Pricing a product (or service) is hard, and there’s no set way of doing it – but there are few things to bear in mind.

### Cost Plus Pricing

If it costs you \$100 to make a product, it might make sense to price it at, say \$120 to give you a \$20 margin. This does form a useful floor to pricing – if you determine that it costs more for you to produce something than you can sell it at, then you’re in deep doo-doo. But it’s generally a dumb idea to use this alone for pricing. Here’s why.

### Value to the Customer

Let’s say that someone buys your product for \$120 and uses it directly to make \$1000. Suddenly you realise that you could have charged \$900 dollars and they would have bought it. In fact:

Price you can charge = value to customer – pain in the ass of using it

The hard part is quantifying that value and pain in the ass. If you’re selling information, or education, the value a customer will gain depends entirely on how they use it. And whatever your product, their perception of their pain in the ass of using it can be changed wildly by how well they know you, whether you can provide support, whether they’ve done it before, and so on.

If you are selling information, you can try to determine its value by estimating how it might change a decision by your customer.

For example – let’s say your customer wants to make an investment of \$1000, but isn’t sure what it will return. They estimate a \$1500 return with a 50% likelihood and a \$500 return with a 50% likelihood, so their expected return is \$1000 invested, and hence they aren’t going to bother investing anything. If your information tells them that it’s all good and it actually is a \$1500 return per \$1 invested, they can make the investment, and will make \$500. Hence, \$500 is the value of your information (minus the pain in the ass factor.)

Now – I know that’s awfully academic, but we can make it more solid. Let’s say your customer is a construction company, and they are thinking about starting a project which depends on a government permit. If you can help estimate the likelihood that the permit will be granted, you can change those probabilities, and turn a guess into a well informed decision.

### Pricing to Competition

That said, business is way messier than that. It just takes too much time to exhaustively estimate every factor that goes into a decision like this (unless you’re dealing with millions of dollars, in which case it probably is a good idea.) So, as a rule of thumb, you can look at what the competitors are pricing at. If a customer can find an alternative to buying your product that’s cheaper, they’ll take it.

More. This is especially true if your product is a commodity (i.e. all the alternatives look just the same, like salt.) But if you can put something in your product that no-one else can replace – a differentiator – that means that you don’t have to worry as much about pricing to the competition. That differentiator could be habit, brand, a relationship or something else.

### Final caveat

With all of this, bear in mind that you should always be looking at things from the perspective of the customer. Coke famously installed temperature sensors in their vending machines so that they could raise the prices of the drinks on hot days. It’s completely logical – there will be more demand on hot days, and the value of a cool drink on a hot day is definitely higher than on a cool day. But it just plain annoyed customers who felt they were being gouged (and they were), so people didn’t buy out of principle.

### Summary

• Pricing to cost forms a useful pricing floor.
• Try to determine what value the customer gains out of your product.
• If that’s too hard, figure out what their alternatives are.
• Differentiate your product if you can.
• Don’t forget to think about the customers.

## Finance Glossary for Dummies

Like technology, finance is an area replete with cool sounding words that no one outside finance understands. The dirty secret – they rarely mean anything complicated. So here’s a simple glossary of terms to help you understand what the hell finance people are talking about.

• Debt: Money that you owe to someone.
• Equity: Money that belongs to the owners of the company.
• Risk: The chance that you’ll make money or not. Risk has value – a risky pound is worth less than a riskless pound. For example – if you bet on a dog winning at the track, you don’t put down the value of what you might win to bet, but a much smaller figure, because winning is risky.
• Security: A security is an investment of any sort, and it’s a word that’s really just meant to confuse non-finance people. For example, if a bank lends money to a someone for a mortgage, they have made an investment in that person. That investment is a mortgage backed security. See?
• Amortisation: This just means payments spread over a certain amount of time. For example, if you are paying for a sofa you just bought, you could make one large payment up front, or make smaller payments over time, i.e. amortise the payments.
• Bond: If you’re a company and you need to borrow money, you can issue a bond. That bond is a promise to pay the bond holder the value that’s on the face of the bond by a certain date.
• Coupon rate: If you decide to issue a bond, you can either pay back your bond holders at the end of a set time (the bond duration), or you could pay back a percentage of the total every so often (say, every month). That percentage is the coupon rate.
• Discount rate: If you put money in the bank in year one, you’ll get that money back with interest in year two. This means that a pound today is more valuable than a pound tomorrow. That rate which determines the time value of money – which in this case is the interest rate – is more generally called a discount rate.
• Stock or Share: If you buy a share, you buy a small part of the company. For small companies, this might mean buying out a founder’s capital investment in part or in total. For a large company, this might be buying a share from an investment market – but essentially both are the same thing.
• Option: An option is, literally, the option (but not the requirement) to buy a share at a predetermined price. You can exercise this option at a future date, or any any time until that future date (depending on the option type).
• Future: A future is an obligation (or contract) to buy at a specific price, at a specific future date. Pretty much the same as an option, but this time there is an obligation to buy.
• Beta: Indicates how well a company does versus the economy. See below!

