The Science and Art of Pricing

CAYENNECONSULTING
innovate | grow | succeed

Science and Art:
Pricing Products & Services
for Profitability

Akira Hirai
Cayenne Consulting, LLC
akira@caycon.com
714.TOP.PLAN

Agenda

 A Bit About Me
 Pricing and Profitability
 Some Boring Old Fundamentals
 Buying Decisions
 Pricing and Business Models
 Some Pricing Tactics
 Pricing Psychology
 Case Study & Summary

2
© 2001-2011, Cayenne Consulting, LLC. All Rights Reserved.

How I Got Here
85 Palo Alto Stanford Linear Accelerator Center Engineering Intern
86 N.H. U.S. Army Corps of Engineers Programmer
87 Boston Let’s Go Travel Guides Sales Manager
88 Boston AdVenture Graphics (Advertising) General Manager
85-89 Boston Harvard University BA, Engineering
89-91 NYC First Manhattan Consulting Group Consultant
91-92 NYC Systematix Development Group Founder/Programmer
92-94 NYC Coopers & Lybrand Managing Consultant
95-99 NYC Salomon Brothers VP, Trading/Risk
99 Cupertino AntiqueID.com Founder/COO
99-00 SFO MyRaptor.com Founder/CEO
01-11 Arizona Cayenne Consulting, LLC Founder/CEO
3

What I Do Now

 Cayenne Consulting
 Established March 7, 2001
 30 Consultants worldwide
• Strategy & tactics • Market research & analysis
• Market positioning • Competitor research & analysis
• Business planning • Interim C-Level leadership
• Financial forecasts & models • Business development
• Investor pitch decks • Executive coaching & mentoring
• Capital formation strategy • Revenue acceleration
• Company valuations • Turnaround consulting

4

Agenda

 A Bit About Me

5

Quick Example

 Fixed costs of $10,000 per month
 Product priced at $100
 COGS (Variable Cost) = $50 per unit
 Gross Margin = $50 per unit
 How many units do I have to sell every month
before I break even?
 Answer:
 Fixed Cost ÷ Gross Margin

 $10,000 ÷ $50 = 200 units to break even
6

Suppose I offer 10% off

 New product price: $90
 Gross Margin = $40 per unit
 What’s my new break even point?
 Answer:
 $10,000 ÷ $40 = 250 units to break even

 I now need to sell 20% more product before
I reach break even

7

Impact of Price on Profits

 Fixed cost $10,000
 Variable cost of $50 per unit
Price Q=175 Q=200 Q=225 Q=250 Q=275
$100 ($1,250) $0 $1,250 $2,500 $3,750
$90 ($3,000) ($2,000) ($1,000) $0 $1,000

 Pricing determines how much product you
need to sell to be profitable

8

Impact of Price on Required Sales

 Fixed costs of $10,000 per month
 Variable cost of $50 per unit
 Target profit: $2,500 per month
 How many units do I need to sell at each price
point to achieve profit target?

Price Quantity
$90 313
$100 250
$110 208
9

Agenda

 A Bit About Me

10

Some Boring Old Fundamentals

 The “Law” of Supply and Demand
 Competitive Markets
 Rational Consumers and Sellers

11

Customers: The Demand Side
Price

Quantity 12

Demand at a Low Price
Price

X
P1

Q1
Quantity 13

Demand at a Higher Price

Y
P2
Price

X
P1

Q2 Q1
Quantity 14

The Demand Curve

Y
P2
Price

X
P1
D

Q2 Q1
Quantity 15

Sellers: The Supply Side
Price

Quantity 16

Supply at a Low Price
Price

X
P1

Q1
Quantity 17

Supply at a Higher Price

Y
P2
Price

X
P1

Q1 Q2
Quantity 18

The Supply Curve

Y S
P2
Price

X
P1

Q1 Q2
Quantity 19

Markets: Supply AND Demand

S

P
Price

D

Q
Quantity 20

Back to Demand
Price

D

Quantity 21

“Elastic” Demand: Very Sensitive to Price
Price

D2

D1

Quantity 22

What Determines Price Elasticity?

