five strategies for developing the optimum pricing strategy

 

  • Supply and demand.
  • Selling and buying.
  • Outputs and inputs.
  • Context and anchors.
  • Psychology and behaviour.

 

CUSTOMER-CENTRIC MARKETING

To be ethical, marketing must be customer-centric. For a business to be ethical, the marketing must be customer-centric. There are few things more unethical than convincing a human being they should buy something they neither need nor want.  

To maximise profitability and performance more generally, business and marketing, in particular, need to be customer-centric. Customer-centric marketing is the key to maximising sales, margins, the average sale per customer, repeat business rates and referral rates.

Like all other aspects of marketing, pricing can and should be customer-centric. Indeed, research suggests that the more customer-centric the pricing strategy, the greater customer satisfaction and business profitability.

PRICING

Perhaps no aspect of marketing is harder to get right than the pricing strategy. This may be why so many businesses rely on the simpleton ‘cost-plus’ pricing approach or simply rely on intuition to set prices. Indeed, pricing is too important to be left to a simpleton ‘cost-plus’ or intuition-driven approach.

My philosophy on pricing, supported by the science, can be summarised as follows:

  • The only value of ‘cost-plus’ pricing is to set a minimum price at which a business can afford to sell a product. It will never determine the optimum price.
  • The business will be more profitable, and the customer will be more satisfied when a ‘value-pricing’ model replaces a ‘cost-plus’ model in determining the final price.
  • Understanding the science, especially the psychology of pricing, is central to developing and adopting the optimum pricing strategy.

 

DEFINITIONS

There are four definitions worth addressing here:

  • Price– the payment that is to be made to purchase a product or service.
  • Pricing strategy– the approach an individual or enterprise employs to determine the rates they charge for their goods and services.
  • Optimum price– the price at which overall profitability will be maximised.
  • Value– the regard that something is held in and its importance, worth, or usefulness.

 

The important points here are:

  • The difference between a price and a pricing strategy. Strategy is about approach and process. It impacts the pricing over the long term.
  • The difference is between price and value, with the price being what the enterprise charges and the value being what the customer buys.
  • The importance of optimum pricing given its critical impact on profitability over the business’s life.

 

 THE IMPORTANCE OF PRICE

No one, I suspect, needs to be told how important price is as part of the overall marketing mix. It might be useful to note why price and finding the optimum price are so important. The optimum price for any good or service is the one that contributes most to maximising the lifetime value of each customer. The optimum price:

  • Strikes the right balance between maximising margins and unit sales.
  • Acts as a branding tool, adding value to the product being sold.
  • Drives satisfaction and repeat purchases when the customer senses value.

 

Price is too important to adopt a simpleton ‘cost-plus’ pricing approach or intuition. All businesses can benefit from a scientific, customer-centric approach to developing and implementing pricing strategies.

FIVE STRATEGIES

Traditional marketing strategies well documented in the literature and well practised in business include:

  • Cost plus– where the selling price of a product is determined by adding a fixed percentage to the production cost.
  • Penetration– where the price of a product is initially set low to rapidly reach a wide fraction of the market and initiate word of mouth.
  • Competition– where the sale price varies according to variations in the price of competitor pricing strategies.
  • Predatory– where the price is at such a low level that other firms cannot compete and are forced to leave the market.
  • Dynamic– where the price varies to reflect changing conditions, such as charging a higher price at a time of greater demand.

 

As important and useful as these strategies might be, this missive addresses more customer-centric approaches to pricing strategy.

QUESTION THE THEORY OF SUPPLY AND DEMAND

The theory of supply and demand dictates that when demand increases, prices will go up and when supply increases, prices will go down. This theory contends that when prices go up, demand goes down – and – when prices go down, demand will go up. However, while the theory of supply and demand might seem intuitive – like other theories in traditional economics – this one is often wrong.

This is demonstrated by the results of a famous Stanford University study.   This study considered two groups and wines at two price points each. Consumers were asked to rate the wines on a scale of 1 to 6 – giving rise to the following findings:

WINE 1

  • Priced at $5.00 – received an enjoyment rating of 2.25 out of 6.
  • Priced at $45.00 – received an enjoyment rating of 3.5 out of 6.

 

WINE 2

  • Priced at $10.00 – received an enjoyment rating of 2.5 out of 6.
  • Priced at $90.00 – received an enjoyment rating of 4.1 out of 6.

 

The traditional view, which seems to dominate thinking in Australia, is that price is simply a barrier to purchase – and, in line with supply and demand theory, that the higher the price, the lower the demand. This Stanford study suggests that price can also drive the perception of value. More than being a barrier to purchase, price is (some might say irrationally) a measure of quality – at least in the minds of consumers. More than anything, this study suggests that price is more complex a variable than many think. 

