Don't Settle for Price-Volume Trade-Offs

Hamilton Consultants White Paper

Anthony Nygren, Will Rodgers

Many business managers get trapped by their belief that raising prices in order to increase margin will lead to a loss of volume. Economics 101 and our perception of "market forces" have conspired to convince us that there is an inevitable trade-off between price and volume: that the only way to gain profit margin is to raise prices but enjoy less volume or to lower prices and hope that the volume will be stimulated such that overall profits are increased.

The good news is that there is an alternative that makes it possible to build both volume and profit margins at the same time...how? Through differentiated pricing. Differentiated pricing allows managers to target prices for particular segments of the market by identifying each segment's price sensitivity based on its perception of value. As a result, differentiated pricing often allows the business to reach customer groups it hasn't before, while capturing the full value of a product offering across the whole spectrum of customers. We will discuss below how companies as diverse as Dell, Federal Express, and Land's End have used this approach to pricing to fuel their success.

Because many business managers don't necessarily understand the theory behind these specific applications, there continue to be two common initial objections to the concept of differentiated pricing. The first-somewhat "knee jerk"-objection is, "it's too good to be true," or "it's downright illegal because Robinson Patman won't allow it." The second objection is that it can't be applied to commodity or near-commodity products because there is insufficient product differentiation. These reactions fail to recognize that a product is not simply a physical object-a widget; it is the physical object plus all of the attributes and services that are associated with the object as purchased by the customer. The value the customer ascribes to this "bundle" is the value of the object plus the value of the associated elements.

For example, a manufacturer of an apparent commodity product-paperclips-might be able to maximize profits through differentiated pricing by segmenting customers across product and service characteristics. Some customers may simply want as many paperclips as they can get for as low a price as possible. Others, however, may want only one specific kind of paperclip in one specific size and color. Others may want to be able to pick up the phone at any hour of any day and place an order for next day delivery. The different needs of each of these groups reflect different levels of value; different levels of value, in turn, call for different prices.

The Problems with the "One Price" Approach
Any one price, even if it has been developed on the basis of market data and in conjunction with overall marketing strategy, risks leaving a huge amount of money on the table. Because each customer-or more realistically, each customer segment-makes a value/price judgment, developing an "average" price at some mid-point along the spectrum of perceived value runs counter to the concept of aligning price and value. The result of this "average" price approach, represented in the following graph, is that the company ends up charging almost everyone the wrong price.

For each of the customer segments that perceive more value than is represented by the single price, profit is being lost. On the other hand, the segments that perceive less value than is represented by the price simply will not buy the product. While effective marketing and sales communications may be able to move each segment's perception of value slightly, this will still only capture those segments whose perceived value is closest to the average price. At the high and low ends, substantial revenue and profit is being left on the table. Moreover, selling a single product to a market at a single price often delivers the highest possible costs at the lowest possible price. This is because the most quality-conscious customer will define the quality level-effectively maximizing costs while the most price sensitive customer will define the price level.

TThe ideal pricing strategy, then, should follow the natural segmentation of the market based on perceived value. By setting prices at or just below the value realized by each customer segment, a company will maximize revenue and profit.

The role of marketing in this process is to identify the customer value segments and set prices accordingly. The role of sales is to maintain the differentiated pricing structure by selling on value, rather than just on price. To successfully implement differentiated pricing, marketing and sales must work together to understand customer needs and redefine the product/service offering in terms that intersect with these needs and will therefore maximize the perception of value. Often, definitions and perceptions of value differ within a single organization from one level of management to another. In such situations, success depends on identifying and targeting the level most likely to understand the full value of the complete product/service "bundle."

Differentiated Pricing In Action
The above chart describes in a basic way the theory behind differentiated pricing. As with any theory, however, the challenge-and the real test of its usefulness-comes in understanding how it can be applied to real business situations. There are three basic strategies for applying differentiated pricing successfully. These strategies are:

• "Product Line"
• "Service Convenience"
• "Value Added"

Product Line
A classic application of "Product Line" price differentiation can be found in the U.S. automobile industry-historically as well as today. The first large-scale manufacturer of cars, Henry Ford, believed that everyone wanted a low-price car and set out to satisfy that desire. However, General Motors realized that "one price for all" was the wrong price for many. They segmented the market across price and performance attributes and developed five "lines"-Chevy at the low end, followed by Pontiac, Buick, Oldsmobile and Cadillac at the high end-that were aligned with these identifiable customer segments. This approach fueled GM's success and dominance up until the '70s, when socioeconomic changes drove the rise of small cars and imports, once again offered at different price points to serve different customer segments.

