Archive for the ‘Pricing’ Tag

Are you charging your customers enough?

Nearly every executive pays lip service to “shareholder value.” But many of them readily, if unwittingly, make business decisions that run counter to that objective.

Over the long run, no variable correlates more strongly with shareholder value than profit maximization — something that many companies do not prioritize in spirit, let alone in practice.

Instead, they often focus on flavor-of-the-month strategies such as market share growth or product innovation. Believe it or not, these are not always compatible with maximizing profit over the long run.

The problem with focusing on market share is that growth is often achieved at the expense of competitors. “Switchers” are the most difficult customers to attract, frequently requiring discounted pricing or free trials, and are also the most difficult to retain. The result is generally a temporary increase in market share that does not translate into higher revenue or lower operating costs.

While focusing on product innovation is always a good place to start, it too can come up short when it comes to maximizing profit. One major reason is a failure to properly price the products. An introductory price that is too low for too long — usually in hopes of stealing market share — may never produce the return a company is hoping for.

The result is that companies often spin their wheels, leaving profit on the table because they don’t understand the true value of their enhanced product — or feel that their brand does not command the heft required to demand premium pricing for premium quality.

Why does pricing go off the rails?

Our consulting firm recently worked with a company whose stock was under-performing relative to its peers. The company’s solution had been to increase market share through product upgrades. Despite considerable money and effort, however, the strategy failed to build top-line revenue and, as a result, investors were unmoved.

When we performed the postmortem we determined that management put a great deal of care into identifying what customers wanted and how to market the products but put little thought into what to charge. Not only were the prices too low to feasibly provide a return on the organization’s R&D investment, customers failed in lieu of premium pricing to grasp the products’ premium quality.

Setting the right price

It can be a challenge to devise and stick to a pricing strategy that reflects the true value of a product or service without compromising competitiveness. Here are a few tips that can make the task a little easier:

  • Ensure that every stakeholder both understands the primacy of long-term profitability and is aligned around that goal;
  • Recognize that there may be special instances when premium pricing should temporarily take the backseat to marketplace competition;
  • Understand your existing and potential customers’ needs and budget and seek to meet both;
  • Enumerate the ways in which your product or service addresses those needs, using tools such as a customer-value model;
  • Consider if or how you need to differentiate and build your brand to support premium pricing.

For more information on our services and work, please visit the Quanta Consulting Inc., web site.

4 dangers to be way of in 2014

The holiday season is a time for celebrating — and prognostications for the coming year. I’m typically an optimist, but not this time.  Though many factors point to a rosier 2014, every company faces some significant direct and indirect risks, many of which lurk below the surface. Fortunately, these dangers can be alleviated with good analytics and planning.

Recent positive economic news (e.g. the strength of equity markets, low interest rates and the abatement of EU and U.S. debt crises) have given corporate managers some cause for optimism. It would be understandable, but hazardous, for managers to let their guard down.  Many risks continue to menace organizations, four of which are:

Stagnating prices

Raising prices is a quick path to higher profits. To wit, a 1% increase in prices with a 30% margin can improve the bottom line by 20%.  Just try making it happen. Since the financial meltdown of 2008, it has been difficult to raise prices while maintaining market share. In Canada’s retail sector, for example, the arrival of Target and Marshalls plus recent grocery price wars, is expected to depress industry profitability for some time.  Many other sectors like services, manufacturing and communications are finding it difficult to sustain margins due to buyer pressure, global competition and steadily increasing costs.

Mitigating the risk

From a pricing perspective, firms need to more aggressively sell their products in markets that are less price sensitive or that are rapidly growing markets, both locally and in the developing world. Furthermore, those companies with differentiated value should look to take pricing up by better aligning price points to the unique benefits delivered.

Cost pressures

Global consultancy EY estimates that a 1% reduction in costs can produce the equivalent of a 10% increase in sales.  Achieving this is another story. In many firms, most of the easy supply chain and headcount rationalization savings have already been tapped. Moreover, the era of low raw material and wage inflation may be coming to an end, tracing to two key drivers —  the recent uptick in consumer demand and the possibility that China’s growth engine will reignite, driving up raw material costs. Adding fuel to the fire is continued exchange and interest rates volatility, which can play havoc with costs.