There are some concepts here that bear a little bit of further explanation.

### Options

Let’s say the value of one share of Yahoo is \$10 right now, and you buy an option on this at a strike price of \$10 which you can exercise in a year. This means that in one year, you can buy a share at the preset strike price (\$10) and sell it at whatever the current market rates, or you can choose to just let the option go. So, if the stock price next year is \$12 you would exercise your option and make \$2, but if the stock price next year is \$8 you would choose to let the option go. Of course, if the market believes the price is going to go up, then it will cost you something to buy that option.

### Beta

I won’t go into a discussion on the CAPM – but sound off in the comments if you want me to change this. Instead, here’s the simple version. Beta indicates how you might expect a company’s returns to vary with respect to the market. If:

• beta = 1.5, it will return 1.5x the market
• beta = 1, it follows the market
• beta = 0.5, it is positive when the market is positive but half as big
• beta = negative, it is positive when the market is negative

So, you can expect the price of large beta stocks to be up when the market is up, and low or negative stocks to be up when the market is in trouble.

How do you determine the beta? By examining historical share prices. By examining the betas of other similar firms. But best of all, by considering consumer behaviour. For example, a firm that manufactures and packages own-brand economy label food might be a negative beta firm, as more people buy economy brand food when times are tough.

### Debt & Equity

Debt and equity are weirdly interchangeable.

Usually, equity holders are the owners of the company, they ultimately call the shots, and profit comes back to them. Debt holders just lend money and get paid back.

But it’s not so simple. If you own one share of GE, you’re not calling any shots. Tax shield effects mean that company profits are going to interest payments for debt holders. And those debt holders might have lent GE so much money that they are calling the shots on what happens with that cash.

There are also these things called hybrid securities which are, literally, a hybrid between debt and equity. Oddly, pure debt and pure equity are both extremes of a scale.

## Perception Of Pricing

Evil marketing at its finest:
We all know that price promotions usually give an uptick in sales, but it doesn’t matter whether you’re actually cutting price – it only matters whether customers think you’re cutting price.

Case in point: GM’s “Employee Discount” pricing, launched on 2005, turned out to be hugely successful for the company in driving unit sales. However, it turns out the the average transaction price during this period was higher than usual, because shoppers had to pay sticker price (no haggling) and were unable to get the same rebates as usual. A double win for the company!

Even worse, it turns out that shoppers don’t pay much attention to pricing. Two marketing professors went around shops asking people if they could recall what the price was of the item they’d just put into their basket. Here’s what happened:

• 31.8% guessed and got it wrong
• 47.1% got it right

The implication there is that price matters, but perhaps less than marketing think it does. Sure, it’s not conclusive – some people could guess right, some people just have bad memories, there’s some variance depending on the item type and so on.

A subsequent study focuses on coffee only – as a staple food, one expects price sensitivity and hence recall to be higher, but the results appear similar. Score one for our conclusion.

However, if we equate “customers think we’re cutting price” with a promo barker, sticker or similar, then we’d need to do a slightly different study. The follow-on study also states that “price-recall accuracy is significantly related to promotion status of the brand and category purchase frequency of the consumer”. So, we have to take the results with a tiny pinch of salt.

Conclusion? If you’re cutting price to drive sales for a promo, just think carefully about how much you actually need to cut. It may be that creating a convincing perception of promo is more important for driving up volume sales.

