We have previously looked at how customers make choices to buy your product or service instead of those of your competitors, and at how to get them to buy more, or to simply pay more for the things that they do buy. As we have seen, there are many elements to the decision to buy, of which price is only one. You need to understand that price can be a positive tool in winning a sale rather than just a route of dropping the price to make the Value Scales balance.
Chapter 6 looked at the idea of bundling items together into packaged prices in the belief that offering a wider range of options will allow our premium customers to buy a premium solution, while our value customers buy our cheaper options. This chapter is specifically focussed on how we can use price as a lever to deliberately move customers from one product or service to another. There are a number of benefits to this, which will be presented.
Essentially, the idea of directional pricing is to encourage customers to buy the products that you want them to buy, by using price as a way of discouraging them from buying other products or encouraging them to buy the ones that you want.
This chapter includes:
The advantages of moving customers to alternative options
Before we look at the how? part of this chapter we need to consider the why? part. What are the benefits of moving a customer to buy one option or another by adjusting price to encourage them to do so?
Once again, most of this is actually a sales skill that needs to be honed and used by the frontline people, but price is a factor in the decision-making that can be very influential in directing the customer to one purchase over another.
A project to drive up the profits of a struggling tourist attraction, DFAP, considered the profitability of the main food outlet on the site. Initial research found a number of important issues. Problems included issues such as that the seating area was right next to the indoor play area, and tables were often clogged up by people just drinking tea or coffee while their children played in the play area, or worse still, they just used a table and made no purchases from the restaurant at all.
Furthermore, when customers looked into the restaurant seating area, they were often put off from ordering food due to the absence of somewhere to sit, or just the perception that it was exceptionally busy and would take a long time to be served. Although this is not at face value a price issue, customers paying restaurant prices for their meal expected to be able to sit at a table to eat it. Without this, the Value Scales tipped the wrong way and often drove customers to use the outdoor fast food options of sandwiches and snacks where sales values and margins were lower.
Freeing up the restaurant space to enable customers to see the value of an indoor sit-down meal option was crucial.
We were then able to look at the individual food offers and consider points, such as the raw material cost of the product and hence the gross profit margin. We also observed the time it took to produce and therefore the wage costs and the impact on the speed through the service area and tills.
The conclusions were fairly obvious:
Clearly, what we wanted to do was to encourage guests to buy more of the profitable items and spend more overall.
The chapter on bundling looked at the idea of packaging items together to encourage customers to spend more, and in this context we did develop a number of meal deal options that offered say a Small pizza, fries and a cold drink at a competitive price compared to the individual components. That is, individually the pizza could be £3.99, fries £1.50 and a drink £1, but the total of £6.49 would be reduced to £5.99 on the meal deal option. This did indeed lead to increasing the average value of each sale. If you want to see a business that is brilliant at this then just visit your nearest McDonald’s!
However, in the context of this chapter I just want to explore how we used directional pricing to affect the sales of pizzas.
Although they sold Small, Medium and Large sizes of pizza, they found that the large pizzas were usually bought by families to share, so they focussed their attention on the Small- and Medium-sized options to see if they could improve profit by using directional pricing techniques.
When they calculated the profit on these two pizza choices they found the following data:
Table 12.1*
|
Cost to produce |
Selling price |
Profit |
Percentage sold |
|
|
Small pizza |
£2.90 |
£4.00 |
£1.10 |
50 per cent |
|
Medium pizza |
£3.20 |
£5.00 |
£1.80 |
50 per cent |
*Numbers are simplified to make the maths easier and to make the point crystal clear. Please don’t get hung up on whether the items should have been priced at £3.99 or £4.99!
What we can see from this data is that the costs of producing a Medium pizza are only marginally above the Small one, just an extra £0.30. The labour costs to make them and the cooking time are almost identical, and there is only a small extra cost for the additional ingredients. Given the extra £1 on the price, the profit was clearly better on the Medium pizza.
