Archive | 4. Pricing Dynamics

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You Need A Reason To Raise Prices

Face it, people hate price increases.  You probably hate them when you are the buyer.  Purchasing agents at large corporations get bonuses based on how big a discount they get.  Price increases directly impact their bonus.  Obviously they don’t like them.

If you raise your price for the simple reason that you want to make more profit, people will hate you.  Maybe a little harsh, but think about the grocery store during a natural disaster that raises the price of bottled water from $1/gallon to $4/gallon.  People only buy it if they have to, and they despise the grocer for taking advantage.

However, it is possible to raise prices if you have a good enough reason.  The most common and obvious reason is your costs increase.  Although purchasers may not be happy, they accept the price of gasoline goes up when the cost of oil increases.  Remember the blog “Chocolate Rising – Price Increase at Hershey’s“?  Hershey was announcing a price increase and blaming the price of sugar.

However, there are other reasons besides cost increases.  This past week there was an article in “Inc” magazine “How I Got Started” which tells the story of how Robin Chase, Founder of Zipcar, had miscalculated their costs early on and had to raise prices if they were going to survive.  She wrote an honest forthcoming email to her customers explaining the predicament, apologizing, and telling them zipcar had to raise prices by 25%.  She received 21 responses and only 2 were complaints.

What is great about this story is it shows that people are willing to accept price increases for the right reasons.  Besides cost increases and humble apologies, what other reasons might they accept?  Another one is limited supply and high demand (yield management) like hotel rooms during the super bowl. (This is different from gouging for water during a disaster because people can choose whether or not to go to the super bowl.  They may not be able to choose if they need water.)

Besides increasing costs, honest mistakes and yield management, can you think of other reasons customers would readily accept price increases?  If so, please share them.

Here’s another twist.  You only need a reason to raise prices if you’re going to raise them on people who know your prices.  If you always sell to new customers, then you can raise prices without feeling their wrath.  Just don’t forget you have competitors.

Mark Stiving, Ph.D. – Pricing Expert, Speaker, Author

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Photo Credit: gfhdickinson

 

The Rise and Fall of Gas Prices – Why so Fast and Slow?

This morning while watching CNBC they were talking about how oil prices are down but we aren’t seeing relief at the pump yet.  When they asked their guests, “why do gas prices go up quickly with the price of oil yet come down slowly when oil prices drop?”  both guests essentially said “I don’t know.”

Do you know?

Economic theory says …  OK, you don’t care about economic theory.  Here’s the practical answer.

When oil prices go up, two major things happen.  First, it is a clear signal to all involved in the channel that we can raise prices.  That’s nice, but it probably isn’t the driving factor by itself.  The most critical factor is the cash flow of the gas station.  Imagine a station owner has a 10,000 gallon tank underground, and he filled it up for say $4.00 per gallon, so he paid $40,000.  In general he makes about a $0.05 per gallon profit, so he expects to get $40,500 back from his investment.

Now if the price of oil goes up 10%, he knows the next time he buys he will have to come up with $44,000 to fill his tank.  These guys aren’t sitting on a lot of money, so they raise prices now to have the money to pay for the next delivery.  The good news for him is all of their competitors are doing the same.  In fact, he and his competitors receive that same clear signal (oil prices are up) at the same time.  It looks like they are coordinating, but they just happen to do the same thing at the same time.

If you care, this is what economic theory says as well.  Prices should be set at the replacement value of the inventory.  Of course that’s not the whole story, because we still have to look at what drives prices down.

Why don’t prices come down as quickly as they go up?  Because a different market force, competition, drives them down slowly.

Imagine two gas stations across the street from each other (and the only ones for miles and miles).  Both have high prices due to high oil prices.  Then the price of oil and hence their price of gas goes down.  If they both keep prices high, they both make good profits.  But one of them decides to lower prices by a penny just to win a few more customers. Then the one across the street lowers his by two pennies.  This goes until they both are at the threshold of what they are willing to sell for and consumers are finally buying gas at the price we would consider “normal” for a specific price of oil.

To summarize, gas prices go up quickly because the station owners use the oil price as a signal to raise prices.  Gas prices go down slowly because competitive forces aren’t as fast as the instantaneous signal.

If you know anyone at CNBC, have them give me a call.  I’d be happy to explain it.   🙂

 

Mark Stiving, Ph.D. – Pricing Expert, Speaker, Author

photo by Neato Coolville

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Should You Raise or Lower Prices?

You are thinking about lowering your price 10% to capture more customers.  Should you?  

