Individualised Pricing:
Boosting Profitability with the Higher Art of Power Pricing
HERMANN SIMON, Simon, Kucher and Partners, GmbH, Bonn
STEPHAN A. BUTSCHER, Simon, Kucher and Partners, GmbH, Bonn
While product and service customisation strategies are employed by a growing number of successful companies on and off the Internet, customised pricing may offer greater potential profit. The basic idea of price customisation is simple: Charge every customer the (individual) price he is willing to pay based on the (individual) value he places on the product. However, identifying that value for each individual customer is often an impossible task. Thus, you have to find a way to bundle customers into segments according to their value perception and then fence off these segments from one another. Managers must therefore first determine the different values customers place on their product and what that value is worth to each in monetary terms. Once this is done and customers are divided into segments, managers can choose among five innovative techniques to implement price customisation (multi-dimensional pricing, multi-person pricing, price bundling, multi-product strategies and normal or Dutch auctions). A possible profit gain of 10-40 per cent could make it well worth investigating this innovative approach to pricing. ©2001 Elsevier Science Ltd. All rights reserved
Keywords: Price Customisation, Auctions, Innovative Pricing, Multiple Brands, Price Bundling, Multi-dimensional Pricing
Product or service customisation has come a long way over the last years. Partly fuelled by new possibilities thanks to the Internet, but even more so by the customers' increasing demand for individual and exclusive products, marketers across many industries are matching products and services to the desires of individual customers. You can order custom-tailored jeans from Levi's, design your own sneakers from Nike (Nike ID), buy chocolate bars with customised wrapping (www.cyberchoey.com) or custom design a pair of skis combining sidecuts, lengths, colours, graphics, and name engraving (www.myski.com). Telecom companies offer over a dozen different calling plans tailored to the needs of different customer segments. These product customisation strategies have boosted profits significantly in many cases because they increase the perceived value-to-customer of these products (Pine, 1993, p. 12ff).
Lost Profits Through Unitary Pricing
However, the element of the marketing mix that is often overlooked in this surge towards designing individual offerings is the price. Companies do recognise that different customers place different values on a given product, but few actually charge customers individual prices. This means giving up a huge profit potential, as Figure 1 shows. The large shaded triangle indicates the total potential profit in a particular market if each customer pays exactly the maximum price (p) they are willing to pay for a certain product based on its perceived value. In this example, the perceived value of the product varies between €1 and €100, and the average is €50. The demand curve shows that at any given price, we will sell 100-p units. For this example we will arbitrarily pick €20 as our unit cost, but the argumentation works for any cost level. If we have a one-price policy in mind, we have to pick the price between €20 and: €100 that maximises profit. The profit generated equals the area of the rectangle with a width that is the distance from the price to the €20 cost and with a height that is the number of units sold at that price. In other words, the height of the demand curve at the selected price. Any price we pick between €20 and €100 cuts out a profit rectangle from inside the big triangle. You can charge a high price and get a low but wide rectangle, or charge a low price and get a high but narrow rectangle. For our chosen scenario, €60 price maximises the size of the profit rectangle (hatched rectangle in Figure 1).
However, even the optimal profit rectangle contains only 50 per cent of the total possible profit (large shaded triangle) and leaves two smaller untapped profit-triangles. The 'money left on the table' triangle includes those customers who buy at: €60, but would have been willing to pay more; the 'passed-up profit triangle includes customers who value the product at more than €2O, but won't buy it , for €60. The challenge is: How can we get from the rectangle to the triangle?
Price customisation allows us to tap the profit opportunities in these 'left-behind' triangles (Dolan and Simon, 1996, p. 118ff). The basic idea of price customisation is simple: charge every customer the (individual) price he is willing to pay based on the (individual) value he places on the product. However, it is often impossible to identify that value for each individual customer (although the Internet allows us to take a big step in that direction). Thus, you have to find a way to bundle customers into segments according to their value perception and then fence off these segments from one another. This fencing is necessary in order to avoid having customers with a high value perception and thus higher willingness to pay take advantage of the low price for the low-value segment.
There are a number of ways to do this. For example, adults may be able and willing to pay €7 for a movie and kids only €5. We 'fence off' the €5 price by making it available only to children under the age of 12. Or in the airline industry, business flyers value a seat more highly than leisure travellers do. So we 'fence off' the low leisure travellers' price with a Saturday night stay requirement which for most business people is not an option.
