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Reference Pricing

Completely unrelated to my usual posting, I had an interesting discussion on Facebook today about the changes that consumers are experiencing. This discussion was about how some items prices remain the same, but the quantity you receive is less.

Case in point: Toilet paper.

Bum Wad or Toilet paperOn the right we see how the roll used to be. Smaller cardboard core, and more paper wrapped around it. On the right, larger core (or more air) and less paper rolled around it. For the same price. Why do manufacturers do this?

An insight into why this works is the concept of “Reference Price“. This is where the consumer has some institutional memory of what they have paid for a good in the past, and when shopping for similar goods, keeps that “reference” in mind.

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Pricing Foundations

One topic that seems to trip up both new and experienced product managers is the process of pricing. As a recent post highlights, the most important lever we have in our bag of tricks to influence the profitability of our products and business, is the price. Yet, establishing a good price, and holding variance to a minimum is a top concern of the product management function.

Judging by the amount of shelf space taken up by books on Pricing, and how much I have personally invested in the process, I suspect that many of my peers and much of the Product Management community also shares this struggle.

While much of the literature I have read is focused around either the brass tacks of the process, and how large organizations often have a team who is 100% focused on pricing effectively, I have found that often, even when there is a Pricing organization, it falls on the shoulders of the Product Manager to define and implement the pricing strategy.

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Pricing – the most important lever

One of the most powerful levers we in product management have for profitability of products is pricing. This may not be intuitive, so an example will illuminate this concept.

First, I will posit that the profit (π) is given by:

π = Q ∗ (P - V) - F

Where Q is the quantity sold, P is the price per unit, V is the variable costs per unit, and F is the fixed cost.

Let’s assume that you have the ability to improve one thing in your operation by one percent. That is you can affect an improvement in variable cost by one percent. Or, you can reduce the fixed costs by 1 percent. Or add 1% additional units to your sales. Or hold the line on pricing by 1%. How does each of these impact the profitability of the business?

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E-commerce and the Reference Price

A recent post discussed one of the foundations for pricing, which is how to establish the true economic value of your product. Part of the process was getting an accurate “reference” price, or what the next best competitive alternative was.

Today1, the NY Times had an interesting article on how out of whack the e-commerce pricing was. The premise was that while originally, the draw to e-commerce (Amazon et. al.) was to get a lower price, that has evolved to be a more convenience as a value proposition. Yet a powerful message conveyed in the shopping process was the “discount” over list price. And marketers are happy to take advantage of this psychological phenomenon.

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On Pricing – Getting to the Economic Value

Continuing on the theme of pricing, one of the core concepts that product marketers and product managers instinctively understand, whether they acknowledge it or not, is the concept of economic value.

We are commonly concerned with creating value by prioritizing our development to focus on features of capabilities that increase the intrinsic value to our target segment(s).

Yet, how to quantify this value, and then identify how to capture it? It is probably best to go back to the basics, and to define some terms.

Reference Price

The first relevant term is the reference price. In a competitive market, this is the price at which a customer can reasonably purchase a product that is comparable. This is also called the next best competitive alternative price (or NBCA price). I like this as it has a direct analog to the concept of Whole Product. You can also call it the “table stakes“.

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Pricing

One of the key responsibilities of product management, and paradoxically, one of the most perplexing, is Pricing. The act of setting a price at which to sell your product or service. Judging by the number of inches (feet) on my bookshelf I have dedicated to various tomes on the art and practice of pricing, it is clearly something I have thought about a lot, and as do many in the product management field, have struggled with.

At its core, the concept of pricing is straightforward. Identify a product or service that a constituency will buy (or likely buy). Determine its “value” to this constituency, and price it accordingly.

Let’s take a concrete example, Spotify1: