The Dart Player’s Guide to Pricing When Prices Fall
by Donald V. Potter
Falling prices threaten many industries today. A decline in product prices, or deflation, can devastate a company’s bottom line. Companies in industries where competition expands faster than demand grows, such as those with overcapacity or high growth, face constant pricing pressure. Over the last 25 years, we have studied several thousand price reductions in more than 70 industries. The experiences of these firms may suggest safer channels to navigate through a market beset by falling prices.
You might think of pricing as like a game of darts. Darts is simple in concept. Less so in execution. The dart board divides into twenty wedges. The player targets each wedge in turn. The player’s placement of the dart in the wedge determines the points on the turn. The more limited the area of the wedge the dart is able to hit, the higher the points accumulated in the turn. Pricing in a falling price environment is similar to darts. You pick your target and then aim for the smallest part of your target that will meet your needs. In pricing, your target is a segment of the customers in your market. Your dart is the component of price that limits your lower price to the smallest segment that demands the lower price. You can limit the spread of a price reduction by asking two questions, in sequence:
- The target: What customer segments will receive the new, lower price?
- The dart: What components of the price will limit the lower price to the segment?
The combined answers to these two questions allow the company to reduce prices with the greatest precision, saving margins.
In this article, we will illustrate this approach using two industries with long term falling prices: airlines and wireless phone services. The airline industry has been in overcapacity most of the time since its deregulation in 1978. It still fights the price battle. Fast growing industries offer similar lessons on lessening the pain of price reductions. The wireless phone industry has had the good fortune to grow faster than most industries. Still, prices have been under long-term pressure because of competitive expansion.
The Target: Customer Segments
Segmentation for pricing focuses on the pricing pressure points and the segments that these pressure points may create. This segmentation will create segments that are primarily defensive or offensive in the company’s intent. You isolate segments for defensive price reductions where you must respond to competitive price reductions in order to avoid losing market share. These segments include segments purchasing price-competitive products or those under assault by aggressive competitors. Even in deflationary markets, there are offensive segments as well. With these segments you use a unique low price to win new sales. Offensive segments result from customers purchasing at a particular time or from the customer segment’s ability to help the company build its margins.
Product Purchased Segments – Defensive Segments
Price competition may be intense around the most common product. Other products, especially those above the standard product price point, may offer less competition and better margins. Price sensitivity at a product price point develops because some customers see little difference among potential suppliers on the benefits of product function, company reliability or convenience of purchase. These customers make their purchase decision in favor of the supplier with the lowest price. In these markets, companies may segment customers around parts of the product system or around products with fewer benefits.
- Segments purchasing a part of a product system
A company may identify the key benefits of the product system and focus the lower prices on only one or a few of those key benefits. The airline industry has done this by charging fees for early boarding, more legroom, meals and checked bags – all once part of the regular ticket price. The wireless business charged extra for roaming, over-limit minutes and data plans. In both cases, the base product price remained low. The extras cost more. The low priced benefit may also work in reverse, with the low price on the extras and the base price remaining high. As examples, airlines offered full fare customers free hotel stays in Europe; wireless firms subsidized their phones.
Purchasers of loss leader products also fit this segmentation. Companies offer these products in order to entice customers to purchase other products. For example, in the airline industry, companies offer bonus miles to new members of frequent flyer plans.
- Segments who might prefer a product with fewer benefits
Price sensitive customers may be signaling that they do not need, or want to pay for, all the benefits that the standard product offers. Some companies find segments of customers who might choose a product with fewer benefits at a lower price. Wireless carriers began pushing their lower cost prepaid plans as the market for their post paid plans began to mature. One airline created late night red-eye flights costing about the same as a bus ticket.
Competitive Supplier Segments – Defensive Segments
The force behind falling prices might be one, or a limited set, of competitors. In these cases, companies focus on defending the customer segments who do, or could, purchase from the discounting competitors. Companies reduce prices for these segments to retain their purchases.
- Specific competitor segments
Price sensitive customers might form segments around an individual discounting competitor or competitor type. The airline industry saw United’s Ted and Delta’s Song services aimed directly at the segments served by the Southwest Airlines of the world. In response to low-cost voice over internet phone competition, VirginMobile released a service allowing its customers to make phone calls on their cell phones using home wireless networks and Wi-Fi hotspots, saving their cellular minutes.
