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Value Based BUYING

Value Based PRICING is the most highly recommended pricing technique by consultants and academics.  The basic concept is setting a price to capture the majority of what your customers are willing to pay.  Before we explain Value Based Pricing, let’s look at Value Based BUYING (VBB).  VBB is how your customers make their decisions when they deliberate about which product to purchase.

Imagine you are at the grocery and you want to buy a can of green beans.  Two cans catch your eye, Safeway Select is a store brand and Del Monte is a National Brand.  Safeway Select costs $1.49 and Del Monte costs $1.69.  How do you choose?  You ask yourself, is the Del Monte can worth 20 cents more?

Is it worth it?   To answer this, you think of everything that is different between the two cans.  You may have had better experiences with Del Monte brand.  One may have less salt.  One may be cut differently.  One may have a prettier label.  It’s completely up to you as to what you think is important.  After you’ve determined the important differences, you place a value on them and then decide if the Del Monte brand is worth 20 cents more than Safeway Select.

Of course you don’t actually do this math.  But that is how your mind makes the decision.  You ask yourself and answer the question, is the Del Monte can worth 20 cents more than the Safeway Select can?

Notice there is no right or wrong answer.  People are different and value things differently.  Some people will prefer Del Monte and others will prefer Safeway Select.  This fact is important when we turn this around in the next blog to discuss Value Based Pricing.

Action:  You’ve been asking your customers what they would have bought if not yours.  Their answers tell you who your toughest competitors are.  Choose one of these competitors and do the Value Based Buying math for yourself.  How much is your product or service?  How much is your competitor’s?  What are all of the differences?  (Don’t be biased.  Be sure to list the areas where your competitor is better.)  How would you value these differences?  How do you think your customers value these differences?

Thinking About Competition

How much do you know about your competitors?  If you’re busy running your own business, probably not much.  Do you know what?  That’s how much your competitors know about you as well.  Not very much.

The lesson to take away is that in most small businesses and in most industries, your competitors are oblivious to your marketing moves.  They don’t see your small price changes.  They are not going to react to them.

So … don’t obsess about your competitors.

You are not in a life or death fight with your competitors.  This is not a game where one of you has to lose and the other has to win.

The only scorecard is how much profit does your company make?  How much money do you put in your pocket?  And at the end of the day, month, quarter or year, nobody compares your score with your competitors.  The only people who really care about your score (income) are you and the IRS.

How should you think about your competition?  They are a data point.  They are an important data point, but they are just a data point.  The only thing that is important about your competition is what your customers and potential customers think about them.  That’s it.  (OK maybe this is an over simplification, but so what.  If you’re a small business person, it’s true in your situation.)

Action:  (same as last blog)  Talk to your customers.  Have conversations with them and in the process work in the following questions:  What other products (or services) did you consider?  How did you decide on this one?  What other sales channels did you consider?  How did you decide on this one?  This is what we want to know about our competition, what our customers think about them.

ps – Price Wars do exist, but they are pretty rare.  Most companies are too into their own world to even know what you are doing, let alone react to it.  Unless you do something “in their face” you will probably not prompt a price war.

Will I? Which one?

Will I?  Which one?  These are two questions your customers answer every time they deliberate about a purchase.  Will I buy a product (or service) in this category?  If so, which one will I buy?

Are you in the market for a new car?  If so, you’re probably looking at your options.  If not, you probably aren’t.

Will you buy chips at the grocery?  If so, which one, Doritos or Lays or …?

Will I? — In an established market, pricing lacks the ability to influence someone to buy in a product category.  Somebody will purchase in a category when they believe there is enough value for them in the products in that category.  You can either build products in categories that people want, or use marketing to convince them they need a product in your brand new product category.  Either way, relatively small changes in price have no effect on customers’ decisions whether or not to buy in the category.

Which one? —  Price plays a huge role in this decision.  Once a potential customer decides to buy a product like yours, they compare your products with your competitors and make a decision based on which one will give them more for the money.  Which one gives them the most value.  Which one meets their needs at the lowest cost.  In any thoughtful decision process at this stage, price is an important factor.

As pricers, we will focus almost exclusively on “Which one?”.

Action:  Talk to your customers.  Have conversations with them and in the process work in the following questions:  What other products (or services) did you consider?  How did you decide on this one?  What other sales channel did you consider?  How did you decide on this one?  The answers to these questions are crucial to our pricing decisions.

Price Segmentation – Introduction (and ID for discount)

Price segmentation is THE MOST POWERFUL TOOL you have at your pricing toolbox.  Every company, big or small, must be thinking about price segmentation.