## Segmentation Or Identity

When marketing a product, it’s generally a good idea to split up the market so you can understand more clearly who you’re targeting, and who you’re not.

Segmentation

The common way of doing this is by segmentation. For example, Ikea normally aims its products at people aged around 30 (among other things) – that’s a type of segmentation by age. Here are some ways you can segment*:

• Geographic: Country, region of the country, urban / rural areas
• Demographic: Age, sex, family size, income, occupation, education level, religion, race, nationality
• Psychographic: Social class, lifestyle, personality type (e.g. introvert / extrovert)
• Behavioural: Light / heavy product user, brand loyalty, usage type (e.g. in combination with another product)

Some of those types of segmentation are independent (e.g. age, gender, nationality) while some could be dependent on each other (geography with nationality, personality type with brand loyalty). So picking your segmentation combination is important. Even worse, there’s no obvious formula for doing a good one.

Identity

Another way of looking at things is to use an identity. It’s a very similar way of looking at things, but acknowledges that one person might belong to more than one segment. For example, a businesswoman might be all Armani at work, but a Miss Sixty consumer at the weekend. So, do they prefer sharp design or bohemian? The answer is both.

Why is this important? Well, if we can find a product that aims at multiple identities – for example, a car that appeals to the sporty AND the practical side, it’s more appealing.

Which one should I use?

The easy answer is that it depends on your product / service. But that’s a cop out.

My opinion – it depends on the size of your subset. Targeting a specific combination of identities is stronger, but it’s going to be a smaller target than just the segment. If your product is an expensive one (like a house or a car) then you don’t have to have a large market, and you can think about identities. If your product is mass market and / or cheap, think about segmentation, so you can get at a specific need.

It’s also worth considering if your product will be used in a specific environment (e.g. a suit) or a more than one environment (e.g. a car or a laptop). With the latter, thinking about identities that cover each of the environments becomes more useful.

—–

*This is adapted from Doyle’s “Marketing Management and Strategy”, a dull but useful book.

## Services Marketing – Starbucks Case Study

I’m doing a course this term called Services Marketing, which does exactly what it says on the tin. Our latest assignment – head into a Starbucks, and create trouble for them to see how they react. Then repeat with a Dunkin Donuts. Even though I don’t drink coffee, it seemed like too much fun to pass up.

Starbucks

I ordered a latte – standard size. Not many other people in the shop. The lady taking my order seemed very pleasant and tried to make a light joke. They didn’t take my name to yell out when it had become ready (thank goodness). I received the latte.

I then tried to return it and get a Mocha, offering no explanation why. The chap who had make my latte turned, initially confused, to the barista next to him. She nodded and said it was okay – after which he took the latte to one side and produced a mocha to my taste. The mocha is slightly more expensive than a latte.

Dunkin’

Dunkin’ Donuts is a US based food chain. They were originally known for donuts (hence the name), but in recent time coffee has become a central offering – so much so that the logo has a coffee cup on rather than a donut:

Same trick – I ordered a latte, took a couple of sips and then tried to swop it. They asked why I wanted to swop it – I replied that I didn’t like it. They just swapped it.

What does that mean?

Both did well – but I got the strong sense at Starbucks that being nice was the party line, while at Dunkin’ I got lucky. I’m drawing that conclusion somewhat from the reputation and the ambiance of both stores – Starbucks is well known as the “3rd place” and has to be welcoming, while Dunkin looks like more of a transactional environment – you come in, pay your money, take your item and bugger off.

The General Opinion

The class generally found that Dunkin’ generally wasn’t as accommodating, and interestingly, that their experiences with Starbucks were inconsistent. We heard stories of two stores just down the road from each other (in New York) having completely different customer service standards.

The Problem With Starbucks

… is one of segmentation. Their target customer while they were in high growth was all about the third place, wasn’t used to premium coffee and just moved slower. Now that time has moved on, a new and significant younger segment who is used to premium coffee just wants to get in, get their coffee and get the hell out. So we can see a shift in what’s important in store:

• Before: Barista knowledge of the coffee, a pleasant environment
• Now: Speed

So we can make two deductions.