- Geographic segments
A competitor who attacks the market with low prices may do so in a limited geography. Segmentation is then geographic. Delta Airlines countered lower prices from AirTran by offering lower fares from Atlanta, where AirTran had a hub, to other cities where the two companies competed. As the new PCS companies entered the wireless market, the established wireless carriers, such as AT&T Wireless, slashed prices, but only in areas where the new companies entered.
- Individual Customer segments
In intensely competitive markets, competitors often seek the largest customers. In these markets, suppliers often cut separate deals with individual customers, especially the largest customers, in order to capture a substantial share of the purchases of these customers. The individual customer becomes the segment. Airline companies have done this with large corporations and with wholesale purchasers. The big wireless carriers have used individual pricing as a key weapon in the battle for elite government and corporate contracts.
Time Segments – Offensive Segments
A falling price environment may offer occasions, or periods of time, where the company can reduce price offensively, offering a uniquely low price in a segment in order to gain market share. This does not work if competitors respond with their own lower prices. During these periods, competitors either can not or will not respond to a company’s discount. The competitors can not respond when they do not know of the discount in order to counter it. The competitors will not respond when they see the discount as unlikely to impact their margins.
- Short Term Sales segments
Competitors may not respond to short-term discounts. When Continental Airlines started service at Chicago’s Midway airport, it offered low fares to thirty cities for about three weeks. To sign new customers in the rapidly growing wireless market, Bell Atlantic reduced its cell phone prices from $40 to $5 for new customers who would sign up within a couple of weeks of the offer. These sales produced little competitive response.
- Relationship Renewal segments
Competition may not know when a company renews a relationship with an established customer. Verizon offered its subscribers a “New Every Two” program. This program allowed a subscriber to get a new phone free every two years with a two year contract renewal.
- Public Relations segments
Public relations discounts go to segments of customers who might take a dim view of the company, such as those who were inconvenienced in some way by the company. Competition rarely knows of these segments. Airline companies offer travel vouchers for customers whose trips were cancelled or who were bumped. Sprint offered lower prices to work-at-home or homebound customers.
- Lagging Performance segments
Competitors in a market may discount to hold some business if they are weak or to liquidate aging inventory. This weak condition cannot last a long time or the discounting competitor will be forced from the market. Competitors may ignore these segments, seeing them as too small to affect their margins. In the early 90s, Braniff regularly offered discounts off the prices of its larger competitors. The competitors knew that Braniff had few daily departures and a small fleet of planes and ignored its pricing. Other examples include discontinued product sales.
Margin Building Segments – Offensive Segments
A deflationary environment is not always a one-sided price negotiation. There are usually opportunities for some customer segments to help the company improve its margins in return for a lower price. These customers are able to help the company improve its revenues or to reduce its costs.
- Revenue Improvement segments
Some customers are able to improve the company’s revenues. Customers may be able to recruit other customers. In the wireless business, both AT&T and Verizon allowed their customers to make unlimited calls to other subscribers of the same carrier. Cingular Wireless, the market leader at the time, allowed subscribers to add a family member to their accounts for an additional charge of only $9.99/month.
Customer segments who also build company revenues include customer segments who might purchase a package of related products, such as a vacation package including air travel, hotel stays and a rental car. Other segments might use a company product which is affiliated with a third party from whom the company receives revenue. The Southwest Airlines web site advertises products, including rental cars and hotels. These partners pay a fee for this advertising.
- Cost Saving segments
More common than revenue improvement segments are those customer segments able to save the company costs in return for a lower price. Some customer segments will buy specified volumes of product, well in excess of the average customer. Air Canada offers pass products allowing customers to purchase bulk tickets at a discount on selected routes and regions.
The wireless industry’s fixed-priced, unlimited data and voice plans are similar examples.
Other customer segments may use fewer resources than the average customer. Airlines offered non-refundable tickets to avoid the costs of cancellations in the standard tickets.
Customers who affiliate themselves with the company may receive lower prices or more benefits because they reduce the company’s marketing costs. The airline industry offers frequent flyer programs just for that reason. Sprint launched Sprint Premier, a loyalty program for customers who had monthly plans valued at $60 or more, or who had been Sprint customers for more than ten years. These customers were able to upgrade their phones at preferred prices after one year instead of two. They also received 25% off accessories and earned additional free minutes.
Some segments are willing to alter the timing of their purchases to buy when the company has slack in its capacity. The Trump Shuttle cut fares for travel on weekends and off-peak hours.
The Dart: Components of the Price
On occasion, segmentation alone may sufficiently limit the scope of a lower price. But, in most cases, companies limit the damage which a lower price inflicts on margins by judicious use of the components of price. The component is your dart in the game, the instrument of precision that limits the lower price to the smallest part of the market possible.