What is it?  Price segmentation is simply charging different prices to different people for the same or similar product or service.  You see examples every time you go shopping:  student prices at movie theaters, senior prices for coffee at McDonald’s, people who use coupons and many more.  The industry that probably does price segmentation better than any other is airlines.  It seems that no two people on a plane payed the same price.

Whether you’re a retailer, restaurant, software company or building physical products, price segmentation applies to you.

The academic literature (sorry for saying that word) describes many characteristics and requirements for price segmentation, but in reality, there are only 2 steps to implement it:  1. segment the market and 2. create a mechanism to charge them different prices.

1.  Segment the market – The first requirement is to find groups of customers, some that are willing to pay more than others.  To keep this simple, let’s hold it to 2 segments, those willing to pay more and those willing to pay less.  Let’s call them the “rich” and the “poor”. This is a pretty common segmentation anyway.  In general poor people are more willing to invest time, energy and effort to get low prices, while rich people are more likely to just buy what they want.

2.  Create a pricing mechanism – This is much harder than it seems.  You can’t simply put up a sign in your store that says “Rich people – $10;  Poor people – $5”.  Nobody would ever confess to being rich. You need a way to get the rich people to voluntarily pay the higher price.

The best way to learn price segmentation is to go through examples.  Let’s look at students at the movie theater.  The movie industry has determined that most of us (non-students) are the “rich”, and students are the “poor”.  This may not be perfectly true, but in general it would be fair to say that students who don’t have full-time jobs are less well off than those of us that work for a living.  However, the movie industry still wants them to come to the theaters so they want to charge them less.  The way they do this is to offer a discount to students, and in order to get the discount, you have to show a student ID.  That way most of us pay the normal price and students get a lower price.

Let’s broaden this a little.  Showing a student ID to get a discount at the theater is an example of a broader type of price segmentation:  ID for discount.  This is used in other ways as well, like when seniors show an ID for a discount.

Action:  How can you ask for an ID to give a discount?  Will seniors or students pay less for your product service?  If no, begin thinking of other price segmentation methods you may be able to use.

In the next several blogs we will look at more examples of price segmentation in action.

Pricing Framework

Pricing is not simple.  There are so many unique characteristics, so many factors to consider.

One way to make pricing easier to understand is to use a framework on how to think about it.  Our pricing framework has 4 components, listed in order of their importance.

  1. Immutable laws of pricing
  2. Price (customer) segmentation
  3. Product categorization
  4. Tactics

Some immutable laws of pricing are necessary to make sure we are all thinking the same way.  The most important one discussed so far is YOU create the value, pricing only captures it.  We will add more over time, but this one is the most important for you to understand while we start. Think of these laws as describing the pricing environment and everything we do will fit within it.

Price segmentation is the first and most profitable pricing technique almost any business can use.  It is the process of figuring out which customers are willing to pay more and creating mechanisms that get them to do so.  The next post will introduce this and start you thinking along those lines.

Every product (or service) needs a purpose.  Why do you offer it?  Once you’ve defined the reason you sell a specific product or service, you can create a price that is consistent with this reason. One example is that a grocery store advertises their very low price of milk to attract shoppers into their store, so milk is a loss-leader.  Over time we will define many purposes a product can fulfill.

The last category, Tactics,  is a catch all where we will discuss miscellaneous pricing techniques like when to use 99 cents at the end of a price.  These are fun, but typically much less important than customer segmentation or product categorization.

Pricing Is The Most Powerful Lever

If there isn’t a magic price that creates a ton of value, then why bother?  The answer is that pricing is the most powerful lever you have to increase your profitability.

Let’s go through an example.  A typical well run Subway franchise may take in about $365,000 per year in gross sales.  However, by the time the food is purchased, royalties are covered, labor, rent and other overhead are paid, the owner may walk away with$60,000 of profit.  If, just through pragmatic pricing, the owner is able to raise prices an average of by 5% without decreasing volume, then the revenue will go up by 18,250.  Since the expenses don’t go up, the owner pocketed that all and now earns $78,250.  This is 30% more income for the Subway owner.  That 5% increase in price generated a 30% increase in profit.  That’s leverage.

Subway is a very well run franchise and there may not be an opportunity to increase prices at all, but what about your business?  Most businesses have opportunities to improve pricing, you just need to look for them.

Action:  How much revenue does your business take in?  How much profit is generated by that revenue?  What if you could increase your revenue by 5% without increasing your costs.  How much additional profit does that generate for you?  Is it worth working at this?

