By Rebecca W. Hamilton, Joydeep Srivastava and Ajay Thomas Abraham September 8, 2010 MIT Sloan Management Review http://ow.ly/2FUqR
Every manager who’s ever set a price has had to wrestle with whether to “partition” the elements — charge separately for such things as shipping, installation or warranties — or to bundle everything into one price. Here’s how to decide.
If you’ve spent time at an airport recently, you’re likely to have overheard a conversation between a surprised non-frequent flyer and a ticket agent about fees for checked luggage. That exchange may have been a loud one if the airline was charging $25 (or more) per bag. Although charging separately for luggage allows airlines to advertise lower ticket prices, potentially increasing sales, incorporating baggage fees into the ticket price might increase the satisfaction of customers en route as well as raise the retention rate of check-in counter agents. And therein lies the rub.
When should a company “nickel-and-dime” customers by charging separately for various extras, and when is it better to keep things simple by combining all of the charges into one total price?
Before answering, consider another example: The price of wall-to-wall carpeting may or may not include the cost of installation or delivery to the customer’s home. Given that most customers neither own a vehicle large enough to transport a living-room–sized piece of carpeting nor have any desire to rent one, delivery is, for all intents and purposes, a required component of the purchase. If nearly all customers will be buying both carpeting and delivery, should the price of the carpeting include delivery or should the company charge for it separately?
On the one hand, assigning a separate dollar value to the delivery component would decrease the price per square foot that the company charges for their carpeting, making its prices appear more competitive when customers comparison shop. Charging separately for delivery also might increase the perceived value of the delivery service to customers and discourage absenteeism when the delivery truck is scheduled to arrive. On the other hand, if delivery is something customers really dislike paying for (like other shipping and handling charges), they might be much happier with the overall transaction if delivery charges were included in the price. Including free delivery could even increase the likelihood that they become repeat customers.
Although standard economic theory dictates that customers should be just as willing to purchase carpeting priced at $500 plus delivery priced at $100 as they are to purchase carpeting with free delivery priced at $600, recent research suggests that price partitioning — the manner in which a total price is divided into components — affects customers’ price perceptions, their willingness to purchase and even their likelihood of repurchasing from the same vendor. The challenge is that when it comes to price partitioning, unfortunately, one approach does not fit all. Whether the strategy of nickel-and-diming your customers or the strategy of “keeping things simple” is more effective for a specific transaction depends on a variety of factors, such as whether customers comparison shop; whether customers are more sensitive to the prices of some components (delivery) than to others (carpeting); whether the price of one component is small or large relative to the others; whether the company controls the costs and quality of a particular component; and which components are most central to what the customer wants.
In this article, we provide managers with a decision framework for price partitioning. We start by assuming that a decision about the total price has already been made, based on both the costs and market demand for components, such as carpet and delivery services. Our focus is on the next step: whether the cost of the individual components (carpet and delivery) should be broken out separately or whether the customer should be presented with just one price, with one of the components (delivery) being offered as “free.” Our decision framework provides a step-by-step approach for managers to decide whether it will be more effective to highlight specific components by pricing them separately or to minimize the focus on specific components by charging less for them or including them in a combined total price.
Before presenting the decision framework, let’s summarize the advantages of partitioning prices, the advantages of combining prices and the strategy of benefits-based price partitioning.
Nickel-and-Diming Customers: The Case for Partitioning Prices
If you’ve looked closely at your phone bill recently, you’ve probably observed that your fee for monthly service isn’t all you’re paying. In addition, you’re paying various taxes and charges that the phone company adds on. In the United States, these include a 911 fee, state and federal taxes, and a federal subscriber line charge.
Similarly, many online retailers charge separately for the products you order and for shipping, even when they know with almost 100% certainty that you won’t be coming by their warehouse a few states away to pick up your purchase. These are examples of partitioned pricing, in which the total price of a product or service is divided into two or more mandatory components. Although the customer is required to pay for all of the components, a separate price is listed for each one.