Mitigating the risk

Product and operational innovation is the key to driving margin improvement.  On the cost side, it is possible for organizations to further reduce cost without cutting key capabilities. For example, managers can reduce development costs and better target needs by co-creating products with their customers and leveraging rapid experimentation practices. Innovative operational strategies can drive higher efficiencies through the implementation of initiatives that reduce complexity, as well as crowdsourcing and gamificationpractices.

Supply chain disruptions

As has been shown many times, unforeseen events like natural disasters or political crises can seriously disrupt a firm’s operations, dramatically impacting product supply and revenue. Risks are magnified when a company’s supply chains are regionally concentrated and highly integrated.  For example, Japan’s Fukoshima nuclear disaster led to global shortages of spare parts  and shuttered assembly plants for Honda and Nissan. A recent report by Swiss Re, a reinsurance company, highlights the ongoing risk of major natural disasters such as flooding, earthquakes and storms.  The report identifies above-average risk for many global economic hubs including: Tokyo, Hong Kong-Guangzhou, New York, Los Angeles and Amsterdam-Rotterdam.

Mitigating the risk

Maintaining a low-cost supply chain must be balanced with the need for added production flexibility and agility.  Managers can minimize this operational risk by having: multiple supply-chain partners for critical and expensive inputs; close and symbiotic relationships with each vendor; and the internal capability (e.g., engineering, procurement) to quickly shift production if necessary.

Cyber attacks

Computer attacks and viruses represent a clear and present threat to every enterpriseand industry.  This year, the Securities Industry and Financial Markets Association released a report that showed  more than half of the world’s securities exchanges had experienced cyber attacks during the past 12 months. Janet Napolitano, the outgoing U.S. homeland security chief, recently said, “Our country will, at some point, face a major cyber event that will have a serious effect on our lives, our economy, and the everyday functioning of our society.” Importantly, these cyber attacks can appear out of the blue.  According to software provider Symantec, 40% of all the computers that were impacted by the Stuxnet virus, which allegedly targeted Iran’s nuclear infrastructure, were located outside of Iran.

Mitigating the risk

Reducing the impact of cyber attacks requires an acknowledgement of the threat, an understanding of internal vulnerabilities and the business continuity plans to deal with potential disruptions. Furthermore, IT managers should work together with their industry peers to explore industry early warning systems and safeguards.

For more information on our services or work, please visit the Quanta Consulting Inc. web site.

Better pricing

The way many firm’s price their products is at odds with their target value proposition, brand image and possibly, financial goals. A recent essay in the Harvard Business Review, Pricing to Create Shared Value outlines a better approach to pricing products and services. Shared-value pricing asks firms to collaborate with their customers to redesign pricing schemes that will increase total value and trust in the brand.  Properly built and implemented, the business benefits are compelling, including: improved customer retention & acquisition, higher customer satisfaction and greater financial returns.

Pricing gone wild

Pricing sends clear messages about what the company thinks of its customers and how it wants to deal with them. While many brand messages say, “We value you as a person,” the pricing practices often say, “We only care about your money.” For many firms, every customer, product and service is seen as an opportunity to be monetized — often in a sneaky fashion. Fee-driven industries like retail banking, airlines and telecom are notorious for ‘slice, dice and price’ approaches that regularly ‘nickel and dime’ consumers with many small charges. Other firms, moreover, go further by exploiting any consumer disadvantage (e.g., lack of information, limited choice, buying complexity) to keep prices unfairly high.

However, times are changing. Both B2C and B2B companies face immediate and serious business risks from ill-advised pricing decisions.  More positively, some forward-thinking managers recognize that they can increase revenues and improve their value proposition by collaborating with their customers to retool their pricing policies and goals.

A new pricing paradigm

With a shared-value approach, the company looks to increase customer value and reduce distrust by redesigning its pricing policies around a customer’s full gamut of needs (versus their own).  For example, managers could engage customers to help create new discount schemes, more flexible ways to purchase a service or lower-risk ways to consume a product. This customer-centric approach will transfer more value to consumers, improve trust in the brand, and drive higher product consumption  (as new users and current customers are attracted to a better value proposition).  In some cases, a shared-value approach can help increase prices.

