SEGMENTED PRICING:

USING PRICE FENCES TO

SEGMENT MARKETS AND
CAPTURE VALUE

By John Hogan and Tom Nagle

Price Fences to Operationally Segment
Markets Below are seven generic approaches to
The use of segmented pricingthe practice segment using price fences and examples of
of charging different customers different how they are used successfully.
pricesis a critical element in every
marketers toolkit. Yet if charging different 1. Segmenting by Buyer Identification
customers different prices were easy, Occasionally, pricing differently among
everyone would do it. So how can it be segments is easy because buyers in the
done? The answer is by creating a profit- different segments have obvious
driven price structure that varies not just the characteristics that distinguish them. For
price, but also the offer or the criteria to instance, barbers charge different prices to
qualify for it. This can be achieved through cut short and long hair because long hair is
price fences. usually more difficult to cut. But
identification of customers in different
Price fences are criteria that customers must segments is rarely so straightforward.
meet to qualify for a lower price. At movie
theaters, price fences are usually based on Often a buyers relative price sensitivity
age (with discounts for children and seniors) does not depend on anything immediately
but are sometimes also based on educational observable or on factors a customer freely
status (full-time students get discounts), or reveals, but rather on how well-informed
possession of a coupon from a local paper about alternatives a customer is. In such
(which benefit locals). All three types of cases, the classification of buyers by
customers have the same need and cost to segment usually requires an expert
serve them, but perceive a different value salesperson trained in soliciting and
from the purchase. evaluating the information necessary for
segmented pricing. The retail price of an
Price fences are one of the most effective automobile is typically set by the
tools a marketer has, but care must be taken salesperson, who evaluates the buyers
to prevent customers from somehow willingness to pay by taking a personal
bypassing the fence. For example, interest in the customer, asking what the
Americans looking for discounts on customer does for a living (ability to pay),
pharmaceuticals travel to Canada to buy the what kinds of cars she has bought before
same brands at lower prices, thwarting the (loyalty to a particular brand), and where she
geographic fence. The art of price fencing lives (value placed on the dealers location).
involves not only finding a natural By the time a deal has been put together, the
separation of buyers by price sensitivity, but salesperson has a fairly good idea of how
also a means to enforce the separation.

