Pricing for Service

"What price should we charge for our service?"

The challenges of service pricing require active participation from marketers who understand
customer needs and behavior and from operations managers who recognize the importance of
matching demand to available capacity. The discussion that follows in this chapter assumes a
basic understanding of the economic costs -fixed, semi variable, and variable- incurred by
companies, as well as the concepts of contribution and break-even analysis.

WHAT MAKES SERVICE PRICING DIFFERENT?

1. No Ownership of Services; It's usually harder for managers to calculate the financial
costs involved in creating an intangible performance for a customer than it is to identify
the labour, materials, machine time, storage, and shipping costs associated with
producing a physical good. Yet without a good understanding of costs, how can managers
hope to price at levels sufficient to achieve a desired profit margin?
2. Higher Ratio of Fixed Costs to Variable Costs; Because of the staff and infrastructure
needed to create performances, many service organizations have a much higher ratio of
fixed costs to variable costs than is found in manufacturing firms. Service businesses with
high fixed costs include those with an expensive physical facility (e.g., a hotel, a hospital,
a university, or a theatre), or a fleet of vehicles (e.g., an airline, a bus company, or a
trucking company), or a network dependent on company-owned infrastructure (e.g., a
telecommunications company, an Internet provider, a railroad, or a gas pipeline). While
the fixed costs may be high for such businesses, the marginal costs for serving one extra
customer may be minimal.
3. Variability of Both Inputs and Outputs; "What should be the basis for service
pricing?" Seemingly similar; units of service may not cost the same to produce, nor may
they be of equal value to all customers. The potential for variability in service
performances (especially those that involve interactions with employees and customers)
means that customers may pay the same price for a service but receive different levels of
quality and value. Alternatively, they may be charged radically different prices for the
same basic service offering, as often happens in the hotel industry.
4. Services Are Hard to Evaluate; The intangibility of service performances and the
invisibility of the backstage facilities and labour make it harder for customers to what
they are getting for their money than when they purchase a physical good. Don't forget
that, in addition to visible and invisible costs, the firm has finally to add a margin to the
bill in order to make a profit for the owner. However customers are making up their
opinion of price solely on base of visible service attributes.

Unit 3
 5. Importance of the Time Factor; Time often drives value. In many instances, customers
are willing to pay more for a service delivered at a preferred-time than for a service
offered at a less convenient time. They may also choose to pay more for faster.
6. Availability of Both Electronic and Physical Distribution Channels; The use of
different channels to deliver the same service can affect costs and perceived value.
Electronic banking transactions are much cheaper for a bank than face-to-face contact in
a branch. While some people like the convenience of impersonal but efficient electronic
transactions, others prefer to deal with a real bank teller. Thus, a service delivered
through a particular channel may have value for one person but not for another.
7. Identifying User Outlays From a customer's standpoint, the monetary price charged by a
supplier is not the only cost or outlay associated with purchase and delivery of a service.
a. Price and Other Financial Expenses Customers often spend additional amounts over
and above the purchase price. Necessary incidental expenses may include travel to the
service site, parking, and purchase of other facilitating goods -or services ranging from
meals to babysitting. We call the total of all these expenses (including the price of the
service itself) the financial outlays associated with purchasing and consuming a service.
b. Non-financial Outlays Customers may occur a variety of non-financial outlays,
representing the time, effort, and discomfort associated with searching for, purchasing,
and using a service. The total costs of purchasing and using a service also include those
associated with search activities We can group non-financial outlays into four distinct
categories
 Time expenditures are inherent in the service delivery process. Time may also be
wasted simply waiting for service. There's an opportunity cost involved because
customers could spend that time in other ways.
 Physical effort including fatigue, discomfort, may be incurred during visits to the
service factory or while using a company's self-service equipment.
 Psychological burdens like mental effort, feelings of inadequacy, or fear may
accompany the tasks of evaluating service alternatives, making a selection, and
using the chosen service.
 Sensory burdens relate to unpleasant sensations affecting any of the five senses.
They may include putting up with noise, unpleasant smells, drafts, excessive heat
or cold, uncomfortable seating or lighting. The total costs of purchasing and
using a service also include those associated with search activities.

FOUNDATION OF PRICING STRATEGY

The foundations underlying pricing strategy can be described as a tripod, with costs to the
provider, competition, and value to the customer. The costs that a firm needs to recover usually
impose a minimum or floor price for a specific service offering. The perceived value of the
offering to customers sets a maximum, or ceiling. The price charged by competitors for similar

Unit 3
services typically determines where, within the floor-to-ceiling range, the price should actually
be set

