I believe markets can speak. When I put my ear close to the market, I hear prices. Pricing is the most interesting thing in the world to me. Over the last twenty years I have had the good fortune to work on some cool pricing problems: mozzarella cheese in the NYC pizza market; long-distance calling post breakup of AT&T (ask your parents); automatic markdowns in the off-price apparel business; allocating seats in grad school courses; character-themed apparel and toys; wool cloth in 1830s America; inventory turnover — or lack of it — in the footwear business in LA; software, services, and merchandise in online auctions. And in the last six years since I started teaching product development and design and working with startups, few topics come up as frequently as pricing a product or service.
I like pricing because it’s at the very heart of the economic engine of any product that aspires to become a business. A business lives on cash. That cash can only come from three places: internally generated cash, debt from lenders, or equity investment from shareholders. Since the supply of debt or equity is finite for any business, internally generated cash (aka “free cash flow” or “cash from operations”) is the only permanent and renewable source of life for the company. Pricing — especially relative to variable costs, asset intensity and fixed overhead — is a primary determinant of whether internally generated cash is a positive or negative number.
Last week I got together in Palo Alto with a group of entrepreneurs to discuss pricing. The topic was “Three Ideas on Pricing.” The ideas came from lessons I learned over the last twenty years of thinking more about pricing than is probably healthy. Here are the three ideas:
1. Good-better-best assortments give you a bigger market. There is an ancient and repeating pattern among winning companies in product markets: good-better-best assortments. That is, a range of options from low price to high price, with functional and aesthetic differences along a spectrum. If you look at advertisements from the early nineteenth and twentieth centuries, you notice that a lot of products are offered in good-better-best assortments. This pattern shows up in farm equipment, stoves, teddy bears, cloth, petticoats, wigs, dresses, hats, shoes, tools, shirts, phonographs, guns — practically any category of product that was for sale. Even today, good-better-best assortments dominate categories like cars, jet aircraft, phones, and software. The differences between good, better and best products in any assortment are a blend of quantitative and qualitative attributes; these differences get summarized in prices. This repeating pattern across many categories and centuries suggests some very basic rule of marketing is at work. I think it’s this: When variation is cheap for producers and highly valued by end users, g-b-b assortments increase the addressable market and returns on capital. Another way to think about the same point is asset efficiency: the same basic set of assets can be used to create more sales by adding SKUs to the assortment at different points along a demand curve. When some pattern repeats as much as g-b-b does, it’s worth some serious thought as to why and how it might apply to your product.
2. Perceived value > price > cost. Robert Dolan and John Gourville wrote a brilliant note on pricing called “Principles of Pricing.” I think it is a piece of genius this note. To oversimplify one of the best parts of the note, the gap between price and cost (so-called incentive to sell) is important to the success of a product or service, but there is another gap that can matter more: the gap between the price and the perceived value to the buyer. D&G argue that in order for anyone to actually purchase a product or service, the perceived value must exceed the price. They label this gap as the “incentive to buy” and they make a compelling case why managing that gap is marketing’s job. Business education puts a ton of emphasis on the price-cost gap (gross margin) and we are training lots of people to pay super-close attention to that aspect of pricing. But the perceived-value-price gap doesn’t get the same attention. It should. The incentive to buy can be increased two ways: lowering price, or increasing perceived value. Unfortunately, if your product isn’t selling and if you are focused only on the price-cost gap, you might reach right away for the price lever to lower it. Perversely, you can accidentally make the situation worse if the lack of demand is really driven by low perceived value. For example, a lower price might signal to your customer that your product is actually not competing on quality or feature basis and it can constrain the economics of your business further even if a lower price ignites demand. The majority of the time that I see a product stalled in a market, it’s because the perceived value is too low. This is best fixed by re-featuring the product and re-marketing it, rather than re-pricing it alone. There are many excellent nuggets in Dolan & Gourville’s note — you should get a copy — but this idea is the one I come back to more than any other.
3. Optional add-on features let users optimize perceived value. Even if you have a wonderful good-better-best product range and each product’s perceived value – price gap is large and healthy, there are more product configurations with higher perceived values than you can offer on a static menu. So why try to guess perfectly right when you can let your users dial up or dial down the features that matter most to them? Leaving features like on-call support, dedicated storage, or, heck, even extra photos on your eBay listing (shout out to my old friend Gallery — an optional feature adopted by 60+% of the listings accounting for hundreds of millions of dollars in 100% margin revenue annually) as optional add-ons allows three excellent things to happen. First, your users become participants in prototyping and iterating your product design. You get real-time feedback on what features and functions they want to add to the basic menu. Second, your users’ perceived value of the product goes up; satisfaction and retention should go up with it. Third, when these add-ons are dearer to your users than they are costly to you to provide, you have a large incremental margin opportunity.
If you and I ever have a chance to talk about pricing, and I hope we do, don’t be surprised if I repeat myself with the points above. And forgive me if I frame too many things in terms of pricing. It’s my hammer, and I see nails everywhere.