Price Customisation Strategies
In our experience, the five major, innovative techniques for implementing price customisation and achieving greater profitability are:
1. Multi-dimensional pricing,
2. Multi-person pricing,
3. Price bundling,
4. Multi-product strategies, and
5. Auctions and Dutch auctions.
Although each technique is operationalised somewhat differently, all have in common that they adjust prices better to individual customers' willingness-to pay and yield profit improvement over unitary pricing.
Multi-dimensional Pricing
In multi-dimensional pricing, two or more price parameters are used instead of one. For example, consider the case of a firm marketing industrial gases supplied in 1-dgh-pressure steel cylinders. With one-dimensional pricing, the gas is sold just on a weight basis at a price of, say,: €2 per pound. Price changes for particular customers or segments can only be made along the one dimension of price per pound and competitive prices are directly comparable. In order to become more flexible in his pricing, one supplier in this market introduced a multi-dimensional price scheme by charging a rental fee per day for the steel cylinder while reducing the per-pound price of the gas (see Figure 2).
Customers pay different transaction prices depending on how fast they use the gas: those who use it quickly pay a lower effective price per pound than those who use it slowly. The manufacturer now has more degrees of freedom in managing prices because changes can be made along two price parameters. He can now offer the same price plan to all, but still yield more revenue per pound from customers with a slower consumption rate. If slower consumption rates mean higher value for a particular segment, this pricing scheme is useful for tapping this value. If the two price components are set correctly, the profit will increase substantially. In this case, the manufacturer increased profits by 25 per cent.
Another example of multi-dimensional pricing with proven profit impact is the German Railroad Corp.'s (a €5-billion company) introduction of the BahnCard (RailCard). The company historically priced transportation between any two points as a simple multiple of the distance between them. However, this one-dimensional price structure was not competitive with driving by car for many potential passengers.
Recognising this, the company introduced the 'BahnCard' for about DM520 (€260) per year for first class and DM260 (€130) for second class. Cardholders can buy tickets at a 50 per cent discount off the standard per-kilometre price for one full year. Thus, the price structure has two dimensions: the card price and the ticket price discounted at 50 per cent. The most important effect is that once a person has bought the card, its price is a sunk cost. With the BahnCard, the train versus car cost-comparison solely depends on the marginal price per kilometre and the train is below the marginal cost of a car for many travellers. The cost per kilometre actually decreases the more the cardholder travels by rail, as shown in Figure 3 (Dolan and Simon, 1996, pp. 179ff).
With 3.5 million cardholders, the BahnCard is very successful, increasing the company's profit by more than €80 million. The number of frequent travellers, the most profitable customer segment, could successfully be increased through this intelligent pricing strategy.
Multi-person Pricing
Multi-person pricing is designed for customer groups of two or more people. In this case, only the first customer pays the 'full price', while all other customers receive a discount. The rationale for the discount is that the second person's willingness-to-pay is less than the first person's. For example, consider a business person going on a business trip and the spouse considering tagging along. Let's say the business traveller's willingness to pay for the airfare is €1000, and the spouse's is only €600. The airline has three alternatives. It can charge €1000 for each ticket and get only the business traveller's business, yielding a contribution of €1000 (assuming variable costs are negligible). Or it can set a price of €600, selling both tickets for a total contribution of €1200. However, a multi-person pricing scheme with €1000 for the first and €600 for the second person (or a bundle of two tickets for €1600) is even better. The couple would buy two tickets, and the contribution increases to €1600, a 33 per cent improvement over the best single price of €600.
Multi-person pricing is also frequently used for larger groups and is increasingly popular in the travel, tourism, hotel, conference, and sports industries. Well prepared multi-person pricing requires detailed information on customers' willingness-to-pay, both for the individuals and for the groups involved. In practice, the typical profit improvements we observe tend to be in the range of 10-15 per cent (Butscher, 1999, p. 32).
Price Bundling just as multi-person pricing works across people, bundling works across products. Two or more products are sold together at a price that is less than the sum of their individual prices. In a pure bundling strategy, only the bundle is sold; in a mixed bundling strategy, the individual products are sold separately as well. Bundling is widely used in industries such as fast food (e.g. McDonald's Value Meals), automobiles (e.g. option packages), tourism (e.g. air and land portions of a trip), information technology (e.g. Microsoft Office) and telecommunications (e.g. cell-phone plus free minutes package). In general, the profit plus with a bundle strategy, if done correctly, can be 10 per cent or higher.
In an interesting case from the automotive industry, a manufacturer was considering offering three package options: 'comfort', 'sports', and 'safety'. A value-to-customer study revealed that adoption rates were quite sensitive to the discounts for the bundles compared to the price of options if purchased individually. Bundling also enabled considerable cost reductions because of lower purchasing prices for the components and reduced complexity in logistics and assembly.