• The people who are getting agitated waiting in line are disrupting the pleasant environment of the older segment
• There isn’t much overlap between the desires of these two segments

So what’s the solution?

Here’s one solution, anyway

If you’ve been keeping an eye out, you may have noticed this – Starbucks Express. This is a store where you don’t even have to interact with anyone – you can just get your coffee and get out.

Will this start to turn off the older segment? Will they start heading to Peets instead? There are no answers yet – this is one case study we’re living in the middle of, so all we can do is wait and see.

## Professor Tedlow at the Computer History Museum

Learning about the birth of the IBM S/360 while at the Computer History Museum is like eating chocolate biscuits wrapped in chocolate as far as I’m concerned. Last week I tasted the goodness.

What’s the System/360?

Back in the day, you bought a computer and programmed for that computer alone. If you bought another one, this ran a different way and you had to program it differently. Now imagine how many PCs you’ve been through, and imagine how it feels for a company that wants to buy a computer, then grows and needs a bigger one. It sucks, and every time you switch it doesn’t matter if you buy an IBM, a Fujitsu or whatever – you have to rewrite everything anyway.

The S/360 was the first line of computers where architecture and hardware were separated. That meant that you could buy a little one, write programs for it, then buy a bigger one when the time came to upgrade. It meant less of a pain in the arse for customers, and a lock-in for IBM. Kerching!

The only problem was that the project was planned to cost \$5bn over four years, which was way over IBM’s annual revenue at the time. They went ahead with the project – but why? They answer, as usual, is a bunch of different reasons.

IBM, the organisation

Tom Watson Sr, who pretty much started IBM from scratch, was a Victorian, moral, old guy. This song probably helps explain better than I can. His son, Tom Watson Jr., was handed the reins just as Sr was shuffling off his mortal coil. They didn’t get on. The father never trusted the son.

This is Watson Sr. Definitely a crusty old dude.

So the son, we suppose, wanted to do something to make IBM his own. But there’s more.

Fear

It seems that there was a culture of fear at IBM at the time. Fear of competitors, sure – but also fear of doing nothing and being squashed as a result. People argued with each other all the time, but the strong culture that Watson Sr. had installed kept the company together and working. This is the amazing part – the agitation that people felt was what drove them to win.

Andy Grove describes some similar stuff in his book about his time at Intel.

`"Fear is powerful in creating and maintaining passion. Fear of competition, fear of bankruptcy, fear of being wrong and fear of losing can all be powerful motivators."`

The strange part for me is that history repeated itself. There’s a formula for a successful culture here, but certainly not a comfortable one.

Here’s another one:

`"Success breeds complacency. Complacency breeds failure. Only the paranoid survive."`

You’ve probably heard that one before, but it’s fascinating. Any successful company’s first instinct is to recognise what they did that was successful and repeat it. As time goes on, they become resistant to doing anything else – I mean, it seems completely illogical. Why would Microsoft do anything to endanger Office or Windows? Why would IBM leave hardware and turn into a services company? But the problem is that it leaves you completely open to attack by a competitor who is free from this way of thinking.

Lots of companies have thought a little further ahead, and released products that cannibalised their own – it’s better to do that to yourself than let someone else do it for you.

The S/360 was one of those projects, and IBM was one of those companies.

The Tutor

The class was taught by Prof Tedlow, who is one of the superstar professors at HBS, and a specialist in business history. It’s unexpected to see someone that skinny fill a stage, but that’s exactly what happened. He had help – the room was littered with old-school IBMers, including a couple of superstars.

That gentleman on the left is Tedlow. And on the right, Gene Amdahl, the chief architect of the S/360. (Oh – and he quit IBM, started Amdahl computers, which flopped and got bought by Fujitsu, to the amusement of the chap now working at Fujitsu who was sitting to my left.)

One more that I didn’t manage to get a picture of – Bob Evans, the S/360 project lead (hat tip to Karae in the comments).

The more things change

There’s nothing really new that happens in business – culture changes, products that change the industry, engineering versus sales and so on.

I thought that technology was an exception.

Maybe not so much.

## Grey Poupon Case Study

Ever heard of Grey Poupon?

I hadn’t. It turns out that it’s a premium mustard. Here’s an old ad – this, of course, is the British version.

