How Airlines Price Flight Tickets

Check this video that shows the logic behing the Airlines pricing strategy.

The Value of BTL/CVM Pricing

BTL (Below-the-line), or CVM (Customer Value Management), or Segmented Pricing are all buzzwords that almost all business people heard about, but…

What is the real value of CVM/BTL Pricing for the business?

I will demonstrate it through a simplified example, so keep in mind that there are many different ways of applying it and this is just an example of a Business to Consumer model which also has above-the-line/open market offers.

So, let’s consider in this example an online retail store.

In this model the ATL (Above-the-line) price is the one presented to all unidentified customers that are surfing the webpages of the online retail store looking for great deals.

The ATL price tend to be aligned with the Demand and Supply curves intersection (Price vs. Quantity), since it is the market equilibrium point.

 Note – Usually the cost per unit sold tend to decrease with incremental quantity, but for the sake of simplicity of this model example, that cost will be stable.

Although the online business is extracting relevant profit with the ATL proposition, as you can see in the graphic above, the company is not maximizing their overall profit and revenue potential.

How to improve business efficiency and extract more revenue and profit from the market?

The business efficiency can be improved through Customer Value Management (CVM), where it can be developed Segmentation Analysis, Targeted Marketing and also Targeted Pricing, communicating tailored offers to those customers through Below-the-line channels, where only selected customers will be exposed to personalized discounted offers.

The company through CVM efficiency improvement will now have multiple supply curves to address different segments that were not willing to pay the ATL price.

So, BTL discounted offers managed through Targeted Marketing, Targeted Pricing and Targeted Communication will generate incremental revenue and incremental profit, since the customers engaged with the online store will increase, generating more sales.

In this example of the online store, how it can be implemented?

• The first step will be always through data analysis; in this example the online store may explore different data sources. Examples: The customer's accounts details in the store, their previous purchase records, or the website cookies that track the pages that the customer visited without buying the items, and others.
• From the data analysis previously described, the online store may now identify different customer segments and deliver to them personalized product/price proposals with the support of revenue/margin optimization models.
• And finally, the tailored offer must be communicated to the customer through a BTL channel (example: newsletter) so it may be promoted individually as an exclusive promotion only valid for that customer.

Following this approach, the online store can now explore new segments that before were out of reach from the ATL proposition, since although they had interest in the product, they were not willing to pay the ATL price and as shown in the graph below, the company will be able to increase their revenue and profit.

The Risk and Challenge…

… It is critical to avoid impacting customers that were willing to pay the ATL price with the BTL discounted prices.

If the segmentation analysis and/or execution are not properly executed, there is a high risk of cannibalization of the ATL revenue by the BTL discounted propositions, therefore leading to revenue erosion, instead of revenue growth as intended.

Keep in mind that proper Customer Value Management through BTL Segmentation and BTL Pricing require a lot of resources, but also don´t forget that the revenue and profit growth opportunities through BTL are also huge.

Note that Customer Value Management (CVM) is not only about BTL discounted offers and this case is just a basic example of how CVM can bring incremental value to a company.

Do you know how much your customers are willing to pay?

Your business success is directly linked to the ability of offering a price that your customers are willing to pay.

As mentioned and detailed in my previous article "What Impacts Pricing", the 3 key pricing drivers are:

• Willingness to pay
• Competition
• Cost Structure

We are now zooming on how to measure the willingness to pay of your targeted audience.

There are many different methodologies to address that research question, but I will be focusing on my preferred technique: Van Westendorp's Price Sensitivity Meter

Why I recommended it?

1. It is easy to execute.
2. The results are clear on interpretation.
3. It follows a quantitative approach; therefore if you apply a representative sample of your targeted segments in your results, you may extrapolate the results for all your targeted segments.

Also, you need to keep in mind that this research method applies open-ended questions combining the valuation at the same time of price and quality.

How to implement this research technique?

1st Step – Identify the target segments of your product/service.

