Is Differential Pricing Right for Your Small Business? 10 Things You Must Consider
Pricing Pointers, Issue #11
The objective of differential pricing is to increase sales and profits by charging different people different prices for the same (or nearly the same) product or service.
Here are 10 important questions to ask to ensure you have the necessary understanding and capabilities to successfully use a differential pricing strategy.
1 - How do buyers vary in their willingness to pay for your product or service?
The value of any product or service is subjective. It depends on who you ask.
Although every buyer receives the same features and functionalities, they do not necessarily gain the same perceived benefits.
This inherent subjectivity means a range of differences in the maximum amount buyers are willing to pay.
Think of buyers as standing on different tiers based on their willingness to pay.
2 - Can you reliably sort buyers based on their price sensitivity or willingness to pay?
Identifying a buyer’s true willingness to pay is challenging. It’s not in the self-interest of a buyer to reveal this.
One could attempt to sort buyers directly through individual price negotiations.
However, haggling is impractical and uneconomical for many products, especially those with low margins.
Another way to sort buyers directly is offering different prices to specific groups of buyers based on some observable characteristic like their age or student status.
Group pricing, while simpler to use, is often imperfect. This is because not every member of a group will not be equally price sensitive.
3 - Which specific type of differential pricing tactics will you employ?
The alternative to directly sorting buyers by their willingness to pay is to create conditions where buyers sort themselves through the choices they make.
This approach is often perceived as fairer because all buyers are presented with the same options to pay less.
These specific tactics involve creating "price-value trade-offs" where buyers must choose between paying less for less value or paying more for more value.
For example, consider “Good, Better, Best” pricing. Price-sensitive buyers will select the more economical, good quality version. Quality-sensitive buyers will choose to pay more for a higher quality level.
4 - What is the optimal number of price points or options to offer your customers?
Offering too many choices can overwhelm and confuse potential customers.
When buyers are confused, they may decide not to purchase, because they are afraid of making the wrong choice
Aim for 2-3 options to make things simpler for buyers and yourself.
Two different price points gives you an alternative to simply discounting when a buyer claims your price is too high. “I can’t give you A for that price, but I can give you B.”
Three price points establish a "middle" or "safe" choice for buyers who don’t know what to choose.
5 - Can you develop clear value distinctions for each different price point?
For different price points to make sense to buyers, they must clearly reflect different levels of value.
Customers who opt to pay more should unequivocally receive more in return, while those who pay less must get less.
This fundamental rule compels buyers to make a conscious trade-off between price they pay and value they will receive.
6 - How will you communicate the value distinctions of each price point to your customers?
Employ descriptive labels such as "good," "better," and "best" to signify different quality levels or versions.
Shift the communication focus from listing product features to explaining the actual benefits those features provide.
Structure the presentation of your price points to make it easy for buyers to compare different options and understand what they will gain or lose.
7- Is your differential pricing approach economical to implement and manage?
Implementing a differential pricing strategy can indeed be economical, especially when compared to the lost profits from a uniform pricing approach.
Indirect differential pricing, where buyers "self-sort" by choosing from a menu of options, is a practical approach compared to direct methods like haggling, especially for low-margin sales.
Many differential pricing tactics do not require significant new expenses. For instance, quantity-dependent, time-dependent, and location-dependent pricing are often quick wins.
8 - Can you prevent reselling between different price segments?
When low-price buyers can easily resell to high-price buyers, it undermines your entire pricing structure.
This practice hurts your profits by preventing higher-paying customers from purchasing at their intended price point.
It is crucial to prevent customers who would pay more from easily acquiring yours products at a lower price.
Services present low resale risk. Their inherent nature makes them difficult, if not impossible, to resell without your approval.
On the other hand, products that are easily storable and movable pose a high resale risk.
One of the most effective strategies to combat reselling is to make the same lower-priced product available to all buyers. But remember to embed it in a price menu built on price-value trade-offs.
9 - Is there a risk of cannibalizing your sales?
Cannibalization happens when your higher-end buyers opt for your lower-priced product or service.
While you still make the sale, you earn fewer contribution margin dollars. This is because higher-end products typically have larger contribution margins.
The core problem is that buyers consider the lower-priced version "good enough."
The main cause is providing too much value for the price in your low-end version, or not enough additional value in your higher-priced version.
10 - Are your chosen differential pricing tactics legal and socially acceptable?
Methods that offer lower prices to some buyers, and not others, based on who the buyer is (e.g., senior citizen discounts), are prone to perceptions of unfairness.
They can even be illegal. Some "ladies nights" promotions, for instance, have been ruled illegal in various jurisdictions due to anti-discrimination laws.
The best safeguard against these perils is to shift the basis of your pricing from who the buyer is to what the buyer does. Every buyer who makes the same choice pays the same price.