Big Picture in Focus: ULO-B:

Know the Tactics of Pricing Differently Across Customer Segments

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Metalanguage
For you to have a deeper and clearer understanding of the topics, the
following essential terms are operationally defined. You will encounter these terms
as we go through the 2nd ULO. Please refer to these definitions in case you will
encounter difficulty in understanding the concepts.
Price Metrics- are the units to which the price is applied. They define the
terms of exchange — what exactly will the buyer receive per unit of price paid

Price Fencing- is the practice of setting up rules and restrictions regarding

the eligibility of an individual to purchase products and services at a specific price.

Essential Knowledge

To understand and perform the aforementioned Big Picture (Unit Learning

Outcomes) for the 3 to 4 weeks, you need to fully understand the following essential
knowledge that will be laid down in the succeeding pages. Please note that you are
not limited to exclusively refer to these resources. Thus, you are expected to utilize
other books, research articles, and other resources that are available in the
university’s library, e.g., ebrary, search.proquest.com, etc.

PRICE STRUCTURES

After developing products or services that create value and

making customers aware of it, a marketer must determine how most profitably to

capture a share of that value in both volume and margin. The challenge is that

individual customers will value the differentiating features of products and services

very differently due to differences in their abilities to pay, their subjective

preferences, their end-use applications, and their prior experience with the product
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category. 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 even with a standard mark-up over cost, it is invariably forced to make large

trade-offs between volume and margin, with gains in volume requiring either lower

prices or higher costs. Fortunately, a well-designed price structure can substantially

mitigate that trade-off.

Except for highly competitive commodities, charging the same price per unit

is rarely the best way to generate revenues. A far more profitable strategy requires

creating a structure of prices that aligns with the differences in economic value and

cost to serve across customer segments. The goal is to capture more revenue from

sales where value or cost to serve is higher accepting lower revenue to earn

additional profits from incremental volume to customers for whom value is less or

the cost to serve them is low.

To 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 below). Segment A

with sales potential of 50,000 units is willing to pay $20 for the firm's product.

Segment B with sales potential of 150,000 units is willing to pay $15, and so

on. What price should the firm set? The right answer is whatever price maximizes

profit contribution. If you calculate the profit contribution at each of the five prices

assuming a variable cost of S5 per unit, the single price that produces the maximum

contribution ($2,750) is $10.

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However, a single-price strategy clearly leaves excess money on the table

for buyers who are willing to pay more: Those willing to pay $20 and S15. At the

price of SIO, those high-end buyers 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 them

higher prices. The second problem is that the supplier leaves nearly half of the

market unsatisfied, even though it could serve those customers profitably 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 carried at a much lower cost per carload than are

manufactured goods, resulting in a much lower contribution margin per carload. Still,

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the large volumes of coal and grain transported enables that low-priced business to

make a substantial contribution to a railroad's high fixed-cost structure. If railroads

were required to charge all shippers the tariff for manufactured goods, they would

likely lose shippers whose commodities would no longer be competitive on a

delivered-cost basis and so 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.

Companies that have a large market share but refuse to serve the lower-

value segments of a market take a risk in doing so. In his book, The Innovator's

Dilemma, Clayton Christensen cites numerous examples of companies that failed

to meet demand from a potentially large, but lower-value segment in a market that

they otherwise dominated. Invariably, someone eventually addressed that need and

used it as a base to partially support the fixed cost investments necessary to

compete for business in higher margin segments.2 For example, Xerox owned the

high end of the copier market. It lost that dominant position only after companies

that had entered at the bottom of the market developed service networks of

sufficient size to support sales of large, higher-priced copiers, such as those bought

by copy centers that required quick service to minimize downtime.

How many segments with different price points should a supplier serve? To

return to our illustration, exhibit above shows that if the firm were able to set two

price points serving two general price segments—high-end buyers willing to pay

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$15 or more, and mid-level buyers willing to pay 15 dollars or more—it could

increase profit contribution by 40 percent. But if the supplier could charge separate

prices to each of the five market segments, it could increase profit contribution by

80 percent to the single price strategy! In principle, more segmentation is always

better. In practice, the extent of price segmentation is limited by the ability of the

seller to manage the

complexity of managing across multiple segments and to enforce the segmentation

at an acceptable cost.

CHALLENGES THAT CAN UNDERMINE SEGMENTED PRICING

Segmentation is much more challenging for pricing than for other aspects of

marketing because customers to whom you intend to charge a higher price have a

strong incentive to undermine it. They will not freely identify themselves as members

of a relatively segment simply to help the seller charge them more, but will try to

disguise themselves as customers who should qualify for a lower price. Channel

intermediaries too can undermine a segmented pricing strategy by buying the

product intended for delivery to customers entitled to a lower price but then actually

diverting it for resale to customers targeted to receive a higher price. Commonly

referred to as gray-market sales, they create a huge challenge for companies

serving international markets because distributors in countries where prices are

lower cross ship products to ones where prices are higher. A manufacturer then

loses higher-priced sales in the high-value country due to gray-market competition

from its own products that have been parallel imported from lower-priced countries.