Bruce Silcoff, president of loyalty solutions company Fairlane Group, is a pioneer in shared-value pricing.  “Successful, long-term, buyer-seller relationships are built on a fundamental commitment to shared goals and objectives,” says Silcoff. “While our competition still relies on disjointed fee-based pricing models to achieve profitability, we have been successful at attracting new business and garnering client loyalty by linking our revenue and profitability with the performance of client programs.”Advertisement

Marco Bertini and John T. Gourville, authors of the Harvard Business Review article, cited the 2012 London Olympic Games as an example of shared-value pricing in action.  In earlier games, pricing policies were regularly criticized for being inflexible, inaccessible and overly expensive.  For 2012, the London Olympic Committee’s (LOC) stated goal was to make the 2012 Olympics “Everybody’s Games,” a mission with a strong and intrinsic requirement for the five core principles of shared-value pricing.

Focus on relationships, not on transactions
Using a single, inflexible price or a complicated pricing scheme is about maximizing a firm’s revenues and operational efficiency, not fostering mutually beneficial customer relationships. The LOC’s approach was to value customers more than their money.  For example, they introduced a ‘pay your age’ pricing scheme and multiple pricing levels to increase affordability and flexibility.  They also sought to gain trust by guaranteeing that higher priced tickets would carry a better viewing experience than tickets costing less money.

Be Proactive
Managers often price in reaction to competitive moves or customer complaints, but rarely based on what matters to the customer (their needs).  To be proactive, the LOC eliminated a major sore point from previous games — the requirement that customers purchase tickets for popular and less popular sports within a bundle.  In its place, the LOC had each sport stand on its own, with its own flexible pricing plan.

Put a premium on flexibility
Inflexible pricing schemes reduce total value by making it difficult for firms to adjust prices in response to changing needs or to better share value with customers who perceive product value and features differently. To provide flexibility, the LOC introduced multiple pricing tiers to better appeal to different needs.  Furthermore, they refused to fix the number of seats in each tier, thereby ensuring they were satisfying actual versus anticipated demand

Promote transparency
Many companies maintain opaque pricing schemes in order to maximize revenue and minimize churn.  Not surprisingly, this often backfires by generating mistrust and churn. The LOC took a completely different approach. In order to better manage expectations, the LOC communicated regularly and fully on ticket availability and pricing, as well as the key features of the ordering process and pricing rationale.

Manage the market’s standards for fairness
A company’s pricing strategy should not be at odds with its customer’s expectations of what is fair.  The LOC went to great lengths to explain to the public (the people who paid for the games) the facts and rationale around pay-your-age pricing and discounts, as well as the percentage of tickets sold at each price band, corporate ticket allocations, etc. To reinforce that there was no preferential treatment, the LOC used a lottery to allocate the tickets.

For more information on our services and work, please visit the Quanta Consulting Inc. web site.

Are bundles bad for business?

According to conventional wisdom, product bundles are a great way to build customer loyalty, drive revenues and improve your brand image.  With a bundling strategy, consumers who purchase one product are tempted with incentives to buy  another, often complementary product.  The marketing premise – supported by solid evidence in many firms – is that companies can maximize total customer revenue by offering a second product at discount versus selling each product individually. Not surprisingly, bundling has become popular in many B2C and B2B markets ranging from telecommunications to financial services.

Bundle with care

Does bundling’s good reputation hold up to research? No, according to professors Alexander Chernev and Aaron Brough in a recent article in the Harvard Business Review.  Their research found significant problems with bundling. Specifically:

  • Consumers will pay more for a single expensive item, such as a TV, than they will for a combination of that item and a cheaper one, such as a radio.  In their study, people were willing to spend $225 on one piece of luggage and $54 on another when the items were offered separately. However when the bags were offered as a package, people were willing to spend just $165 for both
  • Bundling will have a negative effect on the perceived value of a product when a less expensive item is added as part of a bundle. The research found that when consumers were offered a choice between a gym membership and a home gym, slightly more than half preferred the home gym. But when a fitness DVD was included with the home gym, only about a third chose it.

