Pricing by customer segment is a key success factor for many industries. Airlines, for example, use complex algorithms to price seats, resulting in a myriad of prices for the same seat on a flight, much of which is dependent upon who the customer is. That way the airline can charge more to the less price sensitive business traveler, while selling excess seats to price sensitive leisure travelers at prices that are still profitable. Pricing by customer segment can have a dramatic impact on a company’s profitability—driven by its effects on both volume and margin.
While there is a powerful impact pricing by segment has on profitability, the practical difficulties of selling at different price points by customer segment are many. One needs to use methods to segment customers and provide different pricing while minimizing the number of situations that undermine the impact.
Ways pricing by segment can be undermined include:
- Buy-down or dilution: Customers from high price segments find ways to buy at the lower prices offered to other segments
- Negative perceptions on the brand: Customers paying higher prices feel that they are being taken advantage of and subsidizing customers paying lower prices
Fortunately, there are a number of ways to price by segment effectively. The suitability of each approach will depend upon the industry and a company’s particular customer dynamics.
1. Purchase Channel
A customer’s price sensitivity can sometimes be correlated to the channel used to make the purchase. Purchase channels include options such as in-store, online, mail order, and phone. Often companies apply pricing differences by channel because there are differing costs to serve, customers self-select themselves based on the channel, or the knowledge of and ease of purchasing substitutes varies.
2. Purchase Location
Pricing by location is often a strategy based on the price sensitivity of customers in each location. This strategy is predicated on a) alternatives customers have and are aware of and b) general attributes of the population such as income level and value of convenience. This type of pricing is prevalent at tourist spots, also known as tourist traps, where a bottle of water can cost much more than the same bottle at a store a few blocks away.
3. Time of Use
Pricing by time of use is an extremely important strategy for some companies with fixed capacity. Industries that have fixed capacity and perishable inventory include power utility, hotel, airline, parking garage, rental car, and telecom. For example, a revenue opportunity is lost forever when a rental car is not rented; however, many fixed costs, such as insurance and financing, are incurred regardless of usage.
This thinking has lead to peak and off-peak pricing plans. Many cell phone voice plans in the United States offer discounted or free calls on weekends and nights. The volume is at relative low levels during these off-peak periods and hence the system is underutilized. Moreover, it encourages some people to shift calls from peak to off-peak periods, reducing the amount of investment required to build additional capacity that is only used during peak periods. A reduction in the investment in peak period infrastructure has a meaningful impact on profitability.
4. Time of Purchase
The time of purchase is another common means of segmenting buyers and pricing. The clothing industry, for example, has a consistent pricing strategy based on time. Full prices are charged for new fashionable items, which are bought by customers who are passionate about trendy dressing or not prepared to wait until a sale. In addition, clothing prices are discounted at the end of the season or popular sales periods (such as end of the year). These predictable sales times allow the more price sensitive customers to wait consciously and patiently for the sale.
5. Volume Purchased
Companies sometimes offer price discounts for large purchase volumes for a range of reasons:
- Customers purchasing large volumes are more price sensitive. Because the volume of the purchase is high, any unit level discounts often cumulate to meaningful savings
- Competition is more intense for large orders
- Cost to serve a large client is often not much more than a small client, reducing the incremental per unit cost to fulfill a large volume purchase relative to a small one
6. Buyer Assessment
Sometimes customers help identify the segment they belong to. This helps price based on value provided and price sensitivity. There are numerous ways to encourage buyers to identify their customer segment.
Associations and groups: Members of associations and groups often have similar characteristics and needs. For example, senior citizens and students are typically price sensitive and are accustomed to showing their identification cards to receive a discount at places such as movie theaters.
Coupons and rebates: Retailers are heavy users of coupons and rebates to offer discounting. In this situation, buyers self-select themselves. Those who are price sensitive go to the effort to collect, study, and use the coupons and rebates.
Customer evaluation: Companies selling high priced items sometimes use sales people to evaluate the price sensitivity of the potential customers they meet. Real estate agents, as an example, ask potential homebuyers a barrage of personal questions to qualify the person and estimate their price sensitivity.
7. Product or Service Offering
Price variations based on differences between offerings (products or services) create options for the more and less price sensitive customers. Moreover, it lets customers select the offering that provides them the most value. Products that require a reservation, such as a hotel room, frequently have varying prices based on different contract terms. For example, a non-refundable reservation is cheaper than a fully refundable booking for otherwise the same product.
Bundling involves combining the sale of one product or service with the sale of another. Bundling can be done in different ways and for a variety of reasons:
- Selling less attractive inventory
- Up-selling high margin products
- Discounting the price in a way that targets those who are price sensitive
- Promoting the trial of new or premium products without openly showing a discounted price
Tie-in sales occur when the purchase of one item leads to the use of another. This is most commonly used when there is an upfront investment in a product that needs regular replacements or service. Razor blade companies, such as Gillette, sell the razor for a very low price to attract new users, but the razor only works with Gillette blades that need to be replaced regularly. The logic behind this strategy is that it lowers the cost for customers to switch to a new type of razor and the ongoing blade replacement costs are perceived to be minor, especially when customers do not add up the long-term, cumulative cost.
Pricing by metering involves usage impacting the price. The underlying logic is that the more a product or service is used the more valuable it is.
Metered pricing can involve an actual meter counting usage, such as electricity drawn from the grid. In addition, metered style pricing can be done without actual meters, such as enterprise software that is priced based on the number of seats (simultaneous users).
Are You Ready to Improve Your Pricing Strategy?
I hope that this review of the various methods to price by customer segment sparks ideas about how your company can alter their pricing structure to improve profitability.