Let's Talk Price: An Economist's Method

When buying something, PRICE is a big deal. You can't escape the fact that all people, customers, companies, Governments, are stingy and don't want to part with their precious dough when paying for something, but at the same time everyone wants to charge the most when selling something (negotiating salaries, eBay auctions, etc). You must consider that raising prices to $XYZ limits your appeal to the amount of possible consumers that can afford to part with $XYZ, regardless of how valuable, fashionable or delicious your widget is.

So consider the following graph:

The red, downward-sloping line represents a typical demand curve. On the Y-axis (up and down) is Price, and the X-axis (left to right) are the units sold. So imagine you price your product somewhere on this demand curve; will you price low to attract the masses of consumers or price high to achieve an attractive profit margin on each unit sold?

Hopefully you're thinking to yourself, "Maybe somewhere in the middle where I can get a decent margin from a fair sized customer base."

A gold sticker if you were thinking this, no points for second place.

The optimal sacrifice of high prices and high customers occurs when the projected revenue curve is at its apex (highest). In the case above, it is at $20, with 6000 units being sold. Any price above or below this will offer less revenue. Ok great, but is revenue our objective? Sure boasting a revenue report doubling your closest competitor may put a feather in your cap, until your accountants tell you that you've sold everything under cost and you've got the financial head hunters sharpening their blades for a clean scalping.

This is hardly the case but it can happen. Revenue is a myopic approach to pricing goals. The goal should be to maximise profits not revenue.

Profit = Revenue - Cost of Goods Sold

A+ if you were already on this train of thought when I was discussing revenue, again, no points for second place.

Total cost can be expressed as the summation of an overhead or fixed costs (costs that are independent of how much or little you produce, such as rent, interest on debt, salaries of full-time employees) and variable costs (costs that are dependent of production like raw materials and labour) which forms an upward sloping cost curve. But to ascertain the most efficient level of production, average cost must be quantified.

Total Cost = Fixed Costs + Variable Costs

Average Cost = Total Cost ÷ Units Produced

So let's assume you're production plant for widgets is fitted out to reflect the following average cost curve:

The average cost curve takes this shape because it is most efficient at producing your widget in a certain zone inbetween declining economies of scale and increasing diseconomies of scale. So in this instance, this plant should aim to produce at most [5600 to] 7400 units.

Ok so I've been going on about COST, but what we really want to know is how to maximise PROFIT. So just subtracting the Total Cost Curve from the Total Revenue curve will represent a Total Profit curve. From this stage, you should only produce at the point where profit is the highest, which is 5000 units.

This level of production is actually below the production plant's optimal range and also lower than the maximum potential revenue. So as a medium-long term goal for capitalising on profit, you may look at (i) adjusting the plant's production capabilities to become optimal at a lower range, or (ii) chemically brainwash consumers to encourage them that they need more widgets. I'd go for the second option.

Now here's the trouble when you do this in the real world: You don't know what the demand curves are like, and only have some idea or control of your production capabilities and efficiencies. What you have to do is try to achieve the best results from whatever hunches or incomplete information you have available.

Coca-Cola: Queching a Heirarchy of Needs

The American psychologist Abraham Maslow is ranked in the top tier of the 20th Century's thinkers, mainly because of his model: The Hierarchy of Human Needs. He may not be as witty and memorable as Sigmund Freud, but this model does carry on from Freud's work on the Id, Ego and Super-Ego, and is widely accepted in the schools of health and economics.
The Hierarchy of needs is illustrated as the figure below:

Any rational human being will follow this model when fulfilling their various needs. On the first level are physiological needs; these being needs that we physically require for survival: Air, food, water, sleep, clothing, sex, et cetera. So regardless of how much we want to save the whales or write blog entries that will most likely never be read, published or recognised for their literary genius; if our human bodies are not sated with its physiological needs, we will simply wither and die.

So once this level of needs are sated, needs revolving around safety and security become top priority, followed then by love and belonging, esteem then self-actualisation. Remember that you will only pursue the satisfaction of higher level needs once all of the lower level needs are achieved.

But...

Everyone is different. The level of satisfaction for sexual intimacy, for example, will differ depending on how an individual values sexual intimacy. One person will yearn for a long-term, highly involved sexual relationship with another, whereas another may be completely sated with a purely platonic affinity with another, or value a life of celibacy. Crazy, I know...

In a nutshell, the higher up you move in the hierarchy, the more specialised, complex and intangible the needs become; focusing on the higher order demands of your personality and ego. The highest level of needs is self-actualisation. This can thought of as striving for personal growth, development and self expression.

So think about the things you value and which you could classify as fulfilling or enhancing a particular human need. You should be able to connect many brands, products and services with lower level needs compared to those above them. Right?