 Availability of Substitutes
 Necessity
 Percentage of Income
 Duration of Price Change
 Brand Loyalty
 Source of Funds

23

“Elastic” Demand: Very Sensitive to Price

 What are some examples of markets with
elastic demand?
 Leisure airfares

 Liquor

 Cola

 Mobile games and apps

24

“Inelastic” Demand: Price Insensitive
Price

D3 D1

Quantity 25

“Inelastic” Demand: Price Insensitive

 What are some examples of markets with
inelastic demand?
 Healthcare

 Cigarettes

 Gasoline

 Eggs

 Steel

 Guns

26

Science and Art of Pricing

 The Science: Traditional Economics
 Assumes rational market participants

 Perfect access to information

 The Art: Behavioral Economics
 Recognizes people often act irrationally

 Studies how people actually behave

27

Agenda

 A Bit About Me

28

A Tale of Two Jeans

Old Navy True Religion
$11.97 $330.00 29

A Tale of Two Jeans

True Religion Old Navy
$330.00 $11.97 30

How About Two Watches?

Seiko Eterna
$59 $21,900
31

The Consumer’s Choice

Buy Your
Buy Your Product Competitor’s
Product

The
Consumer

Buy a Substitute Do Nothing
Product (Status Quo)

32

Finding the Right Value Proposition

What What
You C
Competitors
Offer Offer
D
A B

What
Customers in This
Target Market
Want

33

Influencing the Buying Decision

Features
Price Quality
Guarantee

Convenience
Sales
Speed
Promotion
Proximity

Choice Associated
Loyalty Benefits

Environment Brand
Packaging Prestige

34

Features

35

Quality / Reliability

36

Guarantees

37

Convenience / Speed / Proximity

38

Associated Benefits: Doing Good

39

Associated Benefits: Being Green

40

Brand / Prestige

41

Loyalty Programs

42

Packaging & Labeling

43

Choice

44

Relationship

45

Loyalty

46

Promotion

47

Sales

48

Influencing the Buying Decision

Features
Price Quality
Guarantee

Convenience
Sales
Speed
Promotion
Proximity

Choice Associated
Loyalty Benefits

Environment Brand
Packaging Prestige

49

Pricing for Profitability

Pricing &
Competitive
Promotion
Influences
Strategy

Value Quantity Total
Proposition Sold Revenues

Fixed &
Variable Profitability
Costs

50

Agenda

 A Bit About Me

51

Business Models

Goods &
Services

Money

You Your Customer
52

A Few Basic Business Models
 Sell goods and services outright
 Annual membership and then sell stuff at a discount
 Sell stuff, but give a punch card so that your 10th purchase is free
 Sell fractional ownership in stuff
 Broker transactions and earn a percentage of the transaction
 Create a marketplace between people and earn a listing fee
 Sell memberships to a service
 Create free content and make money from advertisers
 Create content and charge subscribers for access
 Sell software licenses:
 Annual or one-time; customization, maintenance, and upgrade fees
 By the company, individual seat, individual named user, maximum number of
concurrent users, average number of concurrent users, number of
CPUs, number of transactions processed, etc.
53
 And dozens of other models…

Auction Business Model

54

Name Your Own Pricing Business Model

55

Razor and Blade Business Model

56

Freemium Business Model

57

Business Models

Goods &
Services

Money

You Your Customer
58

Agenda

 A Bit About Me

59

“Cost Plus” Pricing

 Hypercompetitive Markets
 Regulated Markets
 Procurement-driven Markets
 Naïve Sellers

60

“Cost Plus” Pricing

Price of computers falling, in part, because
component costs are falling:
Year Manufacturer Size Cost $ per MB
1956 IBM 5 MB $50,000.00 10,000.00
1981 Apple 5 MB $3,500.00 700.00
1987 Iomega 40 MB $1,799.00 45.00
1995 Seagate 2.1 GB $1,699.00 0.81
1999 Maxtor 10 GB $249.99 0.0288
2003 Maxtor 120 GB $158.00 0.00151
2007 Western Digital 500 GB $152.00 0.000306
2010 Western Digital 1000 GB $71.42 0.0000821

