Sunday, July 22, 2007

Pricing Pencils


I spent one year in college as an art major. I was in for a rude shock when it came time to purchase my supplies for art class.

A simple little everyday #2 pencil is practically free, but a #2 “ART” pencil costs about as much as a case of regular pencils. Regular college paper is also very cheap, but “ART” paper is priced at a small fortune. And so on it went. All the supplies I was buying looked pretty similar to standard office/school supplies, but because it was labeled as a product for artists, the price was considerably higher.

It was at this point that I started to appreciate the meaning of the term “starving artists.”

Businesses make money by selling something. One of the key strategic questions a business must answer is at what price they are going to sell their goods and services. If you price yourself too high, you may miss out on sales to those who underprice you. Conversely, if you price too low, you are walking away from extra profit potential.

The amount of money the marketplace will allow you to charge for products can depend in part on how you position your product to that marketplace. In the story above, one can see that by positioning a product as suitable to “artists,” one can charge a higher price than if one positions that (or a roughly similar product) as being suitable to the masses.

To the average Joe, a pencil is a commodity—the cheapest one works about as well as an expensive one. Just about any pencil will do. However, to a sketch artist, their livelihood is highly dependent on the quality of their sketches. A bad pencil can ruin the quality of their output. As a result, the downside risk of getting a bad pencil is much higher for the artist than for the average Joe. Therefore, the artist is willing to pay more to avoid the downside risk of getting a bad pencil.

Now it may be true that an artist pencil costs more to make than a regular pencil, because the quality control and the raw materials may be at a higher standard. But here is the important lesson: the price one charges for an artist pencil goes up faster than the costs. Hence, the profit margins are fatter on the artist pencil.

Therefore, when determining one’s pricing strategy, one also needs to look at the positioning strategy, since positions can impact your flexibility in pricing.

The principle here is to link pricing decisions to positioning decisions. There are three types of positionings which tend to lend themselves to fatter pricing margins:

1. For the Passionate People
2. For the Hobbyist
3. For the Professional

We will talk about each of these separately.

1) For the Passionate People
In many businesses, a disproportionate share of total sales come very a very small sub-segment of their buyers. These are often the people with a passion for the product. For example, everyone wears shoes. However, it is a smaller sub-segment of the population who is really passionate about shoes. When compared to the rest of the population, these passionate shoe shoppers:

- Own a lot more shoes (and I mean A LOT more shoes)
- Are more likely to pay full price to get the shoes they want
- Are more likely to buy multiple pairs at the same time
- Tend to buy the nicer, pricier shoe styles rather than just basic lower-end shoes

If you can tap into this shoe passion customer, you have less pricing pressure than if you are trying to cater to the masses. Yes, there may be fewer of them, but the passionate ones more than make up for their size through the amount of purchases they make.

Even take something as mundane as lawn fertilizer, which is mostly just a bunch of common chemicals. There are those who are passionate about having the best lawn in the neighborhood. They will spend outlandish sums of money to satisfy their passion, paying a lot more money for the same basic chemicals.

For almost all categories, there is the passion segment. If you can own it, it can increase your pricing options.

2) For the Hobbyist
It always amazes me how much people will spend on their hobby. Normal, rational people on a low income, who carefully budget every other expenditure to the penny will blow big wads of money on their hobby without blinking an eye. It is as if anything labeled “hobby” is exempt from normal cost consciousness and budgeting.

When you walk into one of those huge Cabela’s outdoor sports enthusiast stores, you begin to realize just how much people are willing to spend in the name of a fishing or hunting hobby. The same is true when you walk into a Golf Galaxy store and see everything a golfer could possibly purchase to improve their golfing hobby. We already mentioned how art hobbyists get stuck paying more to support their hobby.

If I was trying to successfully compete against Home Depot, I would position my store as being the ideal place for the fun “hobby” aspects of home improvement, and try to reposition Home Depot as the dull store for the boring tasks of repair and maintenance. Hobbyists are better customers, price-wise and quantity wise.

The beauty of positioning yourself as a hobby store is that its appeal spreads farther than to just hobbyists. If you have a friend/relative/loved one who has a hobby, you can also be brought into the buying frenzy. When it comes time to buy that hobbyist a present, like for birthdays and Christmas, one is often drawn towards buying something to support their hobby.

A friend of mine likes to ride his Harley Davidson motorcycle. That’s his hobby. He says that every birthday and Christmas he gets a lot of Harley Davidson paraphernalia, or just about anything you can stick a Harley Davidson logo on. My friend says he has a whole room full of this stuff and he really doesn’t need or want any more, but people keep buying it for him, year after year. When the birthday rolls around, you need to buy the product then. You cannot wait for the sale which comes after the birthday is over. Hence, once again, you get a better price when you sell hobby goods.

3) For the Professional
When it comes to selling trucks, a lot of the advertising talks about how the truck is capable of handling the stress put on the truck by professionals. GMC even refers to their trucks as “professional grade.” The commercials for trucks tend to show them off-road, hauling over a ton of cargo, just like the pros would do.

Yet most trucks spend the majority of their time stuck in rush hour traffic on a paved road with virtually nothing in the truck bed. They are not owned by “professionals” who rely on their truck for their livelihood. These people just like the idea of having the same quality of truck as the professionals.

As we said earlier, professional artists are willing to pay more for art supplies, because they cannot afford the downside risk of having sub-standard equipment. The same goes for professionals in most fields. As a result, they are willing to pay more.

But so are the people who aspire to be like a professional. They will pay more to buy the same equipment the pros use. If the NASCAR teams use particular brands of tools or parts, then many NASCAR fans who like to fantasize that they are NASCAR professionals will pay a premium to get those same brands. If professional home builders use DeWalt tools, then I want them as my puttering around the house tools as well.

Even though passion people, hobbyists, and professionals may not be the largest sectors of the customer base, they can often be among the best to target, because:

1) They purchase more units than others (they are the heavy user segment)
2) They tend to buy the more profitable part of the product mix.
3) They tend to be willing to pay more and less likely to wait for sale
4) They can suck others into the buying frenzy either as aspirational purchasers or as friends buying gifts.

Usually, there is only one “lowest cost operator” in a business sector. Everyone else is a higher cost operator. If you are not the lowest cost operator, it will be difficult to win with a strategy of having the lowest prices. Therefore, most operators need excuses for why people would pay more. Having a position of being the best for passion people, hobbyists, or professionals can be that excuse.

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