Baker’s Law: Bad Customers Drive Out Good Customers

We hold these truths to be self-evident, that all men are created equal,…
—Thomas Jefferson, The Declaration of Independence, July 4, 1776

Whenever anyone quoted those immortal words from the Declaration of Independence—all men are created equal—Federalist Fisher Ames, an ardent opponent of Thomas Jefferson and a superb congressional orator, would retort: “And differ greatly in the sequel.”

While Fisher’s admonishment might not be the best way to administer a country’s laws—where all should be treated equally—it is profound when it comes to understanding no two customers are equal. A German Proverb teaches, “He who seeks equality should go to a cemetery.”

Maximum vs. Optimal Capacity

All firms have a theoretical maximum capacity and a theoretical optimal capacity. From a strategy perspective, it is essential to see how that capacity is being allocated to each customer segment. Your maximum capacity is the total number of customers you firm can adequately service, while the optimal capacity is the point at which customers can be served adequately while maintaining your competitive advantage and pricing integrity.

Insuring a proper amount of capacity is allocated to various customer segments, while offering a differentiating value proposition within each segment, is an essential element of implementing value pricing strategies. It also prevents bad customers—those who are not willing to pay for the value you deliver—from crowding out good customers.

The Adaptive Capacity Model

Think of your firm as a Boeing 777 airplane, similar the one below.

When United Airlines places a Boeing 777 in service, it adds a certain capacity to its fleet. However, it goes one step further, by dividing up that marginal capacity into five segments:

A. First class
B. Business class
C. Full fare coach
D. Coach
F. Leisure, Priceline.com, and Bereavement fares

The airlines—and hotels, cruise lines, golf courses, car rental agencies, and other industries with fixed capacity—are adept at managing and predicting their adaptive capacity to maximize profitability.

Lessons from Yield Management

The airlines understand it is the last–minute customer who values the seat the most and hence they reserve a portion of each plane’s capacity for their best customers. They do this even at the risk the plane will take off with some of those high price seats empty—and that revenue can never be recaptured since they cannot inventory seats.

Why do they take that risk? Because the rewards of reserving capacity for price insensitive customers comprise the majority of their profits.

Airlines allocate only so many seats to coach, leisure, Priceline.com (or bereavement) seats, which they offer well in advance of the flight. However, no airline adds capacity in order to accommodate these customers.

This point is noteworthy, as too many firms will, in fact, add capacity—or reallocate capacity from higher-valued customers—in order to serve low-valued customers. This is the equivalent of the airlines putting the upper deck in the back of the plane rather than the front.

Furthermore, many companies will turn away high–value, last minute work from its best customers because it is operating near maximum capacity, usually at the low–end of the value curve for price sensitive customers. This is common during peak seasons; the lost profit opportunities are incalculable.

Many worry about running below optimal capacity and cut their prices in order to attract work, especially in downturns or slow cycles. This strategy is fine, but you must understand the tradeoff you’re making. Usually, that capacity could be better utilized selling more valued-added services to your first–class and business-class customers, who are less price sensitive than new customers.

This way, the firm does not cut its price and degrade its pricing integrity in order to attract price sensitive customers, sending a signal into the marketplace it is willing to engage in this strategy and affecting the perception of its value proposition.

The conventional wisdom is you have to be at maximum capacity—where demand exceeds supply—to raise prices. But since when do you have to wait to be fully booked to demand a premium price? Do not confuse working harder (supply-side capacity) with working smarter (demand side pricing).

Prices are determined by value created for the customer, not the internal capacity constraints of your firm.

How much fixed capacity are you allocating to each customer class? What will be the criteria you use to ascertain where in your airplane each customer sits?

By viewing your firm as an airplane with a fixed amount of seats, you will begin to adapt your capacity to those customers who appreciate—and are willing to pay for—your value proposition.

Comments

  1. Do you have a model for how to set these prices? If Standard coach is $100 how much is Business? Discount? First class?

    Maybe Standard = $100
    Business = $250
    First = $400
    Discount = $60

    Or ???

  2. Chris clarified his question for me in an email:

    “On the question I posted, I should have been more clear. I was wondering if the difference in First Class and Coach, etc. could be generalized in a percentage difference.

    In other words, should First Class be 3x coach or only 25% more or does even that vary by industry and even by company within industry.”

    This is an interesting question, and it’s not settled among pricers. For instance, I just looked at American Express’ annual pricing structure: for the Green card, $95; $125 to $150 for the Gold card; and $450 for the Platinum. But then you can get a Black card–if you’re invited–for $2,000.

    But consider airlines. I can fly to Australia from $299 in coach to $12,000 in first class. Some call this dumb bell pricing–meaning the spread between lowest and highest is far too wide–but airlines continue to do it, some quite profitably such as Singapore Airlines. Even at the low end with Southwest you’ll notice quite a spread–on a percentage basis–between highest and lowest fares, depending on a variety of value factors.

    In other words, there is no standard formula or ratio. It all depends on your purpose, strategy and value proposition. What we witness in far too many firms is there’s no Black card for your best customers.

    Since 80% of your profits most likely come from 20% of your customers, a firm needs to design its service offering around its best customers.

    Sure, you can service the price-sensitive segment, but don’t neglect to tempt them with higher value offerings. And don’t be scared to have a Black card. Even if no one buys it, it will sell more Gold cards.

    We at VeraSage are constantly looking at this menu pricing strategy. Next time you’re at Starbucks, notice their menu, an example of great pricing.

    Even better, they have an 8 oz cup of coffee–the normal size–but it’s not on the menu. You have to know about it; in other words, jump over a hurdle, like clipping coupons. Price sensitive customers will do this, others won’t. Try it. Order a “Short” on your next visit.

    Some firms don’t even quote prices on their different menu options, preferring to customize a price for each customer. Firms that do quote prices tend to have large tax practices, with a more homogenous customer base.

    The bottom line, as my friend Paul Dunn used to say: Test, test, test. Experiment, ask customers what they think, and constantly revise based on experience.

    Hope that helps Chris.

  3. Total side note: the Starbuck’s short Cappuccino is the best drink they make. The proportions are perfect.

    Also, when you do order, notice how subdued the barista will call out your drink. “VENTI NO-FOAM LATTE” will be screamed; “short cappuccino” will be whispered.

  4. The last paragraph sums it up”…adapt your capacity to those customers who appreciate-and are willing to pay for-your value proposition.”

    That is which clients appreciate what we do and are prepared to pay for it, until we test that in the market plac we will never know. prior to browsing this site and reading the above i spent 15-20 minutes reviewing a client stratgey and telephing the client to run through it. In doing so I have assissted that couple secure their retirement and make $50000-$100000 over the medium term. I could give the answers to a complex situation becuase I know my subject. By the traditional method they would get a bill for $125 which is all out of proportion to the value I have created or helped them create. The quesyion for me is how do I sell that sevice and knowledge for a fairer price? A fairer price for both parties because for someone in mid career I will withdraw my services unless i get paid a fairer price for what I do. By extension the customer is also a risk here because by paying too little they will risk not getting the serive in the longer term.

  5. This is truly an impressive strategy, which I believe to be true , and one thing you forgot to mention is , while using this strategy maintains your work and pricing integrity , at the same time reduces the pressure and load on you and your employee , since they will not need to work extra hours extra hard to catch up with price sensitive clients [which normally are very demanding and un-understanding ] , but they can enjoy themselves servicing a price insensitive client with a calm mind.

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