61

Market Based Pricing – Real Time

62

Market Based Pricing – Static

63

Segmentation

64

Wealth Segmentation

Value
Discount Pricing Premium Pricing
Pricing
• Low cost • Middle market • High margins
producer strategy • Quality, luxury, e
• Razor thin • Fair price for a xclusivity, scarci
margins solid product ty, etc.
• Make it up in • Compete by • Skim top of the
volume providing good market
• Attract price value for the • “If you have to
shoppers money ask how much it
costs…”

65

Feature / Quality Segmentation

66

Geographic Segmentation

Laguna Beach, CA Chandler, AZ
4 Bed / 3 Bath 4 Bed / 3 Bath
2,437 SF / 0.14 acre 2,566 SF / 0.20 acre
$3,450,000 $199,900
67

Customer Type Segmentation

68

Customer Type Segmentation

69

Time of Day & Day of Week Segmentation

70

Price Break Segmentation

200 @ $7.49 = $1,498.00
201 @ $6.99 = $1,404.99

71

Loss Leaders

72

Sales & Coupons

73

Bundled Pricing

74

Sequential Skimming

75

Agenda

 A Bit About Me

76

You Get What You Pay For

77

You Want What Others Want

78

Pricing Conventions

 Marketing Bulletin study of advertised prices
in 1997:
 60% end in a “9”

 30% end in a “5”

 7% end in a “0”

 3% end in something else

79

Why 99 cents?

 Left digit anchoring effect

$1.99 $3.00
 Many buyers ignore least significant digits
 $19.99 is closer to $19 than to $20

 Stronger effect using small print: $1999

 Moves product below anchor point
 Moves product into lower price band
80

Even Pricing: It Must Be Good…

81

Premiums

 $19.99 vs. $21.99
 Message: Products are comparable, but
one is more expensive than the other
 $19.99 vs. $29.99
 Message: One product is “basic” and the
other is “premium”

82

Reframing

 This product protects up to 25 “workloads”
 $3.50 x 25 x 365 = $31,937 per year!
83

Re-Anchoring

84

Sneaky Price Increases

85

Agenda

 A Bit About Me

86

Case Study: Airline Yield Management
 Service Level: First class, business class, coach, etc.
 Features: Refundable, non-refundable
 Unbundling: Pay only for the features you use (checked
bags, pillows, snacks, paper boarding passes)
 Surcharges: Exclude airport fees, taxes, fuel
surcharges, etc. wen quoting prices
 Time of Purchase: Gradually reduce prices
 Customer Urgency: Save a few seats for last-minute buyers
who will pay any price
 Sales Channel: Direct website, agency website, travel
agent, vacation packages
 Volume Buyers: “Free” seats to frequent travelers
 Pickiness: Sell remaining inventory by introducing
imperfections 87

Should you RAISE your prices?

 Customers may perceive higher quality
 You’ll earn higher margins, so you won’t have
to close as many sales to maintain the same
level of profit
 You might drive away some price-
conscious, high-maintenance customers

88

Should you LOWER your prices?

 You should attract more customers
 Higher volume could mean better economies of
scale, thus lower average costs
 Might attract some profitable long-term
customers
 Might attract cost-conscious, high-
maintenance customers that burden your team
 Might be perceived as being desparate &
nobody wants your product
 Might be perceived as being the “cheap” brand
89

Pragmatic Pricing Strategy

 Understand your value proposition
 Talk to your customers
 Watch competitors closely
 Test, measure, and analyze
 Understand impact on cost, volume, profit
 Don’t confuse correlation with causation
 There are no easy answers!

90

Pricing for Profitability

Pricing &
Competitive
Promotion
Influences
Strategy

Value Quantity Total
Proposition Sold Revenues

Fixed &
Variable Profitability
Costs

91

Further Reading

 The Strategy & Tactics of Pricing
 Thomas Nagle & Reed Holden

 Power Pricing
 Robert Dolan & Herman Simon

 Predictably Irrational
 Dan Ariely

92

CAYENNECONSULTING
innovate | grow | succeed

Pricing Products &
Services for Profitability

Akira Hirai
Cayenne Consulting, LLC
akira@caycon.com
714.TOP.PLAN

The Science and Art of Pricing

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