Figure 4 shows the profit effect of price bundling for various discount rates on all bundles. (Management wanted to price each of the three bundles at the same discount.) The exhibit indexes the profit with no bundling (equivalent to discount level = 0 per cent) to 100. As shown, a 21 per cent discount yields the optimal profit with a profit plus of 22 per cent. At this level, one third of the profit from options comes from the bundles.
You may recall that differences between customers are the driving force behind price customisation. Bundling operates somewhat differently than other schemes because it enhances profitability by reducing the differences between them. The principle, though, is to find those combinations of goods for which willingness-to-pay varies less across customers than willingness-to-pay for individual items. The willingness to-pay for one product can be transferred to another product - and thus exploited - through the bundling scheme. As with the other methods discussed earlier, we need a high level of information to apply bundling astutely. With solid information on an individuals willingness-to-pay, we can determine whether separate pricing (unbundling), pure bundling, or mixed bundling is the best approach. Based on our experience, typical profit increases due to bundling are in the range of 15-25 per cent.
Multi-product Strategies
Many premium brands are increasingly under attack by low-priced 'no-name' products or private labels. Rather than aggressively responding with price cuts, introducing a less expensive alternative (LEA) in the form of a second product line, a second brand, a generic/no-name label, a private label, a fighting brand, or a retailer brand has proven to be a very successful strategy. Dozens of companies have introduced LEAs to protect their top brands and to expand into new segments.. Marriott, for example, has a total of 11 brands (i.e. Marriott, Residence Inn, Fairfield Inn etc.), British Airways recently launched their no-frills airline GO, L'Oreal and Keralogie are sold through different channels to different segments, 3M uses Highland as its second brand next to Post-its, and Panasonic uses its Quasar brand in the lower-end market.
The most important aspect of a multi-product strategy is designing and pricing the LEA right to limit cannibalisation of the premium brand and foster market share gain for the LEA from the price aggressors (see Figure 5). This has to be done by differentiating the different products on key factors and, as a result, building fences between the customer segments:
· Price: In most cases, the price difference between two products is 20-40 per cent.
· Quality: The second product must be of lower quality than the top product without moving below the acceptance barrier of the customers or becoming worse than the low-price competitors. It is hard for managers to 'take away' quality, but is absolutely necessary.
· Service: The service for the top product must be more comprehensive/ of better quality than for the second product.
· Brand: Options are to use the multi-brand (US Airways and Metrojet), the multi-product (Intel Pentium and Intel Celeron) or the 'by'-alternative (Marriott and Courtyard by Marriott). There is no dear best alternative. Using the same brand for all products allows for a more uniform strategy and gives the second product more power to regain lost market share. It is also a good branding strategy if each product is the premium product in its respective segment. Using separate brands for each product level reduces the transparency of the market actions and makes - competitive reaction less probable. It is also the better strategy if a very broad market has to be covered, which might be too big a task for one brand without eroding itself. Also, using multiple brands means that the differentiation on other factors does not have to be as strong compared to using just one brand (Butscher and Hilleke, 1997, pp. 108ff).
· Distribution: The second product can be sold through the same channels as the top product, but only if it is differentiated enough on the other factors. If not, it should be available only in alternative channels. As a matter of fact, the second product/brand can be actively used to gain access to new channels (i.e. discount stores, e-commerce).
For example, a leading manufacturer of lighting products chose the LEA route against cheap imports from China that were 60-70 per cent cheaper than the manufacturer's premium brand and were hurting his profits. The LEA was not only 40 per cent cheaper than its branded cousin, but also had a lower quality (equivalent to its Chinese competitors), a different design, less costly packaging, and was sold by a special sales force through separate channels. Using this strategy, the company avoided attacking the Chinese products too directly by, for example, matching their prices, thereby preventing retaliation and a further downward price spiral. After two years, this carefully planned and implemented LEA strategy was a success. Product and price policy were set together to divide customers properly between the premium brand and the LEA. About 40 per cent of the LEA's sales came from cannibalising the premium brand, but 60 per cent were gained from competing with the Chinese imports., Overall, the market share increased by 17 per cent, and profits increased by 45 per cent.
Auctions and Dutch Auctions
The growth of the Internet has made customer-driven pricing models feasible on a large scale. In terms of price customisation, auctions and Dutch auctions come close to the ideal situation in which every customer pays exactly the maximum of what he is willing to spend.
