The Psychology of Price

by Leigh Caldwell

  XSQ would have tried to include these factors in the price the next time it worked with a client, but some other unpredictable variable would have interfered with the next deal. But what really made this model impractical was the fact that the ultimate payback could not be calculated until well into the future. Some cars are not returned from a lease deal for three years or more, and the residual value cannot be finally calculated until then. So XSQ had to wait several years for full payment for its software. This was survivable in a pilot, but would have badly hurt cash flow if applied across all of its clients.

  But then the marketing director came up with the idea of combining a value proxy with absorption pricing. Instead of trying to calculate the exact value generated by the software, XSQ worked out an approximate figure, which worked out at between £30 and £110 for each car leased, depending on the value of the car and the length of the lease agreement. Then they looked at the business process of the client to find out where they were spending money anyway.

  Two types of transaction dominate the financial model of a leasing company: the £7,000–£20,000 they spend each time they buy a car, and the £500–£1,000 they receive in commission from a finance company when they sign a lease agreement. These therefore seemed to be the right places to charge the fee. XSQ worked out a simple licence fee per car model, charging an average of 0.5% of the value of the car, part payable when the lease agreement was signed and part in a quarterly licence as service payments were received from the end customer. This meant that XSQ’s client was never out of pocket, and in some cases was even able to pass the software licence fee on to its own customers – using the principle of other people’s money.

  This model enabled small leasing companies to manage their cash flow and pay only for the value they were getting, while larger ones ended up paying a higher share of the development costs of the software. XSQ found it was able to charge an average of 40% more through this method than with its previous model.

  Common applications of this technique:

  • selling drinks alongside meals in a restaurant

  • selling food and drinks with a long-distance travel service

  • accessories sold with a car or computer.

  Case study

  Marketing consultant

  CH is a consultant working on marketing projects for clients. Primarily she is a copywriter, helping her clients choose the right words to communicate their message, but she also gives some advice on brand strategy and the visual design of marketing materials.

  CH, like most consultants, uses the traditional pricing structure of a fixed rate per day (with some negotiation depending on the client).

  Typically consultants using this model can earn between £350 and £1,500 a day. (The upper end is hard to reach for individual consultants, but achievable for many consulting firms.) CH has been earning at the lower end of the range, between about £350 and £500 per day, and sells about 50% of her time.

  This model reflects the cost of providing the service for the consultant, but does not recognise the value gained by the client. Using an advert designed by CH, a client might generate £2m in new sales, but it may have taken her only two days to write and therefore she earns only £800.

  There are three reasons why the day-rate model is appealing in this sector.

  First, it reduces the risk to the supplier. Consultants who price according to goals achieved or value generated take a certain amount of risk – will the goal actually happen? If it doesn’t, they may have worked for nothing. A day rate means that the consultant knows how much they will get for each day worked, regardless of results.

  Second, because most consulting services are to some degree bespoke, it can be hard to create a general model that represents client value. This is especially true for highly generalised services such as management consulting. One week you might work on improving customer service standards for telephone staff; the next week, on developing processes to create new relationships in a reseller channel; the next, you are advising on business planning to raise investment funds. The value generated by each of these jobs is very different, and this makes it both hard to measure (developing value measures might take as long as doing the actual consulting) and hard to standardise on a common definition of value.

  Third, because clients are often not concerned directly with value, but instead with whether they are getting ‘a good deal’. Where there is no other measure of how good, or fair, a deal is, clients find it easy to understand day rates. There is an established range of prices for consultancy day rates (as suggested above) and any rate outside this range can look unfair. It is easy for a client to extrapolate from a £4,000/day consulting rate to £800,000/year of income, and to ask whether their supplier really should be earning that much. Conversely, a £100/day rate equates to £20,000/year and the client may start to worry that the supplier undervalues themselves, and this can be a warning signal. So day rates give the client a simple way to evaluate how fair, or sensible, the supplier’s business model is, and in turn offers the client the power to negotiate a lower price. It also lets clients believe they are comparing competing consultants on a like-for-like basis, even though this is objectively almost impossible to do.

  Despite these pressures, a value-based charging method is a much more powerful mechanism for a consultant to use. If your client makes £1m out of the process improvements that you help them implement, you should aim to find a way to charge £100,000–£200,000 for this service. Of course, this has the downside that if you make them only £10,000 you may be paid only £1,500 in return. But if you don’t have the confidence in your skills to be sure of achieving your client’s goals, should you be taking the job?

  Not only is this (arguably) a fairer way to apportion the benefits of the work, but it has some direct beneficial outcomes:

  • It incentivises you to take the jobs that will generate the most value, and turn down those which will not – which is better for economic outcomes, and for your clients, and ultimately better for you.