For example, to satisfy your physiological needs for clothing during these cold Sydney Winters, you could just take a trip to your local Salvo's for a jacket, and that would be fine. But to also fulfill your requirements of safety and security, you would probably want to take a trip to the local shops with better quality clothing so you can feel assured that the clothing is more suitable (proper fitting, acceptable returns policy) and that it will perform well. Furthermore you may want to peacock a bit and let the world know that you exist. Rather than going anywhere cheap and local you decide to take a trip to David Jones or any high-end retailer for something fashionable, more expensive and recognisable. You will conform to what is the norm and gain respect and acceptance (in the fashion world at least) as well as project achievement and confidence, fulfilling your esteem needs.

But if that wasn't enough for a jacket, if you can afford it (or have adequate credit limit) you want more. You value your jackets and your body being kept from wind chill as well as being fashionable but... You want a Burberry trench coat (at least AU$1000 when they're on sale). You want and need it not because its fashionable and functional, but because you have an emotional connection with it, and owning and wearing a Burberry trench coat doesn't just make you happy, but defines your character - it's somewhat symbolic of who you are - fulfilling self-actualisation needs.

And if you think this is completely stupid, you're probably sharing the same opinions with many others but you're probably doing the same. Ever wonder why people drive Ferrari sports cars? Wear Rolex watches? Collect and seldom wear designer stilettos or elaborate handbags? It isn't because they're "wankers" or infected with consumerism, it's because these people have an emotional connection with what this brand or product represents.

This is a great example: Coca-Cola.

Why would you buy a bottle of Coke which retails at around $2.80 in a supermarket to $6 at the Easter Show, when you can get something like Pepsi which is marginally cheaper, or any other generic brand (such as Aldi's GT Cola) for less than half the price? It has been thoroughly tested that Pepsi trumps Coca-Cola everytime based on taste - I personally prefer the "zing" to Coke than the over-fizzy sweetness of Pepsi - which is why in the USA in 1985, they released New Coke: Same packaging, different taste.

Total Failure.

What they didn't realise was that people had this emotional connection with the original recipe, the brand, and its image and had it at top-of-mind as well as willing to pay the marginal premium for it. Any type of new formulation or radical changes to the packaging and image was [and still is] considered sacrilige; which resulted in New Coke's failure. Coca-Cola is a perfect example of a product that serves no physiological benefits, holding high preference over other brands because it is able to serve the higher order needs of esteem and self-actualisation.

Just recently Vegemite medelled with their [almost Century old] recipe for the new generation of Vegemite children and are currently holding a competition to name the new product. Just from an operational standpoint, I don't really like the idea of two products so similar in mass appeal and production; it just kills Kraft's level of operational excellence... but anyway as a marketer I don't like this move. I'm predicting a like outcome as New Coke - but in the meantime I've submitted an entry for the new name: Vege-a-Boom!

The Generic Strategies

The Michael E Porter's Generic Strategies: A great business model that will never go out of corporate or academic fashion. Simply put, for your company to survive you must either (i) make the best products, (ii) make the products cheaper than your competitors, or (iii) serve a small segment of the market. You can't take on a hybrid approach because your company will lose focus on its main strategic advantage.

A Product Leadership strategy is being highly innovative and making "the best" products possible. This approach comes from the early times of currency and bartering when sole traders would specialise in their trade and the best goods would always attract the best customers and highest prices. This was great in the Middle Ages because economic trade activities were limited to your geographic microeconomy, and worked well into the 20th Century until trade barriers were lifted and sweat shops were given their time to shine.

Globalisation and the Internet during the end of the 20th Century brought many competitors into the market place, mainly competing on price. So many companies shifted from trying to create the most innovative and revolutionary product, to making just a standard product as cheaply as possible at a market-acceptable price.

Focusing your marketing strategy on cost efficient production and business processes rather than your product is adopting an Operational Excellence strategy. Utilising this strategy isn't just moving your production from Wollongong to China so you can produce colourful underpants at a cheaper rate [like Pacific Brands - the producer of Bonds - did this year] or migrate your support centre from Sydney, to India then to Africa to take advantage of the lowest English-speaking labour rates but is more focusing on creating lean systems and improving supply chain efficiencies in both response times and cost reductions. General Electric and Toyota are two stand out companies that pride themselves on having exceptionally lean manufacturing techniques. Something that you should also think about is that Operational Excellence is about "making things for cheaper", and not always about making cheap things.

But the downfall in both these two strategies is that their vision towards business success is mainly navigated internally, with little-to-some customer insight adopted. A Product Leader like Sony has always created technologically sound product concepts like the from the Walkman, to digital cameras and even to mobile phones. Their downfall however has been a lack of user adoption because their portable music players have had their market share eaten away since the Discman by the intuitive iPod, cameras are too complicated and laden with too many features, and their Sony Ericsson phones leave much to be desired in comparison to any new Nokia, iPhone or BlackBerry. The problem here was that there are many competing music players, gaming consoles, digital cameras and mobile phones.