1. Cost-Based Pricing Cost-based pricing involves setting prices relative to financial costs.
Companies seeking to make a profit must set a price sufficient to recover the full costs -
variable, semi variable, and fixed- of producing and marketing a service. A sufficient
margin must also be added to provide the desired level of profit at the predicted sales
volume. Going for "skimming" or "penetration" prices, firms need to analyse their cost
structure and identify the sales volume needed to break even at this particular high or low
prices.
Regulatory Pressures; Not all service firms are free to charge whatever price they
choose. Most local utilities -like telephone, water, cable TV, electricity, and gas- have
been regulated historically by government agencies that control all changes in prices and
terms of service. Industry regulators or politicians, responding to complaints about
excessively high prices, sometimes put pressure on these types of businesses to clarify
and account for service costs.
Activity-Based Costing; It's a mistake to look at costs from just an accounting
perspective. Progressive managers view them as an integral part of their company's
efforts to create value for customers. Unfortunately for the accountants, costs have
nothing to do with value, which is market driven. Customers aren't interested in what it
costs the firm to produce a service; instead, they focus on the relationship between price
and value. Activity-based costing (ABC) provides a structured way of thinking about
activities and the resources that they consume.
"ABC analysis enables managers to slice into the business in many different ways; by
product or group of similar products, by individual customer or client group, or by
distribution channel". Thus ABC analysis can pinpoint differences in the costs of serving
individual customers, while traditional cost analysis tends to result in loading the same
overhead costs on all customers.
2. Competition-Based Pricing If customers see little or no difference between the services
offered in the marketplace, they may just choose the cheapest alternative. Under
conditions of competition-based pricing, the firm with the lowest cost per unit of service
enjoys an enviable marketing advantage. It has the option of either competing on price at
levels that higher-cost competitors cannot afford to match, or charging the going market
rate and earning larger profits than competing firms.
Price leadership; In some industries, one firm may act as the price leader, with others
taking their cue from this company. During boom times in competitive industries such as
airlines, gas stations, hotels, and rental cars, firms are often willing to go along with the
leader since prices tend to be set at a level that allows good profits. However, during an
economic downturn, these industries quickly find themselves with surplus productive
capacity. To attract more customers, one firm (often not the original leader) may cut

Unit 3
 prices. Since pricing is the easiest and fastest marketing variable to change, a price war
may result overnight.
Price Bids and Negotiations; Industrial buyers sometimes request bids from competing
service suppliers. The more tightly specified the buyer's requirements, the less
opportunity, out of prices, there is to differentiate one bidder's offer from another. In
alternative to bidding is negotiation. The firm may request proposals from several
suppliers and then negotiate with a short list of those firms that seem the most qualified
and have offered the most relevant or innovative approaches.
3. Value-Based Pricing Service pricing strategies are often unsuccessful because they lack
any clear association between price and value. Three strategies are available for capturing
and communicating the value of a service: uncertainty reduction, relationship
enhancement, and cost leadership
Pricing Strategies to Reduce Uncertainty; If customers are unsure about how much
value they will receive from a particular service, they may remain with a known supplier
or not purchase at all. Benefit-driven pricing helps reduce uncertainty by focusing on that
aspect of the service that directly benefits customers (requiring marketers to research
what aspects of the service the customers do and do not value). This strategy requires
firms to communicate service benefits clearly so that customers can see the relationship
between value and costs.
Relationship Enhancement; Offering discounts when customers purchase two or more
services together may be a viable relationship-building strategy. The greater the number
of different services a customer purchases from a single supplier, the closer the
relationship is likely to be and the lower the prices.
Cost Leadership; This strategy is based on achieving the lowest costs in an industry.
One challenge, when pricing low, is to convince customers that they are also getting good
quality and value! A second challenge is to ensure that economic costs are kept
continuously low enough to enable the firm to make a profit.

PRICING AND DEMAND

In most services, there's an inverse relationship between price levels and demand levels.
Demand tends to fall as price rises. This phenomenon has implications for revenue
planning and also for filling capacity in businesses that experience wide swings in
demand over time.
Price Elasticity
The concept of elasticity describes how sensitive demand is to changes in price. When
price elasticity is at "unity," sales of a service rise (or fall) by the same percentage that
prices fall (or rise). When a small price change has a big impact on sales, demand for that
product is said to be price elastic. But when 'a change in price-has little effect demand-is-
described as price inelastic. Demand can often be segmented according to costumers'
sensitivity to price or service features. For example, few theatres, concert halls, and
stadiums have a single, fixed admission price for performances. Instead, prices vary
Unit 3
 according to (1) seat locations, (2) performance times, (3) projected staging costs, and (4)
the anticipated appeal of the performance. In establishing prices for different blocks of
seats and deciding how many seats to offer within each price block (known as scaling the
house), theatre managers need to estimate the demand within each price category. A poor
pricing decision may result in many empty seats in some price categories and immediate
sell-outs (and disappointed customers) in other categories.
Yield Management
Service organizations often use the percentage of capacity sold as a measure of
operational efficiency. By themselves, however, these percentage figures tell us little
about the relative profitability of the customer base. High utilization rates may be
obtained at the expense of heavy discounting, or even outright give-aways.
Yield management pricing strategies are based on maximizing the revenue yield that can
be derived from available capacity at any given time. Effective yield management models
can significantly improve a company's profitability. Airlines, hotels, and car rental firms,
in particular, have become adept at varying their prices in response to the price sensitivity
of different market segments at different times of the day, week, or season. The challenge
is to capture sufficient customers to fill the organization's perishable capacity without
selling at lower prices to those customers who would have been willing to pay more.
Advances in software and computing power have made it possible for managers to use
sophisticated mathematical models to address complicated yield management issues. In
the case of an airline, for example, these models integrate massive historical databases on
past passenger travel with real-time information on current bookings. The output helps
analysts predict how many passengers would want to travel between two cities at a
particular fare on a flight leaving at a specified time and date. Airlines use yield
management analysis to allocate seats at different fares (known as price buckets) for a
specific flight with the objective of improving its yield.
Customer-Led Pricing: Auctions and Bids
One method of pricing that has attracted a lot of attention with the advent of the Internet
is inviting customers to bid the 'price that they are prepared to pay. The Internet provides
a good medium for auctions because of its ability to aggregate buyers from all around the
world. In the same line, the Web also offers many opportunities for consumers to bid on
prices for goods and services. Rather than approaching individual financial institutions
for a mortgage or other loan, borrowers can enter their requirements and personal
situations at a Web site that solicits bids for the required loans. And online market makers
let buyers decide how much they are willing to offer for many other types of services.