Research suggests several reasons why the phone company and other sellers might use a partitioned pricing strategy rather than quoting their prices using a single combined price. First, consumers tend to focus on the base price they are quoted (the monthly phone service fee) rather than the ancillary fees that boost the total price. And the research suggests that consumers mentally process the base price more thoroughly than they process other components, such as taxes and fees. Thus, when consumers try to recall the total price (the combination of the base price and other components) after seeing a partitioned price, they tend to recall the base price accurately but forget about the other components, thereby remembering a lower total price. That is especially true when the base price is much larger than the other charges, which seem minor in comparison.
A second reason partitioned pricing may be attractive to sellers is that pricing components separately may position their products more favorably when consumers comparison shop, especially when they shop online. Although hotel bills often spill onto multiple pages at checkout with the long list of fees and taxes added to the room price for each night, consumers usually decide where to stay based on the room price that’s quoted to them online or over the phone. Because the norm within the industry is to quote partitioned prices, hotels using partitioned pricing rather than combined pricing are — all other things being equal — likely to attract more guests when consumers comparison shop. If one hotel chose to quote a combined price, including the room price and all of the mandatory taxes and fees, while its competitors quoted the room price without taxes and fees, this hotel’s prices would be perceived as higher.
Finally, a partitioned pricing strategy may help sellers avoid being blamed for charging high prices. The airport taxes and fees that are added on to your airline ticket price are not perceived to be going into the pocket of the airline but into the airport’s coffers. Especially in a tough economy, using a partitioned pricing strategy may help companies recoup their costs when it’s not easy to justify raising prices. When fuel prices go up, a specific fuel surcharge helps to facilitate a “we’re all in this crisis together” mentality rather than the perception that the airlines don’t care how much their prices are squeezing consumers. Partitioning makes prices seem more transparent to consumers, potentially increasing the degree to which they trust the retailer and the perceived fairness of the transaction.
Keep It Simple: The Case for Combining Price Components
So the advantages of price partitioning imply that, as a manager, it’s better to offer a low base price and then hit consumers with a litany of small fees at checkout, right? Not so fast, say researchers who study a phenomenon called “shipping-charge skepticism.” Experimental research shows that some consumers strongly dislike paying for shipping. For those consumers, offers that include shipping in the total price are more attractive than offers that partition the price of the product and shipping into separate components. Data from customers using shopping bots (computer programs that search Internet commerce sites for the best prices — Google Inc.’s Froogle, would be an example) — to purchase books online has demonstrated the same effect. Customers were found to be almost twice as sensitive to changes in shipping charges as they were to changes in the price of the books they were purchasing. This analysis suggests that combining shipping charges and the price of the books makes consumers willing to pay more for the bundle, making combined pricing more advantageous than partitioned pricing.
Under what conditions do combined prices make consumers more satisfied or willing to pay more than partitioned prices? In contrast to the examples of partitioned pricing (telephone and hotel bills), the prices for two different components of a product or service are often combined: Books or shoes ordered online may be shipped for free, new kitchen countertops are sometimes sold with free installation, and new cars may come with a five-year/50,000-mile warranty. The fact that combined prices are common in the marketplace suggests that, under some conditions, it must be advantageous for sellers to take this approach.
One reason for combining prices is to avoid highlighting components such as shipping charges that consumers would rather not think about, or a warranty that might make reliability more of an issue. For example, research conducted by one of the authors shows that when a consumer is considering the purchase of a refrigerator, partitioning the price of a warranty raises more concerns about the appliance’s reliability — hurting purchase likelihood — than partitioning a different component, such as an icemaker.
Another reason for combining prices is to be upfront with consumers and avoid surprising them later with fees that may upset them, ruining customer goodwill. A resort stay that costs a lot more upon checkout than the customer expected may not be remembered favorably the next time the customer goes online to make reservations. Resorts like Club Med offer all-inclusive prices to help consumers relax while they’re on vacation. In a sense, this combined pricing strategy decouples the pleasure of consumption and the pain of paying, allowing consumption to be savored more fully. The price of a stay at Club Med may be high, but repeat business is good because consumers know the price upfront, and they aren’t reminded of the costs every time they enjoy a resort amenity or surprised at checkout by a long list of charges for the amenities they already enjoyed. This kind of goodwill may be why Southwest Airlines Co. recently advertised its “Freedom from Fees” policy, differentiating itself from airlines that add on fuel surcharges and charge fees for checked baggage. (It also eliminates all that yelling at the ticket counters.)
