CHAPTER 3 Price Structure Tactics for Pricing Differently Across Segments ‘After developing products or services that create value, a marketer must then determine how most profitably to capture that value in both volume and ‘margin. The challenge in doing so is that customers value products differently because of different abilities to pay, different preferences, and different intended uses. Moreover, the timing of customers’ needs, the speed of their payments, and the level of service and support they require can drive significant differences in the cost to serve them. When a company tries to serve all customers with one price, or a standard markup in the case of distributors and retailers, it is forced to make large tradeoffs between volume and ‘margin—enabling some customers to acquire the product for much less than they would be willing to pay for it, while others are excluded even though the lower price that they would pay is sufficient to cover variable costs and make a positive contribution to proft. Except for pure commodities, such as ethanol or pork bellies, a single rice per unit is rarely the best way to generate revenues. Realizing a ‘company's profit potential created by the differentiation in its features or serv- ices requires creating a structure of prices that aligns with the differences in ‘economic value and cost to serve across customer segments. The goal of that structure is to mitigate the tradeoff between winning high prices for low volume and high volume for low prices. The goal is to from sales where value or cost to serve is higher, while accepting lower revenue where necessary to drive still profitable volume. Do illustrate the huge benefits of a well-defined segmented price structure, ‘suppose that a supplier faced five different segments, all willing to pay a different price to get the benefits they sought from a product (see Exhibit 3-1). ‘Segment 1 with sales potential of 50,000 units is willing to pay $20 for the firm's product. Segment 2 with sales potential of 150,000 units is willing to pay $15, and so on. What price should the firm set? The right answer in principle aoe] moo Chapter 3 + Price Structure 49 is whatever price maximizes profit contribution. If you calculate the profit contribution at each of the five prices assuming a variable cost of $5 per unit, the single price that produces the maximum contribution ($2,750) is $10. However, a single-price strategy clearly leaves excess money on the table for many buyers who are willing to pay more: those willing to pay $20 and $15. These high-end buyers perceive significantly greater value from purchasing this product, relative to other buyers. At the price of $10, they are enjoying a lot of what economists call “consumer surplus.” The firm would be better off if it could capture some of this surplus by charging higher prices to these buyers. The second problem is that the supplier leaves nearly half of the market unsatisfied, even though it could serve those customers at prices above the $5 per unit variable cost. For industries with high fixed costs, serving those additional customers is often very profitable and, when they constitute large amounts of volume, can be essential for a company’s survival. Railroads could not maintain, let alone expand, their costly infrastructures without a segmented price structure, Railroad tariffs are designed to reflect the differences in the value of the {goods hauled. Coal and unprocessed grains are cartied at a much lower cost per carfoad than are manufactured goods, resuiting in a much lower contribution ‘margin per carload. Stil, the large volumes of coal and grain transported enables that low-priced business to make a substantial contribution to a rallroad's high fixed cost structure. If railroads were required to charge all shippers the tariff for manufactured goods, they would lose shippers whose ‘commodities would no longer be competitive on a delivered cost basis and 80 would lose that profit contribution. On the other hand, if railroads had to charge all shippers the tariff currently charged for a carload of unprocessed grain, their systems would reach capacity before they generated enough Contribution to cover their fixed costs and become profitable. Freight railroads survive and prosper by leveraging their capacity to serve multiple market segments at value-based prices for each segment. Even companies that serve only the premium end of a market often find that i is risky to limit themselves to that segment when they could be lever- aging some common costs to serve other segments as well. In his book, The Innovator's Dilemma, Clayton Christensen cites numerous examples of Companies that failed to meet demand from the lower-performance, lower- ‘margin segment of a market that they dominated. Invariably, someone even tually addressed that need and used it as.a base to pattially support the fixed costs investments necessary to enter higher margin segments.’ For years, Xerox owned the high end of the copier market. It lost that dominant position nly after companies that had entered at the bottom of the market developed service networks of sufficient size to support the higher-priced equipment bought by customer segments, such as copy, centers that require quick service to minimize downtime. How many segments with different price points should a supplier serve? To retum to our ilustration, Exhibit 3-1 shows that ifthe firm were to set two price points serving two general price segments—high-end buyers willing to