Interview Questions

Pricing Strategies for Services


Have you ever noticed what a wide variety of terms service organizations use to describe the prices they set? Universities talk about tuition, professional firms collect fees, and banks charge interest on loans or add service charges.

Some bridges and highways impose tolls, transport operators collect fares, clubs charge subscriptions, utilities set tariffs, insurance companies establish premiums, and hotels establish room rates. These diverse terms are a signal that service industries have historically taken a different approach to pricing than manufacturers.

Answering the question, What price should we charge for our service? is a task that can't be left solely to financial managers. 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. If you haven't previously been exposed to this material or feel you could benefit from a refresher, you may want to review the information in the box titled "Understanding Costs, Contribution, and Break-Even Analysis".

What Makes Service Pricing Different?

Let's consider how some of the differences between goods and services marketing that may affect pricing strategy.

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 labor, 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?

Higher Ratio of Fixed Costs to Variable Costs Because of the labor 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 theater), 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 variable costs for serving one extra customer may be minimal.

Variability of Both Inputs and Outputs. It's not always easy to define a unit of service, raising questions as to what should be the basis for service pricing. And 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 other 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 service offering, as often happens in the hotel industry. Advertising, the do-it-yourself travel site, emphasizes its ability to help customers quickly find the cheapest price for a hotel room (Figure).

Many Services Are Hard to Evaluate The intangibility of service performances and the invisibility of the backstage facilities and labor make it harder for customers to know what they are getting for their money than when they purchase a physical good. Consider the homeowners who call an electrical firm, seeking repairs to a defective circuit. A few days later (if they are lucky) an electrician arrives with a small bag of tools.

Within 20 minutes, the problem is located and a new circuit breaker installed. Presto, everything works! Subsequently, the owners are horrified to receive a bill for $65, most of it for labor charges. But they're overlooking all the fixed costs that the firm needs to recover, such as the office, telephone, vehicles, tools, fuel, and support staff.

The variable costs of the visit are also higher than they appear. Fifteen minutes of driving back and forth plus 5 minutes to unload (and later reload) needed tools and supplies from the van on arrival at the house must be added to the 20 minutes spent at the customers' house. These activities effectively double the labor time devoted to this call. Finally, the firm

Understanding Costs, Contribution, And Break-Even Analysis

Fixed costs sometimes referred to as overheads are those economic costs that a supplier would continue to incur (at least in the short run) even if no services were sold. These costs may include rent, depreciation, utilities, taxes, insurance, salaries and wages for managers and long-term employees, security, and interest payments.

Variable costs refer to the economic costs associated with serving an additional customer, such as making another bank transaction, selling an additional seat in a train or theater, serving an extra hotel guest for the night in a hotel, or completing one more repair job. For many services, such costs are very low. There is, for instance, very little labor or fuel cost involved in transporting an extra bus passenger.

Selling a hotel room for the night has slightly higher variable costs, since the room will need to be cleaned and the linens sent to the laundry after a guest leaves. More significant variable costs are associated with activities like serving food and beverages or installing a new part when making repairs, since they include the provision of costly physical products in addition to labor.

Just because a firm has sold a service at a price that exceeds its variable costs does not mean that the firm is now profitable. There are still fixed and semi variable costs to be covered.

Semi variable costs fall in between fixed and variable costs. They represent expenses that rise or fall in stepwise fashion as the volume of business increases/decreases. Examples include adding an extra flight to meet increased demand on a specific air route, or hiring a part-time employee to work in a restaurant on busy weekends.

Contribution is the difference between the variable cost of selling an extra unit of service and the money received for that service. It goes to cover fixed and semi variable costs before creating profits.

Determining and allocating economic costs can be a challenging task in some service operations. For example, it's difficult to decide how to assign fixed costs in a multi-service facility like a hospital. There are certain fixed costs associated with running the emergency unit. Beyond that there are fixed costs for running the entire hospital.

How much of the hospital's fixed costs should be allocated to the emergency unit? A hospital manager might use one of several approaches to calculate the unit's share of overheads.

