Departments: Consumer & Society
Smart Pricing Strategies for Services HONG Sun-Young
Price: A Key Determinant of Corporate Profitability Instant access to a world of online shopping information has made pricing decisions more difficult, particularly for service providers who operate in a world of increasingly commoditized offerings. Thanks to price comparison websites, post-purchase blog reviews and social networking services, searching before purchase for tips on product prices and benefits is now routine. In fact, product-related data is the most searched item among Korean smartphone users. Price comparisons are sought in 76 percent of searches, followed by discount deals (62.9 percent), store information (56.9 percent) and delivery status (37.7 percent). Thus, when consumers are confronted with services that have little variation, price is often the primary determinant. For service providers, savvy pricing is the best way to fatten profit margins. In fact, studies of various industries show that firms that can raise their prices 1 percent can boost profitability by 10.29 percent. This far outstrips a 1 percent reduction in variable costs (6.25 percent), a 1 percent increase in sales volume (3.28 percent) and a 1 percent reduction in fixed costs (2.45 percent). When an economic downturn arrives, many companies lower prices to shore up profitability. Discounts, however, can backfire if unaccompanied by systematic pricing policies, while price wars usually fail to jump-start profits during a recession. Budget-constrained consumers become indifferent to sales promotion schemes like super special prices. In short, recessions diminish the desire to rush out and shop. Moreover, when economic health returns, it can be difficult to raise prices back to pre-recession levels. Conversely, price markups deemed necessary in providing services tend to drive away customers, if they are deemed excessive. Last year, Net-
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|Figure
1 Impact of Price on Profitability by Industry Price Variable costs Sales volume Fixed cost
25 20.1
20
14.8
15 10 5 0
10.4
10.2 7.6
7 2.8 2 Agriculture, forestry and fishery
4.8
6.8 2.5 2
Mining and construction
3.2 2.8
9.9
8.2
6.8 4
2.5 2
5.1 4.7
7.6 5.1
3.8 3.3 2.5
2.5 2
Finance, Manufacturing Transportation, Wholesale and insurance and communications retail trade real estate and electric services
Services
6.8 2.72.2 Public administration
Source: Raju, J. and Zhang, Z. J. (2010). Smart Pricing. Wharton School.
flix, which provides movies to US households, lost 800,000 subscribers when it raised the price of its combined DVD mailings and video streaming by 60 percent.
Service Pricing Strategies There are four characteristics of services which separate them from physical goods, and these characteristics need to mesh with pricing strategies. First, inventory is perishable—services or capacity lose their value if unsold or unused by a certain time. Second, some standardized service products come in limited supply. High investment levels offered with a low variable cost per unit are often associated with this characteristic, with the typical example being airline seats and hotel rooms. Third, extreme demand swings occur depending on the hour of the day, the day of the week and month, and the season of the year. Finally, price acceptability varies widely among consumers. Comparing intrinsic value is more complex with a service than with a manufactured product.
Conversely, price markups deemed necessary in providing services tend to drive away customers, if they are deemed excessive.
Taking these characteristics into account, this study suggests four pricing strategies that can October 2012 | SERI Quarterly | 101
Smart Pricing Strategies for Services
|Figure
2 Four Smart Pricing Strategies Price Attributes
Pricing Strategies
Perishable inventory
Price differentiation
Fixed quantities
Dynamic pricing
Wide scope of price acceptability
Service bundling/partitioning
Widely fluctuating demand
Consumer-driven pricing
enable service companies to boost profitability while being more attuned and receptive to customer willingness to pay for services.