  • When you are carrying out a project, it guides you to spend your time on the activities that are most valuable, and to eliminate or minimise time-wasting tasks and meetings.

  • As a result, this model is both better for you – because you’ll make more money – and better for your clients – because you’ll do a better job for them.

  It isn’t always easy to implement a value pricing model. The two big difficulties are defining measurements, and persuading your client to accept it.

  Client persuasion can be tough. Clients often think that if you want to change from an established pricing model it’s because you want to charge them more money. You can point out some of the arguments above, but they may say that you should already be doing the best job possible for them, and that is what they are paying for.

  The best response to this is to reposition your service. Easier with new clients than old ones, this means describing what you do, not as a consulting service for hire but as a kind of product offering. You want them to think of you not as a replacement or competitor to an existing service, but as a new way to solve their existing problem. The solution to CH’s pricing dilemma relies on this reframing decision.

  If you want to pitch this to new clients, you may need to offer them a day-rate option as well, so they do not feel you are forcing them down a route they don’t want to take. It may be most effective to offer this new model to them on an especially risky project – perhaps one that they’re uncertain whether to pursue. The results-based or output-based method might make the difference between going ahead with the project or not. And once the precedent is established, it will be easier next time.

  It is often hard to objectively measure the value you create as a consultant, simply because so many other things are changing at the same time. If you help to redesign the marketing message for your client, and afterwards their sales go up by 10%, is that because of your work? Or is it because they increased their advertis
ing budget, or hired a new and talented salesperson? You usually can’t ask the client to cease all other changes in the business in order to measure the effects of your work, and unless they are a big company with many customers and a strong commitment to measuring their marketing efforts, they won’t be able to split their sales messages and accurately compare performance between the two groups.

  So you need to define proxy value measurements. By this I mean variables that are objectively measurable and which are a close representation of the value you create.

  The solution to CH’s pricing problem was the following.

  • Analyse the values of her clients: winning new customers; improving their brand image, selling more stuff to existing clients; improving conversion rates.

  • Convert those into measurable outcomes: successful adverts.

  • Charge £2,000 for an initial strategic consultation, which can be fully offset against future adverts if they decide to use CH for future work (the offsets are limited to 25% of the price of the advert so that she doesn’t end up doing a lot of free work).

  • Charge £750 per advert she writes that the client chooses to implement. At draft stage, the client is given the choice whether to go ahead; if they do, she creates the full advert and the client pays when they publish it.

  • Charge £100 for each time the client re-runs the advert. This gives her a stake in its success. What’s more, it gives her an interest in revisiting the client to help test and improve the advert in the future. This is a good way to sell the client on the benefits of a value-based approach.

  Chapter summary

  • Attaching or comparing the price of your product to something much larger can make it easy for customers to buy without thinking.

  • If you can show that your service enhances the experience, or profitability, of something much bigger, this comparison will look more convincing.

  • You may be able to earn extra revenue by linking your reward to a percentage of the value of a bigger item, especially if you are selling to businesses.

  Chapter 16

  Other people’s money

  I was in a car, being driven along the M4 by Rajiv O’Brien, who described himself as CTC’s head of enterprise sales. It seemed hard to picture just what an enterprise sale of a chocolate teapot might look like, but Maggie had suggested I go with him on a client visit.

  A couple of briefcases rode with us in the back seat, and Rajiv asked me to carry one of them into the client’s office, which we reached just before Bristol. I sat beside him as he started his presentation to the client.

  “How productive are your staff over the course of a day?” he asked.

  The client, Hannah Michaels, the HR director of an insurance company, didn’t know.

  Rajiv pulled out some charts showing average productivity of office staff throughout the course of a day. There was a peak from about 9.30am to 11am, and another short one from 3pm to 3.30pm. At other times, the chart reached no more than half the peak heights.

  “This graph shows how much work people produce at different times of day. It corresponds to the blood sugar levels of the employee, which influence their ability to concentrate.”

  I won’t repeat the whole presentation. The point turned out to be that chocolate teapots – and more generally, a carefully managed schedule of tea, coffee and food throughout the day – was good for health and good for productivity. Rajiv ended up pitching a service combining consultancy, employee advice and provision of daily teapots.

  He asked me to open the briefcase. Inside were five different kinds of teapot, designed for different times of day, with or without sugar. Alongside them sat a manual and an iPad – on which he demonstrated a software program that tracks the employees’ time and alerts when they should be putting another teapot on. It all looked very slick.

  “So we can demonstrate that an employee on this programme can be 15% more productive – which, on your revenue figures, means an extra £75 per day for every employee. Plus, you improve your corporate responsibility rating, and get more loyalty from your staff. For this we charge only £9 per day per employee. What do you think?”