The facts are:

  • Price can be a barrier to purchase, with higher prices reducing demand or driving customers to purchase competitive products.
  • Price can be a driver of the perception of quality, with higher prices driving sales, at least among people who can afford that price.
  • Price can also impact customer satisfaction and, in turn, repeat purchases and referrals, where paying for quality reinforces a view of no compromise.

 

It is important not to rely too heavily on the theory of supply and demand. It is just not that simple. There are even examples in research and business were increasing prices has increased demand. A case study I read recently discussed a situation in which, following months of poor sales, a business owner told one of his managers to discount a range of jewellery by 20%. Miss-understanding the instruction, the manager instead increased the prices by 20% – a mistake that immediately led to increased sales of all jewellery.

Supply and demand sound clever, but humans are more complex than that.

THE DIFFERENCE BETWEEN WHAT IS BEING SOLD AND WHAT IS BEING PURCHASED.

The founder of Revlon cosmetics, Charles Revson, famously said – ‘In the factory Revlon manufactures cosmetics, but in the store, Revlon sells hope. The point is that businesses are invariable selling something very different from the consumer buying. Ultimately the customer is buying value, and it is important to know what that value is. 

Why is it that:

 

 As it turns out, while these findings seem to contradict each other – in the real world, they don’t. The fact is that while consumers may prefer the taste of Pepsi – when going to the store, they are not buying on taste. They are buying a lifestyle. While Pepsi is viewed as a great-tasting soft drink, Coke is seen as part of an attractive lifestyle, and it is the lifestyle customers are buying into.

Understanding this, Coke market lifestyle more than soft drinks.

The technology offered by Apple is most certainly advanced. Enjoying a 55.45% market share as of September 2022, one would think that the Apple I-phone represents the best smartphone technology on the market. But it does not – indeed, far from it. The fact is, however, consumers are not buying a smartphone. They are buying into the Apple branding – the lifestyle, ethos, values and image that Apple stands for – and what owning an I-phone says about the purchaser.

Understanding this, Apple markets style, lifestyle, and other elements of its brand – rather than a ‘smart’ smartphone. 

These two examples highlight the importance of understanding the difference between what the business sells and what the consumer buys. For Coke, the job is not to price a soft drink but rather the lifestyle. For Apple, the job is not to price a smartphone but rather an image. Further, it is almost certainly the case that a soft drink – no matter how good (just ask the vendors of discounted Pepsi) and a smartphone – no matter how smart – will sell for less than a lifestyle and style etc.

It is essential to understand what the customer is purchasing and base the pricing strategy on the value consumers perceive this to deliver. Prices should be based on what the customer is buying, not what the business is selling – and it is ‘what the customer is buying that will influence the perception of value and a price point. This is a big part of the argument for value-based pricing.

FOCUS ON OUTPUTS AND NOT INPUTS.

As a consultant, I am familiar with charging by the hour – that is, charging according to my input into a project. This approach to charging is both common and accepted. I would argue, however, that it is also flawed. It is flawed in that it pays little attention to the value I add in the time I am contracted to a project. It pays no attention to the fact that 10 hours of work will pay a different dividend to different clients.

Why should it matter how much time I spend drafting a marketing strategy? All the client is interested in is the marketing strategy and the value its implementation might add to the enterprise. Following the last section of this missive, while I am selling time – the client is buying a strategy. The client is buying the outcome of that time and the value that outcome can deliver. Further, in most cases, the more the perceived value, the more clients will pay – regardless of how much time I put in.

A client once told me of his experiences with a law firm. When he asked this law firm to complete a complex legal matter for him, they quoted $5000 – because no matter how complex – it delivered very little utility to him. On a second occasion, he provided a straightforward brief – to make an introduction to a prominent person they knew, but he did not. The quote was $10,000. When asked why the fee was so high, the law firm asked my client – ‘can anyone else you know make this introduction? As it turned out, this law firm had adopted a value-pricing model – they charged what work was worth to the client (output), not the time it took to complete (input).

This pricing model may not work for everyone – but everyone should probably consider it. It should at least be on the table. More broadly, however, the value pricing model per se can work for most, if not all, businesses. Why change less than a customer is prepared to pay – or less than would be called for by the value delivered?

Many people will respond by suggesting that their consumers are very price sensitive and will only pay as little as possible. Well, here is just one of the thousands of empirical cases that suggest they are wrong. Before launching a new generation of its Olay brand, Proctor and Gamble tested three price points

  • $12.99
  • $15.99
  • $18.99

 

At $12.99, the sales were good. At $15.99, sales tanked. Finally, at $18.99, sales peaked, causing P and G to price Olay at $18.99, generating $2.4 billion with ongoing annual growth. It seemed that consumers expected to pay more than $15.99 for a quality product and, as such, purchased more at the higher price of $18.99.

