How to Determine Whether to Insure Directors and Officers

In the world of small and mid-sized businesses, there are many misperceptions about directors and officers liability insurance. 

By Inc. Staff |  Dec 15, http://ow.ly/3pHYOS

Some small business executives believe that this type of policy, called D&O for short, is only for publicly traded companies. Not true, experts say. Although privately held businesses don't risk exposure to securities class action suits, a business doesn't have to have shareholders in order for its directors and/or officers to be personally sued. "It really depends on if you have relationships with vendors or customers, or if you intend to seek venture capital funding or other financial investors," says Lisa Jones, a vice president for private business management liability products for the Chubb Group of Insurance Companies. "These are all external exposures for which small business executives can be held accountable."

Second, some small business executives believe that their general liability or umbrella business insurance policies will cover claims involving directors and officers. Not usually, Jones says. "The general liability or umbrella policies don't respond to management liability lawsuits," she says.


Third, some small business executives believe that D&O policies are only for large companies. Not true, again, experts say. A business of any size will usually have officers and possibly directors who can be targeted by litigants over their management of company affairs. Many insurance companies now offer small business executive liability coverage starting at $1,500 per year to protect directors and officers. That's small change to protect against a potential six- or seven-figure settlement.


"It's available. These policies are out there. To not purchase this insurance is foolish," says Chris Cavallaro, managing director of ARC Excess & Surplus, of Garden City,New York, a wholesale insurance brokerage specializing in professional liability products and services.


The following guide will review what D&O insurance is, what types of coverage D&O insurance provides, and tips on purchasing D&O policies for your small business.

D&O Insurance 101

D&O liability insurance protects corporate directors and officers in the event they are personally sued -- often in addition to the company being sued -- by investors, employees, vendors, competitors, and customers, among other parties. The insurance protects directors and officers by covering legal fees, settlements, and other costs; in addition, the coverage sometimes can extend to protect the company if it is named in a suit, as well.


In many cases, when you appoint directors or hire new officers they will demand D&O coverage as a condition of serving or employment because they don't want to put their personal assets at stake. Sometimes outside investors, such as venture capitalists or other financiers, will require D&O policies before providing funding to your business -- they often see the coverage as a way to protect their investment.


Directors and officers are sued for a variety of reasons connected with their company positions, including misuse of company funds, misrepresentation of company assets, fraud, failure to comply with workplace laws, and lack of corporate governance among other issues, Jones says. Simply hiring employees potentially exposes directors or officers to employment practices litigation (EPL), which may be covered by some D&O policies, she adds. "However, if more robust coverage is warranted, it may be best to also purchase an EPL policy that protects not only the directors and officers, but the company itself," says Jones. Claims over employment practices are now the most common lawsuits brought against a company's management. A 2008 Towers Watson(now TowersPerrin) survey found that 40 percent of all reported D&O claims from public, private, and nonprofit entities involved employment practices.


One in six company executives -- or 17 percent -- believe their business will experience a D&O related loss in the next years, according to a survey of decision-makers at 451U.S. companies, more than 90 percent of which had annual revenues of less than $25 million. The survey, sponsored by Chubb, found that one in eight survey respondents -- or 12 percent -- had experienced a D&O lawsuit within the past five years. The costs to settle and/or litigate those cases averaged $225,682, with some losses approaching $5 million, the survey found.
"Customers of private companies are a leading plaintiff in litigation against directors and officer of private companies," Jones says, citing the survey results. Another growing area of D&O suits is over "employee piracy," she says. That's when a key employee leaves a company to start or join a competing firm and the previous employer files suit against the new firm -- and often its directors and officers -- over theft of intellectual property, customers, and other business information.
Bankruptcy is one of the leading causes of loss for a business -- and one of the leading causes of D&O lawsuits, Cavallaro says. A bankruptcy can spark litigation against directors and officers from creditors, lenders, customers, as well as investors. Even if a company doesn't go bankrupt and just needs to downsize, employee layoffs may still prompt claims personally targeting directors and officers, in addition to the business. When a company needs do layoffs, some employees might sue because they feel unfairly persecuted, he adds. They may claim they were let go because of some form of discrimination.

Types of D&O Coverage

The cost of D&aO insurance is based on a variety of different factors, but smaller private companies are considered low-risk by underwriters and could pay as little as $500 per year per million in premiums, according to the Insurance Information Institute (III). (On the other hand, large publicly traded companies are usually considered high-risk and III says they can pay from $10,000 to $30,000 per million in annual premiums.)
For eligibility and rates, D&O insurers look at many different aspects of the business, including the type of business, the company's profit, whether they have had prior claims, and the amount of debt.


