Pricing Strategy Is My Business

The Pricing Newsletter

October 2020

Hello Pricers,

Here's some timely food for thought:

Anyone who believes that their ain't no such thing as a free lunch isn't putting enough effort into his trick-or-treating.

Pricing Question from a Reader

When I was growing up, stores that offered rental furniture by the month were considered disreputable. Now people think nothing of paying monthly for software, clothing, and even power tools. Is the constant push for recurring payments ethical?

It's been more than two years since I last examined the ethics of pricing strategies. Maybe it's time to give it another go.

Why were recurring payments less common in the past?

It seems that all sorts of products are being offered for a small monthly payment. It wasn't always this way. In fact, most vendors required payment upfront for their wares. Even houses, before the advent of the thirty-year mortgage, were purchased with a single lump sum.

So what's changed?

  • Administrative simplification - Thanks to the power of modern database systems, businesses can track millions of customers, payments, and products without breaking a sweat. Even fifty years ago, businesses would have needed legions of accountants and bookkeepers to maintain such vast recordkeeping.
  • Risk reduction - Before the advent of credit scoring techniques, social security numbers, and cross-corporate data sharing, it was nearly impossible for businesses to evaluate the trustworthiness of an unfamiliar buyer. How could any firm have any shred of confidence that a customer on a monthly plan wouldn't stop paying and disappear? This information, combined with technologies such as remote kill switches (cars), deactivation subroutines (software), and ever-present tracking technologies (cell phones) have practically eliminated the risks that businesses would have had to accept.
  • Increased customer need - Once upon a time, most people had modest needs and spent little. The average shopper might have purchased a chicken, or a loaf of bread, or a stack of bricks. He wouldn't have been able to conceptualize, let alone purchased, a laptop, an automobile, or even a subscription to Netflix. As a result, the average person would have seen little benefit in a transaction that involved complexity above and beyond a one-time payment.
  • Increasing fixed costs of production - As economies have modernized, cost structures have changed. The rise of factory production and mass consumption has created a world in which variable costs have become less significant relative to fixed costs. When a product is leased directly from a manufacturer, the marginal cost of replacing a leased product that has been stolen, damaged, or destroyed approaches zero. As a result, replacement costs that would have proven catastrophic under old production methodologies now show up as rounding errors in company ledgers.
  • Growth of financialization - With interest rates at historic lows, and the world's investors hungry for profit, many investors are eager to purchase revenue streams on the secondary market. As a result, companies can sell future revenue streams at nearly face value.
  • A weakened desire for ownership - Having been raised with an abundance mindset, consumers are increasingly willing to use other parties' goods rather than demand ownership of any given product.

Why would vendors move to recurring payments?

Now that we understand why businesses can implement such strategies with greater ease, we must consider why recurring billing practices are in their best interests.

Companies, at least theoretically, have a single motive for taking action: they want to maximize their profits. Recurring charges accomplish this in two ways: they broaden the customer base and increase revenue per customer.

  • Broadened customer base - Reductions to initial out-of-pocket costs tend to attract buyers who are unwilling or unable to pay high upfront prices.
  • Increased per-customer revenue - On a long enough timeline, the sum of recurring payments will tend to exceed a product's equivalent upfront price. Although some buyers may only wish to use a product for a short time, increased lock-in costs, switching costs, as well as the potential for refurbishment may prove sufficient to more than compensate a vendor for a short-term rental.

Do customers prefer monthly payments?

Now that we understand why manufacturers are moving away from one-time payments, we must look to their customers. If we are to assume that recurring payments are ethical, it must follow that customers have the potential to benefit from such an arrangement. As it happens, they can:

  • Opportunity costs - A potential buyer who is flush with cash may have several options for investment. For instance, a business owner may not want to invest a significant portion of his free cash flow on a software system that has the potential to increase his profits by 20%, when he could invest his dollars in a marketing effort with a 200% return on investment instead.
  • Illiquid assets - Many firms and individuals have amassed significant wealth in illiquid forms. For instance, holdings in real estate, intellectual property, and natural resources may be worth a fortune but can prove difficult to sell on short notice. The ability to acquire the use of a good for a low monthly rate would allow such entities to delay the sale of said investments.
  • Temporary periods of reduced income - Many firms and individuals are forced to struggle through periods of low profitability before achieving success. For instance, many students see their earning power jump upon graduation. Shoppers who are forced to pinch pennies in the present, but will have greater wealth in the future, would gladly accept a reduction in initial outlay in exchange for a higher total cost of ownership. This is doubly true if the good somehow aids in the attainment of increased earning power.
  • Increases in availability and utility - As the number of customers for a given product increases, each user's portion of the good's fixed costs decreases. Thus, from an affordability perspective, the greater the number of buyers, the lesser of a financial burden that each buyer must bear. For instance, a nuclear power plant would prove prohibitively expensive for a single household to afford upfront, but may prove exceedingly affordable once its costs are spread amongst millions of households. In such an example, even wealthy individuals would benefit from the broadening of the customer base.
  • Increased flexibility - People and corporations are under increasing pressure to shift their focuses on spending on relatively short notice. Could you imagine how quickly the economy would lock up if its participants were forced to make only long-term capital investments? The use of leases and rentals, rather than traditional upfront purchases, can enable quick adjustments to changes in the status quo.
  • Alignment of incentives - Recurring costs provide a strong incentive for vendors to focus on user needs. If Netflix, for instance, were to stop maintaining its catalog of entertaining films and shows, customers could vote with their feet and cancel their subscriptions immediately.

A framework for judging the ethics of recurring charges

Having surveyed the ins and outs of recurring billing plans, we're finally ready to consider the ethical standards of their use.

Some philosophers would argue that any contract entered into with free will is inherently moral. If this were true, however, we would have no problem with grifting, fraud, or unconscionable contracts. Clearly the issue is not so simple.

I've created a four-question test that you can use to evaluate the ethics of an offering:

  1. Can you identify one or more groups of buyers that will benefit more than they are harmed from a recurring pricing model?
  2. Does your marketing target the identified groups without attracting a significant number of buyers who will be harmed, such as was the case with the Joe Camel ad campaign?
  3. Do the customers who are attracted to your offering belong to the targeted customer segments?
  4. Have the buyers benefited from the nature of your payment strategy?

Assuming that all four points can be answered in the affirmative, the offering is likely to be in the clear from a moral perspective - at least when it comes to your customers.

Of course, there are other stakeholders who can be harmed by creative pricing strategies as well. It may not be obvious, but sometimes recurring payments aren't put into place to increase corporate profitability or to help buyers afford their products. Sometimes recurring payment streams are for the sole purpose of obscuring the value of a given product offering. Managers who need to hit high growth targets or businesses looking to boost estimates of future earnings may move away from upfront pricing in order to increase the size of their user bases by attracting customers who are unlikely to maintain a long-term relationship with the firm. Fortunately the four-question test should apply to such situations as well, with only minor modification.

Conclusion

When implemented with care, recurring payment plans can prove both ethical and incredibly profitable. Though often viewed with suspicion, their use can be beneficial to all parties involved. They can even allow for the development of goods that would otherwise prove impossible to bring to market. If they are suitable for your customers, and your product lines, I would strongly urge you to assuage your conscience and consider their use.

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

Pricing in the News

From the Blog Archives

Notable Pricing Quote

"One of the best rules anybody can learn about investing is to do nothing, absolutely nothing, unless there is something to do... I just wait until there is money lying in the corner, and all I have to do is go over there and pick it up... I wait for a situation that is like the proverbial shooting fish in a barrel." -- Jim Rogers

Shameless Commercial Plug

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