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Monday, October 03, 2016

Does Making A Feature Standard Justify A Price Increase?

When you manage pricing strategy, one of the thornier problems that can land upon your desk is how to adjust expectations when what was previously a premium feature becomes standard. There are numerous examples of this in various industries, but I'll go ahead and stick with the one I'm dealing with, though I'll speak in generalities for confidentiality reasons.

For a long time now, "organic" and "natural" have been claims which command a price premium. This applies whether you're at the grocery store, buying plants or seeds at your local nursery, or buying clothing made from non-GMO cotton. Products that go to the trouble of avoiding biotech usually sell for more.

Let's think for a moment, however, about why that is the case.

One explanation is that organic products sell for more because they cost more to produce. Chemicals may be expensive, but they pay for themselves several times over in reduced labor and and increased productivity. However, can that really be the explanation? Imagine that no one cares whether a product is organic or not, in other words, that the label "organic" has no influence on their decision of which product to buy. If that's the case, all other things being equal, if there are two products on the shelf -- Product A which is $5 and is not organic, and Product B which is priced at $6 and is organic -- people will buy Product A because it is cheaper. Even if we assure the customer that the seller of Product A had a cost of $4 while the seller of Product B had a cost of $5 such that either way the buyer is only providing the seller with $1 of profit, buyers who do not place any monetary value on the label "organic" will simply buy the cheaper product. The difference in cost does not matter unless people think that there is also a difference in quality.

The better explanation is that there is one group of customers who care about buying products that are organic, and another group of customers who are indifferent to the claim. (There might also be some who actively do not want an organic product, but let's ignore that possibility for the moment.) These people either think that organic products are better (taste better, are healthier, etc.) than non-organic products, or they think that there is some ethical imperative to consume organic products instead of others.  Either way, these people place a value on "organic" which makes them willing to pay more for a product which has that label.

When Product A and Product B are both on the shelf, those who care about buying organic products buy Product B and pay the one dollar premium, while those who do not care buy Product A and save a dollar.  In pricing circles, this is what we call "price discrimination".  In this case, 'discrimination' doesn't mean something nefarious or unfair, but rather that by offering two products with different characteristics at two different price points, you're able to capture higher revenue from those who care about the point of difference while still getting a sale (even though at a lower dollar amount) from those who would have been unwilling or unable to pay the higher price.

The difficulty with consolidating the product line and making what was previously a differentiation feature standard is that you lose this price discrimination.  When executives start to think about making a move such as going to an "all products are organic" strategy there are two concerns.  One is a desire to show that the company is 'green' and respects the concerns of young and trendy customers.  However, another is that organic products sell for higher prices (and often higher profits) than non-organic ones.  What this thinking misses is that when a feature such as 'organic' becomes standard, you are now trying to sell that product not only to the people who are willing to pay a price premium for the feature, but also to those who do not place any extra value on it.

This means that for the customers who did not previously buy the organic product, because they did not consider it worth the extra money, the consolidation into an all-organic product line is simply a price increase.  Those customers will respond to the change just like any other price increase, meaning that some of them will no longer buy the product or will buy it less frequently.  Companies are often hesitant to take a price increase on a product unless it has some sort of new 'added value' to justify the higher price (or unless there is an increase in the cost of its components such that they feel confident that competitors will be taking a similar price increase.)  Thus, making what was previously an added value feature standard seems like a more attractive move than simply increasing the price with no changes to the product.  And yet, if the feature is one that one segment of customers does not place any value on, they will respond to it just like any other price increase.

The solution is either to with until a solid majority of customers are already selecting the product with the added value feature -- in this case, until the majority of customers are buying organic.  Or else, hedge against losing customers by continuing to provide a 'value' product which does not include the new standard feature.

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