It’s all in your head

In 5 experiments, real consumers were shown a series of real brand name products—phones, jackets, backpacks, TVs, watches, shoes, luggage, bikes, wine, and sunglasses – varying in price.  Respondents in one group were asked how much they would pay for each item by itself, and those in another group were asked how much they would pay for a bundle combining a high-priced and a low-priced item.

Psychological factors – specifically a process named categorical reasoning – are behind this consumer behavior. People naturally tend to classify products as either expensive or inexpensive.  This categorization influences how they judge products. When an expensive item is bundled with an inexpensive one, people categorize the bundle as less expensive, and this lowers their willingness to pay for it.    

It’s the bundle and price points that matter.  Categorical reasoning does not happen when lower priced products are valued side by side against more expensive products. This effect is only seen only when the two items are considered part of the same offering. Moreover, categorical reasoning does not arise out of differences in the perceived quality of the bundled products. Devaluation can happen when both items are of similar quality and brand image but different price points.

Marketing implications

Bundles aren’t and shouldn’t go away so fast.  However, this research suggests that firms should use them carefully. For example:

  1. Get consumers to focus on non-price attributes like reliability, performance or design.  This will eliminate the price effect since people categorize along just one dimension at a time. The findings show that when customers focus on one of those attributes, they’re much less likely to categorize items in terms of their expensiveness.
  2. Design bundles where each product has similar perceived value, image and price points.

For more information on our products and services, please visit the Quanta Consulting Inc. web site.

Cloud Computing disrupts software pricing

The delivery of software is not the only thing being impacted by the rise of Cloud Computing.   Moving to the Cloud is also disrupting the traditional software pricing model with the potential to dramatically change customer behavior and impact market dynamics. In the future, CC leadership will be as much about getting the pricing model right as it will be about technical excellence.

The ubiquitous cloud

With CC, software applications are delivered as a subscription-based service over the Web much like a utility delivers power over a grid.  This scheme allows a user to purchase only what they need, when they need it, for as long as they need it.  Not surprisingly, customers are embracing this powerful value proposition.  Forrester Research estimates that over 33% of companies now get some of their software delivered as a service.  The market for Cloud-based services is growing over 20% per year.

Next to provisioning, the biggest impact of CC is how software is priced. Fading fast are the days when general-purpose software packages were sold in boxes with a one-time, perpetual software license fee plus expensive maintenance and upgrade charges.   Instead, Cloud-based services are sold through a subscription-based model – customers buy only those applications they need for particular tasks. Not surprisingly, this new paradigm has repercussions on the profitability, revenue and competitive position of every firm that sells digital products. 

Watch your back

According to Saikat Chaudhuri, a Wharton School of Business professor, “The disruption comes when bundles such as Microsoft Office don’t make sense anymore. Instead of big suites, lightweight applications will become the norm.” Today, customers are wary of big software upgrades that carry expensive hardware and operating costs.  Furthermore, they want applications that could be more easily and cheaply ported over to new environments like mobile computing where their users are.

Cloud-based disruption is everywhere.  Google is taking aim at Microsoft’s Office franchise with web-based services.  Cloud providers like Salesforce.com, NetSuite, and SuccessFactors are aiming to poach business customers from SAP and Oracle. Zynga, which publishes popular free games primarily on Facebook, is a threat to traditional game powerhouse Electronic Arts (EA). In this world, dedicated cloud companies with no legacy box revenues have the upper hand as they do not need to worry about cannibalizing their core business. 

If you can’t beat them…

Not surprisingly, traditional software providers are trying to maintain their market position and revenues by launching their own subscription pricing schemes and buying other cloud offerings.  It’s more preferable – though not easy – to cannibalize your own business in a controlled manner than let someone else do it to you.  Pragmatic vendors will also realize that it pays play offense as well as defense. For one thing, subscription-based offerings enable unique business-building opportunities such as the ability to run quick and cost effective product trial and cross sell programs. 

Growing CC penetration could also mean higher industry revenues for some markets.  A few years ago, we did a pricing study for an enterprise software vendor looking to deploy a cloud service in one of their largest product categories.  Management was concerned that total category revenues would fall after the new service was launched.  Our analysis found that adding subscription-based pricing did not lead to a fall in their business.  In fact, it led to modest revenue gains due to increases in lifetime customer value. More importantly, margins improved as a result of lower distribution and customer acquisition costs.

