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Smart Pricing: How Google, Priceline, and Leading Businesses Use Pricing Innovation for Profitability

Jagmohan Raju and Z. Zhang

Last accessed on Wednesday October 7, 2015

23 Highlight(s) | 2 Note(s)

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the biggest problem with cost-plus pricing is that it is an inward-looking approach that tends to distract a company from its customer orientation and obscure the importance of detailed market research.

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Terra Bite Lounge, a coffee shop located in Kirkland, a suburb of Seattle, Washington, is one case in which the benefits of this alternative pricing method are not clear-cut. The café does not list its prices. Customers pay whatever they wish and drop their payments in a locked metal box on the counter, discreetly labeled “All payments and tips here, please.” According to The Wall Street Journal, Terra Bite serves an average of 200 customers per day, who each pay on average $2 to $3.

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Refusing to set prices often cuts out a number of middlemen. For example, because publishers typically earn only 50% on the retail price of a book, voluntary payments by readers of a downloaded e-book produced at near-zero marginal cost don’t need to be that high to generate a profit. For authors, who earn only 5% of a retail sale, the economics might be even more favorable.

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five key qualities as any successful “pay as you wish” pricing program: A product with a low marginal cost A fair-minded customer A product that can be sold credibly at a wide range of prices A strong relationship between buyer and seller A very competitive marketplace

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“pay as you wish” restaurants have done well both in upscale urban neighborhoods and rural coffee shops suggests that “pay as you wish” pricing might be most effective in places with a strong sense of community.

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The Cheesecake Factory, gives away a lot of cheesecake whenever it opens a new location. Established outlets also give customers a lot of food, too (another kind of freebie): huge portions that ensure that 80% of the clientele walk out the door with a bag of leftovers. “It doesn’t hurt to have people walk around with the bags,” explains Howard Overton, Vice President of Business Development and Marketing.7

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customers actually prefer products that cost nothing to those for which they paid a few cents.

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The challenge currently facing the newspaper industry is a good example of why you can’t fight free with free. Newspapers are caught in a terrible bind today. More young readers get their news online, mostly from free sources. Fewer papers being read makes the medium less attractive to advertisers. The papers cut costs, which in turn, makes them less compelling to both groups. At the same time, advertising is migrating to the Internet with incredible rapidity, and newspapers are losing their traditional role in the community as what might be called the original virtual exchange, as a central hub for information about buying and selling various kinds of goods and services. Twenty years ago, consumers used the newspaper to buy and sell their things and to look for cars, houses, and work. Today all those functions have gone online, and perhaps 40% of newspaper revenue has gone with them. Once the only real marketplace for all kinds of goods and services, the local newspaper today is just one of many—most of them free or nearly free. The newspaper industry’s multibillion-dollar classified ad business is being replaced now by eBay; Google; and, maybe most of all, the largely free classified service of Craig’s List, which has grown into what may be the world’s first $5-billion, 25-employee company. Most newspapers have tried to retain their audiences by offering readers free online news. This has been a popular success—some papers have more readers than ever—but not a financial one. For years, papers have tried to expand their online ad sales, but so far, the transition hasn’t worked well. Tom Corbett, an equity analyst for Morningstar, has estimated that the revenue growth of online ads versus the loss of print advertising is running about 1.7¢ gained online for every $1 of print advertising lost. With fewer ads and fewer readers, newspapers are now hemorrhaging cash. The American Newspaper Association estimates that the country’s biggest newspaper chains saw their earnings decline by an average of 198% in 2008. In one typical case, the Hearst Corporation, owner of the San Francisco Chronicle, was faced with the task of trying to trim expenses that totaled 47% of its payroll. Newspaper publishing companies are scrambling to find something, anything, to staunch the red ink—cutting staff, outsourcing production operations to India, and consolidating editing operations into a single, central location. But none of these moves seems likely to do much more than buy a little more time. What could they do instead? Defending against a “free” competitor requires clear-sightedness about the seller’s sources of value. It requires openness to new kinds of value propositions that have arisen because of either advances in technology or changes in the competitive landscape. Finally, it demands a willingness to imagine a fresh role for itself in a changed world. To borrow and extend an analogy recently put forth by The Economist,15 newspapers today are a bit like the…
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Note:Wharton Journal

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Galanz picked August to start the price war because it was the off-peak selling season. Manufacturers generally cut back their production and distribution about that time. Starting a price war at that sleepy time of year would catch their competitors off guard.