The Magic Price is like Santa Claus

Many people I talk with have this belief, maybe it’s just a hope, but a belief that if only they had the right price they would be doing so much better than they are now.  This belief in a magic price makes us feel good, just like Santa Claus makes us feel good.  However, neither are true.  Bummer.

Go back and revisit the last blog YOU Create Value, Price Only Captures It.  You create value with your products, your services and your marketing.  There isn’t a price that will magically create so much value that customers will flock to your product.  In a few circumstances price can add a little bit to your perceived value, but not a Santa Claus amount.  A magic price just doesn’t exist.  Sorry.

So why should you care about pricing?  Because it is amazingly profitable.  A small improvement in pricing can produce a large increase in profit.  See the next blog titled “Pricing Is The Most Powerful Lever” for more details.

Action:  Admit to yourself that you hoped there was a magic price that would make you more successful.  Now repeat after me:  “There is no Santa Claus, and there is no magic price.”   It’s almost time to roll up your sleeves and do some real work on pricing.

YOU Create Value, Price Only Captures It

The value of a product or service is measured by how much your customers are willing to pay for it.  The price you charge is your best estimate of your customers’ willingness to pay.  In its simplest form, your potential customers compare your product with your competitor’s product and your price with your competitor’s price.  If they decide to buy a product in this category, they will buy the one that they think is the best deal for them.  (The term product in this context means products, services, and all of the pieces of the offering like warranty, support, delivery, etc.)

So how much can you charge for your product?  It depends on how much your competitor charges AND MOST IMPORTANTLY how your product is different from your competitors.

If your product is better than your competitor’s, the amount you can charge is the price of your competitor’s product PLUS the amount your customers value your product over the competitions.

If your competitor’s product is better than yours, then you will charge less than your competitor.  Your product then appeals to the price sensitive buyers.  Firms who compete on price focus on keeping their costs as low as possible.

You create real value by improving your products and services relative to your competition, or if you are competing on price, by lowering your costs.

However, consumers don’t buy real value, they buy perceived value.  What do they think about your product?  You may have the best product attribute in the world, but if the customers don’t know or believe that, they won’t pay you a premium for it.  Marketing is about making sure your customers perceive the value you offer.  The best and easiest marketing plans though are about making sure the customers know your real value.  In other words, build real value and communicate honestly about it.

Price turns perceived value into revenue.  Think of it like a value scorecard.  The more value you create and communicate, the higher the score.  As a businessman, you should spend more than 80% of your effort creating real and perceived value for your customers and less than 5% of your time on keeping score (pricing).  (The other 15% is all that bookkeeping and administration stuff we have to do.)  One fantastic byproduct of studying pricing is it will point out areas where you can focus on creating more value.  More on this in later blogs.

Action:  Select one of your products and compare it to your closest competition.  List all of the differences both in your favor and in your competitor’s.  Be sure to include all of the extended attributes like service and warranty.  Think of a single customer and estimate how much that customer knows about and values the differences.  Now brainstorm at least 3 actions to increase your real value.  Brainstorm at least 3 actions to increase this customer’s perception of your value.  Do any of these actions make sense to implement for your business?

Welcome

Welcome to Pragmatic Pricing.  This is the “How To” site for pricing for small businesses.

First, a little about me (sorry).  I love Pricing.  My pricing accomplishments include:  a Ph.D. in pricing (actually marketing) from U.C. Berkeley; a position teaching pricing for 4 years at Ohio State; consulting with several companies on pricing projects; and currently on staff in pricing at a large company (National Semiconductor).

And I read a ton of pricing books and articles.  Pricing books are fun for people like me.  You know … pricing geeks.  For you … probably not.  The common theme in most pricing books is they are about the theories of pricing.  If you’re a small businessperson, you probably don’t care a whit about pricing theory.  You want someone to tell you how to set your prices to improve profitability.  You want actions, not theory.  Hence, the name of this site, Pragmatic Pricing.

Merriam Webster defines pragmatic as “2 : relating to matters of fact or practical affairs often to the exclusion of intellectual or artistic matters : practical as opposed to idealistic”

This site is not about theory.  This isn’t the art of pricing.  This is about practical steps you can do using price to improve your profitability.  You should expect to read about specific action items.  Early in this series we will talk about general concepts (with specific actions) and these concepts apply to every business.  Later, as we dive into very specific actions, some of them may not apply to you.  But for the foreseeable future, please keep coming back because these pricing concepts and actions will make you more profitable.

Thank you for joining us.  Your feedback, participation and/or questions are welcome and appreciated.

Cheers,

Mark Stiving