Now, you would obviously want to sell more Medium pizzas than Small ones, as each one makes around £0.70 more profit, partly because its price was higher but also because the margin was 36 per cent compared to only 27.5 per cent on the smaller one.
When they looked at the numbers, they found that they sold almost exactly the same number of each size. What this told us was that overall, the extra price of £1 was seen as a fair uplift to match the extra value of the bigger size; ie the Value Scales balanced properly for each pizza.
But it is not the business’s objective to ensure that every item sold is priced fairly with others; the objective is to deliver value and make a profit. The question is therefore: What can we do to encourage customers to move from the small pizza to the medium pizza where we make a higher profit?
The box below explains four options and the risks with each. These need to be considered with the inherent uncertainty that we could not work out customer reaction in advance, and would therefore need to take a leap of faith and test an idea in a real-life situation.
1 Free extra toppings on the Medium pizza – Adding extra mushrooms or bacon bits at a cost of 10p has a low impact on the profit margin (£1.80 reduces to £1.70, or 36 per cent reduces to 34 per cent) but it differentiates the value between each option.
The risk with this option is that it would have added an extra £0.10 to the cost of all the Medium pizzas, and if no one upgraded from the Small to the Medium we would have just reduced our overall profits unnecessarily. It is a low risk in the sense that we could trial it for a week and see what happened and then simply remove the special offer sign if it didn’t work.
2 Increase the cost of the Small pizza – We knew already that customers thought that the extra £1 on the price was matched by the extra value of the Medium size, hence the 50:50 split in sales volumes. Therefore, if we set the price of the small at, say, £4.50, many customers may upgrade to the Medium-sized one as a result of the perception of much greater value compared to the new price of the Small one.
This is a little more risky as some customers may not upgrade to the Medium or even stick with the Small at the new higher price, but might simply opt out altogether and not buy either pizza. The reality of course is that they would probably buy something else instead, such as a burger. So again, a modest risk of losing customers overall.
3 Decrease the price of the Medium pizza – The value-for-money issue is the same as the point above; ie if we know that customers currently see the price and value differential as fair, so that dropping the Medium price to, say, £4.80 should nudge a few customers to move from the Small up to the Medium, and we would still be making a higher profit on the larger pizza.
This is a lower risk in the sense of upsetting customers, but like option 1, if we failed to move enough customers from the Small to the Medium by making it seem much better value, then we have just given profit away from all those customers who already bought the higher priced item.
4 Removing the Small option altogether – People who specifically wanted a pizza would have no choice but to buy the Medium (or the large family-sized option) because the less profitable Small option is no longer on offer.
This is a similarly risky option as number 2, in that some customers may not buy the Medium in the absence of the Small option, but in a captive location such as the tourist attraction they would probably buy something else instead. The added advantage for the business is the simplicity of now offering fewer choices and therefore gaining a little simplicity on the menu, making preparation a little quicker and easier.
None of the options are without some risk, either in losing customers or in giving profit away that is not matched by customers opting to buy the more profitable pizza.
We increased the Small pizza by 50 pence. The figures then looked like this:
Table 12.2*
|
Cost to produce |
Selling price |
Profit |
Percentage sold |
|
|
Small pizza |
£2.90 |
£4.50 |
£1.60 |
40 per cent |
|
Medium pizza |
£3.20 |
£5.00 |
£1.80 |
60 per cent |
*Again, numbers are simplified to make the maths easier and to make the point crystal clear.
As you can see from the above, the costs of production are unchanged, the profit on each item is now very similar and the profit margin within a 1 per cent range. Essentially the business didn’t now care which one customers bought as they were happy with the profit on either.
As you can also see from the end column, the impact was to move approximately 10 per cent of the customers from the Small to the Medium option. What did that mean in overall profit terms?
Old Prices
50 small pizzas at £1.10 profit on each |
£55 |
50 medium pizzas at £1.80 profit on each |
£90 |
Total profit for 100 pizzas |
£145 |
New Prices
40 small pizzas at £1.60 profit on each |
£64 |
60 medium pizzas at £1.80 profit on each |
£108 |
Total profit for 100 pizzas |
£172 |
As you can see, we were able to increase the gross profit for each batch of 100 pizzas from £145 to £172. This was an increase of almost 18.6 per cent.