A brave new world

Industry experience suggests that market revenues and profitability will flourish in a CC-intensive world.  According to Wharton Professor Kevin Werbach, business is “…likely to grow, as recurring revenues and micro transactions replace big up-front payments. Look at the Apple App Store…. That represents billions of dollars in revenues for mobile software, which simply didn’t exist before.”  Professor Chaudhuri goes on to add that “As software is broken down into smaller parts, the [lower unit] pricing can stimulate demand.” As an example, the popularity of iTunes’ 99 cent song downloads may have hurt large music labels but not the plethora of independent artists who now enjoy more distribution than ever before.  For the software industry, market profitability will likely remain the same, but more players could share in the rewards.

A CC model also affords many opportunities to leverage pricing innovation.  Similar to an airline or utility, firms could institute variable pricing based on customer demand. For instance, a company could charge more for applications during demand spikes and less in off-peak hours. As in other industries, software vendors will use different models to generate the same profit, if not more, based on lower prices and a broader customer base.

CC represents a seismic shift in the software industry.  While its implications will take a couple of years to fully play out, the impact on pricing strategy and marketing is already being felt today. Pricing leaders take note: the time for strategic thinking and experimentation is nigh.

For more information on our services and work, please visit the Quanta Consulting Inc. web site.

Revenue strategies for a zero growth world

A ‘new normal’ is hindering the revenue generation plans of many North American firms. This climate is characterized by zero (or negative) market growth, margin compression, and cutthroat global competition. Historically, price increases would be a manager’s number one weapon to drive incremental revenue. In this environment, however, it is extremely difficult to do this and still maintain market share. Moreover, most attempts to drive revenues through new product innovation end up failing. And, most markets continue to experience downward price pressure due to product commoditization and a growing private label segment.

To crack their revenue problem, managers should look to other industries for lessons on what works, as follows:

Go where the profit is

Many companies are discovering that higher margins and profits may lie, not in their delivered product or service, but in ancillary services that consumers need and competitors ignore. For example, Apple quickly figured out that its iTunes music service was easily as profitable, scalable and “sticky” with consumers – to the tune of $1.5B in revenues – as selling MP3 players and computers. Rolls-Royce, a leading jet engine manufacturer, discovered that servicing its engines and providing spare parts delivered higher margins and more predictable revenues than engine sales alone. Services now account for over 50% of Rolls-Royce’s revenues.

Super size your solutions

Managers understand that providing products and services deliver higher revenues than products alone. However, what is different today is the nature of these newfangled solutions. Industries as diverse as professional services, transportation, publishing and retail are creating novel solution bundles that take their businesses in new directions. For example, IBM, UPS and Amazon are leveraging their considerable IT and supply chain capabilities to offer client’s innovative performance enhancement solutions that include services like data analytics, consulting, cloud computing services and logistics management. For providers, these new solutions can improve operating leverage, deliver recurring revenue and increase client stickiness. At the same time, these new solutions are subtly redefining the provider’s mission and business model turning them away from a product-focus to an information and IT-driven businesses.

Monetize your latent assets

Content-based firms are beginning to mine the dormant value of their assets, brands and capabilities. Specifically, media companies are evolving from content producers to content custodians and facilitators. For example, leading publications like Bloomberg and The Economist have begun charging higher fees for their subscriptions and have enacted online pay walls. Importantly, they are also exploiting their extensive content and analytics capabilities to deliver research and knowledge leadership services.

Consider new pricing models

Pricing innovation can be cross-pollinated across many sectors. A variable pricing model – where the price changes in real-time based on demand, time or other factors – already proven in the airline industry can be applied to the hospitality, retail, software and entertainment industries. For the past decade, the big aircraft engine companies, including RR, has been providing engines at no charge but billed on a pay-per-time basis (plus support, of course). More than 80% of RR’s engines are now sold this way. New micro payment models like Zipcar (subscription-based and hourly car rentals from staggered locations) and iTunes (purchase 99 cents songs versus more expensive albums) allow consumers to purchase things in small increments from multiple parties, based on their unique needs. Very often, this model spurs product demand, delivers higher margins and increases revenue per use.