The Perfectionist's Trap is when the creator of a new product produces something to their best capabilities. Since they are most probably an expert in their field they'll think to themselves "I have made this product to the highest standards I can perform, therefore it is the best product on the market and customers will buy it." Which thinking may work well when producing something like a $200,000 supercar, avant-garde fashion or any market that is supremely driven by innovation. But generally speaking, the most innovative and advanced product will not always have appeal to consumers. Sony's PS3 has the most GPU power for any console (apart from a computer) as well as having an integrated Blu-Ray player, Wifi, 60GB HDD, and heaps of other stuff you wouldn't think of or use, but has been overshadowed by the technologically inferior Nintendo Wii (for ease-of-use and stimulating viral videos) and the Microsoft XBox 360 (for online capabilities and high quality games) which is the oldest of the three consoles.

Cost leaders can often fall into the trap of continuously trying to make product lines more profitable at the expense of quality and user appeal. The above cartoon by Tom Fishburne is self explanatory.

The problem here really lies in the appeal of these competitive strategies. Cost and Product Leaders make product that "generally" appeals to the masses so they can extract the most revenue and profit. But what about if you narrowed your focus from the entire pie to just a slice of it? Get to know a small segment of the market that shows promise, and deliver a product that specifically suits their needs better than any other brand, product or alternative. This is Customer Intimacy.

Since customer centric companies create the best solution for this small segment of the market, these customers will [or should] take notice of your offer above any of the mass marketed alternatives and also pay the higher base price for it too. And since you specialise in this particular market, you can create economies of scale when you fit your operations to produce just these goods rather than an array of mass marketed ones.

I emailed a company the other day (for content on a later post) and asked whether their focus was on cheap prices, mix of products offered or good service. The reply was this: "we have always had the ambition of providing our customers with the widest range of ... products at the lowest prices everyday, backed with the best service." Sounds like something the CXO's say at their annual shareholders' meetings. But according to Porter, for strategic advantage you should be adopting ONE approach, not trying to do it all; even though it does sound impressive. This particular company however does adopt a customer intimacy (focus) strategy and is very successful. One of my favourite retail stores in fact.

Values Thrice: Exchanging, Equating and Adding Value

'Value' can be a difficult word to describe and define but without us knowing, it is the intangible currency that we have been trading with for centuries - not gold, tobacco, horses, chickens, barrels of rum or the arranged marriage of your first child. A transaction will only occur when two parties are able to exchange something of equal value with each other; assuming both parties will always behave "rationally": Try to think of it like this, would you trade a widget that is worth $100, for anything less than $100?

But believe it or not, this school of thought on the exchange of value is no longer accepted in academic marketing circles. Today, we recognise value as being the difference between how much we pay for something and the benefit we receive from it.

The Value Equation Costs - Benefits = Value

Strange isn't it?

We've moved from thinking of value as being like a commodity that we exchange to the difference between costs and benefits. If you ask me why; I'm not really sure. The first school of thought still makes sense to me. Perhaps we just need a different word to differentiate each model (ideas anyone?). But anyway the latter is what you will learn these days so you better get to know the value equation.

For consumers, value can be monetary (buying something on sale or the generic prescription medicine versus the branded) in the form of thrift or economising but many new age consumers are price insensitive. They see value in having "organic" goods, fair trade coffee beans, a highly recognised designer brand label or buying domestically produced and owned products, regardless of their price - this is totally irrational in my judgement, but to each their own. So when pitching a product to a consumer in the B2C marketplace, take into account what they see value in.

In a business context, think of value as something that increases the revenue of a company or reduces costs for a company. If it doesn't do either, it isn't valuable.

"Value-Added" or "Value-Adding" or applying any type of mathematical process with the word value has become quite the buzz in the industry and academia. Bonuses are distributed on an executive's ability to add or create value to their firm, which is a fair gauge in my opinion. But this puts value into another context: Shareholder Value. This occurs as a result of the Value Equation's application in investments. Adding to shareholder value is when a business operates so effectively that they generate a higher return for their shareholders than they did the previous period (with currency deflated for comparison purposes). In these cases, value is always expressed in a monetary form.

The Value Transfer Model is another application of the same word - Value - in manufacturing or process engineering. This model suggests that if a task doesn't add value to the product, service or match company objectives it should be eliminated to make the supply/value chain more "lean" and "agile". More buzzwords.

So all the rage at the moment with value is being able to create additional wealth for the shareholders. Today's marketplace is just as terrifying and competitive as in the movie Wall Street, but companies aren't trembling in fear of hostile takeovers and asset fire sales; but losing their competitive advantage from their neighbouring rival or some new age global producer based out in the more-developed Asian countries because they aren't able to create value.

Going slightly off topic to conclude, I've heard from many people that a good trick to use in a job interview is to say that you "add value" to the company. So this pitches you as being worth more to the company than they are offering to pay you. Not a bad idea to throw out there, but I think the value-adding buzzword in human resources has become a cliche. I'd recommend only using it if you're an accountant being interviewed by another older account. Actually I wouldn't recommend using too many buzzwords in an interview, you're only going to confuse yourself and the interviewer. Keep It Simple Stupid.