Value based pricing, the art and science behind setting prices that are based on the value a buyer gets from a purchase, rather than on irrelevant factors like the cost of producing something, has created happier buyers and sellers. However, value based pricing fails to fully account for the irrationality of human behavior.
Instead of limiting the focus to just "value", it's time to expand to include behavior. In behavior based pricing, while the company continues to price at the value the customer ascribes to the product, they also seek to understand and manipulate that perception of value, measure, and increase it. Inputs to this new pricing math come not only from the buyers’ behavior, but also from the competitive landscape.
If you read our post on Whole Foods and Walmart spending, you can guess that behavior based pricing is hard at work.
If, instead of pricing everything on cost-plus-margin, you set prices based on observed willingness to pay, you’ll have a variety of unit margins in your store. But each one will have a purpose, derived from behaviors of your customers, and overall your contribution margin (and, possibly, revenue) will be higher. But retail is more complicated than that.
Think about how you bought your last television, and how you bought the trash bags under your sink. Do you remember how you bought the trash bags? You probably don’t even remember looking at the shelf, let alone buying them. But the TV was a big purchase, and you might have looked online, and then gone to a store (or not–probably not) to buy it. You might even have waited for a big sale, around the Super Bowl or the holidays, to make such a big purchase.
These buying behaviors have tremendous implications for pricing strategy for different products. Some products, like the TV, are “hero products”. These are heavily shopped and consumers are highly aware of their prices. Those you would take lower margin on, because a high margin would price you out of the market–and, probably, make the rest of your products seem expensive costing you lifetime customers.
Other, trendy and popular products are not heavily shopped. These might have very high margins. Think of Monster Cable. You’ve bought a TV for $1,000. What’s $50 to make it look its best?
Many other products’ demand shifts, and the only way to keep up with this is to be aware of behaviors of conversion rate trends, the competitive landscape, and other behavioral indicators so that you can ensure that you maintain your value proposition–and overall margins–while maximizing your motivations.
While behavior based pricing accounts for these nuances in how people buy, it goes further: it suggests manipulating them, or, at least, not hurting yourself by making obvious mistakes.
For example, assortment and presentation can affect buying behavior. Showing prices prominently can hurt conversion rate, or push consumers subconsciously to buy a product they like less because they focused on price. Take a look at Tiffany's, for example.
Tiffany.com markets its collections without showing prices until you've hovered or clicked into a product, because they know that the primary question is making sure you choose the product you like most.
Demand for an item can be manipulated by how the item is marketed, merchandised, and promoted. We’ll see cars that go from point A to point B sell for 3 times a nearly identical car, expensive coffee selling even better next to an even more expensive coffee, and ways to simply focus away from prices that might lead to 10% conversion rate improvements. This is because, fundamentally, consumers behave strangely–but predictably, and measurably.
Deciding on across the board margin targets, while simple, clear and measurable, guarantees you will earn a 40% margin on a unit basis, but it also guarantees that you will never make more than a 40% margin. Further, it increases the chances you will have shelves full of unsold product at the end of the season, and be sold out of your most popular items precisely when they become popular and drive traffic to your website or stores.
Focusing on consumer behavior expands the opportunity for you to grow and profit, and prevents loss common in across-the-board cost-plus pricing. You are able to capitalize on several key pricing strategies all at once: value based pricing, loss leaders, anchoring, and more, in a way previously unimaginable. We call this behavior based pricing. Let’s learn how to apply it.
Getting to Know Goldilocks
If you manufacture products and control your product line, or if you manage categories and can add higher or lower end products to influence consumer behavior, you may find what follows interesting.
A fundamental of human behavior is something called extremeness aversion. Put simply, people avoid extremes. This means that having just one option will nearly always convert worse than having three, if the three represent a good, better, and best version, because that arrangement enables buyers to avoid the extremes (high and low) and go for the middle option. We will cover this strategy, “Goldilocks Pricing”, in depth later. But here, let’s see what Goldilocks can teach us about behavior based pricing–in a Porsche.
Let’s say Goldilocks is thinking of buying an SUV, and is looking at the Porsche Cayenne. The 2016 Porsche Cayenne line ranges from the $58,300 base model to the $157,300 Turbo S version. Each trim (as versions are known in the business) has a variety of features, but all of them meet basic safety standards, will get the driver and 4 passengers from point A to point B, and have plenty of power.
Porsche doesn't expect many customers to buy the low-end model, because who wants to own the cheapest version? By the same token, they don't expect many consumers to splash out on the top of the line model. Instead, the middle models from the $74,800 S version to the $114,700 Turbo attract the vast majority of buyers.
Both the lowest and highest end models serve as anchor points to nudge the customer toward spending much more than the base price: upgrading with any number of bells and whistles once they've made the initial purchase decision. And, if anyone does buy that Turbo S, Porsche makes an incredible margin, while those who opt for the cheapskate option likely would have bought a different marque had it not been available at that price point.
Note that the cost for producing all of these versions is similar. The Turbo S is not fully twice as expensive to produce as the base model. Instead what is going on is a thoughtful, well honed pricing strategy that takes advantage of many different consumer behaviors. And the margins they make on the cars do not factor into it. Instead of trying to optimize for margin per model, they optimize for contribution margin on the line overall.
Once Goldilocks has settled on her mid-range version (say, the Cayenne S), she is also anchored in a different way. All dollar decisions are inherently context-relevant. Having decided to pay $74,800, Goldilocks has no trouble paying an additional $500 for power seats. It is minuscule in terms of the overall cost.
We talk to companies all the time who aren’t sure if behavior based pricing is right for them. That sentiment is totally normal. Does it feel right to get a much, much higher margin on some models than on others?
Remember, nothing compels the buyer to buy. If they don’t value your product more than your price, they won’t buy. And if they say “I wish it were cheaper”, but buy anyway–what they say doesn’t matter. You’ve captured the value and observed it in the behavior.
We’ll come back to this fundamental–actual buyer behavior–over and over because it’s core to making behavior based pricing decisions in a digital environment. Whether you’re addressing the paradox of choice (too much selection reduces conversion) or expanding your product line with Goldilocks pricing (higher conversion because of extremeness aversion) the focus will always, necessarily, be on consumer behavior.
If you'd like to explore behiavor based pricing, our forthcoming ebook has a playbook for how to so. Subscribe to the right, or contact us to get an early release.