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Newsletter: July 23, 2010

The Thin Thread of Loyalty | A Case Where “Dynamic” Pricing Might Actually Work | Using Price to Control Capacity | Finally, A Good Price War— I Hope | Good Reading!

The Thin Thread of Loyalty

By Dr. Reed Holden

The tire pressure gauge lit up in the truck several days ago. I fixed the tire this morning and guess what—the warning light stays on. The dealer has to reset it. The car companies are trying to help struggling dealers by forcing consumers to take their cars to the dealers for servicing. I've been burned by enough $150 oil changes that I try to avoid dealer service at all costs. I have to tell you that those little tricks to lock me in don't work and cause me not to want to buy their cars.

It's similar to the problem that Toyota has been running into recently. With loyal customers and a strong brand image, they figured they could cut a few corners. After all, who would notice? The strong brand image gives them a chance to charge a premium over their competitors, so why not figure out how to take costs out and make the vehicles even more profitable? The problem is that consumers do notice the difference or find out about the changes over time. Sources like Consumer Reports (one of my buying bibles) can be revealing. When they do, they either get more price-sensitive, switch loyalty, or both.

Loyal customers are worth their weight in gold. They're willing to pay more, they tell friends about your products, they are less expensive to sell to—that is just the top of the list of reasons to take care of them. So don’t take advantage of them or force them to do things that will weaken their loyalty. Most customers see sellers’ tricks. Yes, they may put up with the foolishness to a point, but in the end, they figure it out, and when they do—bye-bye loyal customers.

What's the relevance for a pricing manager? There are pricing tactics that may buy more short term dollars but end up eroding customer loyalty and sacrifice long-term revenue and profits. Let's look at a few:

• Activity Fees: Banks and airlines have made money charging fees for the little transactions and extra bags. By charging fees, they encourage their loyal customers to look elsewhere. We switched banks last year for our personal and business accounts because of poor service and fees. We met with a manager, but he "couldn't do anything" (right!), so we now have a great relationship with a local bank, with great service and without nickel and diming us.
• Dumbbell Pricing: Charging large differences for essentially the same service or product just because some customers can negotiate better is often used by car companies, medical devices, and some major airlines. It's called dumbbell pricing, because the price distribution looks a bit like a dumbbell—some customers pay very high prices and others pay very low prices. Eventually the hosees (those who are getting HOSED) either negotiate for low prices, leave, or both.
• Charge High Service Fees or Force Price Increases: This tactic is used on only those customers who are willing to pay. Say you institute a 10% price increase and on average get 5% and you feel pretty good about it. The problem is that some customers paid the increase and others didn't—in fact, some even secured higher discounts. This leads to dumbbell pricing with all the associated results.  Here's a question for you—do you hope your customers won't find out about it? They will.
• Excessive Price Increase During a Product Shortage: Charge all you want to the poker players and the price buyers but take care of your loyal customers during times of shortage. Don't try to take advantage of them when products are scarce.

The list is "long and distinguished" (Goose), but the point is important. Loyal customers are critical to the success of a business. Don't alienate them with tactics that don't benefit them. And most of all, don't employ pricing programs that do that either—you, too, will find that loyalty is indeed a very slender thread.

A Case Where “Dynamic” Pricing Might Actually Work

From “Sports Teams Dabble With Variable Pricing,” The New York Times, June 27, 2010

Commentary by Mark Burton

When I first started reading about new uses of “dynamic” pricing, I remember thinking “Sometimes horrible ideas just won’t go away.” If you’ve been around the pricing profession a while, you likely remember that one of the by-products of the dotcom era was a lot of new technology that enabled firms to customize prices according to each customer’s willingness to pay. The story went something like this. Each customer should be considered a unique segment of one with different needs and different levels of value received from an offering. As such there is an optimal price for each customer and matching that price with that customer will maximize revenues and profits.

Sounds great, except that it didn’t work that way... In one infamous example, a senior executive of WW Grainger caused an uproar with customers when he was quoted in The Wall Street Journal regarding his company’s use of technology to provide different prices by cross-referencing customer numbers. While his statement seemed to follow economic theory, to many customers, anger over being taken advantage of for not negotiating hard enough trumped anything they had learned in Econ 101. Once customers figured out that the best way to beat dynamic pricing was to act like price buyers, its application diminished substantially.

I do however, think that dynamic pricing can be a useful tool in certain situations and tickets to sporting events may be one. Why are sporting events different than most industrial goods and why might dynamic pricing work? There are a few good reasons:

• First, the product is perishable. I can only see the Red Sox play the Yankees at Fenway Park on certain dates.
• Second, the value of the product changes each day. I certainly take more pleasure in watching the Red Sox beat the Yankees than I do a weaker team and I clearly prefer watching a game on a 70 degree summer evening instead of in April, when it’s 42 degrees and drizzling.
• Third, and most importantly, there are actually three different price-value combinations at play. I can buy tickets at a fixed price prior to the season; I can buy a dynamically priced- ticket direct from the team, when they’re available; and finally, I can buy a ticket in the secondary market, usually at a much higher price. In short, customers are more likely to feel as though they are being treated fairly, because they have options and particularly because one of those is a fixed-price option.

