SBP 9c: Price Guessing

This principle occurs because services have peculiar cost structures (see SBP: The Costs of Utilization), are variable and nonstandard (see SBP: Heterogeneous Production), and are of uncertain value prior to purchase (see SBP: The Marketing of Properties).

What is the best amount to charge for a service?

How much should customers be charged for a particular service? The answer may not be obvious. For example, how much should a customer pay for a nights' stay at a hotel? Imagine that the owner of a new hotel hires a consultant to advise him on how much to charge customers. The conversation goes something like the following:

Owner: So, how much should we charge customers for a night's stay at our hotel?

Consultant: That depends.

Owner: On what?

Consultant: How much does it cost to serve each customer? If you tell me your cost per customer and your desired gross profit margin, I can calculate the price.

Owner: Well, there is the cost of housekeeping, the cost of soap bars, the cost of heating and cooling, the cost of laundering towels and bedding, and the cost of check-in and check-out. It comes to about $8 per customer. I would like to generate a 20 percent profit margin.

Consultant: No problem. That would be $8/(1- 0.20)=$10. Therefore, you should charge each customer $10 for a 20 percent profit margin.

Owner: What about my mortgage and insurance on the property? That is about $10,000 per month.

Consultant: How much per customer?

Owner: Depends on our occupancy rate.

Consultant: Well, since the occupancy rate depends on how much you charge, it might be difficult to determine cost based on your costs. How about if you tell me what your competitors are charging.

Owner: The nearest hotel to the south charges $39.95 per night. The one to the north charges $139 per night. Of course the one to the north is nicer than the one to the south.

Consultant: Which is most like your hotel?

Owner: Well, we don't have as many features as the $139 hotel, but we are newer and cleaner than they are. We have pretty much the same features as the $39.95 hotel. In fact, from the outside our hotel looks similar to that hotel.

Consultant: So you probably should charge more than $39.95, but not a lot more, unless customers think newness and cleanliness is more important than other features, in which case you can charge closer to $139. By charging more you might give customers the idea that you are in the same class as the $139 hotel, but they may be disappointed with your lack of amenities.

Owner: That is kind of a broad range-from $39.95 to $139.

Consultant: Yes, perhaps we should look at what customers are willing to pay. How valuable is a hotel room to a customer?

Owner: Which customer?

Consultant: A typical customer.

Owner: Some customers stay on business and others on leisure travel. Some are paying out of their own pockets, and others are paying from an expense account. Some business travelers have fixed per diem amounts, and others have any expenses reimbursed. Sometimes customers stay here because there are no other vacancies in town, and other times almost all hotel rooms in town are vacant. Some customer shop around for the lowest price, and others want to stay here because we are near the convention center. I am not sure which of these we would call the “typical customer,” since our customers and their circumstances vary quite widely.

Consultant: I see what you mean. You may need to charge every customer a different amount, based on what you think each is willing to pay.

Owner: That sounds like a great idea, but I don't think I am willing to pay you much for that advice.

This imaginary dialogue illustrates some of the difficulty in determining the price of services. The consultant haphazardly tried three popular approaches to product pricing:

• Cost-based pricing. With this approach, companies determine what their per-item costs are, tack on a desired gross profit margin, and the result is the price to the customer. It can be extremely difficult to estimate the per-item cost of services since variable costs are often insignificant (see SBP: The Costs of Utilization).

• Market-based pricing. One form of market-based pricing is competitor-based, which is to base price on what competitors are charging. Services are often heterogeneous, making it difficult to compare one service provider to another. A hotel is not the same as another hotel. A four hundred-mile flight to New York is not the same as a four hundred-mile flight to Peoria. Dinner at McDonald's is not the same as dinner at the Deluxe hamburger shop. Service companies can have a hard time assessing who the true competitors are. In fact, the true competitors may not even appear to be in the same industry. Do television, the opera, amusement parks, and sporting events compete with one another? If they are all competing for the customers' entertainment dollars, should the opera be priced to compete with the professional sports team?

• Value-based pricing. Under this approach, companies attempt to set the price commensurate with the value received by the customer. Again, heterogeneous production implies that the value different customers receive from the service can vary dramatically. For a given price, some customers will get much more value than they pay for while other customers will pay too much. In some cases, service companies attempt to estimate how much value is received by various customers, as manifested by a willingness to pay. Such companies wind up charging different amounts to different customers for similar services.

