Gauging Customer Price Sensitivity

In their book The Strategy and Tactics of Pricing: A Guide to Profitable Decision Making, Second Edition, Thomas T. Nagle and Reed K. Holden offer a set of questions that should be asked in order to gauge customer price sensitivity:

1. Perceived substitutes effect. What alternatives are buyers (or segments of buyers) typically aware of when making a purchase? To what extent are buyers aware of the prices of those substitutes? To what extent can buyers’ price expectations be influenced by the positioning of one brand relative to particular alternatives, or by the alternatives offered them?

2. Unique value effect. Does the product have any unique (tangible or intangible) attributes that differentiate it from competing products? What attributes do customers believe are important when choosing a supplier? How much do buyers value unique, differentiating attributes? How can one increase the perceived importance of differentiating attributes and/or reduce the importance of those offered by the competition?

3. Switching cost effect. To what extent have buyers already made investments (both monetary and psychological) in dealing with one supplier that they would need to incur again if they switched suppliers? For how long are buyers locked in by those expenditures?

4. Difficult comparison effect. How difficult is it for buyers to compare the offers of different suppliers? (Be sure to account for the Internet in your answer). Can the attributes of a product be determined by observation, or must the product be purchased and consumed to learn what it offers? What portion of the market has positive past experience with your products? With the brands of the competition? Is the product highly complex, requiring costly specialists to evaluate its differentiating

5. Price–quality effect. Is a prestige image an important attribute of the product? Is the product enhanced in value when its price excludes some consumers? Is the product of unknown quality and are there few reliable cues for ascertaining quality before purchase?

6. Expenditure effect. How significant are buyers’ expenditures for the product in absolute dollar terms (for business buyers) and as a portion of income (for end consumers)?

7. End-benefit effect. What end–benefits do buyers seek from the product? How price sensitive are buyers to the cost of the end–benefit? What portion of the end-benefit does the price of the product account for? To what extent can the product be repositioned in customers minds as related to an end–benefit for which the buyer is less cost sensitive or which has a larger total cost?

8. Shared-cost effect. Does the buyer pay the full cost of the product? If not, what portion of the cost does the buyer pay?

9. Fairness effect. How does the product’s current price compare with prices people have paid in the past for products in this category? What do buyers expect to pay for similar products in similar purchase contexts? Is the product seen as necessary to maintain a previously enjoyed standard of living, or is it purchased to gain something more out of life?

10. Inventory effect. Do buyers hold inventories of the product? Do they expect the current price to be temporary?

Customer Selection

1. In business for at least three years. This is generally enough time for the client to become established, prove he or she has some management skill, and appreciate the importance and need for professional assistance.

2. Pleasant, outgoing personality. There’s no point in spending time with unpleasant people. In our experience, pleasant, outgoing people seem to have more successful businesses. Their personalities are unquestionably a contributing factor to their success.

3. Willing to listen to advice. Even nice people don’t always listen to advice. You will be wasting your time if the person you’re working with “knows it all” or refuses to take your recommendations. Be careful not to use this to rationalize your inability to sell your service potential. More often than not, a person doesn’t listen to advice because it hasn’t been communicated in an understandable manner or the payoff hasn’t been clearly stated.

4. Positive disposition. Unfortunately, the business world is full of people who have had such a hard time the only way they can live with themselves is by blaming everyone else for their problems. If a client refuses to take personal responsibility for the condition of the business and is unwilling to look positively at the environment and existing opportunities, youd be well advised to look elsewhere for clients. Of course, your ideal client will be a positive person who is not simply an ambitious dreamer. Its important to maintain a balance between ambition and potential. Rome wasn’t built in a day, they say. Nor are great businesses.

5. Technically competent. It goes without saying that all the fancy marketing, management, and performance standards will come to nothing if the client’s product or service is technically flawed.

6. Business is profitable. Accountants typically are called in to assume the role of company doctor for an ailing business. Naturally, many of the approaches and skills required to turn a business around are the same tools used to make an already sound business better. However, it is much smarter, in terms of the success probability, to work with businesses that are already profitable – but underperforming – than with businesses in a loss situation (unless that is your specialty). Clearly you need to consider this criterion individually for each potential client.

7. Business is not chronically undercapitalized. This will generally apply only to relatively new businesses that have experienced rapid, uncontrolled growth or to businesses that have experienced several periods of sustained losses. Again, you need to consider this criterion individually for each potential client. But, other things being equal, pass up this opportunity for an easier one.

