Have you ever tried selling something on eBay? Doing so may be quite an exciting, as well as useful exercise for the purpose of this article. Forget about auction-style approach that made eBay famous in the first place and try the “buy it now” option. Not only will it make our exercise more realistic, it will also save you some money, given eBay recently changed their fee structure, making such transactions for the sellers 70% cheaper than they used to be 2 years ago.
Is your item sold yet? Then keep reading.
Quite possibly, the first thought that occurred to you was, “how much do I sell it for?” or something along those lines. Guess what? You are not the first one, you are not the last – such question truly exhausts business people of all ranks – from high-flying executives and directors to young entrepreneurs starting their ventures to mom and pop shop owners. Pricing, whether you like it or not, is among the most crucial and strenuous business decision you’ll ever make. So you better get it right.
What is the “right” price you ask? The answer to this question is mystifying yet seems much easier than it is when going through an economics or a marketing textbook. To the economist and to most newcomers to the world of business the “market” or the relative price is right – price at which the buyer and the seller are willing to transact. Surprisingly, a large number of firms are willing to accept what the market dictates and start working their way through by adjusting costs to derive desired level of profit. Problem with this approach, however, is that the price becomes an external variable – the one over which managers have no control. They become trapped in the world, where all they can excel at is cutting costs. Needless to say, such a trap changes the rules of the game, where race to the bottom becomes the ultimate result. Rest assured customers’ demands for lower prices will not end any time soon. Over time, without significant improvement in productivity (which is very hard to achieve today, given most companies already use “best-in-class” practices) managers will have no choice but to share the pain in the form of lower profits with those employees to whom they pay the lowest salary in the world.
There is another class of firms, which surprisingly make up only about 10% of the market. They have been much ahead in their thinking about the ‘price’. They understood that much like gypsies who sell door-to-door, they can create variations of the product (it doesn’t need to be a “never-seen-before” type, as long as it makes the customer feel they are getting something unique) and voila – they start setting the price themselves! In essence, every customer pays what they think the product is worth to them. The catch is that the firm would not sell the product below a certain threshold price, thus limiting its customer base only to those who truly see the value in the product at the price charged. Such principle is known as a “value-based pricing”. It works exceptionally well when the value the product represents to the customer is evident and is easily quantifiable. For instance, you manage to reorganize production process for the customer, in such a way that it will save them $150,000 next year. In theory, you should be able to charge up to $150,000 for the work you did. In reality, however, most of the customers would not pay more than 50% of that sum. In fact, most of the managers who actually work with value-based pricing, agree that customers rarely pay more than 20%-30% of the value they get.
Another important aspect that is hidden behind “value-based pricing” is the assumption that the firm did segmentation analysis of the market and broke down its customers into at least three groups (i.e. “value”, “performance” and “premium”)[1]. Under such arrangement, “value” customers represent those who care about nothing but the core product the firm provides[2]. “Performance” customers place value on tangible improvements, while “premium” customers would be willing to pay the premium as long as all their needs and wants are met. It is evident that segmentation does not only pertain to simply sorting customers by their willingness to pay, but the product variation must also be reflective of the segment. For instance, take a transportation provider such as FedEx, whose “premium” customer is not only entitled to the guaranteed delivery time, but also has access to all real-time visibility features, to which a “value” customer does not.
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Note: Buyers need not to be categorized based on percentage of contributed revenue, it may also be done based on $-value (i.e. $25K / $100K / $1MM). Values are chosen only for illustrative purposes. |
Another important aspect that firms should keep in mind when setting prices is the fact that value-based-pricing is rather effective only with incremental value the firm can create for the customer over and above competition. In order to understand why, let’s look at the following situation. Suppose M&M grocery store retails chicken for $1.49/lb. If the customer had to breed, grow and dissect their own chicken, it would probably cost them close to $10/lb, since farmers who raise chickens have economies of scale and an average customer does not. In essence, M&M has already created value for the customer, simply by buying in bulk and retailing the chicken for $1.49 rather than for $10 (a mark at which the customer would be indifferent between buying from the store and raising the chicken themselves). However, in the competitive market every grocery store would be retailing chicken for $1.49 if not for less. Once the customer has more than one choice (store vs. do-it-yourself), there is little value for the customer, despite that our grocery store originally created $8.50 in savings for the customer. In order for M&M to avoid being the victim of market forces, it may offer regular chicken and pre-cut. Knowing that the average person makes $16/hr and it takes 15 minutes to cut the chicken, M&M would essentially save the customer $4 by pre-cutting the chicken for them. Pricing regular chicken at $1.49/lb (standard market price) and $3.49 for pre-cut would create ample opportunity for M&M to extract value from customers. It is therefore imperative for firms to understand that when they create their margin matrix, the values should not be chosen based on what the firm “wants” to make, but rather based on what value it actually creates for the customer. Firms must understand that setting the price based on a random pick is a recipe for disaster. It is most often the case that customer’s expectations do not grow in direct proportion with the premium charged – in fact, they grow at a much faster rate, placing greater pressure on the firm to deliver. Premium price can easily turn the most loyal and profitable customer to an “at-risk” type if the firm fails to deliver flawless execution.
On a final note, firms must well understand that all things being equal (in terms of buying power), “premium” service should not be given away for the price of “performance”. Doing so will inevitably hurt the firm’s profitability, as now all “performance” customers will migrate to the “premium” product, while still paying the price of the “performance”. In fact, “performance” segment will cease to exist, as customers will now only see the “value” and “premium” variation of the product. Eventually, such blurring of segments will bring the firm to the same situation that the firms discussed initially face in the market – they will entirely lose control of the price, eroding the potential for earning excess profits.
By the way, if you are still selling that item on eBay, go back and reassess what you are charging. You may be leaving money on the table if you set the price too low. On the other hand, with too high of a price you are poised to get a negative feedback for unmet expectations of your customer. And no, eBay will not feel sorry for you, just like the market would not feel sorry for firms that do not get their pricing right. It is that important after all.
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