To compound things even more, often customers do not even know the value of the service prior to purchase (see SBP: The Marketing of Properties). Pricing can thus be used as a signal to customers about how much value to expect. This is particularly applicable when the value is still not fully known even after the service has been received (“credence properties”). For example, one part-time counselor reported charging about $50 per hour for counseling initially. He was busy enough that he raised his rate to something like $100 per hour, and became even busier. At something like $150 his reputation seemed to do even better. The customers were apparently perceiving that they were getting better counseling from the $150 counselor than from the $50 counselor, even though it was the same counselor.

Obviously, pricing is an important decision for any company. Theory would seem to indicate that there is an optimal pricing level for any given product or service, but things are usually more complicated than that. If a company prices too high, they lose customers and if they price too low, they will lose potential revenues. What is “too high” and “too low” can change from day to day and even from customer to customer. Therefore, pricing decisions in service can often be an ongoing concern.

The following are a few examples of pricing approaches which are used by service businesses. Which combination is most appropriate depends on the nature of the particular service industry, environment, and business.

Standardized pricing

Some service industries have a tradition of a particular type of pricing. For example, real estate agents in the U.S. typically charge a 6% commission on the sale of residential property. It is not exactly clear how that tradition came to be, whether by vote of some real estate organization or by happenstance. The advantage of such standardized pricing is that it removes the need for constant negotiation with the customer. It also simplifies the process for deciding which real estate agent to use. Further, it limits the likelihood of competitors starting a price war. Price wars are great for customers but harmful to service providers.

Competitive (market-based) pricing

In some service industries, customers are price-sensitive and typically know what prices are before they select a service provider. This allows customers to shop around before making a decision, and forces companies to watch competitors' prices.

Signal pricing

With some services, particularly those high in credence properties (see SBP: The Marketing of Properties), there is a feeling that the more it costs, the better the service. The customer's concern may be that if he or she is not paying enough, the service might not be too valuable. Other than price, it may be difficult to identify obvious criteria by which to judge the quality of a service. For example, my wife sometimes has gotten her hair cut at a place that charges $45 (ugh!), even though she does not seem to like the result any more than when she has gone to the places that charge $6.50. It is difficult to say exactly what a “good” haircut is (but easier to tell what a bad haircut is). But, there is just a feeling that you are going to get a better haircut from a $45 stylist than from a $6.50 stylist.

Variable pricing (often value-based)

If the value that customers attribute to the service varies significantly from one customer to another, then the company may want to charge each customer according to what he or she is willing to pay. The key is estimating how much each customer is willing to pay and legally setting the price according to that discrimination, then having pricing policies which set a price according to that discrimination. For example, an airline customer who has to take an emergency trip to Chicago to transact some important business is willing to pay a lot more for an airline ticket than a person who wants to fly to Chicago to visit Aunt Edna. The way airlines legally discriminate among customers is according to the amount of lead time the ticket is purchased prior to the flight. A ticket bought less than seven days before a flight will usually cost a lot more than one bought many weeks ahead. Also, airlines discriminate according to how long the stay over is for round-trip flights. Business people often do not want to stay over weekends, so tickets without a Saturday night stay are more expensive. Aunt Edna's visitors are more flexible, and usually more price-sensitive since their willingness to pay is much lower.

Yield management involves a form of variable pricing in which the price is determined not only by customer willingness to pay (a demand factor) but also by the amount of capacity which is available at any given time (a supply factor). Yield management works in situations where customers typically purchase the service some time before receiving it, such as through reservation systems. The service provider desires to get as much revenue (“yield”) out of the available capacity as possible. They forecast demand for the service and make overall capacity planning decisions. Then, as time passes, they adjust the price to customers according to demand that has occurred up to that point. If sales (reservations) are higher than what was forecasted, the price is typically raised. If sales/reservations are lower than the forecast, the price may be dropped. Also, there can be specific classifications of service that can reserved or unreserved for potential higher-paying customers (such as last-minute reservations that will cost a lot of money). Complex computer algorithms are employed to manage the ongoing price adjustments.

It is common for service providers to employ some combination of the above strategies. Services pricing can be a complex process, and pricing practice within an industry can change over time.

One example of standardized pricing is residential property appraisal services. In this area appraisers charge $300 for a standard interior appraisal. It is not because of a law or some other mandate. It is just what is charged.

Sometime standardized pricing is regulated, such as what people pay for local telephone service. If companies priced telephone service according to cost, they would charge rural customers a lot more than urban customers. Since local telephone service has traditionally been a monopoly (in the U.S.), it is highly regulated by public utilities commissions. Businesses can be charged more than residential customers, but local telephone companies usually are not allowed to discriminate among residential customers according to willingness to pay.