8. Business is not dominated by a small number of customers or suppliers. This is a strategic issue. If a business is subject to severe buyer or supplier dominance and it does not otherwise have any significant competitive strength, you might be less than excited to take it on. In these circumstances, it is very difficult to do much because margins are often dictated by the supplier or the buyer. Unless there are immediately obvious ways for the firm to create and retain value, it’s hard to do much for the business.

9. Clearly established demand for the product or service. There is no question that new products or services have the potential for very substantial rewards. The first successful entrant into the industry usually has a big payoff. But statistics speak for themselves. New product or service ventures have a high failure rate. Furthermore, innovative entrepreneurs generally commit all their resources to the design concept. So there’s not likely to be much left over to cover your investment and the costs involved in creating a market. As with the other criteria, assess this one individually for each potential client. You may decide to take such an assignment as an entrepreneurial investment of sweat equity (e.g., stock options), but limit this type of investment in your client portfolio (and be sure it doesn’t detract from your firm’s overall mission).

10. Business has a scope for product or service differentiation through innovative marketing. Another strategic issue. If you believe you could significantly affect margin or volume through a sound marketing strategy, the client would be ideal – given other factors, of course. If, on the other hand, you’re not really sure you’d start, then you may want to pass up the opportunity.

11. Business has scope for improved productivity through innovative management planning and control. A business that fails criterion #10 could score well on this one. Think about what you could do to improve internal efficiencies. Specifically, note that where performance is not being systematically measured, there’s almost always scope to improve it. A cursory review of your potential client’s internal management information system will give you a very good idea of the potential here.

Key Predictive Indicators for a Professional Knowledge Firm

(Excerpted from Measure What Matters to Customers: Using Key Predictive Indicators, Chapter 11, by Ronald J. Baker. New Jersey: John Wiley & Sons, Inc., 2006).

Our VeraSage Institute Team has been fortunate enough to conduct hundreds of workshops around the world on this very issue, and have had professionals from all categories brainstorm to come up with some Key Predictive Indicators (KPIs) for a professional knowledge firm. We believe the following KPIs are a superior alternative to timesheets, as they attempt to define success the same way the customer does. This provides the firm with a competitive advantage, which translates to enhanced pricing power.

Here are some firm–wide KPIs selected by those firms who have quit using timesheets for a more customer–focused set of predictive indicators.

Firm–Wide KPIs—Velocity

  • Turnaround Time

Firm Wide KPIs—Financial

  • Innovation sales

Firm Wide KPIs—Customer

  • Customer loyalty
  • Share of customer wallet
  • Value Gap
  • Customer Referrals
  • Number and quality of customer contacts per week

It is important to note there is ample evidence that between three to five KPIs should be enough for any business in order to have predictive value for customer behavior. Though I wanted to provide enough so you can at least begin to think in this direction—and perhaps develop even better KPIs for your particular firm—it is important to keep in mind I am emphatically not suggesting you adopt all of the preceding KPIs. Do not boil the ocean. If you try to track too many KPIs, you end up knowing nothing, and would simply replace the timesheet measure with something even more burdensome.

Another caution: When choosing your firm’s KPIs, do not over–intellectualize the process. Selecting KPIs is not merely a matter of left–brain analysis; your firms right brain is important, too. You are testing a theory, which will greatly influence what you are measuring and observing. You are looking for KPIs that will measure and reward results over activities, output over input, performance over methodology, responsibilities over procedures, and effectiveness over efficiency.

Let us analyze each of the firm–wide KPIs above, explain their logic, the results they are trying to measure, the behavior they are trying to encourage, how some professional knowledge firms have implemented them, and even improved upon how they can be used to enhance a customer’s experience in dealing with their professional. It should be noted that not all of the following KPIs are leading, some are coincident, and some may even be lagging, depending on how often they are disseminated throughout the organization.

Turnaround Time. Michael Dell likes to refer to the time lag between a customer placing an order and the company assembling and shipping the finished product as velocity. We believe professional knowledge firms should also be diligent about tracking when each project comes in, establishing a desired completion date, and measuring the percentage of on–time delivery. This prevents procrastination, missed deadlines, and projects lingering in the firm while the customer is kept in the dark.