Every price has at least three, and usually four, components: the benefit package, the basis of charge, the list price and, usually, some optional components of price. You use these price components to contain the spread of lower prices, even within your target customer segments. While we describe these as four components of price, most are mechanisms, associated with price, that change the performance of the product rather than its price.
These four components of price may develop the business as well as limit the spread of low prices. They each accomplish at least one of four objectives that develop the business. First, they may encourage near term purchases. Second, they may build the relationship of trust between the company and the customer. Third, they may tailor the product to fit better the needs of some segments of customers. And, finally, they may broaden the relationships with the current and prospective customers in the market.
The first component of a price is the set of benefits, the performance package, the customer purchases in the main product. This set of benefits, the functions it offers, the reliability assurances and the convenience of purchase of the product, determine the costs and price of the product. The company may reach a new lower price by reducing the performance benefits at the same time as it changes price. The cost savings from the benefit reductions may create acceptable margins for the company.
Companies use this component most frequently with product Purchased and Competitive Supplier segments. However, a company may change the benefit package to serve any of the four segment groups we discussed above. JetBlue found a substantial Product Purchased segment attracted by a lower price for leaner benefits: no meals, no round trip fares and no first class seating. United’s Ted and Delta’s Sony services reduced customer benefits and costs to compete against the low fare airlines serving a Competitive Supplier segment.
As Continental West entered a new market between San Jose and Los Angeles, it chose a Time segment for a stripped-benefit product. It offered ultra-cheap fares, when purchased 14 days in advance, for a limited number of seats on any day but Tuesdays and Wednesdays. The wireless industry’s introduction of the unlimited plans, including talk, text, data and walkie-talkie, served a Margin Building segment, purchasing a package of related products.
The basis of charge is the unit measure that quantifies either the price of the main product or a component of the price. By changing the basis of the charge, you allow the customer the use of the product for a lower out-of-pocket payment. Its most common usage occurs in Margin Building segments. For example, a change in the basis of charge may create a package of the original product. Cathay Pacific Airways offered a pass package that changed the basis of charge. Its 21 day pass allowed a passenger unlimited flights between 18 cities in Asia for $1299. The new pass was time-based package where the normal basis of charge was trip-based.
A change in the basis may create an effective increase in the previous price per unit when the company sells a fraction of the previous product, including renting a product for a period of time. Examples include fractional sales of homes, yachts and corporate jets.
The list price is the stated price for a unit of the main product. A change in the list price may occur with any segment. It is the most commonly applied of the four components of price. This component appears frequently as a discount to counter a competitor in a Competitive Supplier segment. To fight back against the market inroads made by Ryan Air, Europe’s leading discounter, British Airways, Air France and Lufthansa slashed their own list fares on overlapping flights. In the wireless industry, Virgin Mobile USA reduced its unlimited wireless service plan’s list price from $80 to $50, to put it on a par with the plans introduced by Sprint Nextel, Leap Wireless and MetroPCS.
If the company reduces its list price, it always relies on its segmentation to limit the damage to its margins. Our examples illustrate this. The European airlines limited discounts to Competitive Supplier segments in geographic markets where they competed against Ryan Air. The Virgin Mobile discount aimed at retaining Competitive Supplier segments served by particular competitors.
Optional Components of the Price
The fourth potential component of your price is an optional component. These optional components of price appear in most markets but are always present where price is falling. The use of optional components is the primary means of reducing price for all but the Competitive Supplier segment. The name may mislead you. Most of these changes to the pricing mechanism really change the performance package, the set of benefits, the company offers the customer. A few change the price. The company may use these optional components to change the function, reliability, convenience or price of the product.
Function: Function benefits affect the user of the product. Several optional components of price change the function of the product at a price point. These function benefit changes often add something to the main product. These are the most common of the optional components of price. They include:
- A discount in kind. The customer receives a lower effective price by receiving more product in the new unit of product purchased than in the previous version of the product, without paying more for the unit of product. In the wireless industry, competitors offered increasing amounts of free time for calls, especially on nights and weekends, while holding the nominal prices of the product steady. In the late 80s, air carriers offered 2 for 1 promotions.
- A payment. The customer receives a payment to offset some cost related to the product. The payment may be a fixed sum or an amount tied to a specific cost the customer incurs. Independence Air promised customers that if their bag did not arrive at the final destination when they did, their flight was free.
- A sample. The customer receives a lower effective price in the form of a sample of the product for sale. This component differs from a discount-in-kind because there is no payment required for the sample.