2nd Step – Calculate how many potential customers are in these targeted segments.

3rd Step – From your customers universe, evaluate how many customers you need to contact in your representative sample to be able to get meaningful findings. Therefore it is recommend to contact a sample that conveys a confidence interval of 95% with a margin of error of less than 5%.

4th Step – Conduct the survey (can be in-person, by telephone, or online) with 4 open ended questions (the wording of the questions can be adjusted)

• At what price would you think that the product is too expensive to consider? ("Too Expensive" results)
• At what price would you think that the product is so inexpensive that you would question the quality and not consider it? ("Too Cheap" results)
• At what price would you think the product is becoming expensive, but you still might consider it? ("Not a Bargain" results)
• At what price would you think the product is a bargain, therefore a great buy for the money? ("Bargain" results)

From these questions you may cross the data that you collected with a cumulative perspective (Count of Customers % vs. Price Points) and create a graph similar as this:

The distance between the 2 mentioned below intersection points will give you the range of "Accepted Prices" for your product/service, from a willingness to pay perspective.

• "Not a Bargain" & "Too Cheap" lines
• "Bargain" & "Too Expensive" lines

Some researchers claim that the optimal price is on the intersection of the "Too Cheap" & "Too Expensive" lines, but I challenge that view because as already mentioned the "willingness to pay" isn't the only key driver on pricing to assess the optimal price.

You may argue that Brand strategy and Brand reputation should also be included in these pricing research assessments... and you are right!

Brand value contribution is already incorporated in this research indirectly, as long as your survey questions also mention your brand, if so, customers will incorporate your perceived brand quality and reputation when assessing the product/service price and quality value.

Conclusions:

1. This Pricing research technique will enable you to understand the acceptable price ranges for your product/service from the customer willingness to pay perspective.
2. You will only find the optimal price point (within the ranges) for your product/service after also incorporating in your assessment the other mentioned pricing drivers (Cost Structure and Competition).

As mentioned on the " What Impacts Pricing" article, the willingness to pay is really important, but it is just one of the 3 key pricing drivers.

Therefore the final price setting decision cannot rely only on the Van Westendorp's model analysis. It must also consider the profitability assessment based on your cost structure and the expected competition reactions to your pricing move.

What Impacts Pricing?

When a business manager is setting a price, he or she must understand first, all internal and external variables that may impact that decision.

So, what impacts pricing?

Price setting is impacted by 3 main drivers and the relative importance between them may be different from location to location, industry to industry and/or company to company:

1st Driver - Willingness to Pay
From Economics perspective, this critical pricing driver is boosted from the "Demand" side of the equation.

As you may expect, it has sub-layers as well:

• Customer perception

You always need to keep in mind that in the market field, perception is reality.

As already explained in the article “Brand Strategy vs. Pricing Strategy”, you can in fact have the best product in the market but that is useless if customers´s don´t perceive that quality.

• Brand Value

On top of the rational value of the product or service that you are offering, you may also have an emotional value from your brand that enables differentiation, allows to charge a premium price and also generates customer loyalty.

An example of brand value materialized in additional pricing value occurs when you have two shirts, with the same design, with the same material, from the same factory and you are able to sell that shirt with a higher price if it is branded with a recognizable and appreciated brand.

• Nature of the Product/Service

From the customer point of view there are some key questions that will allow you to understand the nature of your product/service.

Is your product/service unique or exclusive? Do you have a patent?

If you are alone in the market you probably will be able to explore higher margins, at least until competitors arrive and only if there isn´t any regulatory control.

What is the overall customer demand for your product/service category?

It’s common sense that demand is the number one key element that will affect your success. Usually the focus is on the present demand, however with forecasted technology development, "demand" can be observed also as "potential demand".

Example: When mobile phone touchscreens were launched, there wasn’t any current demand; it was a new product category that was developed under the assumptions of potential demand migrating from the mainstream keypad mobile phones.

Is it easy to find in the market any substitute for your product/services?

