Price

Structure
Tactics for Pricing Di erently Across
Segments
 After developing products or se ices that create value, a marketer must
then determine how most pro tably to capture that value in both volume
and margin.
 e challenge in doing so is that customers value products di erently
because of di erent abilities to pay, di erent preferences, and di erent
intended uses.
Moreover, the timing of customers’ needs, the speed of their payments,
and the level of se ice and suppo they require can drive
signi cant di erences in the cost to se e them. Mstrong\
•A single price per unit is rarely the best way to generate revenues.
•Realizing a company’s pro t potential created by the
di erentiation in its features or se ices requires creating a
structure of prices that aligns with the di erences in economic
value and cost to se e across customer segments.
• e goal of that structure is to mitigate the tradeo between
winning high prices for low volume and high volume for low prices.
• e goal is to capture more revenue from sales where value or
cost to se e is higher, while accepting lower revenue where
necessa to drive still pro table volume.
oTo illustrate the huge bene ts of a well-de ned segmented price
structure, suppose that a supplier faced ve di erent segments, all
willing to pay a di erent price to get the bene ts they sought from a
product.
oSegment 1 with sales potential of 50,000 units is willing to pay $20 for
the
rm’s product. Segment 2 with sales potential of 150,000 units is
willing to pay $15, and so on. What price should the rm set? e right
answer in principle is whatever price maximizes pro t contribution.
oIf you calculate the pro t contribution at each of the ve 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.
 ese high-end buyers perceive signi cantly 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.”
 e rm would be better o if it could capture some of this
surplus by charging higher prices to these buyers.
 e second problem is that the supplier leaves nearly half of
the market unsatis ed, even though it could se e those
customers at prices above the $5 per unit variable cost.
For industries with high xed costs, se ing those additional
customers is often ve pro table and, when they constitute large
amounts of volume, can be essential for a company’s su ival.
Even companies that se e only the premium end of a market often
nd that it is risky to limit themselves to that segment when they could
be leveraging some common costs to se e other segments as well.
For years, Xerox owned the high end of the copier market. It lost that
dominant
bottom of position
the only
market after companies
developed se ice that had
networks entered
of su at the
cient size to
suppo the higher-priced equipment bought by customer segments,
such as copy, centers that require quick se ice to minimize downtime.
•How many segments with di erent price points should a supplier
se e?
•To return to our illustration, if the rm were to set two price points
se ing two general price segments—high-end buyers willing to pay
$15 or more, and mid-level buyers willing to pay $8 or more—it could
increase pro t contribution by 40 percent. But if the supplier could
charge separate prices to each of the ve market segments, it could
increase pro t contribution by 80 percent relative to the single price
strategy.
•In principle, more segmentation is always better.
•In practice, however, the extent of price segmentation is limited by
the ability of the seller to enforce it at an acceptable cost.
So how can sellers charge di erent prices
to di erent customers and for di erent
applications?
 e answer is by creating a segmented price structure that varies
not just the price, but also adjusts the o er or the criteria to
qualify for it.
oA segmented price structure is one that causes revenues to va
with di erences in the two key elements that drive potential
pro tability: the economic value that customers receive and the
incremental cost to se e them.
o ere are three mechanisms that one can use to maintain such a
segmented structure: price-o er con guration, price metrics, and
price fences.
oEach is appropriate for addressing di erent reasons for the
existence of value-based segments.
PRICE-OFFER CONFIGURATION
When di erences in the value of an o er across segments is
caused by di erences in the value associated with features,
se ices, or both, a seller can segment the market by
con guring di erent o ers for di erent segments.
Using o er design to implement segmented pricing requires
minimal enforcement of the segments because customers
self-select the o ers that determine their prices.
 e segmented pricing of airline seats is based pa ially on o er design, with
passengers freely choosing whether they want the price that includes the ability
to cancel or change ights freely, or want to forgo that feature in return for a
much more discounted price.
To determine whether it would be pro table to add another o er combination
to the menu of choices, you would need to create a spreadsheet analogous to
the one in Exhibit 3-2.
With that spreadsheet, you could analyze whether the additional o er
combination costs more to administer than the incremental pro ts it would
contribute.
e right number of price points depends in each case on the sizes of the
customer segments, the value and cost-to-se e di erences between them, and
the cost ine ciency from a proliferation of o ers.
 To create an e ective price structure, one must rst determine which
features and se ices the rm should price à la ca e, leaving customers
to customize their own o ers and which features and se ices to bundle
into packages.
 ere are multiple arguments against pricing all individual features and
se ices separately.