- A free, or heavily discounted, product from a third party. After the attacks on the World Trade Towers, some international airlines offered fares that included two free nights at a hotel when a passenger booked a flight from New York to London. Verizon’s “New Every Two” phone offer is another example of this component of price.
- A free, or heavily discounted, product from the company, other than the product on sale. During the fare wars of the mid-2000s, American Airlines allowed its most valuable AAdvantage members to upgrade their seats using miles, even if they had purchased a deeply discounted ticket. In the wireless industry, Verizon Wireless allowed customers with monthly plans of $60 or more to pick five friends for free unlimited talk, even if those friends were not Verizon customers.
Reliability: Reliability affects both the user and the buyer. It refers to the customer’s trust that the company will deliver on the promises it makes or implies in its relationship. Optional components offering more reliability include:
- A Price Cap. The company offers to limit the increase in price the buyer might face or to limit the total amount the buyer might pay for a product or service. Delta introduced a plan that would cap one-way coach fares in the continental United States at $499 and one-way first class fares at $599.
- A Put. The customer receives an assurance of the quality of the product through the right to “put” it back to the company. It signals to the customer that the company stands behind its product. A “put” may also reduce customers’ personal anxieties. Jet Blue’s “Promise Program” completely refunded the cost of unused tickets if the customer lost a job after the purchase.
- A Call. The company grants the customer the right to purchase the product at a stated price for a specific period of time that is longer than the norm. This reliability innovation assures the customer that he will not be charged higher prices during the period of the relationship. Continental Airlines introduced a “call” with its Fare Lock service in 2011. This service allowed a customer to hold a price for a period of time for a small flat fee.
- A Meet or Release agreement. The company allows the customer, who is on a contract with the company, to present a competitive price offer. The company then meets that price offer or allows the customer to buy from the competitor. This component assures the customer that he will not pay a higher price than is appropriate for the market conditions that exist during the period of the contract.
- A Performance Contingency. The final payment by the customer depends on the company’s achievement of specific objectives, including all performance and price guarantees.
Convenience: Convenience affects the buyer of the product. Convenience refers to the ease with which a customer can find, choose, pay for and install the product. The most common type of this component is an extension in the payment term. These extensions allow the customer immediate use of the product on a promise to pay later than is customary in the industry. This option includes the company’s offering of financing, either subsidized or unsubsidized, to the customer. It is a convenience innovation because it reduces the customer’s time and effort to pay for the product and allows the customer to use the product with less delay. Years ago, airlines used this component in their “fly now, pay later” plans.
Price: The final group of optional components reduces the customer’s effective cash price. These include:
- A Rebate. Companies use a rebate when there is some uncertainty on the discount the customer will earn. American Airlines and American Express teamed up to offer a credit card that gave cash rebates on travel of as much as 10%. American Airlines aimed this program at mid-sized companies where it hoped to bolster its business travel. Extra cell phones on a family wireless plans are “free” after a customer rebate.
- A Coupon. The coupon reduces the product price for the price sensitive customer while leaving the other customers to pay the regular price. In its high growth years, Southwest Airlines sent $50 certificates, good on any ticket, to interested customers.
- A Fee Waiver. The company may chose to waive fees that are charged on some portion of the product, such as set-up fees. American Airlines dropped its $5 booking fee to get a frequent flyer award ticket in the expectation that this fee waiver would improve its relationships with its most valuable customers.
- A Trade-in Allowance. The customer receives a reduction in the price of the new product upon surrendering the old product. In the wireless industry, long-time T-Mobile customers who transferred a line from another carrier to their family plans received a $135 credit applicable to their future bills.
The company’s judicious use of the four components of price, the dart that limits the price change’s impact on margins, also assists the company in some less obvious ways. The component may increase both sales and margins by creating a new, lower, price point. The optional price components usually involve lower costs to the company than they have value for the customer. Many have even lower costs to the company than the size of their target segments would imply because some qualifying customers will not use them. And, finally, except for the change in the list price, the other three price components have a temporary character. They change the customer’s value proposition without changing the list price on the main product. The list price remains intact while the company waits for market conditions to improve.
Price competition may be fierce. This condition calls for a shrewd and measured response, a dart player’s precision, to protect both margins and customer relationships.
THE SOURCES FOR STRATEGYSTREET.COM: For over 30 years we observed the evolution of more than 100 industries, many hostile. We put their facts into frameworks applicable to all industries and found patterns. Strategystreet.com describes the inductive results of these thousands of observations and their patterns.