Dell computer, like many computer and high technology manufacturers, has created infinite amounts of product by allowing the customer to buy a custom-designed computer. For example, one can get a Latitude C510 notebook computer through the Dell Web site for $1099, $1299, or $1755, depending on the customers' choices of the amount of memory, the size of the hard drive, and the features of the CD drive. In the retail clothing industry, Land's End has likewise created multiple iterations of the same product by offering men's shirts in many different styles, weights, and levels of quality. Thus it is possible to get a white men's button down shirt for as little as $18.50 and as much as $48.00.

Service Convenience
Overnight package delivery companies like Federal Express offer a textbook example of Service Convenience pricing. Fundamentally, Federal Express does nothing more than deliver packages from one location to another. They are able to differentiate prices, however, because customers can be segmented according to how much they are willing to pay for the convenience of faster delivery. Thus, shipping the same package from Massachusetts to California can cost $43.94 or $15.86 or $9.41, depending on whether it is delivered the next morning, the next afternoon, or within three days.

Moreover, the pricing of gasoline-a commodity product-is heavily influenced by service convenience. Gas stations closer to a highway and at a major intersections can charge more than those at less convenient locations because many customers are willing to pay more to avoid having to drive substantially out of their way to find gas. In the last twenty years, many stations have added another layer of convenience by offering consumables-snacks, drinks, magazines, cigarettes-in addition to gas. The prices for these items are substantially higher than in supermarkets because, for certain customer segments, there is value in the convenience of being able to buy at the same time as get gas.

Value Added
In publishing, the migration to an electronic platform has opened the door to the Value Added strategy of differentiated pricing. The shift away from the static print medium to the electronic has meant that "products" can no longer be conceived of as the traditional bound paper volume, but rather must be seen as the individual units of content. These content units can be reorganized, aggregated, and delivered in different ways to create a multitude of offerings to serve a diverse group of customers. At the New York Times online, for example, readers are able to obtain access, for a fee, to a handpicked collection of past articles on a specific topic. The added value here is the aggregation of specific articles of particular interest. Even the most basic transaction-charging a small fee for the ability to download or print a single article is an example of the Value Added approach to differentiated pricing in that it allows a customer to select and buy only what he or she wants. Casual readers may not be sufficiently interested in a publication's content to pay for a full subscription, but may be willing to pay for a single article of particular interest.

Entertainment events-theatrical performances, music concerts, sporting events-offer another opportunity for differentiated pricing. For any of these events, a customer effectively rents a seat that allows him/her to watch the action. Prices are differentiated, however, on the basis of the value added through the proximity of the seat to the action. While the action and the physical properties of the seats are exactly the same, a ticket to watch a Chicago Bulls home basketball game could cost $145, $90, $55, $42, or $26, depending on the location of the seat. For some customers, the value added through proximity would be worth the extra money, while others might be satisfied simply to be at the game.

The airline industry in recent years provides a good example of bad differentiated pricing. In high fixed costs businesses like airlines and other transport there is a mindset to use up all the capacity because the marginal cost of an additional customer is very small. Thus, the airlines provided low fares for anyone willing to schedule their seat well in advance and kept prices high for last minute business travelers. While this seems to be the kind of pricing approach lauded above, it actually created two significant problems. First, this logic only works for filling up one plane flight. What the low fares did, in essence, was encourage the airlines to add flights and evermore fixed costs at high lease rates and never really solve their problem of underutilized capacity. Second, the approach annoys the airlines' most profitable customer, the business traveler, by forcing him/her to pay ten times the rate of the person in the neighboring seat. At some point, some airline will figure it out (or will observe how commercial office owners rent space to compatible tenants at similar prices). Southwest remains one of the few airlines with a straightforward offer, simple pricing, and a user experience where everyone can understand the price/value equation.

Turning Theory Into Reality
Whatever the approach, developing a differentiated pricing strategy should follow a series of steps meant to avoid the kinds of problems described in the preceding paragraph.

• First, segment the market around the key components of customer value. Typically, an understanding of customers' price sensitivity must be arrived at through in-depth market research that focuses on learning what drives customers to make specific value/price trade-offs. These trade-offs must also be set within the context of existing market conditions and product/service alternatives.
• Based on this analysis, isolate market segments to the extent possible. In order to avoid the airline industry pitfall of antagonizing the most profitable customers, it is also important that these segments can either be kept separate in some way or that the price differences between the segments do not exceed the differentiated in perceived value.
• Once the segments have been identified and isolated, they can then be aligned with the optimum product/service offering using one of the approaches described above. In reality, customers can't always articulate perfectly what price/service offering would appeal most to them based on their perception of value. Often, therefore, the development of the "ideal" offering for each segment will be an iterative process involving both market research and field-testing.

The result: pricing that is right for everyone-including the seller, who should see a dramatic improvement on the bottom line.

Hamilton Consultants © 2002