A single price for a bundle of features and se ices reduces transactions
costs for both customers and sellers.
 e costs to make and deliver most products and se ices increase with
the number of variations allowed, although technology is reducing the
cost of mass customization.
Lastly, research has shown that people are less sensitive to the cost of
value-added features and se ices when bundled as a single expenditure.

Optimizing an O er Bundle
By creating more than one bundled option designed to appeal to di erent
segments, a marketer can get most of the bene ts described above along with
the nancial rewards of segmentation.
Auto manufacturers, for example, put features together in the “spo package”
or the “luxu edition” that have a single price for that bundle of options, while
cable TV operators create di erent bundles focused on families, spo s
enthusiasts, and movie bu s. Since ve few buyers would want just one
element of the bundle without putting any value on the others, few sales are
lost relative to the bundling e ciencies achieved.
Adding to the bene ts of bundling, sellers can often earn more pro t by
pricing a bundle than they could by pricing the individual elements when a
pa icular relationship exists among the features included in the bundle.
Bundling is pro t enhancing when it is possible to bundle features
and se ices that create high value for some signi cant customer
segments but more moderate value for another.
A simple à la ca e price for one feature or se ice that optimized
pro tability from one segment would necessarily over or under price
other segments. Bundling, however, can facilitate more pro table,
value-based pricing to each segment.
e following example illustrates the principle when the same features
can be priced pro tably for more than one segment, but the most
pro table price level for di erent segments is not the same.
 Musical ente ainment can provide an ideal oppo unity
for pro table bundling, where the “features” valued
di erently by di erent segments are the di erent types of
pe ormances.
In Boston, where the authors live, one can buy tickets in
a series that includes a few headline pe ormers—such as
Green Day, Jay-Z, or Kenny Chesney—as well as some
lesser-known but often more “innovative” pe ormers such
as Kings of Leon or Solja Boy.
 e challenge is that there are two large customer
segments to which these conce s appeal.
 ere is a large general ente ainment segment that views music as just one
ente ainment option.
People in this segment are willing to pay a lot to hear great headline pe ormers, so
revenue from them is maximized at a high ticket price (say $60 per ticket). However,
they need to be induced to t a conce that is more innovative (no more than $25
per ticket).
Without their suppo , it is unlikely that innovative conce s could attract a large
enough audience to justify o ering them.
Fo unately, since Boston is home to multiple music schools and music a cionados,
there is a smaller segment that is willing to pay as much or more to see new,
innovative pe ormers as to see headliner pe ormers.
However, because much of this segment consists of students and musicians, they
are more price sensitive to the headline pe ormers whose music they have already
experienced.
e challenge is to maximize income from these two segments combined.
Designing Segment Speci c
Bundles
oBundling can also facilitate segmented pricing, thus increasing pro tability, when di erent
customer segments have di erent price sensitivity for a “core” product or se ice (for example,
lodging at a popular vacation spot).
oWhen it is possible to nd features or se ices that one segment values highly and another
does not (for example, access to a pro-quality golf course or a “kids’ club” where children can
be left safely and ente ained), it is easy to design segment-speci c pricing by bundling.
o e golfer evaluates the sum of the room cost plus the golf cost in guring the cost of the
vacation. If the golfer values lodging at this location by $100 per night more than the family, he
will pay up to $100 more per day for greens fees than he would at an equal quality course in a
less desirable location. (Assuming, of course, that no cheaper but equal quality course is
available near this location.) Since the family did not come to play golf, they are una ected by
high greens fees.
Unbundling Strategically
•While bundling can be a pro t-enhancing strategy for segmentation, it often has the
opposite e ect when variable cost se ices are bundled simply to di erentiate an o ering.
•For example, a business-to-business equipment company might t to convince
customers to pay more for its machines by bundling the promise of faster warranty repair
se ice and free delive anywhere, and a business-to-consumer airline might hope to
charge more for its tickets because they include free baggage handling and agent
assistance with rese ations.
•Such price-o er structures often undermine rather than enhance pro ts and can be fatal
to companies that cling to them in competitive markets
PRICE METRICS
•Price metrics are the units to which the price is applied.
• ey de ne the terms of exchange—what exactly will the buyer receive per unit of price
paid. ere are often a range of possible options.
•For example, a health club could charge per hour of use, per visit, per an “annual
membership” for unlimited access, or per some measure of bene t (inches lost at the waist
or gained at the chest).
• e club might also va those prices by time of day (low for a midday membership,
higher for peak-time membership) or by season of the year to re ect di erences in the
oppo unity cost of capacity.