Even if you are the only provider in your product/service category, if customers can satisfy their needs with other offers even if not exactly the same, those substitutes will affect your pricing as well.

Example: During the Napolean wars, tea became a substitute product of coffee in England and English colonies, which changed consumption behaviors in those places until today.

Is your product/service easy to compare with others?

Even if your product/service is unique and if there isn’t any substitute offer in the market, you still must evaluate what are the relevant pricing references around, because customers will always try to evaluate if your price reasonable.

Example: Some companies are trying to launch space trips offers. When the first company launches that service, customers are already expecting a mark-up on top of the premium airline fees, therefore although is not the same service, there is already a baseline as a reference from the customer perspective.

What is the importance of your product/service category in the customer monthly budget?

Your competition is not only from your industry. You are also competing with your customer overall wallet share, so you must understand how important is your product/service category for your customers.

What is the benefit acquired when your product/service is purchased?

It’s the easiest answer for you, because probably you already have it written in your product/service slogan.

Is it possible to split the product/service price in installments?

Depending of the product/service nature, or price value, you must evaluate if you can sell your product/service in smaller installments and even communicate your price in installments instead of the total price. That is very common in automotive industry.

What is the investment already made by the customer before buying your product/service?

In this case investment is not only about money. It can be time, it can be travel distance or emotional involvement. Just keep in mind that, the greater is the previous investment of the customer the more hooked is your customer to your product/service, so you may have a chance to charge him a premium price.

Is it possible for the customer to stock your product?

In some industries this question is critical, especially when temporary price discount promotions are considered.

When the product is perishable, the customer cannot stock it for a long time therefore a temporary discount will not impact significantly your future sales. However if your customers can stockpile your product and if there is a huge temporary price discount, it is expected that many of your customers will anticipate their purchases, and although it looks a promotion success in the short term, your future sales will suffer a huge hit.

What is the nature of the demand of your product/service related with customer income?

It is very important that you know your product/service nature, to avoid making pricing mistakes in the future.

Therefore if the customer income increases how that impacts your product/service demand?

1. If the demand decreases, you are dealing with an inferior good type of product/service.
2. If the demand increases but at a lower level than the income variation, you are dealing with a normal good type of product/service.
3. If the demand increases more that the income variation, you are dealing with a luxury good type.

Let me clarify that if you are dealing with an inferior good is not negative per se. There are many “inferior goods” that are very successful in the market and they tend to shine even more in economic downturn cycles.

2nd Driver - Competition
Your positioning in the market is relative to your competitors positioning.

An usual mistake that marketeers make is that they think they can define alone their product or brand positioning in the market.

That is a huge mistake because your Brand/Offer positioning is made solely by your customers and also considering your competitors Brands/Offers, therefore what marketeers can do is define and implement a strategy to aim an intended positioning, but that positioning is never 100% under control of the business manager.

Before you define your pricing strategy it’s imperative that you make a comparative analysis with your current and potential competitors, regarding:

• Prices
• Perceived Quality
• Market Share

Keep in mind that you must expect a reaction from your competitors when you make a market move.

3rd Driver - Cost Structure
This driver influences the supply curve in the market and is the backbone of your strategy because it is through this assessment that you will understand your pricing limits.

Regardless of the willingness to pay of your customers or your competitors positioning, to survive, you must have a sustainable cost structure to be competitive in the market.

Understanding and controlling your costs defines your competitiveness level in the market, your margins and in the end your profit so that is why it is so important in pricing.

So, the first step to understand your cost structure is to split your costs in 3 different types:

. Variable costs – This type of cost is directly linked with your production or selling operation and it is applicable per unit produced and/or sold. Therefore you only have these costs if you are active in your business (producing or selling), so if you would froze your business activity, those costs would stop immediately.

On the long run in competitive markets, all prices tend to meet the variable cost per unit.

So, with that premise when you launch a new product line without incremental fixed costs, the Variable Cost Method is applied to evaluate that price setting.