Don’t assume you know what the target market will pay or even what they are paying for. Think value and leverage research to inform a value pricing model.

CONTEXT AND ANCHORS.

Studying unknown quantities, researchers Tversky and Kahneman asked two samples of consumers what percentage of African countries were members of the ‘United Nations. The first sample was primed with the number 65 and reported an average of 45%, and the second sample was primed with the number 10 and reported an average of 25%.

People find it very difficult to estimate the unknown without anchors – reference points- more often than not, these anchors or reference points influence perceptions.

Consumers find it very difficult to judge value without anchors or reference points. If you were asked if $100.00 represented good value for a ‘Tskerm’, you would almost certainly respond with a blank stare. I know I would. How could I judge value without knowing what a ‘Tskerm’ is? Indeed, without understanding what other brands of Tskerm’ sell for, you would not know if this offer represented value.

Value is a perception based on rational and irrational assessment of a range of factors. Value is not absolute. Consumers make an assessment based on the information available to them. Value also varies over time. I will almost certainly pay more for s Coke when desperately hot and thirsty – while I would pay nothing for it under normal circumstances. Equally, I Might pay more for a Coke if sparkling water and other alternatives are not available.

Apple is well known for offering three product options – economy – mid-range, and premium, and in almost all cases, the ‘mid-range product’ achieves more than 60% of sales. The cheaper and dearer products provide a context in which the mid-range products are considered the ‘Goldilocks product’. This strategy is now used by businesses all over the planet and with great results.

There is no such thing as ‘absolute value’. Value is entirely contextual. Making value difficult to compare is also a strategy commonly used by health insurance companies and businesses that position the product they are marketing as being in a unique category. If a product is seen as in a unique category, it is easier to ascribe a higher value to it. The importance of anchors and context is highlighted in the following study by Daniel Ariely, where he worked with The Economist magazine, offering potential subscribers two purchase options:

OPTION 1 

  • Print and digital – $125.00
  • Digital only – $59.00

 

OPTION 2

  • Print only – $125.00. 
  • Print and digital – $125.00
  • Digital – $59.00.

 

 The findings were as follows:

OPTION 1

  • Print and digital – 32% of sales
  • Digital-only – 68% of sales

 

OPTION 2 

  • Print only – nil. 
  • Print and digital – 84%.
  • Digital – 16%

 

 By adding a third decoy option (Print Only for $125), the researchers increased the income of the Economist by 43% – without selling any of the decoy options. The decoy made the print plus digital (which cost the Economist no more, to appear to be superior value)

Understanding and leveraging the context is critical. An anchor or decoy adds context. 

The customer experience. Some would suggest that Joshua Bell is among the two or three greatest violinists in the world today. He is undoubtedly good – playing regularly at the greatest venues, including – Lincoln Centre. Kaufman Music Centre and Carnegie Hall. Tickets to his concerts sell for many hundreds of dollars, with box tickets attracting an even higher price.

In an experiment in 2007, Bell played his violin in the Washington subway, busking in front of thousands of people. Bell had a grand total of $52.17 in his busker’s hat during this busking concert. One of those contributing to the hat recognised Bell and, thinking he was “down on his luck”, put $20.00 in the hat – meaning that all the others gave just $32.17 – even though they were listening to one of the best violinists in the world. The latter would normally attract a ticket price in the hundreds.

Out of the context of a concert hall, Bell’s music quality is harder to judge. 

Here is another insight regarding context. A recent New York Department of Consumer Affairs study looked at 90 brands offering identical products (such as shaving equipment) – but targeting them differentially at men and women. Using subtle colours (pink and black) and design differences – some products were said to be for men, and others were said to be for women.

All products are sold in the manner expected and continue to be available. The study found that despite a lack of relevant differences between the products, those targeting women were an average of 7% more expensive than those targeting me. Further, it was found that 42% of products targeting women were more costly than those targeting men.

In this case, colour created a context and made the products more appealing to women, so much so that they were prepared to pay more. Thousands of factors can add the context needed to judge value and whether or not to purchase at a particular price point. Here are just some of them:

  • An anchor.
  • Availability
  • Service standards.

 

There are many more. Understanding the factors that add context is critical when developing a pricing strategy.

UNDERSTAND PSYCHOLOGY AND BEHAVIOUR.

Psychology is often used to manipulate consumers. That is not the approach recommended here. To be customer-centric, it is important to understand consumers and how they respond psychologically to critical stimuli like price and how a price is presented.