Turnaround time can be tracked at the firm–wide level, as well as the team member level. If a particular team member is missing deadlines, it is a good indication s/he has been given too much work, does not have adequate training to do what has been assigned, is unclear on the assignment responsibilities, or is simply not up to the job. Whichever it is, the turnaround time provides a leading indicator to firm executives to intervene and correct any problems in real time. The timesheet does not provide this advantage, because once it has been discovered, the problems are history.

Innovation Sales. This metric measures revenue from services introduced in recent years, and measures the firm’s innovation in offering additional services to its customers. It is an essential measurement to determine the lifetime value of the firm to the customer. For example, Hewlett–Packard wants 50 percent of its revenue from products that did not exist two years ago. Intel achieves 100 percent of its revenues from products developed within the last three years. 3M targets 30 percent from products that did not exist four years ago.

Firms spend an enormous amount of resources measuring billable hours, realization rates and other internal metrics, but we have found very few that measure innovation sales and make it a key component of its strategic vision. This is not to say firms are anti–innovation, it is more a matter of not being pro–innovation, by not having measurements and reward systems in place to encourage this behavior. Innovation is essential to creating new wealth.

Customer Loyalty. Frederick Reichheld, in his work with Bain & Company, estimates fewer than 20 percent of corporate leaders rigorously track customer retention. For professional knowledge firms, who derive anywhere from 80 to 95 percent of their revenue from existing customers, this is a big oversight. Also, when you consider it costs an average of four to eleven times more to acquire a customer than to retain one, this metric must become part of the firm’s value system.

Share of Customer Wallet. This changes the firm’s focus from market share and revenue growth to better growth by increasing the percentage the firm derives from each customer’s budget for professional services. To increase this share over time, the firm must be up front with all customers that share of wallet is an important part of their long–term relationship. Unless it has a strategic reason for doing so, the firm should not allow its customers to distribute its work among many firms. It should make it part of the expectation with each customer that it wants the lion’s share of their work, over the long run. This insures a deeper relationship, increased loyalty, higher switching costs, premium prices, and greater profitability.

Value Gap. This measurement attempts to expose the gap between how much the firm could be yielding from its customers compared to how much it actually is. It is an excellent way to reward cross–selling additional services, increase the lifetime value of the firm to the customer, and gain a larger percentage of the customer’s wallet. Marriott International uses predictive analytics, through its Hotel Optimization program. Marriott has developed a revenue opportunity model, comparing actual revenues as a percentage of optimal prices that could have been charged. It attributes the narrowing of this gap, from 83% to 91%, to this analysis. What actions can your firm take to close the value gap?

Customer Referrals. Because word of mouth is the most effective way to acquire the right kind of customers, referrals from existing customers are a leading indicator that the firm is delighting its current customers. A firm has no business taking on new customers if its existing customers are not completely happy. Also, if the firm’s leaders are interested in promoting rainmaking activities at all levels within the firm—and rewarding them commensurately—customer referrals can also demonstrate the firm is asking its existing customers for contacts they believe could derive the same benefits as they do from doing business with the firm.

Number and Quality of Customer Contacts Per Week. Since two–thirds of customers defect from firms because of perceived indifference, why not encourage all of the firm’s team members to meet regularly with the customers they serve? This keeps the firm visible and in front of the customer; will lead to a higher wallet share, more referrals, and increased loyalty; and aid in the development of communication and listening skills of team members.

However, this KPI cannot be gamed just to achieve some arbitrary quota of contacts per week; it must also consist of subjective evaluations of the quality of each contact: what was discussed, the body language of the customer, additional services discovered, and a host of other judgments that are simply too oblique to be measured quantitatively, but are the true characteristics of providing a good experience for customers while demonstrating you care about them.

Segmenting Customers for Price Discrimination

According to Tom Nagle and Reed Holden in their book The Strategy and Tactics of Pricing, there are seven effective segmentation strategies to specifically identify different types of customers in order to capture the consumer surplus.

Segmenting by Buyer Identification

Senior discounts, children’s prices, college students, and coupon clippers are all examples of different buyers. Barbers may cut children’s hair at a substantial discount, realizing that home haircutting is an effective substitution. They may offer these prices when they have excess capacity (midweek, usually), so as to not interfere with the demand of customers who can get their haircuts only on certain days (on Saturdays, for example).

Airlines, hotels, and rental car companies discriminate against business travelers, and while they don’t have ways to specifically identify them, they use other methods that approximate this information. These includes the booking dates compared to the departure dates, Saturday layovers, etc. While these methods are by no means absolutely certain to identify a business traveler from a leisure traveler, they produce approximate results, which are relatively accurate.