One word of caution: This can all go wrong, if teams are not transparent on what drives differences in prices from game to game or if the gap between the fixed and dynamic prices gets too large. Put another way, if the price-value equation is not clear or is viewed as being unfair, consumers will react to dynamic pricing the same way that many business buyers did in the past.

Using Price to Control Capacity

From “Verizon May Move to Tiered Pricing for Data Plans,”  Visagemobil.com

Commentary by Dr. Reed Holden

AT&T's network has been dramatically overloaded in recent years, causing scores of complaints by customers. Yes, they did get an exclusive on the iPhone, but the bad news is that their network wasn't up to snuff to handle the increased demand from the estimated 6 to 14 million additional users. To exacerbate the issue of capacity, customers are using the phones more: not only for calls but for data to support the wide range of applications.

So now AT&T is thinking of moving away from their all-you-can-dial pricing buffet and adopting tiered pricing for users. That's oddly appropriate, since it was AT&T's off-peak pricing of long distance services over fifty years ago that made them so successful. Boy, what a difference fifty years can make. At any rate, this move is long overdue. With the new Droid causing some users to move over to the more robust Verizon network and Verizon is also likely to get their own version of the iPhone in the next year, AT&T may be closing the gate after the horse has already left the barn.

The ultimate strategic use of pricing is to control the capacity utilization of the firm. Be it phone minutes, hotel rooms, or even we lowly professional services firms, price can be used to fill under-utilized capacity. Good pricing can also shift demand in peak-periods to off-peak periods and reduce the need and cost of expansion. In the case of AT&T, charging the power users extra for unlimited access to the airwaves will do one of two things. It will either cause them to leave (unlikely—but not a bad thing) or begin to pay for the needed increases in network capacity that AT&T is scrambling for.

The trick with this type of pricing strategy is that it has to be anticipated and implemented in a timely manner. In this case, the strategy should have been in the wings shortly after the original phone's introduction three years ago.  And it should have been implemented as soon as it was clear that the one-size-fits all pricing strategy would cause overloaded systems and spotty service.  It made no sense for AT&T to wait so long, because during that time, they alienated customers.  Having waited so long, when an alternative comes, unhappy customers will be the first to leave for Verizon. Yes, the iPhone has a great lock on the business, but the Golden Cage of demanded products can quickly become tarnished, if you can't service the customers. And when someone like Verizon comes along with a key, people will be real happy to get out.

Finally, A Good Price War— I Hope

By Dr. Reed Holden

First, there was a price war in e-books, now there's a price war in e-readers. Terrific. We finally have a price war that might be good. After all, so many of the price wars we've seen in technology and services have caused profits to disappear from many industries. The reason this might be a good one is that it will get more of us using e-readers and finally get avid readers into the 21st century.

I wrote in the last newsletter about how my newspaper is no longer on my doorstep. Next week, it will be on my iPad. The Boston Globe still pesters me with discounts and Kesner, our delivery guy is still giving us free papers to try to lure us back. But I'm finally going digital. Why? Because I believe the iPad gives us something that is an experience that is similar to flipping the newspaper.

What's the result? The traditional e-readers from Amazon and Barnes & Noble are going through a price war that is driving the price down. The net result is that their devices are selling like hotcakes. The current "cheapest" one is the Barnes & Noble Kobo, which is sold out. Predictions are that the prices will continue to drop to below $150—that's over a 30% discount over prices earlier this year.

The reason this price war works is that it's a high growth market—there are a plethora of new customers coming in. They're drawn by lower prices and increasing applications. 2009 sales of the devices were just under 3 million units. Projections for 2010 are over 6 million. That's high growth, and in high-growth markets, costs come down faster than prices, and everyone makes more money. The real bonus is to schleps like me, who can finally unload the paper and the pile of books I carry on long trips.

My iPad will pay for itself in less than one year, with the reduction in purchase prices of books and magazines. Plus, the publishers make more money—incremental cost of an e-book is zero—which is why Apple is trying to drive prices down even more on the books. It's interesting to note that they're staying above the fray with their iPad prices—that's because it's a great device, and users know they'll get content cheaper.

The e-reader price war has been and will continue to be fun to watch.  

Good Reading!

1. Prisoner's Dilemma by William Poundstone, Anchor Books, New York, New York, 1993. If you're a student of competitive strategy, you know about the Prisoner's Dilemma. If you want to learn more about how it was created and subsequently used with offshoots, this would be a pretty good book to read. It digs deep into the people like John von Neumann and how his and other competitive theories were put to use at the government think tank Rand Corp. A good historical book.
2. The Big Short: Inside the Doomsday Machine by Michael Lewis, 2010, WW Norton & Co., New York, NY. Michael Lewis writes great stories, and this one is about the few guys who sifted through the complex financial instruments in 2006 & 2007 to make money on the decline in value of CDO's. But it's also about the guys who let it happen. This one could have also been called "ignorance and greed," but it's a good story anyway.
3. The Boston Consulting Group on Strategy: Classic Concepts and New Perspectives, Carl W. Stern and Michael S. Deimler Editors, 2006, John Wiley, Hoboken, New Jersey. This is a collection of articles written by various people at BCG over the past 30+ years. While interesting, it does lack a unifying theory ("On strategy" just isn't enough, since it means many things) that pulls everything together. Rather than reading this book, you'd be better served going back to some of the more forward thinking people in the area of strategy.