basic form, it is a succinct, formalexpression of the company’s marketing strategy, described in a customer-centric way.
As such, the value proposition influences the relative weights managers give to the other three decision inputs.
Here are two examples:
Aldi
A discount grocery chain, emphasizes its costs and its prices relative to competitors. It will price its products to remain significantlylower than its competitors
The following table shows the direct relationship between the value proposition and the pricing strategy:
Marketing Strategy Cost leadership Premium branding Comparative framing
Pricing input emphasis Cost Customer value Reference prices
Example for a valueproposition “We have the lowest prices” “We have the best quality”
“We are better than ourcompetitors”
Operational focusKeep costs lowFocus on efficiency
Drive innovation Monitor competitorscarefully
Panera Bread
Their value proposition is “craveable wellness and elevated experiences,” and they place greater emphasis oncustomer value and less on costs or reference prices. It charges higher prices than its competitors, and as long asthey remain within the reasonable range of prices, consumers will come
H o w d o w e u s e t h e f o u r p i l l a r s o f p r i c i n g i n r e a l l i f e ?
Let’s look at the following example of pricing a mussels appetizer. The restaurant business has two types of costs: direct to the dish andindirect (rent, utilities, labor, taxes…), and the rule of thumb is that the direct cost should be 30% of the menu price for the dish.
Carefully add newfeatures
Emphasize quality andbrand imageDelight customers
Imitate featuresDrive costs down
Pricing goal Low price image Premium brand image Superior value image
Pricing tactics
Use loss leadersUse prices that end in 9 todenote a bargainUse everyday low pricesto support low price-imagePublicize small marginsEncourage pricetransparency
Use rounded pricesAvoid frequent pricepromotionsOffer product bundlesReduce visibility of pricesReward customer loyaltyand referrals
Respond quickly tocompetitors’ pricechangesUse price comparisonadvertisingMatch competitors’ pricesOffer low price guarantee
Examples of
companies
Aldi, Walmart,
Southwest Airlines
Schlumberger,
Panera Bread, Cartier
Hyundai, Taco Bell,
Sprint
Click for accessible text contained in the image above.
The value pricing framework uses all the above inputs and is summarized in the graphic below. Based on the value proposition, weightswill be assigned to costs (W1), customer value (W2), and reference prices (W3). Assuming that the value proposition is to serve as aneighborhood café, it may want to put higher weight on reference prices (W3) and lower on costs (W1) and customer value (W2).
Pr i c i ng Dec i s i ons
There are four types of pricing decisions managers can make:
1. Pricing a new product . When pricing a completely new product (or radical innovation), the company has no precedent so it has tohave a good understanding of customer value and its own value proposition.
2. Pricing a new version of existing product . In this decision, the price of the previous version carries the most weight. Customerswill evaluate the incremental benefits in comparison to the price of the new version, and that’s how they’ll decide whether to buy.
3. Price change in response to consumer preferences . When customer valuation of the product changes (due to any factor,including newly available alternatives, economic environment shifts such as recession, etc.), pricing changes with a greater focus onunderstanding the change in customer valuation. A really cool example is how the razor industry had to lower prices in recent yearsbecause it is now considered fashionable and sexy to have a beard. Men just don’t shave as much as they used to!
4. Price change in response to anything else (related to the business side). This can be due to changes in costs (usually when theybecome more expensive), change in management goals (like increase market share), or change in competitors’ prices. Thesechanges do not affect customer valuation. In these changes, costs and reference prices will be weighted more heavily than before.
90% of all pricing decisions are 2-4 above, and the overwhelming majority of them are small changes (in % of the original price).
After these decisions are made, the price is set, but that doesn’t mean customers pay that price. There is a gap between the asked-priceand the earned-price due to discounts and other incentives customers get. But make no mistake, the higher the gap is, the worse it is forthe company (this is discussed more in the reading on pages 18-9). On the other hand, it is neither possible, nor desirable, to reduce theprice realization gap to zero. This would mean that every single one of our customers pays every single dollar we ask for, and this ispossible only if (a) we are the Soup Nazi, or (b) our prices are far lower than they should be.
Measu r i ng P r i c i ng Success
Intuitively, but incorrectly, many think of effective pricing in terms of sales or profit margin maximization. Both are ill-advised: sales can beeasily maximized if the price is lowered, and profit margin can be easily maximized if price is close to the ceiling. These two goals areclearly conflicting.
Customers like to buy from companies whose pricing strategies are fair, transparent, stable, and aligned with the economic value deliveredby the product. Apple is an excellent example: the iPhone is an expensive product but customers flock to stores every time a new phone isreleased because customers find its price to be congenial. Online retailers who change prices constantly to maximize profit usually upsetand deter customers who hate this type of pricing as it complicates their decision processes.
Generally there is a tradeoff between customer satisfaction and financial success—giving consumers more benefits will certainly increasetheir satisfaction but without commensurate price increase, it is a recipe for profit erosion.
From the employees’ perspective, a well strategized and executed pricing strategy that is fair and aligned with product benefits is easy toexplain to customers when making a sale. It boosts employees’ confidence and morale and thus increases their satisfaction and thereforetheir loyalty and willingness to work hard.
Read how Costco uses the value pricing framework in the chapter from How to Price Effectively (linkedon this week's overview page and at the top of this page), and here(https://www.cnbc.com/2022/07/11/costco-ceos-one-word-answer-to-whether-he-would-raise-the-price-of-hot-dogs-no.html) for why the price of hotdog at Costco is still $1.50 when everyone else raises prices.