That is the essence of directional pricing.
The most critical issue with the principle of directional pricing is to make sure you know the current facts before you consider tinkering with the prices. You absolutely need to know the exact profit you make on every item you sell. That is not just as simple as the gross profit on each one (although that is a very good starting place) but should cover things such as the impact of returns by customers, or complementary sales. In other words, it is no good pushing customers to buy product A that seems to be more profitable if that item is frequently returned for refunds, or if product B generates significant future revenues. The lawnmower business may have one brand of mower that generates more profit but which is forever breaking down within the warranty period, or may prefer to sell a lower profit petrol mower than a higher profit electric one that has no ongoing service and maintenance revenues.
When you know the true profit on each item, you also need to know the numbers you sell of each. In many businesses this could be a simple button-pressing exercise to interrogate the computer, but in the pizza example the till records simply said pizza until we made them show the specifics of the size. We could identify the volumes based on the prices but it is a lot easier if the computer or smart till can spit out the numbers.
When you know these facts, you need to establish what economists call the elasticity of demand for the products. That is, its sensitivity to price. In other words, what will be the impact on sales volumes as prices rise or fall? The problem of course is that there is no book with this data. It will vary from business to business and customer to customer, and even day to day. What you need to do is to test it by good old-fashioned trial and error.
The starting point is to identify products or services where customers could choose option A or option B based on their perception of value. That could be as simple as Small- or Medium-sized pizza, or it could be any pizza versus any burger. In Chapter 6 we looked at the example of a professional services firm that offered Gold-, Silver- or Bronze-level options containing different service levels, such as variations on the frequency of contact.
When you know the true costs and profit of alternative options, and you are clear on where customers can choose option A or B, then you can start to explore the impact of using price to move customers to the one you want them to buy.
My suggestion would be to test this gently by talking with a few trusted customers to ask their views on value for money; ie would they buy option A or B at £X prices, and would that decision change if the prices changed to £Y.
You could also test prices on individual customers or groups that are already unprofitable and where you may therefore accept an outcome of losing the customer altogether. Or you could test it on a branch-by-branch basis where you have multiple outlets and compare the results from each.
There is, however, a very important point that must be understood. In earlier chapters we looked at the fact that most businesses are already charging below the level of the customer’s real view of value. This lack of confidence to charge the right price is a fundamental problem for many businesses. Therefore, a basic strategy for many businesses is just to nudge the prices up slightly and see what happens. In my experience of a great many businesses, nothing happens. Customers accept the higher price and the business simply makes more money. The changes are so small and the existing value so high that customers just don’t react. The object of directional pricing is that we want them to react. We want them to choose a more profitable option as our pricing has either made that option appear much better value for money or the alternative option much worse value, encouraging them to switch. Therefore, small changes in price are unlikely to give us any really valuable data to assess customers’ reactions to price.
If we had changed the price of the pizzas to, say, £4.03 and £4.97 (once again ignoring the significance of numbers or price thresholds covered in earlier chapters) the reality is that we may have seen no measurable change in the volumes and concluded that there was no point in pressing on with the plan.
What many projects that look at pricing tell us is that very few businesses even think about the idea of encouraging customers to buy their most profitable products, and are just pleased that they have bought anything at all!
Ouch!
If you combine the thinking on the issues covered in Chapter 6 with some additional effort to consider the points covered in this chapter, many businesses will be able to develop bundled options that are priced in such a way as to ensure customers are encouraged to pick the ones that generate the most profit. All it really requires is clarity on the financials and a desire to try.
Setting extreme prices to make other offers seem comparatively attractive
The final point I want to make is the situation where we use a very high top-end price to encourage customers to buy a lower-priced option by creating an impression of exceptional value for money.