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What constitutes the right circumstances? The calculations that executives at Galanz and Changhong made fit into a simple framework Western executives are familiar with in a different context: incremental break-even analysis (IBEA)—a simple equation used to set prices that also contains almost everything an executive needs to know to plan, execute, and fight a price war.

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if a price war must be fought, don’t just take a defensive posture. Once again, Sun-Tzu put it best: “One who cannot be victorious assumes a defensive posture; one who can be victorious attacks.”

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Filene argued that companies needed to pay more attention to setting prices that matched the income of their customers. “The businessman of the future, whether manufacturer or merchant, will make more money by reducing prices than the businessman of the past ever made by raising them,” he predicted.9 Filene clearly understood that everybody loves a bargain!

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Simply tracking sales data using the automatic pricing method Filene developed nearly 100 years ago should, at least theoretically, optimize prices nearly as well as some of today’s seven-figure price-optimization software.

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a fast Dutch auction brought in lower returns than a sealed-bid auction, and slower Dutch auctions tended to yield more than the sealed bid.29

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Our colleague Peter Fader described Priceline’s core customers as “the niche group of price-sensitive consumers who doggedly clip out supermarket coupons week after week.”

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Coupon use, always counter-cyclical, first became big business during the Depression and peaked in a downturn six decades later, in 1992—significantly, perhaps, just four years before the Internet took off as a commercial entity.23

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Marketing profitability can also be a good metric to build employee incentives around because it encourages thinking not just within the confines of one department or category, but about that category’s role in the entire store.

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Bezos once put it: Companies get skills-focused, instead of customer-needs focused. When [companies] think about extending their business into some new area, the first question is “[W]hy should we do that—we don’t have any skills in that area.” That approach puts a finite lifetime on a company because the world changes, and what used to be cutting-edge skills have turned into something your customers may not need anymore. A much more stable strategy is to start with “What do my customers need?” Then do an inventory of the gaps in your skills.22 And, we might add, price your offerings to accommodate and influence consumer buying behaviors to truly maximize your profit.

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positive externality—in this case, the chance to rub elbows with some bright and successful people. It’s not exactly a new idea: An ancient Chinese story sums up a phenomenon that’s still alive and well in many places and contexts: Once upon a time in China, a prominent scholar paid 1000 tael for a house. Not so long afterward, a merchant moved in next door. At one point, the two met and, as neighbors would, started discussing the price of real estate. “How much did you pay?” the scholar asked. “Nine thousand tael,” said his new neighbor. “But I only paid 1,000 for mine, and that wasn’t long ago,” said the startled scholar. “Why did you pay so much?” “I paid 1,000 tael for the house, same as you,” the merchant said. “What about that extra 8,000?” “That I paid for the neighbor!”

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a darker Chinese proverb about the dangers of being exceptional: When hunting birds, you kill the one that flies out of the bush first.

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one in three large institutional investment managers admitted they didn’t always run a background check on the fund managers with whom they invested, even though, as fiduciaries, they have a legal responsibility to invest prudently.22 The high fee evidently led them to let down their guard a bit by identifying fund managers as fellow members of the same professional clan.

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For years, American luxury cars competed on price against foreign cars that refused to play the game, a process that ultimately helped destroy some formerly strong brands, such as Cadillac.

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“Pricing is the moment of truth—all of marketing comes to focus in the pricing decision.” E. Raymond Corey, Industrial Marketing: Cases and Concepts (Englewood Cliffs N.J.: Prentice Hall, 1962)

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