. Fixed Costs – Those are different from the previousones because they don’t depend directly on your activity, which means that you still have them even if you stop producing or selling your product/service for some time.

Example: Even if you don’t produce or sell anything, you still have to pay your office rent. That is an example of a fixed cost.

When launching a new business or a new offer portfolio that requires an incremental CAPEX budget (Capital Expense), the Total Cost Method (variable costs + fixed costs) is more suitable to evaluate the price setting.

. Opportunity Costs – These costs are extremely important and harder to manage since most of them are driven by assumptions and by future forecasts. Long story short, it is the expected outcome of the best alternative of your intended action.

Usually the Opportunity Cost Method is applied by companies already set in the market when they are evaluating a change on their products (offer replacement or price adjustment) without incremental fixed or variable costs.

Sometimes this method is also applied on top of one of the previous two described (variable or total cost methods).



CONCLUSION
Price setting is a complex business activity with many variables to consider within the 3 key drivers:

1. Willingness to Pay
2. Competition
3. Cost Structure

The main objective of this article is to show that Pricing should not be driven by gut feeling and you would be surprised with the number of companies that drive their pricing strategy solely based on gut feeling instead of these drivers.

Pricing Wars – Rational Explanation of an Irrational Behavior

Pricing wars are frequent in almost all industries and if you ask business directors about it, 99% of them agree that it hurts their business and they only did it because their competitor started it.

So, if Pricing Wars are a race to the bottom, why are those so frequent?

To understand that behavior in the market, the best approach is looking at “the prisoner's dilemma” from game theory that shows why two completely "rational" individuals might not cooperate, even if it appears that it is in their best interest to do so.

(This model was originally developed by Merrill Flood and Melvin Dresher in 1950)

Below you will find an example of the model adjusted to a Pricing War between two companies:

To understand this dynamic you need to keep in mind that business managers from different companies cannot speak with each other about their pricing policies (mandatory by law in many countries), therefore they are unable to meet or speak to align their pricing strategies.

This lack of communication between companies, which is imposed by most governments to promote competition, triggers a huge fear within the companies.

Business Managers feel fear? Why? 

Because, if the other company drops their prices suddenly and your company doesn´t, there is a huge risk of losing market share, therefore losing revenues to the competitor. On the other hand, your competitor feels the same fear towards your company.

So, if the companies are unable to communicate, both feel a huge risk in case the other company strikes first and that builds a great pressure on managers.

This fear automatically drives pricing aggressiveness and that pressure tends to bring prices down on both sides and by keeping almost the same market share in the end, both companies’ loose revenues after a Pricing War.

So, since both companies probably will end much worse than before, Pricing Wars are irrational, although there is a rational explanation for it.

Smart Pricing – The Next Generation

Smart Pricing is a Pricing Strategy that can be implemented in many different industries and combines the following:

• Profitability - Design an offer/promotion/service/product which is profitable. 
• Relevancy - Identify the customer’s profile that may consider the offer relevant. 
• Segmentation – Push the proposition only to the customer’s segment that the offer will be relevant and profitable.
• Timing – Identify the trigger event that has associated a higher probability of the offer adoption and push/promote the offer at that moment.

“Smart Pricing" sounds only as another marketing buzzword… not true.

So, it is easier to visualize the Smart Pricing concept through an example:

"Imagine a coffee shop that through a loyalty card tracks the orders of their customers.

From that, the coffee shop knows that a specific regular customer always order one medium size coffee and never orders any food.

Additionally, in this example there are the assumptions that the difference between a medium and a large coffee is only $1 and the coffee margin is high, and without a sale cannibalization, a discount of 75% on the coffee upgrade it still be profitable.

So, next time that specific customer checks in with the loyalty card, the shop assistant would be notified in the machine that the customer is eligible for a special promotion that day – he can upgrade is coffee to large only for 25 cents, instead of paying the normal price of $1.

