Price Segmentation: From Fences to Magnets
Author: Debra Patek
Pricing, at its core, is about capturing value. Through segmentation, we can capture even more value by leveraging differences in willingness to pay (WTP). The idea is simple: set lower prices for those less willing to pay, and higher prices for those who'll pay more. By doing so, we optimize revenue across diverse customer scenarios.
Yet, segmentation extends beyond categorizing customers or adjusting prices—it’s about aligning with broader objectives while adapting to business and competitive constraints. The key lies in matching segmentation to these underlying realities.
Here’s the challenge. Segmentation methods are as varied as the customers and products they're designed for, differing in scope, granularity, and technique. With so many options available, understanding and choosing between them can be overwhelming.
The Big Picture: Fences and Magnets
However, when we step back and take a broader view, we see that price segmentation essentially boils down to two core actions: building 'Fences' to ensure the right price reaches the right customer and creating 'Magnets' to attract customers by aligning products and pricing with their needs. ‘Fences’ are about capturing existing value, while ‘Magnets’ are designed to draw in additional value. Whether used individually or in tandem, each plays a distinct role.
For clarity, we'll use the terms ‘Fences’ and ‘Magnets’ to represent these foundational approaches. Now, let's unpack these core approaches in more detail.
Segmented Pricing Strategies [Fences]
Core Concept: Often referred to as segmented or differential pricing, ‘Fences’ create clear price boundaries to isolate and monetize differences in willingness to pay.
Economic Basis: You might recognize this type of segmentation from economics, where it is called "price discrimination". Despite the negative connotation, it can make products more affordable for price sensitive buyers, without compromising total revenue.
The left demand curve shows limited revenue from a single price. The right illustrates increased total revenue through segmented pricing, showcasing multiple, additive revenue streams.
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Application in Practice
In theory, price segmentation is straightforward: match the price to a customer's willingness to pay. But in practice, it hinges on the effective identification of significant variations in willingness to pay and the enforcement of 'fences'.
Quantifying WTP can be a challenge. It often involves combining insights from various data sources like sales records, surveys, and customer feedback to understand buying behaviors, gauge price elasticity, and assess economic value. It's also beneficial to draw on the insights and experience of customer facing employees (sales, customer service) as a supplement to data analysis.
Often, direct measures of willingness to pay or elasticity are replaced by proxies. These substitutes, based on personal or situational attributes correlated with value or willingness to pay, act as 'fences' that deter resale and maintain price integrity. Figure 2 illustrates some common segmentation fences.
Figure 2: Common Segmentation ‘Fences’
Real world examples of this type of segmentation include:
· Apple’s Education Pricing offers reduced prices to students and educators
· Soft drinks are priced significantly higher at entertainment venues than at fast food restaurants
· Senior citizen discounts rely on age as a proxy for WTP
· Theater Tickets are higher for weekend evening shows compared to weekday matinees
· Bulk Purchases typically have reduced per-unit prices
Segmented Pricing Opportunities and Challenges:
‘Fences’ can offer quick returns but demand careful planning to balance the associated benefits and risks.
The Upside: When done right, ‘Fences’ offers several benefits:
· Increased Revenue: Aligning prices with each segment’s WTP boosts revenue
· Market Expansion: Attracts diverse customers by offering varied pricing
· Purchase Incentives: Motivates increased purchases or long-term commitments
· Quick Adaptation: Enables rapid price adjustments to market shifts
The Downside: There are challenges to mitigate:
· Customer Alienation Risk: Clear criteria are essential to avoid trust erosion due to inconsistent pricing
· Risk of Brand Dilution: This can occur especially when lower pricing is introduced in expanded markets
· Regulatory Considerations: Potential legal and regulatory challenges, especially globally
· Arbitrage Risks: The potential for customers to exploit pricing differentials
· Operational Complexity: The necessity for well-organized management and system support
‘Fences’ are a potent tool for tailored pricing strategies, driving both revenue growth and market diversification. However, the associated challenges require careful thought to protect brand image and customer trust.
While ‘Fences’ offers immediate financial gains, the second strategy, 'Magnets,' focuses on building long-term value by understanding and aligning with diverse customer needs.
Value-Based Segmentation [Magnets]
Core Concept: More commonly known as value-based price segmentation, ‘Magnets’ align offerings with each segment’s distinct value drivers, enhancing perceived value and WTP through tailored strategies.
Bottom of Form
Economic Basis: Different segments are driven by distinct value propositions, each with its own demand curve. Value-based 'magnets' stimulate demand, resulting in a rightward shift in the demand curve, as shown in Figure 3.