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And, to add to the insult, sales are lost even in the low-price country due to

shortages that develop when products are diverted away from the low-price market.

Gray-market diversions by channel intermediaries can undermine not only different

pricing by region but also by application. There are examples where a specific drug

can have two different uses with correspondingly two different levels of clinical value

delivered. For example, a drug used to treat a high-risk disease like cancer might

also be useful for treating eye irritation. The challenge for a pharmaceutical

company is to develop a strategy that allows it to charge differently depending on

how the drug is being used. One common tactic is to introduce two versions of the

drug, each with a unique brand name and dosing guidelines, even if the active

ingredient is the same. The challenge, of course, is that some enterprising

physicians might purchase the cheaper version of the drug, adjust the dosing to

achieve the same result in the higher clinical-value setting, and pocket the difference

in cost of the drugs used in the procedure.

In markets where sales are made directly, without a channel intermediary, it

is easier to charge different prices to different customers. Recognizing the huge

potential for profit improvement from aligning price with value, many companies

adopt flexible pricing policies, empowering sales reps and sales management to

discount prices for customers whom they perceive to be more price sensitive, while

charging higher prices when the customer is unaware of better alternatives or

perceives that what differentiates the offer worth a higher price.

Flexible pricing can work in markets where customers buy a complex product

or service very infrequently, such as when they are purchasing funeral services for

a recently departed relative or a business hires a law firm to defend it against a

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novel civil suit. Customers making infrequent purchases, especially of products that

are difficult to compare prior to purchase, are often Uninformed about the

differences in price and features among competitors and about the value that those

differences might create for them. They must rely on the supplier for advice about

what to buy, which leads them to reveal information to the supplier that enables the

supplier to judge their relative price sensitivity with some accuracy.

Staying flexible in negotiating customer-specific prices in this way can

improve both revenue and profitability when selling to uninformed buyers, It has

proven horribly counterproductive, however, for setting prices for customers with

whom a seller has, or hopes to establish, an ongoing commercial relationship. The

problem arises because buyers, especially those who are professional purchasing

agents, learn over time how to manipulate a seller's flexible pricing policy and will

do so aggressively to gain competitive advantage, o: to avoid being put at a

disadvantage. Moreover, sales reps learn that it is easier to make a case to their

own management for why some customer needs a bigger discount than it is to

justify prices to buyers where access to decisionmakers is more limited and the real

purchasing process less well understood. a firm's negotiated prices become aligned

with differences among buyers' ability to negotiate and manipulate the seller's

expectations rather than with differences in value received and cost to serve.

Flexible pricing in this case undermines rather than reinforces profitability.

To prevent losing control of pricing to entrepreneurial

channel intermediaries to customers who are the smart negotiators, a company

must understand how drivers of value and cost to serve differ across customers and

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develop price structures that align price levels proactively to reflect those

differences. There are three mechanisms that one can use, individually, but more

often in combination, to form a segmented price structure: Offer configurations,

and price fences.

1. Offer Configurations

3. Price Metrics, and

4. Price Fences

Price Metrics

Not all differences in value across segments reflect differences in the

features or services desired. Value received is sometimes not even related to

differences in the quantity of the product consumed necessitating a price structure

that involves earning revenues unrelated to the quantity of the product or service

provided. For example, in the field of health care, both government and private

payers are resisting paying for health care on a fee-for-service basis since delivery

of more days in the hospital or more tests is often indicative of poor treatment

choices, not better patient care.

Price metrics are the units to which the price is applied. They define the terms

of exchange—what exactly the buyer will receive per unit of price paid. There are

often a range of possible options. What reflects the common categories of price

metrics? Per unit, per use, per time spent consuming, per person who consumes,

per amount of benefit received are among the few.

The problem with most price metrics is that they are adopted by default or

For example, initially, software companies charged a price per copy installed on one

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server machine. In most cases, that led to a poor alignment with value. A few

creative vendors recognized that when more users accessed the software, the

buyer was getting more value. Consequently, they changed the price metric from a

price "per server" to a price "per seat," resulting in customers paying more when

they had more users accessing the software. When this per-seat metric proved

much more profitable for the computer-aided and financial analysis companies that

adopted it, other software companies copied it. For many of their applications,

however, the number of users still aligned poorly with value, leaving many

customers under-priced while pricing others out of the market. The most thoughtful

among them created still better price metrics. Leaders in manufacturing software

replaced "price seat" with "price per production unit" Storage management software

suppliers replaced "price per server" with a "price per gigabit of data moved." Each

time a company discovers a better metric than its competitors, it gains margin from

existing customers, incremental revenue from customers formerly priced out of its

markets, or both.

Creating Good Price Metrics

There are five criteria for determining the most profitable price metrics for an

offering (Exhibit 4-4). The first criterion for a good price metric is that it tracks with

differences in value across segments. While offer design

facilitates pricing differently based upon what people chose to buy, a price metric

not based upon units of purchase can facilitate different pricing for the same offer.

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Performance-Based Metrics

An ideal price metric would tie what the customer pays for a product or

service directly to the economic value received and the incremental cost to serve.