PUTTING PRICING STRATEGIES INTO PRACTICE

Unit 3
 Although the main decision in pricing is usually seen as how much to charge, there are
other important decisions to be made.
How Much to Charge? Realistic decisions on pricing are critical for financial health.
The pricing tripod model provides a useful departure point. The task begins with
determining the relevant costs, which set the relevant "floor" price. The second step is to
establish a "ceiling" price for specific market segments. This involves assessing market
sensitivity to different prices, which reflects both the overall value of the service to
prospective customers and their ability to pay. Competitive prices provide a third input.
The wider the gap between the floor and ceiling prices, the more room there is for
maneuvering. If a ceiling price is below the floor price, the manager has several choices.
One alternative is to recognize that the service is non-competitive, in which case it should
be discontinued. The other is to modify it in ways that differentiate it from the
competition and add value for prospective customers. This makes it competitive at a
higher price.
What Should Be the Basis for Pricing? To set a price, managers must define the unit of
service consumption. Should it be based on completing a specific service task, such as
repairing a piece of equipment, cleaning a jacket, or cutting a customer's hair? Should it
be based on admission to a service performance, such as a conference, film, concert, or
sports event? Should it be time based, as in using an hour of a lawyer's time, occupying a
hotel room for a night, or renting a car for a week? Should it be tied to value, as when an
insurance company scales its premiums to reflect the amount of coverage provided or a
realtor takes a percentage commission on the selling price of a house?

Some service prices are tied to consumption of physical resources like food, water, or
natural gas. Rather than charging customers an hourly rate for occupying a table and
chairs, restaurants put a sizeable mark-up on the food and drink items consumed.
Price Bundling; Many services unite a core product with various supplementary
services, such as a cruise ship where the tariff includes meals and bar service. Should
such service packages be priced as a whole (referred to as a "bundle") or should each
element be priced separately? If people prefer to avoid making many small payments,
price bundling may be preferable -and it's certainly simpler to administer.
Discounting; To attract the attention of prospective buyers or to boost sales during a
period of low demand, firms may discount their prices, often publicizing this price cut
with coupons or an advertising campaign.

Who Should Collect Payment?

Sometimes firms choose to delegate provision of supplementary services like billing to
an intermediary. Although the original supplier pays a commission, using a third party
may still be cheaper and more efficient than performing those tasks itself. Commonly
used intermediaries include travel agents who make hotel and transportation bookings;

Unit 3
 ticket agents who sell seats for theatres, concert halls, and sports stadiums; and retailers
who sell services ranging from prepaid phone cards to home and equipment repair.

Where Should Payment Be Made? Payment for many services is collected at the
service facility just before or immediately following service delivery. When consumers
purchase a service well in advance of using it, there are obvious benefits to using
intermediaries that are more conveniently located, or allowing payment by mail
(Airports, theatres, and stadiums, for instance, are often, situated some distance from
where potential customers live or work.) A growing number of service providers now
accept credit cards for telephone bookings and sales over the Internet.

When Should Payment Be Made? Two basic options are to ask customers to pay in
advance (e.g., an admission charge, airline ticket, or postage stamps), or to bill them on
completion of service delivery (e.g., restaurant bills and repair charges). Occasionally a
service provider may ask for an initial payment in advance of service delivery, with the
balance being due later (e.g., management consulting). This approach is also quite
common with expensive repair and maintenance jobs, especially when the firm -often a
small business with limited working capital- must buy materials up front.

How Should Payment Be Made? Service businesses must decide on the types of
payments they will accept. Although cash is a simple payment method, it raises security
problems and is not always convenient for customers (especially for large purchases).
Checks are convenient for customers, but sellers need to develop controls to discourage
invalid payment. Credit cards are convenient and have the advantage of being accepted
worldwide, regardless of currency. Businesses that refuse to accept such cards
increasingly find themselves at a competitive disadvantage

Unit 3