As you can see, the ad screams premium branding, and the American version is no different. It’s a good ad – a touch of light comedy, and it communicates the brand value well.

But it failed to drive sales for the strangest reason. It turns out that people bought Grey Poupon, but they then never used it because it was too premium. They actually used crappy mustard, but saved the Grey Poupon for special occasions. So it sat in the larder, and they never bought another one.

The solution? They changed the packaging from the premium thick glass jar … to a squeezy bottle. And here it is, snapped at a local eatery.

## Value Based Pricing

We received a talk on pricing this evening which I thought was a great illustration. I present it here for your delight. Yep – this post contains pricing theory and fertiliser. Please keep reading?

It’s lonely out here, but maybe I should stop mowping

Nobody likes a grass

Your company, Freddy’s Fertiliser, produces regular fertiliser for grass. As you’d expect, the grass becomes greener, and it grows faster.

One day, your R&D people stumble upon a secret formula that makes grass green, but also halves how fast it grows. Strangely, this product is cheaper to make than your regular fertiliser. What do you charge for it?

Pricing To Cost

It turns out that most companies answer the question in this way.

`Price = our cost + some margin`

As this new fertiliser is cheaper to make, it should be cheaper to buy, right? This is simple to think about, but there are two important problems.

• It’s difficult to determine what your cost actually is. Do you use variable cost? Do you try to allocate out some of your fixed costs? If you do, you need to know how many you’ll sell, and forecasting can be more magic than science.
• Most people figure out how much margin they should be make by looking at their competitors, but in a small or nascent market, it’s likely that everyone is guessing.

Pricing To Value

So here’s the other way of looking at it. How about we price a product according to what a customer might pay for it?

`Consumer value = usage benefit + emotional benefit - monetary cost - pain in the ass cost`

• Usage benefit: What tangible benefit will the customer get out of using it?
• Emotional benefit: Does the customer want to be associated with the product? Do they love your brand? Or hate it?
• Monetary cost: The Benjamins.
• Pain in the ass cost: This are other costs like having to learn how to use a product, having to buy complementary goods and so on.

Keep Off The Grass

The cool part about having your grass grow more slowly is that you don’t have to mow it as often. That’s of some benefit to end consumers, but it helps most when you have to mow as part of your business costs.

Golf courses.

Golf courses have a huge pain in the rear keeping their grass at a reasonable level, and they have a lot of grass to mow. So how much more should they be paying for it?

Here’s the answer – it’s worth the difference between their current situation and using the new fertiliser, minus a little bit. Let’s think about the two product benefits again:

• It makes grass greener. The old fertiliser does too, so this adds up to a big fat zero.
• It makes grass grow slower. Let’s say that it halves the growth rate. That means you need to mow half as much. Take the mowing budget for the year, divide it in two, then divide that by the number of bags you expect to sell over a year. That’s how much you can add to the price.

Marketing Hat

Then, you put your marketing hat on. You’re now making way more margin – the costs are lower, and the price is higher. Use some of that margin to pay for different packaging. Disassociate it from regular fertiliser. Actually, don’t even call it fertiliser any more.

To be honest – this is all fairly logical. There’s no magic in here. You just have to remember to consider it next time you need to price something. Just think of fertiliser.

## Karen May, Executive VP of Global HR, Kraft

In this evening’s Managerial Leadership class, we were able to welcome Karen, who is a bigwig at Kraft. (For anyone who doesn’t know anything about Kraft, it’s a \$35bn company with 104,000 employees.) It turns out that she used to work for our professor at Baxter, so he was able to twist her arm into coming along and sharing with us some of her insights.

As might be expected, we asked a bunch about how best to handle our career development. Here’s what she came back with.

• Create your own path. Don’t expect anyone to mark out a path to the top for you. Having unusual experiences is a bonus, as you can bring fresh perspectives to your role.
• Bring yourself to work. You should feel like you’re being yourself, and you don’t have to hide anything about your personality, or that you have a family – that sort of thing. Both you and your workplace should fit each other.
• Development is your job. Only a minimal part of your development happens during training – most of it happens on the job itself, and you need to form a plan for that development. It doesn’t require budget – just the time to reflect on what you need to work on and why.
• You have weaknesses. Lay them out and have people help you. You can help others with things you’re strong at, but don’t be afraid to ask for help if you need it.
• Sometimes, setting big goals like “I need to become a better leader” means that nothing will get done. So set small goals instead, like “I need to go to the dentist this month” or “I need to build a relationship with this person”. These goals are more easily achievable, and add up the same thing.