Creating Good Price Metrics
 e rst criterion for a good price metric is that it tracks with di erences in value across
segments.
Second, a good metric tracks with di erences in the cost to se e across customer segments.
A third criterion for a good metric is that it is easy to implement without any ambiguity about
what charge the customer has incurred.
 e fou h criterion for evaluating a price metric is how the metric makes your pricing appear
in comparison with competitors’ pricing, and the impact of that on the perceived attractiveness
of your o er.
 e fth and nal criterion for evaluating a price metric is how the metric aligns with how
buyers experience the value in use of the product or se ice.
Pe ormance-Based Metrics
oAn ideal price metric would tie what the customer pays for a product or se ice directly to
the economic value received and the incremental cost to se e.
oIn a few cases, called “pe ormance-based” pricing, price structures can actually work that
way.
oAttorneys 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.
o Internet ads are usually priced based on the number of “click-throughs” rather than the
traditional metric for adve ising: cost “per thousand” exposure.
Tie-Ins as Metrics
 A ve common challenge for a company that sells capital goods is that the value of
owning them can va widely across segments based upon how intensely they are used.
For example, a company that makes a uniquely e cient 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 eve
time that machine went through one cycle.
 at, in fact, is how Xerox priced its copiers at launch, leasing them at a price based
upon machine usage and refusing to sell them outright.
For the canning machine manufacturer that did not expect to have se ice people at the
client site on a regular basis, the idea of a usage-based lease was not practical.
What was practical was a “tie-in sale” that contractually required purchasers of the
canning machine to use it only with cans sold by the seller at a premium price.
 us, the true cost of the machine was not just its low explicit price but also the net
present value of the price premiums paid for the tied-in cans.
PRICE FENCES
 Sometimes value di ers between customer segments even when all the features and
measurable bene ts are the same.
Value can di er between customer segments and uses simply because they involve
di erent “formulas” for conve ing features and bene ts into economic values. e
di erence may be tied to di erences in income, in alternatives available, or in
psychological bene ts that are di cult to measure objectively. Unless there is a good
“proxy” metric that just happens to correlate with the resulting di erences in value, the
seller needs to nd a price fence: a means to charge di erent customers di erent price
levels for the same products and se ices using the same metrics.
 Price fences are xed 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 (bene ting “locals” who know more alternatives).
Price fences are the least complicated way to charge di erent prices to re ect di erent
levels of value.
Buyer Identi cation Fences
Occasionally pricing goods and se ices at di erent levels across segments is easy
because customers have obvious characteristics that sellers can use to identify them.
Barbers charge di erent prices for sho and long hair because long hair takes more time
to cut. But, during nonpeak hours, barbers also cut children’s hair at a substantial
discount, despite the fact that children can be more challenging and time consuming.
 e rationale in this case is entirely to drive business with a discount for a more price-
sensitive segment. Many parents view home haircuts as acceptable alternatives to costly
barber cuts for their children, even though they would never bear the risk of letting their
spouses cut their own hair. For barbers, simple obse ation of the customer segment,
children, is the key to segmented pricing.
Purchase Location Fence
When customers who perceive di erent values buy at di erent locations, they can be
segmented by purchase location.
 is is common practice for a wide range of products.

Dentists, opticians, and other professionals sometimes have multiple o ces in di erent
pa s of a city, each with a di erent price schedule re ecting di erences in the target
clients’ price sensitivity. Many groce chains classify their stores by intensity of
competition and apply lower markups in those localities where competition is most intense.
Time of Purchase Fences
 When customers in di erent market segments purchase at di erent times, one can segment
them for pricing by time of purchase.
 eaters segment their markets by o ering midday matinees at substantially reduced prices,
attracting price-sensitive viewers who are not employed during the day at times when the
theater has ample excess capacity. Less price-sensitive evening patrons cannot so easily
arrange dates or work schedules to take advantage of the cheaper midday ticket prices.
Priority pricing is one example of segmenting by time of purchase. New products in a retail
store are o ered at full price, or sometimes premium surcharges over full price in the case of
extreme excess demand. Over time, as product appeal fades in comparison to newer
competitive alternatives, buyers discount the product’s value until they are willing to pay only a
fraction of its original price for leftover models.
Purchase Quantity Fences
When customers in di erent segments buy di erent quantities, one can sometimes
segment them for pricing with quantity discounts.
 ere are four types of quantity discount tactics: volume discounts, order discounts, step
discounts, and two-pa prices. All are common when dealing with di erences in price
sensitivity, costs, and competition.