Approaches to Price Tiering

What is tiering?

Before we jump to an answer, let's take a look at what tiering is.

Tiering is an admission that a one-size-fits-all approach to pricing is inefficient.

• Shoppers who aren't willing to pay a given price will refuse to buy.
• Shoppers who would have been willing to spend more than a given price will wind up paying less than they otherwise would have.

By offering goods at different prices, businesses can still earn money from frugal shoppers while at the same time obtain higher sums from their spendthrift comrades.

There are two common approaches that firms use to create tiered offerings:

• Tiering by customer characteristics
• Tiering by offering characteristics

Your question relates to the former, so we'll examine that option first.

The case for tiering by customer characteristics

Many managers love the idea of tiering by customer characteristics, because it requires relatively little in the way of analysis and decision-making. All a firm's managers have to do is group their customers into a couple of distinct buckets, and assign each a different price.

There are a variety of ways to divide up one's customers, but here are the three that seem to be the most popular:

• Revenue
• Profit
• Magnitude of outcome

Many people believe that the companies with the highest revenue are willing to pay the most money for a given offering. Unfortunately, this belief doesn't always hold true. There are many reasons for this, the most obvious being that there is no direct relationship between revenue and profit across industries. An aircraft manufacturer, for instance, may enjoy tremendous revenue, but spend the vast majority of it buying hardware from third parties. A software firm, on the other hand, may have far lower revenues but be able to keep the majority of them as profit. Even firms within the same industry may have very different cost structures, due to organizational makeup, capital investments, and niche approach.

For those reasons, and many others, many firms have turned to using profit as the primary consideration. Unfortunately, it too is a flawed metric. A firm's profitability need not be proportional to it willingness to pay for a given item. I have no doubt that a local sawmill would pay far more for a system to manage sawdust than would Google, Facebook, and Netflix combined. Even within the same industry, needs can vary quite a bit. In The Software Pricing Handbook I wrote about the hoops that I had to jump through to expense a technical book while working for a very profitable Fortune 500 company. Let's just say that even if a business has plenty of profit, its individual departments might not have a single dollar to spare. Even if profits were a perfect metric, many firms would be hesitant to share their accounting records with their vendors.

Many firms have realized the problems with tiering by revenue and by profit and now attempt to tier by the potential for value deliverance. This will often be discussed under the guise of value pricing, a concept I delved into back in issue 3 of The Pricing Newsletter. All things being equal, tying the price of one's offerings to the benefit that consumers receive seems fair and tends to align the incentives of both parties.

Assuming the method requires minimal invasive investigation and monitoring costs (which may not be a realistic presumption), it might work well. However, it can be difficult to offer it on a large scale. Further, customers who cross thresholds between pricing tiers may feel as though they are being charged much more for what is essentially an unchanged offering. The discontinuity of pricing between packages may challenge the notion of incentive alignment, as the vendor may choose to focus on pushing its customers into the next higher bracket, rather than helping its customers to achieve their long-term goals. Finally, even when a vendor's assessment of value is right on the mark, the estimation may not be shared by potential buyers. Even if both parties agree on a dollar value for presumed value, other factors such as opportunity costs, cash flow, and financial liquidity may reduce the amount of money that a shopper is willing to exchange for the seller's offering.

Tiering by offering characteristics

It turns out that letting shoppers make vendor-influenced decisions involving return on investment and value requires a lot less work and has the potential to yield greater profits.

While I wouldn't suggest asking customers directly what they think an offering is worth or allow them to set their own prices, sellers can provide an array of options with increasing levels of value and price. Shoppers are then able to select the packages that best meet their needs, without any risky guesswork required on the part of the vendor.

Let's look at an example from a car wash:

Service Tier	Cost
Wash	$8
Wash and wax	$15
Wash, wax and detailing	$75

This style of tiering is all about contingencies. If a shopper thinks that one offering is too expensive, he can drop down to a less costly one, rather than walk away. Similarly, if a customer sees value in a higher offering, he can jump up to the next level. Firms with a bit of sales skill might even be able to encourage interested shoppers to jump to a higher tier.

Granted, this system isn't perfect. With unlimited time and information (two assumptions that are givens in most economics textbooks, but rare in the real world), a firm could probably come up with personalized offerings that would generate higher levels of profit. Nevertheless, this form of tiering by offering provides an effortless system for addressing a variety of customers with a variety of needs.

Monitoring and compliance costs under this system are eliminated, as is any hint of perverse incentives in how customers will be serviced.

Even more important for the vendor, this tiering scheme provides the opportunity for beachheads. Risk-averse customers can purchase the lowest-tier offering with an eye to buying the detailing service in the table above, if they are satisfied with the basic washing package. By offering the opportunity to receive a small bit of service at a low cost, a vendor can dramatically increase its pricing power when it comes time to speak about more expensive offerings.. This is because the seller has reduced the presence of uncertainties in its buyers' minds.

Although the car wash example utilizes a bundling strategy in which additional items are added at each successive tier, other methods can be used as well. I provided detailed examples of how a T-shirt vendor could use offering-based price tiering to improve the profitability of his business in a previous newsletter.

Conclusion

Tiering is a powerful means of appealing to many types of buyers with different abilities and willingness to pay. Although there are always exceptions, I'd suggest that firms look to offering-based tiers rather than customer-based tiers.

The more options you can provide to a given customer, the more opportunities he'll have to say, "Yes!"

Questions come from readers like you. If you'd like your questions answered, send them my way.