Strategic Planning Analogy #508: Profiting from Free

THE STORY
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.

THE ANALOGY
“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
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.

SUMMARY
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.

FINAL THOUGHTS

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.

Strategic Planning Analogy #503: Unbundled Subsidies

THE STORY

When I used to eat at a fast food restaurant, I’d order a burger and fries. But then I realized that the low price menu would have burgers for about the same price as those french fries. After that, I skipped the fries and ordered a second burger.

My logic went like this: Fries are merely grease sponges—just empty calories filled with fat and covered with too much sodium. By contrast, at least with the cheap burger I was getting some protein. They cost about the same and filled me up about the same and were equally tasty. Therefore, instead of getting a burger and fries, I started getting two burgers.

That was all fine by me. But I don’t think the fast food restaurants enjoyed my new decision. After all, they made a good profit on the fries but were losing money on that low-cost second burger.

THE ANALOGY

No matter what business you are in, your customer has choices. Even in a monopoly situation, the customer has choices. They can choose a substitute from another industry or choose not to purchase at all.

Many of the decisions businesses make affect those choices, such as product assortment and pricing. When the fast food industry added low-price value items to their menu, they changed the way I made choices about how I eat.

Unfortunately, my change was to the detriment of the fast food restaurants. I switched from high-margin fries to a negative margin value burger. And it was THEIR decision which caused my changed behavior to work against them. Their actions made me a less profitable customer.

So don’t limit your discussions about what is strategic only to big issues like positioning and productivity. Even smaller issues, like the pricing of a burger, can have a huge impact on performance for years to come.

Think of it like making a small decision about whether or not to bring a woodpecker on board your boat. It’s just a little bird. But one day the woodpecker pecks a hole in the boat. Even then, one little hole is not a big deal—it can be repaired. Over time, however, the woodpecker pecks a great many holes in the boat and it sinks. It is the accumulation of many small, bad consequences from that one little decision about birds which sank the boat.

This is also true for business. It is usually not the big decisions which bring a company down. After all, executives spend a lot of time making sure they get the big decisions right—that’s why they’re called “Big Decisions.” No, it’s the accumulation of many small daily decisions (decided poorly) which sink a company.

Little decisions start chain reactions in how customers make choices. Any one of them may not hurt you, but in total they can create a disaster. If those daily decisions are not made within a strategic context or are not thought through thoroughly, they can destroy the grand design or your larger strategy. After all, your strategy is not what you say, but what you do. And what you do is determined every day with those small decisions. So strategy needs to “sweat the small stuff.”

THE PRINCIPLE

The underlying principle behind the fast food mess is “unbundled subsidies.” And if you are not careful, unbundled subsidies can ruin business models for a lot more industries than just fast food.

1) The Origin Of Subsidies

Many industries are highly competitive. This creates severe downward pressure on prices (competition won’t let you raise prices). And to top it off, we’ve trained consumers to not have to pay full price for anything. Just ask the customers of JCPenney. When JCPenney eliminated sales, they lost over one quarter of their business. It turns out that people expect deals and won’t willingly pay full price.

Therefore, highly desired items are often sold at little to no margin (or even a negative margin). So how do you make money when your key items are sold at or near a loss? The answer is subsidies. You get customers to buy additional items that have a high enough margin to offset the loss on the core.

In fast food, the high margin drinks and fries subsidize the low margin burgers. On big-ticket electronic items, high margin extended warranties traditionally subsidized the low margin device. The base sticker price on a car is kept low, but they get you with high margin upgrades, accessories, financing and repair work. Low margin industrial goods are often subsidized with service contracts. Low margin printers are subsidized with high margin ink.

It has become the way of the world. In order to compete on price versus competitors and satisfy customers who want a deal, core items are becoming like loss leaders, forcing businesses to surround them with subsidies in order to survive.

2) Unbundling of Loss Leaders and Subsidies

Originally, the idea was to try to bundle the loss leaders and subsidies as tightly as possible. That way, every purchase could still remain profitable because the loss leaders and subsidies were sold together. In the fast food world, they were called “Combo Meals”—you had to buy the whole bundle of food to get the deal.

Other industries followed with their own version of the bundle. Cable and telecom companies bundled phone/internet/TV. HP used patents so that you could only use their high margin ink on their printers.

But the hypercompetitive world started causing the bundle to fall apart. Between 2000 and 2002, McDonald’s rolled out the Dollar Menu in the US. Now you could buy the cheap items without also buying the subsidies.

In the telecommunications industry, companies started turning subsidies into additional loss leaders. For example, charges for texting used to be the subsidy for voice calls. Then texting became free and had to be subsidized by data downloads. I was talking to someone in the industry who said it is a constant race to find the next subsidy, because someone in the industry is always trying to turn the current subsidy into a loss to get an edge.

And then the dotcom world came up with the “Freemium” model. In this model, most people pay absolutely nothing for the service (it’s free) while a small minority pay for a premium version. This is how linkedin works. I pay nothing for the basic service because it is subsidized by a totally different customer, usually a recruiter, who buys a premium version. Or Zynga had most people playing Farmville for free while a small minority subsidized the whole system by purchasing virtual farm equipment.

This all starts to become dangerous territory when loss leaders and subsidies are unbundled. In fast food, you get people like me who now load up on the loss leaders and avoid the subsidies. In telecommunications, there is the risk of running out of new sources for subsidies to support the ever expanding list of loss leaders.

The price of loss leader consumer electronics got so low that it became “disposable pricing.” If something went wrong, you could afford to just replace it, erasing the need to buy the extended warranty subsidy.

The freemium model runs the risk of the two audiences getting out of balance, with not enough payers to subsidize the freeloaders. Zynga just announced huge layoffs because they are having trouble with their business model.

And it is hard to go backwards on these trends. The telecommunication folks want to dial back the unlimited data plans but are meeting strong resistance. When the fast food people try to dial back the value menus, the customers revolt. Newspapers have been trying to get people to pay for the online version (which used to be free) with only varying levels of success.

Once you set up a subsidy system, you redefine the expected cost for the loss leader. “Regular” price becomes the loss leader price. Consumers see anything higher as outrageously high pricing. This makes it very difficult to reverse the pricing once the loss leader position has been made.

But now that the subsidies are becoming ever more unbundled from the loss leader, it is more difficult to ensure that enough subsidies are sold to offset the loss leader prices. Profits become more elusive. Risk of failure is increased.

3. Lessons Learned

What can we learn from this? First, small actions today have consequences well into the future. And it may not be initially obvious today what those consequences may be. Therefore, before making some of these small actions, we need to take time to consider their impact on the larger picture. Otherwise, we may unintentionally be dismantling our grand strategy one brick at a time.

Second, if strategists (or strategic thoughts) are only limited to an annual offsite meeting, they will be unable to adequately impact all those little day to day decisions. We need to get strategic context around a larger proportion of our decision making.

SUMMARY

Strategy should be more than just big thoughts around big decisions. It needs to permeate the organization more regularly and further down the organization, where many of the more mundane decisions are made. After all, these more “mundane” decisions can accumulate to the point to where they threaten the entire strategy.

FINAL THOUGHTS

How many decisions are made in your business without asking the question “How can this decision impact the long-term viability of our strategy or company?”