## The Power Game

In last week’s Managerial Leadership class, we played a fascinating game directed by Professor Buck. Here’s how to play.

Ingredients: 30 or more managers, one dollar each

Time to cook: 30 mins

Instructions:

• Take one dollar from each of the managers.
• Segment out the managers. Make a random 3 top management, a random few middle management, and the rest on the bottom.
• Give 2/3 of the cash to the top managers, and 1/3 of the cash to the middle managers.
• Communicate the rules of the game. Top management can talk to anyone. Middle management have to knock before entering a room containing top management. Bottom management can’t talk to top management, and have to know before entering a room containing middle management.
• Separate the three tiers into different rooms.

Note that there is no real objective for the organisation.

Scaling up

Following the discussion of our simulation and previous examples our Prof had conducted, we came away with a bunch of insights.

Firstly, here’s how everyone feels.

• Top tier: burdened with responsibility
• Middle tier: unsure what they need to do exactly
• Bottom tier: powerless, bored. (Some people in this tier left during the simulation.)

Isn’t that a wonderful microcosm of a real company? Here’s what we learned.

• The first five minutes are critical. (This is just like a CEO’s “first 90 days”.) For the leaders, they go very quickly – for the bottom tier who have no idea what to do yet, they go very slowly.
• Management should say something to the bottom tier as soon as possible. In this case where noone has any clue, that can’t stop management communicating.
• It may be tempting to wait until you have a full plan before presenting it to the bottom tier. However, this means you will wait too long.
• Being totally authoritative is not going to work. Being totally participative is not going to work. The bottom tier both need direction, and need to participate. This is a fundamental contradiction.

Here’s what I see as the solutions to this problem.

• It seems that the best way is to come to the bottom tier as soon as possible and say “we have no idea what we’re doing, but we’re working on it. By the way, let us know if you have any ideas.”
• If the organisation is not small, or if what you’re deciding isn’t that important, or if you need to decide quickly, eliminate middle tiers and make decisions in a more dictatorial fashion.

The People Have Spoken

After the game, Professor Buck shared a story with us about another instance of the game. Here’s what happened.

The top tier went away, taking the money with them. They thought about it for a long time – most of the game time – and decided that the best thing was to go to the local shop, buy a whole bunch of snacks and drinks, and have a party for the remaining part of the class. They were pretty pleased with themselves, and thought that this was the best idea that they could have come up with.

Meanwhile the bottom tier was left to its own devices. They had a long debate over the time they had … and they decided that the best thing was to go to the local shop, buy a whole bunch of snacks and drinks, and have a party for the remaining part of the class. They were pretty pleased with themselves, and thought that this was the best idea that they could have come up with.

So the top tier do exactly that, and go and buy the snacks and drinks. They walk in at the end of the time, and lay everything out on a table at the front of the classroom, and turn to the crowd, expecting a great reception for the idea.

Then, one of the bottom tier in the front row gets up, walks over to the food, and throws it onto the floor.

For the remainder of the time, noone will touch any of the food even though it is exactly what they wanted.

This was a wonderful illustration of this principle:

• People will execute a decision if they are part of the decision process, even if they disagree.
• People will refuse to execute a decision if they are not part of the decision process, even if they agree.

Culture Testing

Another quick tidbit – you know how everyone says you need a shared culture and that it needs to align? Bizarrely, it’s possible to test roughly for culture.

• Ask: what do you do?
• Ask: and why is that important?
• Ask: and why is that important?
• Ask: and why is that important?
• Ask: and why is that important?
• Ask: and why is that important?

The last answer will report culture. Some will say “to deliver shareholder value”, some will report “to make people happier”, some will report “so I can get paid” and so on. It’s a neat way of getting an answer on culture, and once you have that you can check whether everyone is aligned with each other, and whether they are aligned with the mission of the company.