Figure 3: Value-Based Demand Shifts
The left demand curve shows limited revenue from a single price. The right shows the results of an increase in demand resulting from a value-based strategy, which shifts the demand curve to the right, resulting in a higher price at the same quantity demanded.
APPLICATION IN PRACTICE
Understanding Purchase Drivers: ‘Magnets’ is more than just an understanding of customer needs or wants, but a deeper dive into the underlying factors driving purchase decisions, emphasizing the role price plays in these decisions. Specifically, this approach looks at the trade-offs customers are willing to make between price and other benefits, with a focus on where those needs intersect with profitability. Techniques like conjoint analysis and maxdiff are especially useful for quantifying these trade-offs, providing insights into how customers value different features and benefits relative to price.
One of the core advantages of ‘value-based segmentation lies in identifying varied drivers behind different levels of willingness to pay (WTP). Regardless of price sensitivity, every segment has distinct buying motivations. A customer on a tight budget, for example, has different purchasing triggers than a bulk buyer looking to minimize unit cost. Similarly, those less sensitive to price may prioritize innovative features, brand reputation, or environmental benefits. Uncovering these underlying motivations is key and helps move the conversation from price to value. Figure 4 highlights common factors that drive willingness to pay a premium price.
Figure 4: Common Drivers of Premium Pricing ‘Magnets’
Increasing WTP via Distinct Value Propositions:
Building on these insights, increasing WTP via distinct value propositions becomes the next focus. The first critical step is identifying customer motivations. It goes beyond just satisfying customer needs. It's about attracting customers by tailoring offerings and prices to their unique values, which in turn enhances loyalty and boosts profitability. Though cost cutting and boosting volume have their place, aligning price with perceived value is often a more substantial source of value enhancement.
The goal is straightforward: align price with perceived value and elevate perceived value to raise the price.
Quick wins can be achieved by aligning prices and communication to the value already inherent in products. For a more lasting impact, and to enhance perceived value, in-depth research and the development of tailored offerings can cater to the needs and values of different segments. Strategies might include expanding the product line to offer more variety or even introducing new sub-brands specifically designed to appeal to particular customer groups.
Real-world applications of these drivers are diverse, with companies either zeroing in on niche markets or broadening their horizons to tailor offerings that resonate with varied customer values and expectations. Examples include:
Delta and other airlines segment based on the level of service and comfort
Buffalo Trace Distillery offers bourbons at different price points (Buffalo Trace, Eagle Rare, Pappy Van Winkle) each catering to a different segment based on aging, rarity, and taste.
Estée Lauder offers luxury products via different brands e.g. MAC for younger audiences and Aveda for eco-conscious.
Value Based Pricing Opportunities and Challenges:
Value-based approaches shifts the focus from price to value, justifying higher prices and building loyalty but introduces complexities.
Enhanced Customer Loyalty: Tailored offerings increase customer satisfaction and loyalty
Higher Perceived Value: Tailored offerings can command higher prices.
Brand Differentiation: Alignment with segment value propositions helps stand out in the market.
Enhanced Brand Perception: Balances brand while accommodating cost-sensitive customers
Challenges to Consider:
Increased Complexity: Due to need for tailored products and marketing.
Investment Required: Upfront research and customization cost can be substantial.
Delayed ROI: Due to the investment needs ROI may not be immediate.
Value-based approaches involve upfront investment but can unlock higher levels of WTP by aligning offerings with specific customer needs and values. Companies must balance customer expectations with brand identity.
Application of Insights
‘Fences' capitalizes on immediate revenue by exploiting current customer willingness to pay, though it can pose challenges to the brand and customer experience. 'Magnets', requiring an initial investment, builds long-term loyalty by aligning offerings with customer needs, elevating perceived value.
Together, they form a balanced strategy. 'Fences' quickly taps into existing value from the market; while 'Magnets' nurtures and expands that value over time. This combination helps deliver near term revenue and promotes long-term loyalty and growth.
High Level Steps:
Segment Identification: Combine data analytics and qualitative insights to identify and understand distinct segments.
Fences Application: Establish, communicate, and review pricing boundaries, ensuring they are clear, justified, and effectively enforced.
Magnets Development: Uncover each segment's unique value drivers and adjust offerings and messaging to reflect these, ensuring optimized pricing for increased value capture.
COMPARISON OF APPROACHES
The following table provides a detailed comparison of two primary segmentation strategies, 'Fences' and 'Magnets', breaking down their respective impacts, opportunities, and challenges across key business areas.
'Fences' yields immediate revenue at the potential cost of the brand experience. 'Magnets' invests in long-term loyalty by aligning offerings with customer needs. Combined, they balance quick profit and long-term value, leveraging the strengths of both for revenue growth and customer loyalty.