Psychological pricing occurs when prices are expressed in a way that appeals more to consumers. It is pricing that appeals to the consumer’s emotions. Psychological pricing strategies recognise the profound effect psychology has on how consumers perceive and respond to prices and how those prices are expressed. Examples of psychological pricing include:

  • The comma effect – where $1499 is seen as cheaper than $1,499
  • The number 9 effect – where $9.99 is seen as cheaper than $10.00.
  • The precision effect – where $325,425 is seen as lower than $325,000
  • The restriction effect – where 6 or 8 options trump an unlimited number.
  • The timing effect – ‘X for $29.00’ is better value than ‘$29.00 for X.”
  • The size effect – where $9.99 is considered cheaper than $9.99.

 

These are just some of the many psychological approaches to pricing that might be considered when drafting a pricing strategy and should be addressed in executing that strategy. These psychological approaches to pricing, and many more like them, can significantly impact the consumer response to a price or pricing strategy. All are backed by research and empirical evidence. Here are two examples:

Research by Thomas, Simon and Kadiyali found that for real estate, at least $325,425 may be considered cheaper than $325,00. They concluded that this was because $325,425 was seen as more precise and represented a more ‘considered’ price. Further, the consumer sees less room for negotiation when the price is viewed as more specific. Research suggests that precision, or the perception of it, is most important with larger numbers.

Research completed by Karmarkar, Shiv and Knutson involved giving participants $40 to spend and using an MRI to monitor brain function during the purchase or decision-making process.

  • Option 1 Showing the product and then highlighting the price.
  • Option 2 Highlighting the price and then showing the product.

 

The researchers found that when confronted with these options, the participants asked themselves different questions:

  • Option 1 – Do I like this product?
  • Option 2 – Is this product worth the price?

 

 Option one emphasised the product, while option two emphasised the price. As a result, participants asked very different questions. This is an important finding. Communicating value occurs much more readily when the consumer makes the purchase decision in terms of the quality of the product and not value economics.

INSIGHTS

  1. The psychology of pricing – consumers judge $1499 as cheaper than $1,499. 
  2. The psychology of pricing – consumers judge $325,425 as better value than $325,000.
  3. The psychology of pricing – consumers judge ‘X for $29.00’ better value than ‘$29.00 for X’.
  4. The psychology of pricing – consumers judge $39.99 as better value than $40.00 and $35.95.
  5. The psychology of pricing – consumers judge $1500 as being cheaper than $1500.00.

 

ANOTHER PERSPECTIVE

 

RECOMMENDED READING

 

 TIPS

  1. To price optimally – move past the weak theory of supply and demand. 
  2. To price optimally – distinguish what you are selling and what your customer is buying.
  3. To price optimally – place the priority on outputs rather than inputs. 
  4. To price optimally – manage the context within which purchases are made. 
  5. To price optimally – understand the 25 cognitive biases that impact perception. 

 

 QUESTIONS

  1. Why, when 80% of people in a blind taste test prefer Pepsi over Coca-Cola, does Coke enjoy nearly twice the market share of Pepsi?
  2. Why, when P&G tested three price points ($12.99. $15.99 and $18.99) for its Olay product, did unit sales peek at the $18.99 price point?
  3. Why would women pay an average of 7% more for shavers than men pay when the only difference is colour, with women’s shavers being pink?
  4. Why would $325,425 be viewed by consumers as better value for a house than $325,000?
  5. Why do Apple I-phones enjoy a 55% market share when the technology they are using is no better and often less advanced than that used by the competition?

 

STATISTICS

  1. 80%of leaders are good at crafting strategy, but only 44% are good at implementation 
  2. 61%of executives feel they are not prepared for the strategic challenges they face upon being appointed to senior leadership roles 
  3. Only 2%of leaders are confident that they will achieve 80–100% of their strategic objectives.
  4. Only 18%say that hiring people with the necessary business skills or leadership talent to drive strategy implementation is a very high priority at their firms. 
  5. 65%of companies are ‘somewhat ineffective’ or worse at introducing change caused by strategic initiatives.

 

Return on investment in marketing is maximised when the customer is at the centre of the strategic planning process. Many businesses claim to be customer-centric, but few are – resulting in higher marketing costs and a lower average customer lifetime value.

A customer-centric business understands the needs, wants, and expectations of its target market – why members do what they do – and how best to cause members of the market to behave in a way that maximises performance. 

I work with clients to understand customer needs, wants and expectations; and develop strategies that leverage the power of consumer behaviour to maximise return on investment while at the same time embracing the ethics of customer-centric business. 

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