Spring 2006 SPG Insights

sensitive the buyers purchase decision will on Tuesdays in order to meet exceptional
be to the products price. demand on Fridays. Seats left unused on
Tuesday flights are lost, whereas the ability
2. Segmenting by Purchase Location to serve customers on Friday afternoon is
Customers who perceive different values, limited by capacity at that time. Therefore,
and who buy at different locations, can be airlines charge more on the days that seats
segmented by purchase location. For are in demand, and less on days when they
example, dentists, opticians, and other have excess capacity.
professionals sometimes have multiple
offices in different parts of a city, each with 4. Segmenting by Purchase Quantity
a different price schedule reflecting When customers in different segments buy
differences in their clients price sensitivity. different quantities, one can sometimes
segment them for pricing with quantity
A segmented pricing tactic common for discounts. There are four types of quantity
pricing bulky industrial products, such as discount tacticsvolume discounts, order
steel and coal, is freight absorption. Freight discounts, step discounts, and two-part
absorption is the agreement by the seller to pricesexamples of which follow.
bear part of the shipping costs of the
product, the amount depending upon the Volume discounts are based on the
buyers location. The purpose is to segment customers total purchases rather than on the
buyers according to the attractiveness of amount purchased at any one time. For
their alternatives. A steel mill in Pittsburgh, example, steel manufacturers grant auto
for example, might agree to charge buyers companies substantially lower prices than
the cost of shipping from either Pittsburgh they offer other industrial buyers because
or from Chicago, where his major auto manufacturers use such large volumes
competitor is located. The seller in that they could easily operate their own
Pittsburgh receives only the price the buyer mills.
pays, less the absorbed portion of any excess
cost to ship from Pittsburgh. This enables Order discounts are used when sellers vary
the Pittsburgh supplier to cut price to prices by the size of an order rather than by
customers nearer the competitor without the size of a customers total purchase. This
having to cut price to customers for whom is because many of the costs of processing
his Chicago competitors have no location an order are unrelated to the size of it;
advantage. consequently, the per-unit cost of processing
and shipping declines with the quantity
3. Segmenting by Time of Purchase ordered. For this reason, sellers generally
When customers in different market prefer that buyers place large, infrequent
segments purchase at different times, they orders rather than small, frequent ones.
can be segmented for pricing by time of
purchase. Theaters segment their markets by Step discounts apply only to a purchase
offering midday matinees at substantially beyond a specified amount. This is to
reduced prices, attracting the price-sensitive encourage individual buyers to purchase
retirees, students, and unemployed workers more of a product without having to cut the
who can most easily attend at such times. price on smaller quantities for which they
Less price-sensitive evening patrons cannot would pay a higher price. Step discounting
so easily arrange dates or work schedules to may segment not only different customers,
take advantage of the cheaper midday ticket but also different purchases by the same
prices. customers. Such pricing is common for
public utilities from which customers buy
Segmenting by time is also useful when water and electricity for multiple uses and
demand varies significantly with the time of place a different value on for each use.
purchase but the product or service is not
storable. Airlines, for example, face greater Two-part pricing involves two separate
demand for seats on Mondays, Thursdays, charges to consume a single product. For
and Fridays than on other days. However, example, car rental companies have a daily
they cannot store the excess seats they have rate plus a mileage charge, and health clubs
Spring 2006 SPG Insights 2
charge an annual membership fee plus by differences in alternatives, uses, or
additional fees for tennis court time. In these income. To make this tactic work, one must
cases, heavy users pay less than do light offer a lower-priced version that is in some
users for the same product, since the fixed way inadequate to meet the needs of price-
fee is spread over more units. insensitive buyers but still acceptable to
price-sensitive buyers. Microsoft has a
5. Segmenting by Product Bundling lower-priced version of its dominant
Product bundling is a widely used tactic for Windows operating software, targeted at
segmented pricing. Restaurants bundle foods first-time computer users in developing
into fixed-price dinners, generally a cheaper countries. This Windows Starter Edition
alternative to the same items served la allows users to open only three applications
carte. Bundling is a successful tactic because at a time and restricts instant messaging. It
the products bundled together have a also offers limited word processing, no out-
particular relationship to one another in their of-the-box Internet access, and a screen
value to different buyer segments. resolution that wont support the newest
computer games. The cost to limit the
Most firms use optional bundling where capabilities of this new product is minimal,
products can be bought separately, but the consisting mostly of turning off different
option is available to buy them in a bundle elements of the softwares code.
at prices below their cost if bought
separately. Optional bundling is more In Summary The Importance of
profitable than indivisible bundling Segmented Pricing
whenever some buyers value one of the Designing an optimal price structure that
items in the bundle very highly but value the effectively segments your market and
other less than it costs to offer it. For maximizes your profitable sales
example, residential cable companies offer opportunities is clearly among the most
bundles of cable internet, cable-based difficult aspects of pricing strategy. While
telephone, and cable television services for the types of segmentation tactics discussed
reduced prices off their la carte price. can serve as a guide to separating markets,
finding a basis for segmentation (i.e., a
6. Segmenting by Tie-Ins and Metering particular buyer characteristic or a particular
Segmentation by tie-ins or metering is often bundling combination) ultimately requires
important for pricing tangible and intangible creative insight. Since each example of
assets, because buyers generally place segmented pricing is unique in its method of
greater value on an asset the more intensely implementation, there can be no simple
they use it. Food processors canning fruit formula. Finding a basis for segmentation is
year-round in California value canning the key to maintaining a strong competitive
machines more than fish packers do in position; in some cases, it is essential to
Alaska, who can salmon-fish only a few remaining viable.
months each year. In such cases, tactics that
segment buyers by use intensity can
substantially improve both sales volume and
profitability.

In service-based companies, tie-in contracts

Tom Nagle and John Hogan are Group Leaders in the
are frequently used to reduce the cost for Cambridge office of Strategic Pricing Group, a
new buyers to try their services. Wireless member of Monitor Group. They can be reached at
phone providers offer a digital telephone for tom_nagle@monitor.com and
a nominal fee, and sometimes for free, if the john_hogan@monitor.com.
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buyer agrees to purchase a long-term service
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7. Segmenting by Product Design www.strategicpricinggroup.com.
The important factor in segmenting by
product design is differences in value driven
Spring 2006 SPG Insights 3