Pricing innovation can significantly impact a company’s business model. For a gaming firm like Microsoft, a change could involve the shift from a single X-box game launch every 1-2 years to a 365-day business, with packaged good launches sustained by frequent updates, downloadable content and extensions into social and mobile platforms.

Raise your prices

Contrary to conventional wisdom, it is possible (and essential with rapidly increasing input costs) to raise prices in low growth environments. However, managers need to be smart about how and where they do it. Opportunities to increase prices often exist in sleepy or price inelastic product categories where the firm faces weak or non-existent competition and channel partners, where their pricing is not aligned (i.e. it is too low) with value delivered or where the switching costs of leaving one supplier for another are high.

Organic revenue growth is very possible if leaders are willing to rethink their business model, better understand their customer’s needs & habits, and refine their product and service offering. All that is needed is curiosity, an analytical approach and courage.

For more information on our services and work, please visit the Quanta Consulting Inc. web site.

Renewable energy’s moment of truth

After 30 years of booms and busts, the renewable energy industry is at a crossroads.  Between 2003 and 2008, the sector (which includes solar, wind, biomass and geothermal technologies) expanded rapidly, propelled by strong government support, high levels of private investment, technological innovation and high fossil fuel prices. However, since 2008 the RE industry has stumbled due to slower economic growth, power generation over capacity and declining competitiveness due to falling natural gas prices.   

Will the sector bounce back and grow to become a mature industry or will it fall victim to the classic boom-and-bust new technology cycle?  Two recent arguments highlight the current level of uncertainty surrounding the business. 

Booz & Co. argues that RE has finally evolved into a self-sustaining industry based on some key developments:

Geographic dispersal

RE sources are no longer confined to a few regions or markets. For perspective, 55% of the U.S.’s RE capacity in 2005 was located in just two regions (the western and southeastern regions).  Today, thanks to generous subsidies these two regions represent just 40% of a larger total capacity.  Dispersal is also occurring globally with each region now able to select the optimal mix of energy sources that suits their needs.

Technology diversity

RE is more diverse today than it was 20 years ago (when biomass was the only game in town) thanks to major advances in solar and wind technologies.  These advances have delivered major improvements in project usability, cost reduction and generation capacity.  As a result, most local areas now enjoy a variety of competitive RE alternatives; falling installation & operating costs and; a greater range of consumer and industrial applications.

Too big to fail

RE is now big business supporting a strong foundation of global and local players who have committed billions of dollars to new production capacity, distribution and R&D.  This investment is unlikely to evaporate in a market slowdown.  In most regions, a large ecosystem of critical support services has evolved including project installers, sub-contractors, and energy brokers.  This ecosystem can help accelerate RE’s share of the energy market beyond current single digit levels.

So RE has a bright future…or does it? A recent article in Foreign Affairs, “The Crisis in Clean Energy” contends that the industry is headed for a crash due to 3 fundamental challenges:

Weak economics

Most RE programs are not financially viable without generous government subsidies, regulations, and tax credits. This intervention has led to market distortions that do not reflect optimal investment allocation and market pricing. Capital has flooded into technologies and capacity that are subsidized and easy to build today but are unlikely to be innovative and large enough to compete against traditional energy sources in the long term.  In fact, over 85% of all RE investment has been plowed into technology that is not financially viable without subsidies.  Any declines in the price of traditional fuels – oil, natural gas and coal – will only worsen RE’s competitiveness and increase the reliance on subsidies.

Fading incentives

Given the existing economic and political climate, the RE sector can no longer rely on strong political and fiscal support.  Many governments are already pruning vital subsidies and tax credits.  Overall, these incentives provided 20% of all 2010 global RE investment.  Falling government support can not come at a worse time.  New industries typically depend on large and steady public/private investments to move from a start-up to a commercially-viable sector.  Moreover, the embryonic RE industry – utilities and multi-nationals notwithstanding – features hundreds of small firms who are highly vulnerable to changes in public policy and costs.

The bear is here

Equity markets are already foreshadowing problems. The WilderHill New Energy Global Innovation Index, which tracks the performance of 100 clean energy stocks worldwide, fell by 14% in 2010, underperforming the S&P 500 by more than 20%. As equity markets go, so does critical early stage technology and commercialization funding.  In fact, many North American venture capital firms have already scaled back or have canceled their RE investment arms.