These could include

  1. the percentage of total floor space that it occupies
  2. the percentage of employee hours or payroll that it accounts for or
  3. the percentage of total patient contact hours involved

. Each method is likely to yield a totally different fixed-cost allocation. One method might indicate that the emergency unit is very profitable, another might make it seem like a break-even operation, and a third might suggest that the unit is losing money.

Break-even analysis. Managers need to know at what sales volume a service will become profitable. This is called the breakeven point. The necessary analysis involves dividing the total fixed and semi variable costs by the contribution obtained on each unit of service. For instance, if a 100-room hotel needs to cover fixed and semi variable costs of $2 million a year and the average contribution per room-night is $100, then the hotel will need to sell 20,000 room-nights per year out of a total annual capacity of 36,500.

If prices are cut by an average of $20 per room night (or variable costs rise by $20), then the contribution will drop to $80 and the hotel's break-even volume will rise to 25,000 room nights. Has to add a margin to the bill in order to make a profit for the owner. However, these intrinsic costs are not readily visible to the customers, who are making their comparisons of price versus value based solely on visible service attributes.

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 delivery of some services compare the cost of express mail against that of regular mail. Sometimes greater speed increases operating costs for the service provider, reflecting the need to pay overtime wages or use more expensive equipment.

In other instances, achieving faster turnaround is simply a matter of giving priority to one customer over another. For instance, clothes requiring express dry-cleaning take the same amount of time to clean. The firm saves time for these customers by moving their jobs to the head of the line.

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.

Companies must balance customer needs and preferences against the desire to reduce production costs, because in some cases customers may be willing to accept a price increase in order to have access to a physical distribution channel.

Ethical Concerns

Services often invite performance and pricing abuses. The problem is especially acute for services that are high in credence attributes, whose quality and benefits are hard to evaluate even after delivery.

Exploiting Customer Ignorance When customers don't know what they are getting from a service supplier, are not present when the work is being performed, and lack the technical skills to know if a good job has been done, they are vulnerable to paying for work that wasn't done, wasn't necessary, or was poorly executed. Although ( price can serve as a surrogate for quality, it's sometimes hard to be sure if the extra value is really there.

This is an important issue, since customers may rely more heavily on price cues as an indication of service value when perceived risks (e.g., functional, financial, ( psychological, or social) are high. Web sites sometimes take advantage of customer ignorance, particularly where airline tickets are concerned. Although there are many Internet travel sites, finding the cheapest fare isn't easy. Price line initially confused customers by not clarifying that airport taxes and fuel surcharges had to be added to ticket prices.

Complexity and Unfairness

Pricing schedules for services are often quite complex. Changing circumstances sometimes result in complicated pricing schedules that are difficult for consumers to interpret. Consider the credit card industry. Traditionally, the banks that issue these cards received revenues from two sources: a small percentage of the value of each transaction (paid by the merchant), and high interest charges on credit balances.

As credit cards became more popular, costs started ( to rise for the banks on two fronts. First, more customers defaulted on their balances, leading to a big increase in bad debts. Second, as competition increased between banks, marketing expenses rose and gold and platinum cards started offering more affluent customers features like free travel insurance, emergency card replacement, and points redeemable for air miles.

But as marketing expenses were rising, more customers started to pay off their monthly balances in full and competition led to lower interest rates, resulting in lower revenues. So the banks increased other charges and imposed new fees that were often confusing to customers. Details of charges by one major bank for its platinum card are shown in the box entitled "Charges, Fees, and Terms for a Platinum Visa Card."

Another industry that has gained notoriety for its complex and sometimes misleading pricing schedules is cellular telephone service. Consumer Reports has warned its readers about such practices as rounding up calling time to the nearest minute, misrepresentation of "free" service elements that turn out not to be so, and huge cancellation fees ($150 to $200) for terminating a one-year contract before it expires.

Complexity makes it easier and perhaps more tempting for firms to engage in unethical behavior. The car rental industry has attracted some notoriety for advertising bargain rental prices and then telling customers on arrival that other fees like collision insurance and personal insurance are compulsory. And employees sometimes fail to clarify certain "small print" contract terms such as a high per mile charge that is added once the car exceeds a very low threshold of free miles.