Ask yourself:  “Will you make more or less profit?”

The answer is, it depends on how much new business you think you can win and your current gross margin.  The chart on the right is called an iso-Profit table.  It tells you the percentage change in customers you need for a certain percentage change in price, assuming a specific gross margin.  Let’s go through an example.

You have have a product with 50% gross margin and you are considering lowering your price 10%.  This table says you need 25% more customers just to make as much profit as you currently do.  So before lowering your price, do you believe you can grow your sales volume by 25%?  Not an easy task.

On the other hand, if you consider raising price on your 50% gross margin product by 10%, you can lose 17% of your customers and still break even.

Look at the 25% gross margin column.  Lowering price by 10% requires a 67% increase in sales volume.  It is obvious why you wouldn’t want to lower prices on low margin parts. In fact, you could raise prices by 10% and as long as you lose fewer than 29% of your customer you will make more profit.

The cells with N/A mean it’s impossible to make up the profit.  For example, if you have a product with only 25% gross margin and you lower the price by 30% you lose money on every item sold.  It is impossible to make up the profit you had at 25% gross margin.

The lesson for today – Do not lower (or raise) prices without an estimate of its effect on your sales volume.  Then determine if you will make more or less profit at the new price.  Yes, there may be strategic reasons you want to make less profit on an item, but at least go in expecting a drop in profit.  Then you can be explicit on how you will make up that profit elsewhere.

 

Mark Stiving, Ph.D. – Pricing expert, Speaker, Author

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Lipitor Pricing – It’s Value Based

Introduced in 1997, Lipitor produced $13 Billion of revenue per year at its peak.  Although there have been some alternatives available for quite a while, none work as well as Lipitor.  But that is coming to an end. 

November 2011, Lipitor’s patent expired.  Although Pfizer will be using many tricks to maintain some high pricing for their branded product, they have already released their own generic version at half the price of Lipitor.  Experts believe that within 6 months many companies will have generics and the prices will stabilize around 10% of Lipitor’s current price.

Nothing earth-shattering here, just a great example of watching Value Based Pricing in action.  While the patent protection existed, Pfizer was able to capture a very large premium for Lipitor.  The alternatives were nowhere near as good, and customers find huge value out of preventing heart attacks.  Hence, people paid these high prices. This is “value in use”, the functional value of the product.

Now that the patent has expired, alternatives that work as well as the original (i.e. generics) will be coming onto the market.  Customers will have a choices.  Pfizer can no longer capture the “value in use”, they must charge for the value based at least partly on the prices of the alternatives.  This is “value in choice”.

Another dynamic we can expect to see.  The alternatives to Lipitor that were less effective but less expensive will suffer greatly.  As Lipitor generic prices plummet, so will sales of the Lipitor alternatives.

Lipitor, under patent protection, had the Pricing Power that Warren Buffet looks for.  Without patent protection, all pricing power is gone.

 

Mark Stiving, Ph.D. – Pricing expert, speaker, author

Photo by colros

Netflix Pricing Mistake?

Only time will tell if yesterday’s Netflix price hike is a mistake or not, but this is certainly a great learning experience.  We can make predictions of the results and then watch what happens.  Topics of interest include price increases, bundling,  segmentation, and most importantly costs.

Price increases – What phenomenal proof of the concepts raised in the post Consumer Price Increases.  That blog described how customers are on auto-pilot with repeat purchases, but when faced with a price increase they re-evaluate their purchase decision.  Read any commentary on the Netflix price increase and you find customer after customer claiming to cancel their subscription.  Even though I’m not effected that much, I’m considering changing or cancelling my Netflix subscription.  The point is the mere act of raising prices is causing many of their customers to reconsider their choices.  Probably not ideal for Netflix.

Bundling – OK, we don’t have all the data, but it sure seems that someone from Netflix should go to bundling school.  Here we have two products that are slightly complementary and slight substitutes.  Meaning, some people who signed up for DVDs enjoy the occasionally streamed video, and some who enjoy streamed videos likely enjoy an occasional DVD.  Put the two together in a package with a slight increase in price and most customers will choose both, not one or the other.  Netflix just forced every one of these customers to decide if they wanted one or the other or pay for both separately.  Possibly another solution would have been to slightly raise the bundled price, and be sure to offer each package separately.  The key here is to continue offering the bundle.  Netflix just killed the bundle.