Perhaps both arguments are right.  If the RE industry can weather short term economic storms and kick the subsidy habit, then it may be able to fully leverage a foundation of global industry players, capacity and expertise. The next 12 months will be interesting.

For more information on our services and work, please visit the Quanta Consulting Inc. web site.

Behavioral Economics 101: Influencing Customer Choice

Learnings from Behavioral Economics (and its related discipline behavioral finance) have important ramifications for many industries such as wealth management, consumer goods, insurance, healthcare, technology and professional services.  BE findings are grounded in science, based on cognitive and social psychology experiments conducted over the past 30 years.  Managers can use BE to help understand how consumers decide which products they purchase, when they purchase them and what they pay for them.   Firms that ignore these learnings run the risk of squandering capital, upsetting customers and missing revenue opportunities.  Although many BE principles are well known, it is surprising how many managers are unaware of the basic concepts when designing, pricing and distributing their offering. For example:   

Loss Aversion says that people strongly prefer avoiding losses to acquiring gains.  Some studies suggest that losses are twice as powerful, psychologically, as gains.  Loss aversion has many implications for marketers. To improve retention, use trial periods to take advantage of the buyer’s tendency to value the good more after she uses it. Additionally, when debating whether to reduce prices consumers would prefer to avoid a publicized price increase than get a price decrease (assuming the net effect of a price change is zero).

The Endowment Effect suggests that individuals tend to place a higher value on a product that they own versus an identical product that they use but do not own.  In consumer and engineering goods businesses, encouraging purchase of a good, as opposed to a leasing arrangement, is more likely to increase customer satisfaction. Furthermore, delivering a digital good in a package will communicate higher value because it provides a tangible manifestation of ownership (versus digital files on a PC)

People experiencing a Status Quo Bias will not change an established behavior unless the incentive and ease of change is compelling.  Research suggests that a new product must deliver 9 times the value as the incumbent – regardless of the risk profile – to incite someone to switch.  Though the existence of a SQB is obvious, many companies launch new products and upgrade old ones without delivering better value.  Even when the new product does have demonstratable benefits, many firms fail to communicate these advantages through advertising and messaging 

According to the Money Illusion, individuals tend to think of money in nominal rather than real terms (i.e. after the effects of inflation or extra costs).  As a result, MI can influence pricing in many ways. Price stickiness occurs when companies are reluctant to raise prices or change sales contracts in response to inflationary effects.  Not only does profitability suffer – especially if input costs are rising – but the brand image can slowly move out of synch with the desired price level. Furthermore, the MI suggests that an a la carte pricing approach (with costs added incrementally) will generate more trial than a bundled pricing strategy that reflects total cost.

Herd behavior describes how individuals can act together without planned direction.  Stock market bubbles and crashes are an obvious example of this effect.  Savvy organizations are leveraging herding behavior through crowdsourcing strategies that trigger word of mouth promotion, perform support and develop open source products like software. More tactically, marketers can exploit herding effects by using leadership positioning in advertising or by publicizing large client lists and case studies.

BE is not the final answer for all product or investment decisions.  However, managers would be prudent to heed its key observations as part of its product management activities. In a future post, we will consider how BE impacts strategic decision making in organizations.

For more information on our services and experience, please visit the Quanta Consulting Inc. web site.

iGetit – iTunes and Pricing Digital Content

Are iTunes and other purveyors of digital content leaving revenue on the table with their pricing practices?  Many suspected this and now there is empirical research to provide evidence.

Before April 2009, every iTunes song was sold at a uniform $0.99 price.  (Only after April 2009 has iTunes switched to a tiered pricing system albeit a crude one). Yet, in virtually every other market, similar products are sold at different price points reflecting diverse product attributes & configurations, local market conditions and different competitive environments.   Why do online content retailers like iTunes offer uniform pricing when others practice price discrimination?  