Auctions are an ancient form of pricing. Interested parties bid on a product that is for sale and have a chance to increase their bid as other bidders top their original bid. The product is typically sold to the party that in the end places the highest bid (there are alternatives where the second highest bid wins). Auctions require that all bidders are either physically present at the site of the auction or can participate via telephone or another technology. The Internet has made auctions a tool for the masses, as it enables everybody around the world with access to the Internet to participate in an auction on an auction website such as ebay.com, ricardo.de and ricardobiz.com. Auctions are becoming more and more popular in business-to-consumer, business-to-business and consumer-to- consumer cases.
Auctions are the best pricing strategy to extract the maximum willingness-to-pay for a product that currently exists in the market, as determined by the highest bid. Of course the highest bidder might still have been willing to pay an even higher price. But still, auctions are the pricing method that, if several identical products are sold, enable the seller to come very close to extracting the full profit triangle (Figure 1). Each subsequent sale will add another piece to the triangle, moving from right to left, as the highest bids become lower (customers with a higher willingness-to-pay will have satisfied their demand at a higher price and drop out of the bidding process for the next unit, leaving only those customers with a lower willingness-to-pay).
In Dutch auctions, the starting price is a price slightly above the highest price a seller thinks he can achieve. The price then begins to drop and the first customer to signal his willingness to buy at the current price gets the sale. Similar to the regular auctions, this pricing system allows extraction of the maximum willingness-to-pay for a product that currently exists in the market, as it creates competition between customers. A customer could wait for the price to drop below his personal price limit, but then has to take the risk of another customer snatching the sale. Again, this system allows the seller to come very dose to extracting the complete profit triangle. International car rental company Sixt uses this format to auction off its used car pool.
In order to make either auction form effective, however, you have to ensure that a large enough number of customers can and will participate in the auction. The participating audience should be an exact mirror of your entire market or, ideally, all your potential customers should participate. The Internet is an excellent way to achieve this. But, depending on what market you are in, this might mean that you have to enable access to the auction through different technologies. For example, if your market has a low Internet penetration (i.e. small businesses, low income consumer segments etc.), you will have to allow access to the auction through telephone or beeper too.
Implementation
As we have pointed out in these examples, implementation of price customisation can yield significant gains in profit - not 2 or 5 per cent, but rather 10 or 40 per cent -, so it is well worth investigating. However, effective implementation requires information on:
· the value customers place on a product,
· their price elasticity’s,
· the product's cost structure and how it is affected by volume changes,
· logistics and its impact both on cost and the organisation,
· the organisational impact of new pricing schemes etc.
An in-depth investigation of customers' valuation of a product using a variety of techniques, including cost-structure studies, managerial judgements, and customer surveys is necessary. We have found conjoint measurement to be an especially useful tool for the valuation of products and identifying the underlying drivers for those valuations. Furthermore, decision support models have to be used to simulate the effect of different pricing strategies and price levels on revenues and profits. From these simulations you can then derive the price elasticities of customers and customer segments. Price customisation is not easy, but under the right circumstances, the potential rewards are great.
References
Butscher, S. (1999) Using pricing to increase customer loyalty. The Journal of Professional Pricing 8(l), 29-32.
Butscher, S. and Hilleke, K. (1997) How to use a two-product strategy against low price competition. Pricing Strategy and Practice 5(3),108-115.
Dolan, R.J. and Simon, H. (1996) Power Pricing - How Managing Price Transforms the Bottom Line. Free Press, New York
Pine H, BJ. (1993) Mass Customisation. Harvard Business School Press, Boston.
HERMANN SIMON, Simon, Kucher and Partners GmbH, Haydnstrasse 6, D-53115 Bonn, Germany. Email: bonn@simon-kucher .com
Hermann Simon is Chairman and CEO of Simon, Kucher and Partners, Strategy and Marketing Consultants in Bonn, Munich, Cambridge (USA), Paris and Vienna, as well as Visiting Professor at the London Business School. He has written and co-authored numerous books, including Hidden Champions - Lessons from 500 of the World's Best Unknown Companies, and Power Pricing. His books and articles have been published in 15 languages,
STEPHAN A. BUTSCHER, Simon, Kucher and Partners GmbH, Haydnstrasse 6, D-53115 Bonn, Germany. Email: sbutscher@simon-kucher.com
Stephan Butscher is a Director of Simon, Kucher and Partners. He is author of several books including Customer Clubs and Loyalty Programmes. He will be responsible for Simon, Kucher and Partners' London office, which will open in 2002.
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