Another way to identify the price sensitivity of different customers is through salespeople. This is why car salesman are trained to ask a litany of questions designed to approximate the value to any one customer of purchasing from their dealership: Where do you live, is the car for business or pleasure, what do you do for a living, how long have you lived in the area, what kind of car do you drive now and where did you purchase it, what are the alternatives you are considering, etc. This is all valuable information for the salesman to place the particular buyer on the demand curve and gauge their price sensitivity.

Segmenting by Purchase Location

Ski lift and amusement park tickets can be purchased cheaper at grocery stores than they can on–site, where the less affluent (or those seeking deals) would tend to take the time to purchase them. Dentists, opticians, and other professionals sometimes maintain separate offices, in different parts of the same city, or in different cities, that charge different prices based upon the economic and demographic make-up of each. When you factor in the international market, location becomes very complex. Note the prices for golfing in areas favored by Japanese tourists, who cannot get tee times in Japan.

One of the dangers of segmenting by location is arbitrage. Norplant, for example, sells for $350 in the United States, but for as low as $24 in less developed countries. With arbitrage, some buyers might purchase in the low–cost area and sell in the high-priced area, thereby keeping the consumer surplus for themselves. This isn’t an issue with services or goods that are consumer on location, but it certainly is if you are selling widgets in different locations. With the increasing use of the Internet to make purchases, being able to segment by location will become more and more difficult.

Segmenting by Time of Purchase

Theaters offering midday matinees, restaurants having cheaper prices for lunch rather than dinner, cellular and utility companies pricing based upon peak and off–peak times, vacation spots vary prices between on– and off–season, and publishers pricing hardcover books higher than soft covers because of their earlier publication dates.

All of these methods are a way to segment the market between high–value and low–value users. If one is making a cellular phone call on the way home to order a pizza (at an off–peak time), that is a low–value use. If the same person made a call in the middle of the same day and closed a big account, that is a much higher–use call, and thus they will be less sensitive to its price. Again, the company does not possess perfect information on what each customer is doing, so they resort to methods that approximate the value delivered.

Segmenting by Purchase Quantity

Quantity discounts are usually based on volume, order size, step discounts or two–part prices. Customers who buy in large volumes tend to be more price sensitive, less costly to service and have more incentive to shop for a cheaper price. Thus, they are offered volume discounts. When offering discounts to business buyers, one must be careful not to violate the antitrust laws against price discrimination, as discussed in Chapter 18. Order discounts are usually given based upon the size of one order. Sometimes it behooves competitors to pool their orders in order to receive these favorable prices and maybe even transportation discounts. Step discounts, on the other hand, don’t apply to the total quantity purchased, but only to the excess beyond a specified amount. The rationale behind this policy is to encourage the individual buyer to purchase more of the item, without discounting the price on smaller quantities for which they might be price insensitive.

Two–part pricing involve two separate charges to consume a single product. Amusement parks might charge an entrance fee and then price tickets for certain attractions extra. Rental car companies use a flat price plus a price per mile, health care and country clubs charge both membership fees and monthly dues, while night clubs charge a cover at the door as well as for drinks and food.

Segmenting by Product Design

Different versions in a product or service offering are a very effective way to segment a market. Premium gasoline, for instance, only costs the oil companies approximately $0.04 more in refining, but sells at the pump anywhere from $0.10 to $0.15 more. Business travelers value highly the ability to change, on short notice, their tickets, and thus one advantage to paying the higher prices they do is this privilege. This is one reason airlines require positive identification of the passenger; otherwise, firms would soon start-up to purchase discounted tickets and sell them to businesspeople closer to flight times.

Certainly cosmetics use design features in their packaging and ingredients to cater to different market segments. Cadillac sells for a relatively higher premium over its cost to manufacture than, say, an Oldsmobile, even though are manufactured in the same plants, with slight cost differences.

Segmenting by Product Bundling

Newspapers usually have a morning and evening edition, selling advertising in bundles for each. Restaurants bundle food on the dinner menu as opposed to a la carte, usually at cheaper prices. Symphonies, theaters, and sports teams bundle a package of events into season tickets Why is this such an effective pricing tactic? Because the bundled products have a particular value to different buyer segments. Advertising space in the morning edition of the newspaper is valued more by one segment (grocers, retailers) than by another segment (theaters, restaurants), whereas the reverse is true for the later edition.