  Hannah clearly found it difficult to disagree with the figures, though she claimed not to be able to make a decision without approval from the board. Rajiv suggested a pilot programme.

  “How much can you approve without going to the board? Would they make you wait for a board meeting to spend £1,000 a month?”

  “I suppose not. What would we get for that?”

  “We could run a pilot for three months with a team of 10 staff. I’d be giving you a discount but I’m willing to do that if you agree to evaluate it after each month to see whether it should roll out to the rest of the staff.”

  Hannah thought for a minute and agreed to give it a try.

  On the way back, Rajiv explained some of what just happened.

  “First and most important, she is spending other people’s money. We wouldn’t easily get anyone to put £1,000 of their own money into something untried, but when the money belongs to the company, the pain of shelling it out from your own wallet is not there. In fact, people can make more rational decisions – based on costs and benefits – with their employer’s money than with their own.

  “Second, I used monthly payments, anchoring, absorption, per-employee pricing and a trial period – all to reduce her sensitivity to the size of the payment.

  “Third, I gave her a clear rationale for the purchase. Maybe she doesn’t believe, in her gut, in the productivity figures. But now she has a clear rationale if her decision is questioned by anyone else in the company. In fact, she can argue that the potential productivity gains across the whole company are so high, and the cost of the trial so low, that she wouldn’t be doing her duty if she didn’t try it.”

  Three months later I checked in with Rajiv. It turned out that the pilot had been a success – the 10 selected people were 10% more productive [note: I suspect the Hawthorne Effect,3 but that’s a different story] and the insurance company had placed an order for all 400 of its staff, which worked out to over £600,000 per year. “Not bad for a few cups of tea,” as Rajiv pointed out.

  There are two powerful aspects to the way the teapots are sold in this chapter.

  The first is that a product has been converted into a service – with some intangible expertise bundled in, and made tangible through the physical teapots and the software tool. Tangibility is an important aspect of pricing; it is easier for people to make a decision to buy something if they can feel it in their hand – it gives them a clearer idea of what they are buying and can help to remove a source of doubt.

  Tangible objects also give rise to the endowment effect, a psychological phenomenon whereby people value something more highly once they have held it in their hands (explained in more detail in Chapter 11). This is related to loss aversion, which means that the pain of losing something you already have is greater than the pleasure of gaining an object of equivalent value. Both of these can be used to good effect in making people put a higher value on what you sell.

  The second effect comes from other people’s money. In this example, Hannah Michaels is spending her company’s money, not her own. You can see the same effect when toyshops sell to children, who are not price-sensitive because the money being spent usually belongs to their parents or grandparents. Of course, price is still an issue – the object being bought must be perceived as worth more than the money spent – but the fact that someone else’s money is being used removes a whole series of psychological barriers to purchase.

  A lot of what prevents us from buying things are cognitive factors: fear of making a mistake; the potential regret of buying something that wasn’t as good as we expected; worry about looking silly; or the indecisiveness that comes from not knowing the experience we will get from a purchase. It is much easier for a business purchaser to get around these issues and move the decision on to concrete grounds.

  There are other c
hallenges in selling to businesses – they are more likely to look at competitors, less likely to be influenced by deferred payments, and their decisions may be less influenced by the intangible value that we create through anchoring and decoys. But these effects still work, even if not quite as strongly as on personal purchases.

  How to apply it

  Your business may already be committed to selling only to consumers or only to businesses. In this case, the decision has mostly been made for you. But you can still find ways to move the conversation in the right direction.

  If you sell to consumers, there are three main mechanisms you can use.

  1. Create a purchase that can be made by a third party. For example, jewellery is often bought for its wearer by their partner and not by the wearer themselves. De Beers famously promoted diamonds as the standard for engagement rings in Europe and the USA throughout the course of the twentieth century, and eventually managed to create a (somewhat chauvinistic) price expectation, that men buying an engagement ring should spend one month’s salary on it. Recently I have heard someone trying to suggest that two months is the new standard. Shameless, but I have to admire their chutzpah.

  2. Show how the purchase can be absorbed into, or netted off against, a third-party spend. For instance, if you sell new furniture, this can be incorporated into the process of buying a house, and financed by slightly increasing the amount borrowed on the mortgage. The consumer feels like they’re spending the bank’s money instead of their own, so it becomes easier to make the purchase.

  3. Find a business justification for the purchase, and show buyers that they can claim it as a business expense.

  4. Develop a way to sell it to businesses directly. To do this, you should go back to the benefit and value tables from Chapters 1 and 3 and look at additional value that could be gained by businesses. You can be quite creative, as CTC was with its enterprise productivity service; or it may be as simple as offering your product as an incentive that companies can give as a gift to their customers or employees. In any case, the values involved in this decision will be different from those at play in a personal purchase.