In a few cases, called performance-based pricing, price structures can actually work

that way. Attorneys often litigate civil cases for which they are paid their out-of-

pocket expenses plus a share of the award if they win, rather than for hours worked.

Internet ads are usually priced based on the number of click-throughs rather than

the traditional metric for advertising: Cost "per thousand" exposure. Systems that

control the lights, heating, and cooling within office buildings are sometimes

installed in return for contracts that share the energy cost savings, rather than

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charges for the equipment installed In each case, the price metric naturally charges

customers differently for the same product or service based on differences in the

value they receive.

Tie-Ins as Metrics

A very common challenge for a company that sells capital goods is that the

value of owning them can vary widely across segments based upon how intensely

they are used. For example, a company that makes a uniquely efficient canning

machine might like to sell it both to salmon packers in Alaska, who will use it

intensely for only a couple months each year, as well as to fruit and vegetable

packers in California, who will use it to can crops all year round. One option would

be to put a meter on the machine to record every time that machine went through

one cycle. That, in fact, is how Xerox priced its copiers at launch, by leasing them

at a price based upon machine usage and refusing to sell them outright.

In service-based companies, tie-in contracts are frequently used to reduce

the cost for new buyers to try their services. Wireless phone providers offer a digital

telephone for a nominal fee, and sometimes free, if the buyer agrees to purchase a

long-term service contract to use the company's wireless network for 12 or 24

months. Satellite entertainment companies offer households a satellite dish and

receiver unit for a greatly reduced price when buyers agree to subscribe to a higher-

priced entertainment package of channels for a minimum of 12 or 24 months. These

packages can be particularly effective for low-knowledge buyers who perceive

significant risk in investing in a new and little-known technology—and then

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developing them into loyal buyers who become accustomed to the

firm's technology and programming.

Buyer Fences

Sometimes value differs between customer segments even when all the

features and measurable benefits are the same. Value can differ between customer

segments and uses simply because they involve different formulas for converting

features and benefits into economic values. The difference may be tied to

differences in income, in alternatives available, or in psychological benefits that are

difficult to measure objectively. Unless there is a good proxy metric that just

happens to correlate with the resulting differences in value, the seller needs to find

a price fence: A means to charge different customers different price levels for the

same products and services using the same metrics.

Price fences are fixed criteria that customers must meet to qualify for a lower

price. At theaters, museums, and similar venues, price fences are usually based on

age (with discounts for children under 12 years of age and for seniors) but are

sometimes also based on educational status (full-time students get discounts), or

possession of a coupon from a local paper (benefiting locals who know more

alternatives). All three types of customers have the same needs and cost to serve

them, but perceive a different value from the purchase. Price fences are the least

complicated way to charge different prices to reflect different levels of value.

Unfortunately, while simple to administer, the obvious price fences

sometimes create resentment and are often too easy for customers to get over

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whenever there is an economic incentive to do so. Thus, finding a fence that will

work in your market usually requires some creativity.

1. Buyer Identification Fences

2. Purchase Location Fences

3. Time-of-Purchase Fences

4. Purchase Quantity Fences

Self-Help: You can also refer to the sources below to help you further
understand the lesson:
Check these resources for more:
1. Agrawal, A. K., & Yadav, S. (2020). Price and profit structuring for single manufacturer
multi-buyer integrated inventory supply chain under price-sensitive demand
condition. Computers & Industrial Engineering, 139, 106208.
2. Vidrova, Z., Nadanyiova, M., & Kliestikova, J. (2020, March). PRICE FENCES AS A
MECHANISM OF COMPANYS DIFFERENT PRICING TO CUSTOMERS WITH
DIFFERENT WILLINGNESS TO PAY. In Economic and Social Development (Book of
Proceedings), 51st International Scientific Conference on Economic and Social (p.
554).

Let’s Check ( Activity 2)

Choose the letter of the correct answer.
1. ________ is directly tying the economic value received and the
incremental cost to serve.
a. Performance-based metrics
b. Buyer fences
c. Buyer configurations
d. Price metrics
2. _______ refers to the units to which the price is applied.
a. Price metrics
b. Performance-based metrics
c. Buyer fences

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d. Buyer configurations
3. _______ are fixed criteria that customers must meet to qualify for a
lower price.
a. Price fences
b. Price metrics
c. Buyer configuration
d. Buyer fences

Let’s Analyze (Activity 2)

Essay:
1. Differentiate Price Fence and Price metrics
2. Explain the Purchase Quantity Fences.

In a Nutshell (Activity 2)

1. In Summary, designing an optimal price structure that effectively

segments your market and maximizes your opportunities is clearly
among the most difficult, but potentially rewarding, aspects of pricing
strategy.

2. _____________________________________________________

3. _____________________________________________________

4. _____________________________________________________

5. _____________________________________________________

Q&A LIST 2
If you have any questions and clarifications for this lesson, please do not hesitate
to reach out via Quipper or FB Page or other convenient modes. You may list down
all your issues/questions below and write the answers after the clarification.

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Questions/Issues Answers

1.

2.

3.

4.

5.

KEYWORDS INDEX
Price structure, time-of-purchase fences, price metrics, price fence, price bundles

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