The "hidden extras" phenomenon for car rentals in some Florida resort towns got so bad at one point that people were joking: "the car is free, the keys are extra! "A not uncommon practice is to charge fees for refueling a partially empty tank that far exceed what the driver would pay at the pump.

When customers know that they are vulnerable to potential abuse, they become [ suspicious of both the firm and its employees. Assuming that a firm has honest manage meant, the best approach is a proactive one, spelling out  all fees and expenses clearly in advance so that there are no surprises. A related approach is to develop a simple fee structure so that customers can easily understand the financial implications of a specific usage situation.

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. Let's take a look at what's involved (Figure). As we do so, please consider your own experiences in different service contexts.

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.

No financial Outlays Customers may incur a variety of no financial outlays, representing the time, effort, and discomfort associated with searching for, purchasing, and using a service. We can group no 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, and occasionally even injury) 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 then using the chosen service. Services that are high in experience and credence attributes may create psychological burdens like anxiety since service outcomes are more difficult to evaluate.
  • 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, visually unappealing environments, and even unpleasant tastes.

The total costs of purchasing and using a service also include those associated with search activities. When you were looking at colleges, how much money, time, and effort did you spend before deciding where to apply? And how much effort would you put into comparing alternative haircutters if your existing one was no longer available? There may even be further outlays after service delivery is completed.

A doctor may diagnose a medical problem for a patient and then prescribe a course of physical therapy and drugs to be continued over several months. Obtaining refunds after service failures may force customers to waste time, money, and effort in trying to resolve the problem.

Understanding Net Value

When customers evaluate a service, they consider the benefits it offers relative to the financial and no financial outlays they will incur in purchasing and using it. Although there are several ways to describe value, we have chosen to define value as "what I get for what I give." Net value is defined as the sum of all the perceived benefits (gross value) minus the sum of all the perceived outlays for the customer.

The greater the positive difference between the two, the greater the net value. If the perceived costs and other outlays are greater than the perceived benefits, then the service in question will possess negative net value.

Perceptions of net value may vary widely between customers, and even for the same customer depending on the situation. How customers feel about the net value of a service may be sharply different post-use and pre-use, reflecting the experiential qualities of many services. When customers use a service and find that it has cost more and delivered fewer benefits than expected, they are unlikely to repurchase it and may complain about "poor value."

You can think of the value calculations that customers make in their minds as being similar to weighing materials on an old-fashioned pair of scales, with product benefits in one tray and the outlays associated with obtaining those benefits in the other (Figure).When customers evaluate competing services, they are basically comparing the relative net values.

Increasing Net Value by Reducing No financial Outlays Although our focus in this chapter is mainly on the monetary aspects of pricing, you've probably noticed that people often pay a premium to save time, minimize unwanted effort, and obtain greater comfort.

In other words, they are willing to pay higher prices to reduce their no financial outlays. Marketers can increase the net value of a service by adding benefits to the core product, enhancing supplementary services, or reducing the financial costs and other outlays associated with purchase and use of the product.

People who fly first class versus coach class are paying for more spacious seating, better food, and more personalized attention from flight attendants in return for a more expensive fare. Other types of service companies have also recognized the different trade-offs that customers are willing to make and have created multiple levels of service. For example, Capital One Financial provides thousands of credit card options with varying benefits and interest rates.

The company uses its sophisticated database technology to segment the market based on spending patterns and other consumer characteristics. It is then able to offer personally customized bundles of benefits that add value for customers while reducing risk for Capital One.

In many cases, service firms can improve value by minimizing unwanted no financial outlays for customers. Reducing such outlays may even cause firms to increase the monetary price for their services while still offering what customers perceive as "good value." Strategies for reducing no financial outlays include:

  • Reducing the time involved in service purchase, delivery, and consumption especially time wasted in waiting for service delivery
  • Minimizing unwanted psychological burdens during all stages of service consumption
  • Eliminating unwanted physical effort, especially during the search and delivery processes
  • Decreasing unpleasant sensory burdens by creating more attractive visual environments, reducing noise, installing more comfortable furniture and equipment, curtailing offensive smells, and ensuring that foods, drinks, or medicines taste appealing

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