Segmentation – I wish I had all of Netflix data right now so I could figure out what they are thinking (or not).   There are customers who currently buy the bundle but mostly use streaming.  There are those who buy the bundle but mostly use DVDs.  There are those who are heavy users of both.  I can understand why they might want to raise prices on those who are heavy users of both services, but not those who lean heavily one way or the other.  A small incremental price for a service rarely used seems like a great deal.  (I speak from experience in that they bundled streaming with my DVD’s, but I rarely use it.  So they have been receiving an incremental fee from me for months.)

Costs – More data I wish I knew.  How do they pay for the license to stream?  Is it per view or is it per subscriber?  This is actually an important question.  If it is per subscriber, then Netflix may have to “allocate” a large portion of each subscriber’s fees to pay the licenses.  In other words, they depend on say $5 per customer just to pay the content providers.  If this is the case, then a heavy DVD user (and light streaming user) may be a customer who costs them money to serve (i.e. no profit).

However, if Netflix pays per video streamed, then this is an amazingly bad decision.  Heavy DVD users don’t watch many streams and heavy streaming customers don’t watch many DVDs.  Why not take the incremental $2 per customer?   My guess is Netflix pays a fixed fee and them a small incremental per view fee after that.

I honestly want to scream when I read “Given the long life we think DVDs by mail will have, treating DVDs as a $2 add on to our unlimited streaming plan neither makes great financial sense nor satisfies people who just want DVDs.”  Are you serious?  Instead of streaming plus $2 for DVDs, what about DVDs plus $2 for streaming?  I would love to know their costs for serving each streaming customer.

From what I’ve read, it seems that Netflix’ goal is to get more people to move to streaming only.  However, the complaints with content and quality make it unlikely they will replace DVD’s completely.  They created a plan to force customers to choose quickly.

What would you do if you were Netflix?

Here is my proposal:

  • Raise the prices on the bundle by $1.
  • Make sure there is a DVD only plan available for $7.99.
  • Next year, raise the price on the bundle and the DVD plan by $1 each.
  • Do it again the next year.
  • Do it again the next year.  (Eventually the DVD business will be gone.)

These small price increases would move their customers in their strategic direction without alienating them so badly.

The best part about this whole situation … time will tell us what happens with the Netflix pricing decisions.  I believe Netflix will be pretty badly hurt by their decision.  You may recall a recent blog where I adamantly stated “Customers HATE price increases.”  My prediction?  Netflix will change this policy soon.  Let’s see what happens.

Raising prices again – New products

As I’ve said here several times now, customers hate price increases.  However, as pointed out to me several times this past week, customers only hate price increases they know about.  One example is the price of toothpaste.  If the price of toothpaste goes up from $2.49 to $2.69, does anybody notice?  It’s likely that customers purchase toothpaste infrequently enough that they don’t remember what they last paid.  Therefore, they probably wouldn’t notice the price increase.

The shrinking candy bar was an example of something you may be able to do to “hide” your price increases.  If customers don’t notice the change in size, they won’t notice the price increase.

Another technique, similar to the shrinking candy bar, is to change your product and your price at the same time.  Chris Hopf of Pricing Wire pointed out that Odwalla just changed their packaging.  They went from a 15.2 oz package to a new eco-friendly 12 oz package, a 21% decrease in package size.  Simultaneously they lowered their price from $3.29 to $2.99, only a 9% decrease in price.  They went from $.216/oz to $.249/oz, a 15% per oz price increase.  To be fair, the Odwalla Tweet site confirms that they changed the package and lowered the price to the channel.  The actual end price is set by the retailer.  Regardless of who gets credit.  The price to the consumer just went up 15%, but will probably never be noticed.

And that is the point.  The price increase will never be noticed.  Customers do not hate price increases they don’t detect.

What can you do?  Can you change your product and your price simultaneously to “hide” any price increases?  Besides size, you could create higher or lower quality products, or add or subtract features.  Changing the product and price at the same time obfuscates any intended price increases.

Please send me any recent examples you find.

Here Comes Inflation – Don’t Raise Prices Quickly

Norm Brodsky in the Street Smarts column of Inc magazine titled How to Prepare Your Business for Inflation shared his absolute confidence that inflation is on its way.  I agree.  Some of his advice for how to handle it was spot-on.  He suggests buying hard assets and, in situations like a lease where you are the buyer, lock in long-term contracts if possible.

However, Norm erred with the following advice.  “Finally, I would try very hard to raise prices, even if it’s just 1 or 2 percent a year. That way, when inflation spikes, you won’t have to hit your customers with a big increase all at once.”