An example of competitive pricing is long-distance telephone service (since deregulation). Long-distance companies are continually dropping per-minute prices a fraction of a cent to beat competitors. Price is a major theme of long-distance service advertising. One company even called itself the “Dime Line,” even though they seem to have now dropped their prices below a dime in response to competitive pressures.

Most examples of signal pricing are with services high in credence properties-where judging the quality of the service relies on the judgment of experts or others. Examples are:

• Education. Parents might be concerned about sending their children to a new private school that is inexpensive for no apparent reason.
• Consulting. Firms might be hesitant about hiring a consultant that charges lower than expected fees.
• Health care. Many customers will avoid going to a dentist that advertises discount prices.

Variable pricing occurs in situations where companies are able to estimate the value of the service to each individual customer. I have taken a few vacation cruises, and always on the super-saver discounts. On one cruise I was standing in line for some reason when fellow passengers broke into discussion about how much they paid for the cruise. Oh no! Trouble was brewing! I paid about half of what was paid by those who paid the brochure price for my cabin category. (I was smart enough to not participate in the conversation.) I had paid in giving up my convenience-traveling at a time I would not have otherwise, handling my own transportation to the ship port, etc.-because I was not willing to pay as much in cruise fare. Other passengers were willing (or unknowing) to pay more to cruise at their convenience.

Another example of variable pricing is auto inspection stations in the state of Utah. Each car must be registered during a given month, which requires an annual emissions and safety inspection. Inspection stations charge more at the end and the beginning of each month, when procrastinators get their cars inspected, since procrastinators are willing to pay more to avoid expensive tickets for not being registered.

Since the time of U.S. airline deregulation, air travel pricing has become a bizarre and often confusing process. Prior to deregulation, pricing was standardized with a flight from one point to another being fixed by the government.

Customers benefitted greatly by deregulation, largely because of competitive pricing. Occasional fare wars have made air travel extremely affordable and attractive. (A few years ago my family and I flew from Salt Lake City to Seattle and back for $150 total!) When one airline drops prices, the other airlines are usually forced to follow.

Airlines are probably the most prevalent users of variable pricing and yield management. It is not uncommon for price shoppers to call an airline for three or four days in a row to see if the price of a future flight is going up or going down. It would not be surprising to find a flight of one hundred passengers paying fifty different prices for identical seats.

One “innovation” Southwest Airlines has espoused is simplified pricing, with only a few standard fares for each flight. One purpose is to simplify the decision for passengers. This system has a chance of working because Southwest's fares are generally twenty percent or more below competing airline fares.

With manufacturing, variable costs often dominate, thereby allowing cost-based pricing; products can be objectively compared to facilitate market-based pricing; and market surveys can be conducted to allow value-based pricing. Therefore, pricing decisions for manufactured goods tend to be much more certain than for services.

1. What tends to be the basis for pricing decisions in this industry? Costs? Competitors prices? Availability? Demand? Inflation? Others? How frequently do prices change?
2. Is pricing relatively standardized in this service industry? What is the standard pricing method? What would happen if a company priced significantly above or below that standardized pricing?
3. Is pricing a significant competitive dimension? Is pricing a common theme in advertising and promotion? How do customers typically gather price information for comparison?
4. Is pricing a signal about the quality of the service? Would customers prefer to pay more if they thought that as a result they would receive better service? What are other ways customers can pre-judge quality more accurately than by price?
5. Is each customer typically charged a different pricing rate for this service? How does the service provider estimate “willingness to pay?” What are some company policies about pricing that discriminate according to customer willingness to pay?

First, identify which of the four pricing strategies listed in this Service Business Principle is most prevalent in your target service business (standardized pricing, competitive pricing, signaling pricing, variable pricing). Comment on the why that pricing strategy occurs in that industry.

Second, diagram (flowchart) the process of determining the price to charge for the particular service process listed above. As part of your diagram, indicate what information is gathered from customers or competitors in making the pricing decision. Describe when and how that information is gathered. Include some decision rules for making pricing decisions. (Examples of decision rules might be “If the airline passenger stays over a Saturday night, reduce the round trip fare by some percent,” or “If a competing airline offers a lower price on that route, match it.”)

What are problems with this pricing process which might cause the service provider to make pricing decisions with bad outcomes? (An example would be charging the standard $300 to appraise a home which is so large that it takes twice as long to complete. Another example is pricing wars with competitors. Another example is incorrectly estimating willingness to pay and therefore pricing your service out of the market.)