Microsoft bundles its Internet access software with its operating system, and new computers come bundled with various software packages. Automobiles can be purchased with various options, and come with standard options, a very effective way to bundle of offerings to different price sensitive segments. Airlines will sometimes bundle entire travel packages, offering golf, tennis, or other activities. Disney’s cruise line bundles a trip to Walt Disney World in Orlando, Florida, as part of the price of the cruise. (See the discussion of menu pricing, and how this type of bundling applies to the professional service firm, in Chapter 12).

Segmenting by Tie-Ins and Meterings

In Chapter 5 we discussed how IBM used to sell their punch cards at a price premium in order to charge a higher price to those who used and thus valued their computers more. Before the Clayton Antitrust Act of 1914, tie–in sales were common. American Can, for instance, leased its canning machines with the requirement that they be used to close only American’s cans. Since the passage of the Clayton Act, the courts have refused to accept tying agreements, except for service contracts where it is essential to maintain the performance and/or the reputation of a new product. While using the tying method with a contract may be illegal, opportunities still exist to use this tactic without contract. For example, razor–blade manufacturers design unique razors that require customers to purchase their blades for refill.

Segmenting by metering is common among photocopy manufacturers, because they know a customer who makes 20,000 copies a month values their machine more than the customer who makes 5,000 copies a month. This tactic is also employed by printer manufacturers, charging a premium for toner cartridges and other supplies, thereby effectively charging higher prices to those customers who use and thus value the product more.

Segmented pricing is among the most effective pricing tactics that a business can employ, and it also among the most difficult. It takes enormous creativity, market and customer research in order to be effective. With the increasing propensity for customers to utilize the Internet to make their purchases, market segmentation will take on a new dynamic. While it will become easier to segment potential customers based upon their profiles and buying habits, it will also require experimentation with different pricing policies. Nevertheless, customer segmentation is a part of any effective marketing strategy, and its potential to add to profitability should never be ignored.

Change Orders

Here is a sample Change Order (download the pdf) to be used in conjunction with the Fixed Price Agreement (download the sample file).

The Consultant Customer’s Bill of Rights

Before beginning a consulting engagement, be able to answer the following questions on behalf of your customer (adapted from Dangerous Company, by James O’Shea and Charles Madigan):

1) Why are you doing this? What do you want to achieve?

2) Do I need outsiders to help reach this goal? Don’t forget to assess the brilliance within your own company before you go trying to buy some from outside.

3) If I hire a consulting company, which employees will they send? Make it a part of the contract.

4) What will it cost? (And how long will it take?) Avoid open–ended arrangements and vague promises. Base payments on performance and on your satisfaction. If the task involves high risk, make certain the consulting company is sharing in the risk, not just in the rewards, of the relationship.

5) Never give up control. The best consulting engagements do not take over operation, they complement them.

6) Don’t be unhappy for even a day. If you sense something is going wrong, confront it immediately and demand repairs.

7) Beware of glib talkers with books. Insist on tailor–made consulting engagements that recognize the unique nature of your business.

8) Value your employees. One of the most common complaints about consultants is that they talk down to the locals or ignore their ideas. You are buying intelligence, not arrogance.

9) Measure the process. Make certain you have your own internal measure of how a procedure is progressing.

10) If it’s not broke, don’t try to fix it. It is in the consulting company’s interest to find trouble where you see calm waters.

Human Capital Questions

Peter Drucker believed the main focus of the knowledge worker needs to be on the task to be done—with all other distractions eliminated as much as possible—and this is defined by the worker him– or herself. Asking knowledge workers the following questions (adapted from Peter Drucker and other sources) about their jobs is a rich source of learning a great deal about any organization. This will help your firm change from a human resources allocation mentality to one of attracting intellectual capital investors, who are ultimately volunteers.

  • What should my contribution be?
  • What should you be expected to contribute?
  • How fair are those expectations?
  • How could I make the greatest contribution using my strengths, my ways of performing, my values, to what needs to be done?
  • What results have to be achieved to make a difference?
  • What hinders you in doing your task and should be eliminated?
  • What progress are you making in your career?
  • How is the firm helping you to achieve your professional goals and aspirations?
  • What does the firm do right and what should it continue doing?
  • What are the firm’s weaknesses and what should it stop doing?
  • What critical things should the firm start doing?