I respectfully disagree.  First you should try using every trick in the book to avoid raising prices.  We had one tactic last week on Shrinking Your Candybar.  There will be more methods to follow.  However, if you absolutely have to raise price, my advice is the opposite of Norm’s.  Hold off raising prices as long as possible, and when you do, make it big so you don’t have to do it again for a while.

There are two big reasons for this.  First, you may recall the blog on “The Effects of Consumers’ Price Expectations on Sellers’ Dynamic Pricing Strategies”.  The article was by Hong Yuan and Song Han and was published in Journal of Marketing Research, Feb 2011.  The important take-away from this perspective is this:

Our customers tend to purchase the same thing over and over.  Their decision-making is on auto-pilot.  However, whenever we raise prices we force them to revisit their purchase decision.  The fewer price increases you use, the fewer times your customers re-think their decisions.  So use fewer price increases to keep more customers.

The second reason I recommend one large price increase over many small increases lies in the graph to the right that describes prospect theory.  In this graph, the axis labeled Losses and Gains represents the price increases and decreases.  The value axis is how much the customer values the increase or decrease.   Notice the curve in the lower left area.  This curve implies the following:

Your customer may dislike (have a negative value) of a 10% price increase by some amount.  Your customer will dislike a 20% price increase more, but not twice as much more.  So one price increase of 20% creates less negative value than two 10% price increases.  Let me say that again in different words, because it’s important.  You will tick off your customer less with one large price increase than with multiple smaller price increases that total the same.

My advice – try very hard to not raise prices.  If you have to, do it less often.  Infrequent larger price increases are better (less painful) than more frequent smaller ones.  As with almost everything in pricing, this is not a hard and fast rule.  You must pay attention to your competition and your customers’ responses.  But given a choice, opt for fewer price increases.

Mark Stiving, Ph.D.

Recession is over(?) – Shrink your candy bar

The recession is over.  Even if it isn’t, inflation is starting to grow.  Either way, you are likely wondering how you’re going to raise prices.

One truth of pricing is that customers HATE price increases.  We hate them both as consumers and as businesspeople who now have to find a way to pass them on, or make less profit.  How can you make up for your increased costs while minimizing the negative impact on your customers?  Shrink your candy bar.

“Inflation makes balloons larger and candy bars smaller”  said David L. Kurtz, business author.

Likely you’ve noticed or heard about how candy manufacturers handle this situation.  When costs increase, instead of raising the price of the candy bar, they simply shrink how much candy bar you receive.  They don’t change the package size, and the only real change on the label is the new net weight.

I’d like to tell you the story of how when I was a kid we’d ride our bikes down to the apothecary and spend a quarter on a candy bar.  Then one day, seemingly just like any other, I arrived with my quarter in hand, starving for a Snickers bar.  I purchased one, gobbled it down, but was still hungry.  They gave me less Snickers in my bar.  I was upset!  I had been cheated!!!  I stormed up to the counter guy and screamed “WHERE IS THE REST OF MY SNICKERS BAR?” … I said I’d like to tell you this story but you see it isn’t true.  Throughout my entire childhood I bought Snicker’s for a quarter and never noticed that they continued to shrink the candy bar.  And that’s the point.  I never noticed.  And neither will many or most of your customers.

By shrinking the candy bar, we don’t notice the change as much as we would if they had simply raised the price.

What does this mean for you?  Is there something you can do to lower your costs that your customers are likely to not notice or care a lot about.  You can even de-bundle the feature or service and offer it as an option the way the airlines have de-bundled checked baggage service.  If you currently offer free shipping, can you de-bundle that?  Can you slow down the speed of your free shipping to save some costs?

Undoubtedly you’ve known about shrinking candy bars before this blog, but have you ever thought about how to apply this concept to your business?  Now is the time.  Good ideas won’t come easy so you’ll have to think.  Then again, nothing worthwhile is ever easy.

This is but one tactic to raise prices without really raising prices.  More to follow.

I Hate Price Increases – Do It Better

Customers hate price increases. It’s a visceral animosity that just comes naturally.  You want to be very careful when raising prices to avoid raising this ire.

For example, I’ve had the same company clean my house for several years now.  A little over a year ago, my cleaner raised my rate 5%.  I wasn’t happy.  I thought about finding a new cleaner but didn’t want to go through the hassle so I sucked it up.  A month ago, they raised my rates by another 5%.  They accompanied it with an explanation that their costs had gone up, fuel costs. Unhappy and unsatisfied with the explanation, I cancelled their service and began the search for a new cleaner.