Based on what I have witnessed in firms selling digital content, their pricing strategy was not rooted in deep customer analytics and demand elasticity studies. Rather, the rationale for uniform pricing centered on the need for simplicity and the desire to get a $0.99 price point.  Revenue modeling was performed in a quick n’ dirty fashion and was driven off of the yearly revenue objective, as opposed to what would be the projected bottom-up demand at various pricing levels.  While simplicity and speed are their own virtues, new research suggests that iTunes and other digital content retailers can maximize profits through different pricing schemes.

A new study from The Wharton School of Business studied how buyers and sellers of online music valued songs under different pricing schemes.  Studying over 23,000 different song valuations over the past 2 years allowed the researchers to measure total revenue based on different demand projections at various pricing levels.  The conclusions were very interesting. The seller’s revenue was maximized at a uniform pricing per song that ranged from $1.46 to $2.30, significantly higher than iTunes’ $0.99 per song.

The Wharton researchers went further and evaluated a variety of pricing strategies.  One scheme, which is currently being utilized by iTunes in a limited way, considered a song-specific model.  In this strategy, more popular or contemporary music would carry a higher unit price than older music.  The results indicated that this tactic would raise total revenues by only 3% versus a uniform price strategy.

The model that maximized revenue (and generated a 30% lift versus the best uniform price point) was where the online seller charged an entry fee for use of the service and then a modest fee per song.  The study determined the optimal entry fee to be $21.19 and the optimal price per song to be $0.37.  Some firms have figured this out.  Spotify, an iTunes rival, has developed a similar “all you can eat” model with its premium service.   Interestingly, the research also showed that bundling songs (similar to an album) with a higher package price – but at a per song discount to the $0.99 price point – produced almost identical revenues as the entry fee plus price per song model.

As any COO worth their salt will tell you, there is always extra cost (e.g., complexity, implementation) to deploying multiple pricing schemes as compared to a uniform pricing strategy.  However, as the Wharton study proves, it should be possible through comprehensive research and testing to determine the optimal pricing model and price points that maximizes revenue, safeguards customer goodwill and minimizes operational cost.

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The High Cost of Free – The Freemium Revenue Model

Is there truth to Milton Friedman’s famous adage that ‘there is no such thing as a free lunch’?  Many technology executives would say no.  Once the sole purview of retailers, consumers goods firms and media channels,  giving away free products and services is now the rage in a number of sectors including software and social media.  Many Web-based B2C and B2B companies, like YouTube, Facebook and Skype, have attracted attracting millions of users by giving away their service in the hope of making money from them in the future through premium upgrades, advertising and up sells like support and documentation. 

This Freemium business model is appealing for firms that enjoy high gross margins, low distribution costs, and where the software purchase cost is a small proportion of total cost of ownership.  On the consumer side, convincing only 1% of millions of users to pay is enough to reach profitability, given rich margins.  The economics are also appealing for B2B software vendors.  Software purchase cost often makes up only about one-fifth of the total cost of IT ownership once integration, training and support are factored in.  For a solutions provider, giving away proprietary or packaged open source software (which helps lock clients in) but charging higher prices for other necessary services has proven to be a lucrative model for many firms including Red Hat, Sun and Dell.

However, while appealing in principle, freemiums are a challenge to make work.  According to reports, Flickr, Skype (which eBay wants to unload), and YouTube are not yet in the black while many others suffer in the twilight zone of low market penetration.  For many of the popular social media sites, advertising and affiliation programs was always the easy answer for making free pay. But that rarely covered expenses even before a glut of advertising space and a severe recession cut the revenue stream. 

Firms that are tempted by the Freemium strategy may want to consider a few things-

  1. Fickle consumers – With zero sunk cost, many consumers will quickly jettison free products or services (can you say Friendster, MySpace) even when there are switching costs.  Ensuring loyalty let alone driving conversion to paid products is difficult to do without higher marketing spending and regular improvements to the customer experience. 
  2. More complex offering – Firms need to define, market and organize themselves more broadly as a solutions providers versus pure-play software builders.  This challenges focus, scalability and operating leverage.
  3. Lower brand value – Free product usually signals low perceived value and brand image.  With that comes low emotional commitment and product loyalty.
  4. Reduced strategic flexibility – Without the pricing lever, charging nothing gives you little strategic room to attract customers outside of functionality and user experience, all of which can not be supported by zero operating margins. 

Perhaps Milton Friedman was on to something after all.

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