A Contingent Approach: The Strategy of Benefits-Based Price Partitioning
Although most managers are familiar with the concept of selling benefits — not features — in their marketing communications, this concept hasn’t been adopted as widely in the area of pricing, and particularly price partitioning. In this section, we describe why the approach of benefits-based price partitioning — pricing components based on customers’ sensitivity to the price of each component — can be a win for both managers and customers.
One of the reasons cost-plus pricing has continued to be popular among managers is that it has the advantage of being perceived as fair by consumers. Research indicates that customers believe companies are entitled to a reasonable profit margin and that cost-based price increases to preserve a company’s profit margin are fair, but they feel morally outraged when companies opportunistically increase prices to increase their profits. A classic article by Nobel Prize winner Daniel Kahneman and his colleagues illustrates this principle by showing that customers believe a cost-based increase in the price of snow shovels is fair, but a demand-based increase in the price of snow shovels during a snowstorm is unfair. Similar to cost-plus pricing, when managers use cost-plus price partitioning with a uniform profit margin across components, it is straightforward to justify why a specific price is being charged for a particular component.
However, keeping your profit margin constant across price components may not maximize either profit or customer satisfaction. Recent research we conducted shows that customers are more price sensitive for components that they feel provide them with less benefit (“low-benefit” components, such as installation or shipping) relative to components they feel provide them with more benefit (“high-benefit” components, such as auto parts or books). In other words, customers are happier to pay for some components (auto parts or books) than for others (installation or shipping). Thus, for customers buying books online, a price partition in which the profit margin on shipping is low — or even negative — and the profit margin on books is high will be systematically more attractive to customers than a partition of the same total price in which the profit margin on shipping and books is the same. Taken to the logical extreme, this strategy suggests that customers prefer combined pricing in which a component they don’t like paying for is included in a single total price, rather than partitioned pricing in which they pay some proportion of the total price for each component.
In contrast to a strategy in which the same profit margin is expected for each price component, benefits-based price partitioning suggests that profit margins should be higher for components for which customers are less price sensitive and lower for components for which customers are more price sensitive. By holding the total price constant, research shows that customers will be more likely to buy when components they don’t like are de-emphasized (either by decreasing their profit margin or by combining them into a total price) and components they do like are highlighted (either by increasing their profit margin or by partitioning them from other components). It’s hard to argue against a strategy that improves outcomes for both the seller (by increasing customer purchase intentions) and the customer (via greater customer satisfaction and perceived value) while keeping the total price constant.
A Decision Framework for Benefits-Based Price Partitioning
Given all this, a manager who is responsible for pricing products may ask which is the better approach: partitioning prices or combining prices? In this section, we provide guidelines based on empirical research with consumers for deciding which will be the more effective approach for a particular case. Important decision factors include whether consumers tend to comparison shop; whether competitors partition or combine prices across components; whether any of the components evoke negative emotions (such as anger inspired by shipping charges or worry triggered by charges for a warranty); whether the delivery, quality and costs are controlled by the company; and whether the components are aligned with specific goals of the customers being served (such as meeting the need satisfied by a new product or providing compensation for a beloved used car being traded in).
The discussion that follows is based on the numbered decision points in the decision tree.
Decision 1: Is the consumer already committed to making a purchase from you?
Yes: If consumers have already committed to making the purchase from you, price partitioning will have less influence on their decisions. For example, in the case of long-term customer relationships, research on customer satisfaction shows that more- satisfied customers are less price sensitive. However, price partitioning can still affect the consumer’s satisfaction with their purchase. Go to Decision 6.
No: If the consumer has not yet committed to making a purchase from you, and is likely to comparison shop, price partitioning is much more critical. Price partitioning creates lower price perceptions than combining prices, making comparisons with competitors more favorable. Go to Decision 2.