It was only 5%.  The time I’ve spent time looking for a new cleaner is probably worth more than I’ll save.  But I did it anyway.  Ouch.  This was painful for me and probably more painful for the cleaning company.

What can we learn?  Customers hate price increases, so do your best to not increase them.  If I could advise my cleaner on their pricing it would be to not raise prices on existing customers, rather raise the rates for new customers coming in.  It’s not easy to find new customers and customer acquisition costs are high.  Once you have a customer happily paying, make sure you keep him or her happily paying.  Raising prices causes many customers to rethink their previously automatic purchase decisions.  Don’t do it unless you absolutely have to.

Here is another way to look at this.  When I first selected a house cleaner, I likely compared several cleaners, their reputations and their prices.  When I chose one, the decision was made.  If the price next week is the same as the price last week, well, I already made that decision.  Why revisit it.  However, if the price next week is higher, then maybe the decision I originally made should be changed.  Maybe I should revisit the topic.  Of course this is the rational explanation, but let me assure you that my decision was also emotional.

From the cleaner’s perspective, it is always possible I was a “bad” customer and my cleaner was happy to see me go.  In that case, he did the right thing by raising my price.  Either I pay more and he’s happier, or I leave and he’s OK with that.  If you have to raise prices, consider only raising prices on your “bad” customers, the ones you would not be unhappy to see leave.

My cleaner attempted to do one thing right, he blamed the price increase on rising costs.  Unfortunately in his case it wasn’t credible.  How do higher gas prices significantly effect the cost of cleaning my house?  After all I’m paying for the electricity they use to run the equipment.  Customers are more likely to accept price increases when you can justify that your costs have gone up.  The justification has to be believable.

All pricing situations are different.  If you have a situation where you have loyal customers that purchase over and over again, then here is a summary of the lessons to learn from this house cleaner situation.

  1. Don’t raise prices
  2. If you have to raise prices, do it selectively.  Consider raising prices for only new customers or “bad” customers.
  3. If you still have to raise prices, justify it with increased costs.

The Pragmatic Pricer – Mark Stiving

Dynamic Pricing – Winners and Winners

It is amazing how people are instantly skeptical of companies, especially when they change pricing strategies.  The thinking probably goes something like “the only reason a company would change pricing strategy would be to get higher prices from their customers.”

This may be true most of the time, so maybe our skepticism is justified.  However, sometimes a new pricing strategy comes along that helps customers.  For example, Ticketmaster has been in the news lately for announcing they will be using Dynamic Pricing.  The idea is the price of tickets will be closer to what the customer is willing to pay.  The attractiveness of the concert or sporting event will drive the pricing.

The skeptics have come out.  The Washington Post opens their blurb with:  “Tickets to concerts might be getting more expensive. But don’t worry, that money won’t be going to scalpers – it will be going to Ticketmaster!”

Let’s look at this from the perspective of three different customers.

The first customer is the one who is willing to pay any amount to see an event.  They currently pay whatever scalpers charge, which is the market price for the ticket.  In the current system the producer of the event gets the face value of the ticket, Ticketmaster gets a fee, and the scalper gets the sometimes very large mark-up.  After dynamic pricing is implemented, the event producer will get the much larger face value, and ticketmaster probably gets a higher fee.  The losers are the scalpers who are cut out of the transaction.  The winner is the event.  It seems right that the performers get more when customers pay more.  The customer also wins since they eliminate the uncertainty involved with purchasing scalped tickets.

The second customer is the one who would like to see the event, but wouldn’t pay the face value.  Dynamic pricing will help him because the prices on empty seats will continue to come down.  The price may drop low enough that he is willing to purchase the ticket.  In this case, the customer wins because he gets to see the show he otherwise wouldn’t, and the event wins because they sold a seat that would have gone empty.

The third customer is the only one who gets hurt.  There are customers out there who are willing to pay the face value of a ticket plus the time and energy to stand in line and buy a great ticket when it is first released.  That option will be taken away.  No longer can someone trade effort or connections to get good seats at great prices.  The unfortunate result is these are probably the biggest fans, the ones a touring band would like in the front rows.  Yet if that is the goal, we can certainly create other methods to achieve it.

It seems to me that Dynamic Pricing by Ticketmaster is a great thing.  It makes more tickets available to those who wouldn’t have normally attended and it puts the profit from the big spenders in the pockets of the event producers and artists.  Wow, a method for the company to make more money while helping out the little guy.