CASE STUDY
A small plumbing business specializes in installing bespoke bathrooms for individual customers. Typically, the price for a standard fit-out may be between £5k to £10k depending on what bathroom the customer wants and their choice of quality of fittings, etc. Ordinarily the business owner would simply offer options in the range of £5k to £10k and then debate with the customer what they want and what they can afford. This may be presented as say Gold, Silver or Bronze levels as described previously. The customer will make their selection based on their own personal perception of the Value Scales at each price point.
What happens if we now add a Platinum option at £25k?
It does several things. First, it suggests that that the plumber is certainly capable of delivering a Wow! bathroom that is out of this world. This gives the customer much greater confidence that he is more than capable of delivering any of the lower-priced options to very high standards; ie it adds credibility to the quality message that the plumber wants to convey.
Second, by just having a £25k option, the plumber makes the £10k option seem much better value for money compared to when that was the top-of-the-range price. A customer who was thinking £10,000 seems a lot, will no longer see that amount as so expensive. Although it may not change their ability to afford any option, they will certainly see the £10k choice as better value for money than when it was the top price.
Finally, he might occasionally be amazed by a customer who says, ‘Great – go ahead with the £25k option!’
Many businesses would benefit by adding a very high top-end option to the choices the customer has because, regardless of whether any of them buy it, the perception of value for all other choices increases.
A business selling large, garden play equipment had a range of products that stretched from around £1,000 to almost £10,000 in price. They found it really hard to get many customers to select the most expensive option, until they added the absolute child’s dream of a garden castle costing almost £16,000. Over the following year they only sold one of these top-of-the-range options, but the sales of the previously most expensive choice more than doubled.
With any business, the number one priority is to try and achieve a sale. Once the seller is in the area where that is possible – ie the Value Scales are moving around the balanced position, they should then be considering what they want to sell. That may be driven by a motivation to shift particular lines of slow-moving stock, or to sell a more profitable option to the customer.
This is where directional pricing comes into play: flexing the prices of the various options our customers could choose, as a lever to nudge them towards the products we want to sell.
If the business’s motivation is to try and shift slow-moving stock, this is almost always done by simply dropping the price of those items, when this may be just as easily achieved by increasing the price of the alternatives.
If the motivation is to use directional pricing to increase the overall profit, then the problem is that there are rarely sufficient facts about profit margins to use this tool properly. Before a business can even consider playing around with prices to direct customers from one product to another, they absolutely need to know exactly what profits they make on each one.
If you combine these issues with the guidance in Chapter 6 on how to bundle items and offer variations of these to customers, then directional pricing techniques can be a powerful tool in any pricing strategy.
1 Make sure you know the profit margin of every product or service that you sell.
2 When you have the information from 1, you should then identify who should have access to this information so that it is properly used. The pricing team will need to set target prices, maximum discounts figures, etc and to determine prices of comparable items as part of the directional pricing approach. However, be careful that the facts on profits are not simply used by frontline people to sell down to the lowest level possible to achieve a sale.
3 Identify any items for which there is a current need to promote sales. That may be based on high stock levels or potential obsolescence. Review prices to encourage sales of these items (ie lower price if you buy 10 items, rather than a lower price overall).
4 Diarize a repeat of action three- or six-monthly or at quarterly intervals so that you have a rolling programme of stock clearances.
5 Identify all products where customers can choose to purchase two or more similar items (eg petrol or electric lawnmowers or Gold, Silver and Bronze options) and where they therefore make a choice as to which one they buy. For these items:
a Ensure you know the profit you make on each option (see 1).
b Identify any additional issues such as the potential for ongoing revenues or associated purchases.
c Identify your preferences as to which product you wish to prioritize for sale.
d Get the pricing team to set price variances to test how you can move customers to your preferred option.
e Once the pricing team are happy with the results at d, get them to train frontline staff appropriately and update all relevant sales materials.
6 Make sure your current systems are capable of identifying sales by line items on your products or services lists; ie Small pizzas vs Medium pizzas rather than just pizzas.
7 Look at all of the products and services you sell and identify a Platinum option that can be added to your price lists in order to improve the perception of value for all other choices.