Price Differentiation Willingness to pay for an identical service can vary among consumers, and companies can use a price differentiation system to find out what customers consider an acceptable price. Under a price differentiation system, consumers are segmented into groups based on non-demographic factors like price sensitivity and consumption patterns. Price system data sets can enable detailed analysis of customer preferences, time of use, number of customers, refund rules and waiting time. After studying its customer base, the Walt Disney Co. discovered that guests who want to make multiple visits to its theme parks are willing to pay $24 for each additional day after their first visit. In its price discrimination matrix, Disney charges $79 for a one-day adult ticket to its theme park but only $243 for a 10-ticket package, a 69 percent savings from the full price of ten single visits. Recently, about 60 percent of US online retail102 | www.seriquarterly.com
Discounts for loyal customers, price-sensitive customers, and launching of new services Optimal price determination system based on demand Free services, price partitioning and price bundling
Pay what you want, reverse auctions
ers have customized prices by using data aggregation software that surmised shopping behavior based on a consumer’s address, type of computer used and length of time to click through towards a seller’s payment page. The online travel agency Orbitz, for example, shows Apple Macintosh users more expensive hotel recommendations, because the company noticed that Mac users are willing to pay more for hotels than Windows users. During a recession, service providers can avoid costly price wars and retain customers by identifying customers that are highly price sensitive and offering exclusive discounts to them. Amazon’s “Subscribe & Save” program enables consumers to have household basics delivered at intervals of one to six months with only a few computer clicks. With free shipping and an automatic discount of 5 to 15 percent on all items, this program is compelling enough to attract customers that want to be thrifty but want to avoid tedious price-comparison research and shopping trips.
Dynamic Pricing Dynamic pricing is a flexible system that attempts
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to smooth out large fluctuations in demand and time-sensitive value of services. Since the 1970s, the airline and hotel industries have been trying to increase both sales and profits with a wide variety of different prices based on current reservations and potential demand. In 2005, a task force at Marriott International developed the hotel company’s “Group Pricing Optimizer (GPO)” system. Unlike individual bookings, there were formerly many difficulties in finding optimal group rates for large-scale |Figure
3 Price-response Function
Probability to win 1.0 0.8 0.6 0.4 0.2 0 50
|Figure
100
200
250
300 Price($)
200
250
300 Price($)
4 Profit Function
Profit function ($) 350 300 250 200 150 100 50 0 50 100
|Figure
150
150
Coupled with a rapid increase of consumer data and advanced data analysis technologies, dynamic pricing has spread to a broader variety of service providers. They take into account key variables besides sales history and prospective demand. In 2009, the San Francisco Giants experienced great success in using dynamic pricing for certain sections of seating in the stadium, starting a nationwide trend. In the 2012 baseball season, 17 of the 30 major league teams used the concept. The Giants dynamically priced single-game tickets by analyzing the effects of 12 variables on fan attendance, including popularity of opposing teams, game day weather forecasts, day of the week, and starting pitching lineups. During the 2009 season alone, 25,000 extra tickets were sold, generating an extra $500,000 in revenue, even though dynamic pricing only applied to low-cost bleachers and upper deck seats.
Service Bundling or Partitioning Another pricing strategy involves combining a product with low marginal cost with other products. The aim is to lower customers’ price perspective. In other words a basic service is sold at a low price to lead to the purchase of other products, which can generate profits for a company’s suite of services faster than separate transactions.
5 Expected Profits
Expected profit ($) 70 60 50 40 30 20 10 0 50 100 150 200 Optimal price
events and conferences because of special group needs, as well as differing lengths of stay and different characteristics among attendees. The GPO system provided Marriott with a faster, more consistent way to calculate potential room rates for a group and the potential profit at each price level. Marriott could thus quickly deduce optimal rates to maximize profits.
250
300 Price($)
YG Entertainment, Korea’s second largest entertainment agency, recently opened up a store on October 2012 | SERI Quarterly | 103
Smart Pricing Strategies for Services
eBay (stores.ebay.com/ygentertainment), offering over 50 types of merchandise totaling more than 8,000 pieces (including branded glow sticks and Tshirts) for local and overseas fans of K-Pop artists like Big Bang and 2NE1. With albums put up for sale at low prices, the company is using music sales as a stepping stone to selling concert tickets, merchandise and memorabilia. Instead of presenting a service’s total all-inclusive price, partitioning the price into individual components is another way to lower perceived price. Partitioned pricing is more advantageous in conditions where customers are sensitive to the price of a basic service and think that price transparency is high. Tune Hotels, a budget hotel company in Malaysia, reduced the per night cost of its rooms to $3 but assessed additional charges for room amenities like towels, shampoo and air conditioning. Conversely, bundled pricing may be preferable if customers feel uneasy about paying à la carte prices even though the basic rate may be attractive. Going against the trend in the airline industry, in which many airlines have added on fuel surcharges and baggage fees to air tickets, Southwest Airlines strives to boost customer loyalty and satisfaction levels with its “Freedom from Fees” policy, which bundles all basic services in its ticket price.