If the customer doesn´t adopt the promotion, the shop probably still gets the usual medium size coffee sale… but if the customer bites it, there is a short term positive revenue and margin impact and from the product seeding there is a relevant probability of behavior change on the customer, if he starts ordering in the future a large coffee instead of a medium, even without a discount."

The Smart Pricing drivers on this example were:

• Profitability – The discount on the coffee upgrade is still profitable.
• Relevancy – The targeted customer already orders regularly a coffee, so the promotion is on top of what the customer is looking for. 
• Segmentation – Only customers that regularly order a medium coffee would be eligible and would be presented with this promotion.
• Timing – By proposing this deal when the customer is already buying one coffee in the shop increases the probability of the customer taking up the promotion, instead of sending him this promotion through a newsletter by email.

The Smart Pricing strategy is an effective way to increase revenues, profits and also customer satisfaction, engagement and loyalty.

Brand Strategy vs. Pricing Strategy

In the marketplace, perception is reality.

You can have in fact the best product in the market but that is useless if the customers’ don´t perceive that, or even worse, if the customers perceive another product as better than yours when in fact that is not true.

You must keep in mind that Pricing is not only a tool to generate revenues or margin. Pricing is also the key statement about the quality of your product.

Remember that no one believes that the cheapest product in the store is the best one, therefore Pricing is also a powerful brand positioning tool. 

To be successful, when you design the price of your product you need to consider the costs, the required margins, competition prices and also the current customer perception of your brand.

Why the current customer perception of your brand is so important when you design your Pricing Strategy?

The answer is… Trust. 

If there is lack of consistency between your prices and your brand image perception, customers will have trust issues with you, because your overall messages are conflicting.

Example: If you already positioned your brand in the market as a low cost service provider and you launch a new service in the market with a premium price, your new service and in the long term also your all business may be in jeopardy because you are losing consistency and customers don´t trust conflicting messages and customers tend to avoid brands that they don’t trust.

So, the key conclusions are:

Pricing is not only about margins… Pricing is also a powerful brand positioning tool.

• Your Pricing Strategy must be aligned with your Brand Positioning Strategy
• If not, you will trigger trust issues in your customers that in the long term may jeopardize all your business.

Pricing Strategies - Skimming

The purpose of this strategy is to optimize profits in the long run, by segmenting the market in three types of consumers:
- “Pioneer” customers who are willing to pay a premium price to be the first to access your offer.
- “Common” customers who are only willing to pay a “value for money” price.
- “Opportunistic” customers who only buy when facing and outstanding price/discount.

Then the market is sliced in three timeframes to take the best of those three consumer segments:
- On the launch the price is set high to maximize profits on the “Pioneers”
- After the “Pioneers” segment is exhausted, the strategy is to decrease the price to take now a broader segment – the “Common” customers.
- And in the end, usually when a new other product is already replacing this one, they decrease even more the price to tackle the last segment – the “Opportunistic” consumer.

However, this pricing approach is not appropriate or available to all markets due to:
- Legal reasons – Some markets/product have their prices regulated.
- Some markets/products have extreme elastic demand which means that any price variation can collapse the demand.
- This strategy invites other competitors to enter the market, so or you have a very unique product, or the exclusivity of the market (e.g. patent) or the entry cost on that line of business is very high avoiding the entry of more competitors.
Example of a market that usually follows successfully the "Price Skimming" strategy:
- On the video games market, you can observe that usually those brands launch their new products with a premium price and usually those prices decrease over time until it reaches only 10% of the original price aiming to the “Opportunistic” segment in the end.

Supporting new entrepreneurs

In May 2013 I was invited by Beta-Start to make a coaching session for new entrepreneurs.

I made a presentation about a key element in Marketing which is usually forgotten when people think about Marketing.

The theme of my presentation was Pricing, more specifically about Pricing Methods and Pricing Strategies, followed by a Q&A session.

It was a real pleasure and I wish all the best to these new businessman and businesswoman on their new endeavors.

If you are a new entrepreneur, check out Beta-Start in the link below:
http://www.beta-start.com/