Monday, July 29, 2013

Strategic Planning Analogy #508: Profiting from Free

When I was in college, I was desperate to find a job to help pay my college expenses. I ended up taking a job at a call center. The job consisted of calling people to tell them they had won three “free” magazine subscriptions. All they had to do to get their free magazines was pay a small “processing fee.”

As it turns out, that small “processing fee” just so happened to equal the cost of subscribing to those magazines. So the magazines were not free at all. It was a deception. I could not stand deceiving people that way, so I quit after three days.

“Free” is an effective marketing tool. People love to get things for free. And if you cannot do “free” then selling below cost is the next best tool. The problem is that it is hard to make a profit if you give everything away for free or sell well below cost.

Therefore, if you price something as free, you need to get income in another way. That can be a difficult problem to solve. In the story, they solved the problem through deception. That is not usually the best long-term strategy, since the deceptions eventually tend to come out in the open—and people don’t like finding out they were deceived.

In this blog we will look at a list of other ways to bridge the gap so that you can hit a price the market loves and still make money.     

The principle here is that the choice of one’s pricing strategy can be one of the most important strategic decisions one can make. And that decision should not be seen as an add-on at the end. In other words, don’t build your strategy first and then decide where to set the price. Pricing needs to be integral to the entire strategy formation—from beginning to end…Why?

1) Free Only Works If the Business Model is Designed to Make it Work
First, in order to support free or below cost pricing, you need a business model which pinpoints other sources of income. If you don’t predetermine those other sources when designing the business model, they will not magically appear later. You need a justification in the business model for why additional money should flow into company (and where it comes from), so that enough money will show up to cover the losses on the core product.

The entire revenue stream needs to be looked at simultaneously, to ensure that total inflows cover your outflows and produce a profit. In this holistic approach, you may find that the model needs adjustments in order to make it all work. For example, you may need:

1.     An additional type of sales force (like people to sell advertising in addition to people to give away the product); or
2.     An additional appeal to an additional customer base (like finding a way to appeal to both premium paying customers and free customers); or
3.      A different production or product design (like a stripped down free model so that you can sell upgrades or perhaps a version more appealing to advertisers).
4.     A broader portfolio of products in the mix (like adding highly profitable french fries to the menu in order to compensate for the loss on selling the hamburger)

Unless you look at all the pieces together, there is a good chance you won’t get enough pieces right to make the whole business work.

2) Subsidies Are Becoming the Norm
The second reason why pricing concerns need to be up-front and integral to the business model development is because the idea of selling free or below cost is becoming the norm. This is no longer just a problem for people selling low cost hamburgers. It is impacting nearly every industry. For example, almost the entire social-based economy has a free element to it. The younger generation who grew up with social media have an expectation that a whole host of items should be free (or highly subsidized), like information and entertainment.

You even see it now in portions of the large durable goods and business-to-business spaces. And if it isn’t there now, it will get there eventually.

The competitive pressure is too great. To create a strategic position which stands out in a hyper-competitive, hyper-saturated environment where consumers are bombarded with too many messages and too little time, you have to exaggerate. To own quality, you need to offer ultra-high quality to get noticed and get credit for it. Similarly, to own service, you need to offer ultra-high service. To own price, you need to offer ultra-low prices. These exaggerations make it difficult to price the core products at a level to cover what it takes to achieve “ultra” status.

Therefore, one cannot count on always being to sell everything one offers at a price which covers all of its costs. It is safer to say that one should count on at least a portion of one’s business to always need some kind of subsidy in order to price at market levels.

Strategies to Win With Free or Below Cost Pricing
So how do we create strategic business models so that below cost pricing is covered? Here are some suggestions:

1)     Bundling. This is epitomized by the fast food combo meal. To sell the below cost burger, they bundle it with a high margin drink and fries, so that the whole bundle becomes profitable, even if the burger is still priced below cost. This is why salespeople try to sell below-cost computers in a bundle with cables, extended warranties, software, etc.

2)     Fees: To make money on low airfares, airlines add all sorts of fees for baggage, preferred seating, meals and anything else they can think of. Offers for products on TV add “postage and handling” fees to the low price. My telemarketing story added fees.

3)     Freemium Model: Common with social media sites are free basic sites, with others paying a premium price for premium features found in the premium version. The idea is that the more users there are on a site, more valuable it is to premium members (network effect). Therefore, it is worth it to sites like Linkedin to build a large free base in order to increase its value to recruiters (who are more willing to pay to access a large base).

4)     Subsidy (Advertising): If you can get a lot of people interested in something due to being free, then there are often advertisers (or others) who will pay to access those people you’ve gathered. This is common in entertainment (like magazines or web sites). Also, check out a doctor’s office to see how many items have ads from pharmaceutical firms. There are ads everywhere! If you can advertise there, why not anywhere else?

5)     Addiction: In the illegal drug trade there is a saying that “the first dose is always free.” The idea is that it is worth it to give away the first dose of the drug, because it will create addictive behavior that will get them coming back to pay for additional doses for many years. This can work for free chips at a casino. Also, I know of a company that gave away free bags of premium dog food. They knew that if they got the dogs hooked on the premium brands, they would refuse to eat the cheap brands anymore.

6)     3rd Party Payers:  If you cannot get customers to pay, get someone else to pay on their behalf. Lots of firms advertise “free” products or services which are subsidized by the government (through programs like Medicare). Convince children to beg their grandparents to buy something for them. Sell “free” benefits to employees by getting their employers to buy it for them (like health club memberships or pet insurance).

7)     Add-ons: Put a low price on a stripped-down basic automobile and then charge a fortune for all the deluxe add-on features.

8)     Refills: Charge a low price for the razor and charge a fortune for the razor blades. Or charge a low price for the printer and a fortune for the ink refills. Or sell the Barbie doll cheaply and charge a bundle for all of the outfits. The idea is to establish your base cheaply and then get a high margin on replacing the items that go with the base.

9)     Delayed Timing: Make it free now, but get paid later. This is the idea of extending credit so that customers pay nothing at time of purchase. This works for automobiles (just sign and drive). There has been a leap in demand for solar panels since going from an upfront purchase model to more of a pay-as-you-go model.

And the list can go on.

In the hyper-competitive world of today, about the only way to create a position which stands out is by exaggerating features to the extreme. And often, it is difficult to charge a high enough price to cover the cost of that exaggeration. Therefore, one needs a business model which finds other ways to get adequately compensated. And the only way to ensure that occurs is to design it into the core business model from the very beginning. So address your pricing and income strategy at the beginning and all the way through the business model development. It is too important to try to just tack pricing on at the very end.

The whole world is becoming more like those telemarketers or the fast food combo meals. Therefore you need to think more like them and look for ways to subsidize below cost pricing.

No comments:

Post a Comment