Consumer-driven Pricing As customer perceived value of a service is highly subjective, customer-driven pricing reflects the buyer’s judgment. Especially in the case of content products, a name-your-ownprice mechanism that lets consumers suggest their own price can be implemented, because the variable cost of serving an additional customer is minimal or next to nothing. Launched in 2002, Korea’s online news outlet OhmyNews created a new journalism culture by operating under the motto “every citizen is a reporter.” It 104 | www.seriquarterly.com
has since drawn ordinary individuals to become active players in content production through a combination of professional and citizen journalists, paid for with a “tip-jar” revenue-source system that invites readers to reward citizen reporters with small donations. For each article written by a citizen contributor, readers are encouraged to pay a certain amount of money, ranging from 1,000 up to 30,000 won, by clicking a link to their bank account, credit card or mobile phone. The payout after deducting value-added tax and fees is thus made directly to the citizen reporter. The writer of one particularly popular article received nearly 17 million won from its readers, while the average reward per published article is about 4,700 won. In order to move beyond existing categories and develop new products and pricing systems, companies need to spot and reflect consumer needs in pricing policies. Last year, United Airlines and Lufthansa Airlines, both members of the Star Alliance network, gathered information from frequent travelers about airline services and the prices consumers are willing to pay. A group of 161 elite-level frequent flyers on Star Alliance carriers spent $130,000 to charter a United Airlines jet, where they carried out discussions on airline service policies while they were flying. As expected, the top source of dissatisfaction with their airline experience was prices (29 percent). Topping their wish list was more space. Among the suggestions was a “Tommy Class” in which passengers pay 50 percent more than regular coach to keep a seat next to them vacant, like the business-class cabins offered by European airlines for flights within Europe. Another idea they proposed is to exempt frequent flyers from refund rules or fees for any changes to their itinerary after every 50 flights or so. United Airlines had its executives traveling with the group, and both Lufthansa and Air
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Canada met with the group.
Implications Although a recessionary period amplifies price sensitivity, service companies should regard the downturn as an optimal time to introduce new pricing policies, shoring up profitability. Even in a recession, it is possible to generate an incremental 2 to 3 percent increase in profitability if companies focus on pricing strategy rather than customer retention, sales and cost reduction. To this end, expertise in pricing must be acquired through analysis of customer profitability, price sensitivity and pricing by competitors. This knowledge can then be used to find the best price regardless of cyclical fluctuations or price changes by competitors. Furthermore, service companies must enhance consumer trust and loyalty levels by persuasively conveying the value in their prices, and differentiating their services. Most consumers object to different pricing for the same products or services. According to a study by the University of Pennsylvania’s Annenberg Public Policy Center, 87 percent of US online shoppers said that price discrimination based on individual customers or customer segments is unacceptable, and 76 percent agreed that it would be unpleasant to pay more than others do for the purchase of an identical product. Amazon learned this in September 2000, when its regular customers learned that the Internet retailer had offered new buyers DVDs at a substantially lower price. After being bombarded with criticism, Amazon refunded the difference in price to anyone who had paid more for the same DVD. Service providers should accordingly forestall complaints by understanding consumer psychology and behavior when setting up pricing criteria. Finally, corporate departments that take part in pricing decisions (including product development, marketing and sales) need to work togeth-
er to strengthen pricing capabilities. Close cooperation between these departments can build a sophisticated pricing system that promptly suggests new prices during changes in the business environment. At Waste Management, the largest waste collection and recycling company in the United States, leaders from the IT, marketing and sales departments work as members of its pricing committee and jointly participate in measuring the value of services and making the optimal price decisions. As a result, the company saw an extra $218 million, about 2 percent of total sales revenue, by maintaining optimal prices that are 0.5 to 1 percent above the consumer price index, even as the sluggish US economy has competitors cutting prices. To sum up, service companies must implement pricing from a strategic viewpoint that facilitates long-term profit and growth, rather than the one devoted to reaching short-term sales goals. Translation: Yi Chiwon
Keywords Smart pricing, economic downturn, price differentiation, dynamic pricing
HONG Sun-Young is a research fellow at SERI. Her research focuses on service quality engineering, service process design and quality function deployment (QFD). She holds an ME in Industrial Engineering from Pohang University of Science and Technology. Contact:
[email protected]
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