Decision 2: Given that the consumer will engage in comparison shopping, do competitors partition prices?
Yes: There are often norms within a particular industry or even a particular purchase context concerning which components are priced separately. For example, the cost of shipping a book to the customer is typically partitioned when a customer buys a book from Barnes & Noble Inc. online, but the cost of shipping a book to the store is typically included in the price of the book when the customer buys from a local Barnes & Noble retailer. These norms serve as customers’ internal reference prices for specific components. Customers’ internal reference prices will affect the prices they are willing to pay for specific components, the price they believe it is fair to charge for these components and their perceptions of the component’s value for the money.
If the industry norm is to partition the price of a component, as in the case of the airline industry’s and hotel industry’s almost universal partitioning of taxes from fees for services, pricing components separately will position products more favorably when consumers comparison shop than using a combined price.
However, when consumers strongly dislike paying for certain components, it can be a good competitive strategy to include fees for these components in a combined price. Breakaway companies like Amazon.com Inc. were among the first to offer free shipping on at least some orders, and many companies have followed their lead. Knowing that consumers don’t like paying extra fees for baggage and other airline services, Southwest Airlines has bucked industry norms with its “Freedom from Fees” campaign. Go to Decision 5.
No: If the industry norm is to combine prices, as when family-oriented restaurants sell entrees with side dishes included, partitioning may be perceived as nickel-and-diming customers, even if the partitioned prices appear more attractive relative to competitors’ prices. Go to Decision 3.
Decision 3: Is the price of the component small relative to the price of other components?
Yes: If the price of the component is small relative to the price of other components, consumers do not seem to weigh the price of the small component as much as the price of a relatively larger component. For example, research shows that eBay Inc. bidders do not bid significantly less when the required shipping charges for an item are high than when they are low, suggesting that they are not fully accounting for shipping costs. Moreover, when asked to recall prices, consumers tend to underestimate the total price when the prices of the components are partitioned relative to when the prices are not partitioned. Recommendation: Nickel-and-dime your customers by partitioning prices. END.
No: If the price of the partitioned component is large relative to the price of the other components, partitioning becomes less effective than when the price of the partitioned component is small relative to the other components. For example, when study participants compared a $49.95 product price + $5 shipping charge with a combined price of $54.95, they preferred the partitioned price. In contrast, when they compared a $49.95 product price + $25 shipping charge with a combined price of $74.95, they preferred the combined price. Put simply, large partitioned components are less likely to be ignored than small partitioned components. Go to Decision 4.
Decision 4: Do consumers react negatively to the partitioned component (shipping, warranty, labor)?
Yes: Suppose that the partitioned component is one that consumers feel very negatively about, such as shipping. Many consumers find paying a separate price for shipping more aversive than paying a higher combined price with “free” shipping. Online measurement company comScore Inc. reported that free shipping influenced more than 40% of e-commerce transactions during the end-of-year holiday season in 2009. In an empirical study of consumers using shopping bots, consumers were almost twice as sensitive to changes in shipping charges relative to changes in the price of the books they were purchasing. Another empirical study of real purchase decisions showed that purchases increased more when consumers were offered free shipping than when they were offered a monetary discount of the same value. Greater sensitivity to the price of shipping than to the prices of other components indicates that combining the negatively regarded component with other components should increase purchase intentions relative to partitioning the component.
Which other components are perceived negatively by consumers? Recent research suggests that charges for labor, such as installation, are also perceived negatively. The logical conclusion? Decreasing the price of these components relative to the prices of other components makes prices more attractive.26 (One caveat, though, is that consumers’ perceptions of labor can be changed by describing labor as providing more benefits to the consumer, such as by highlighting the importance of fine craftsmanship.
Other components might remind consumers of issues you’d rather not have them think about at the point of sale. For example, charging a separate price for a warranty can make a consumer think more about reliability than including the warranty in a higher combined price, making partitioned prices less attractive than combined prices. Notably, even a lack of information indicating what the surcharge is for can make consumers perceive it as unfair. A recent study showed that although partitioned pricing led to higher purchase intentions than combined pricing when the surcharge was attributed to a specific purpose, combined pricing led to higher purchase intentions than partitioned pricing when a surcharge of the same magnitude was simply described as a “surcharge” and was not attributed to a specific purpose.
In summary, if the component is one that consumers perceive negatively, consumer reactions are likely to be more favorable when this component is combined with other components rather than partitioned. Recommendation: Keep things simple by combining prices across components. END.
No: Paying a separate price for a desired benefit, such as an extra feature on a product, is not as aversive as paying the same separate price for a disliked or unwanted component. For example, in one study, partitioning the price of an icemaker from that of a refrigerator had a less negative effect than partitioning the same price for a warranty. If consumers do not react negatively to the component, there are some conditions under which partitioning will be more effective than combining the price of the component with other components. Go to Decision 5.
Decision 5: Does your company control the costs/quality/delivery of the component?
Yes: If the delivery, quality and cost of the component are under the control of the company, the company cannot blame others for the costs or for service failures. Whether partitioning or combining prices is more attractive depends on the compatibility between the component and consumers’ goals. Go to Decision 6.
No: If the delivery, quality and costs of the component are under the control of someone else, it may be more effective to partition the component so that the costs can be attributed to a third-party provider. In the case of components like taxes and fees, partitioning can make the base price look smaller in addition to making it clear that the company is not responsible for the charges. Recommendation: Nickel-and-dime your customers by partitioning prices.
Decision 6: Does the partitioned component satisfy a goal for consumers?
Yes: Consumers are more sensitive to the prices of components that are not consistent with their goals than to the prices of components that are. Thus, to maximize price satisfaction, components that are more consistent with consumers’ goals should be larger than components that are less consistent with consumers’ goals. If the component is aligned with a specific goal of the customers being served, such as being compensated for a used car being traded in, partitioning the component will make the overall price more attractive. Recommendation: Nickel-and-dime your customers by partitioning prices.
No: If the component does not satisfy a goal for consumers, they will be more sensitive to the price of this component than to the price of other components that are more central to their goals. Recommendation: Keep things simple by combining prices across components.
Summary
When should managers nickel-and-dime their customers by charging separately for various extras, and when is it better to keep things simple by combining all of the charges into one total price? Our analysis of research on partitioned pricing suggests that it’s better to nickel-and-dime customers when the partitioned component is consistent with customers’ goals. Consider that consumers who head to a restaurant hungry for pizza would rather pay $15 for a pizza and get a free order of buffalo wings than pay the same price for an order of buffalo wings and have a “free” pizza thrown in. It can also be better to nickel-and-dime customers to signal that the price of a particular component is under the control of a third party rather than under your control, as in the case of taxes. Finally, nickel-and-diming can be more effective when the size of the partitioned component is small relative to the size of the other components, because consumers tend to focus on the base price rather than on small surcharges. Just be sure that you don’t ruin your customers’ rosy view of the relationship later by hitting them with a litany of unexpected fees.
However, there are several conditions under which keeping things simple by combining price components into a single total price can be more effective. If a component does not relate to the consumer’s most salient purchase goals, it is often better to combine prices across components than to highlight the component by partitioning it. If customers have a negative reaction to a component like shipping, delivery or installation, minimizing this component or combining it with other components can increase purchase intentions as well as customer satisfaction.
Clearly, there are situations in which partitioned pricing is more effective than combined pricing and vice versa. The trick for successful managers is to be aware of the conditions under which one strategy is more effective than the other. The benefits-based partitioned pricing framework and decision tree provided in this article equip managers to make more informed decisions that result in increased purchase intentions, greater satisfaction, and more positive customer attitudes toward the company.
Rebecca W. Hamilton is an associate professor of marketing, Joydeep Srivastava is a professor of marketing and Ajay Thomas Abraham is a PhD student in marketing, all at the Robert H. Smith School of Business at the University of Maryland.
Kevin Brown www.kbsinsight.blogspot.com
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