In addition, insurers want to see that you have communicated the company's policies to employees. "You should have a most up-to-date employee manual. Codes should be posted in the lunch room. And everyone should be disclosed. People need to sign an employee waiver, upon employment because it's hard to get someone to sign something after they've been employed," Cavallaro says. That employee statement should indicate that the person is employed at will and can, essentially, be fired at any time, he says.


There are a few different types of D&O coverage, although most often the coverage is rolled into a package that contains a portfolio of products designed to respond to a private company's management liability exposure, one of which is D&O.  Insurance carriers have different packages, including varying levels of coverage and the ability to add additional coverage levels. Here is a rundown on the typical construction of a D&O policy designed for a privately held business:

• Side A covers directors, officers, and employees for defense costs, settlement fees, or judgments in the event that the company or non-profit cannot indemnify them, such as if the company has declared bankruptcy.
• Side B covers the company or organization for directors', officers', and employees' losses when it does indemnify them.
• Side C coverage is also known as "entity coverage" because it financially protects the corporation in its own right.

Tips on Purchasing D&O Policies

As with any type of insurance coverage, small and mid-sized businesses should work with an agent or broker who understands D&O policies and the intricacies involved in coverage. D&O may be offered with a portfolio of other products, as well.


Some of the issues to consider when shopping for a policy include the following:

• Should you limit coverage to directors and officers or include coverage for the entity, as well?
• Make sure the policy will cover innocent directors if one member is found guilty of wrongdoing. Policies will cover allegations of criminal misconduct up to the point of adjudication.
• Do you need additional coverage, which is usually sold in increments of $1 million of coverage?
• Read the fine print to ensure that the policy covers a wide range of claims, from regulatory actions to criminal investigations to employee lawsuits.

Jones also advises businesses to have a separate coverage limit for D&O policies if that coverage is being bundled with an EPL policy. The reason is that you want to ensure coverage for personal liability of directors and officers in the event a claim against the company depletes the EPL policy limit.


Unfortunately, some business executives find out too late why they need D&O insurance. "Once they have had a claim, they understand why they need the insurance," says Jones. "It's really important to have that executive understand before they're sued where they're vulnerable and who might sue them."

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Recommended Resources:

D&O Market Overview
Insurance powerhouse Aon’s quarterly look at the latest available information on pricing, limits, and deductibles/retentions. Registration is required.
Taking Risks with Risk
Highlights from the Chubb 2010 Private Company Risk Survey.
Directors and Officers Liability Insurance Trends
Survey of D&O purchasing trends by TowersPerrin.
Complete Guide to D&O Insurance
Directorship magazine’s special report on D&O risk and liability.

Kevin  Brown - www.kbsinsight.blogspot.com 

Why the Best Entrepreneurs Are Closet Pessimists

Inc Magazine - Nov 30th 2010 - Scott Gerber http://ow.ly/3ih2B

In the new economy where the fight for market share and revenue is more fierce than ever, young entrepreneurs cannot afford to be overly optimistic about any of their goals, tactics, or initiatives

Optimism can kill your business. There, I said it. Let the comments and rants begin (and if they are anything like those written in response to my Why "Be Passionate" Is Awful Advice post, I'm sure another great debate is on the horizon). But before you say that I'm clueless, out-of-touch with Gen Y, or a detriment to entrepreneurs, allow me to explain my position. 

When I started my first business in 2003 - one that ended up being a colossal failure that almost bankrupted me (which I now refer to as "the company that shalt not be named") - I was optimistic about everything. Every "creative" marketing idea was touted as if it was destined to be a "guaranteed winner" capable of generating tons of high quality leads right out of the gate. My partners came out of every sales meeting as if we had been victorious (we even foolishly spent money on mini-celebrations at the local pub after most presentations).  Our business plan's seven figure financial forecasts seemed like certainties to us (we even made them "more reasonable" and scaled them back from our original eight figure forecasts). However, there was only one thing true about each of these scenarios.

They were all false, utterly unrealistic, and ended up playing a large role in the company going belly up.

In truth, our marketing campaign results were beyond subpar. Rarely did "the company that shalt not be named" convert sales - even after "great" meetings. And the fact that the company went bankrupt, well, that just shows you how credible our projections were.

The company folded in a little over a year as the result of my partners and I being overly optimistic every step of the way. Had I thought through our marketing campaigns more, learned from my selling mistakes or been more grounded with my financials - instead of being in the clouds and "hoping for the best" - the company that shalt not be named might still be in existence today.

In the new economy where the fight for market share and revenue is more fierce than ever, young entrepreneurs cannot afford to be overly optimistic about any of their goals, tactics, or initiatives. Excessive optimism leads to phrases such as "it will all work out somehow" rather than realistic mindsets such as "how can we make this work at all costs." In many cases, having a "the glass is half full" mentality blinds an entrepreneur from seeing all of the true challenges and issues that surrounds his business and decisions. In business, as in life, things don't always work out - and almost never work out as planned.

In my opinion, the best entrepreneurs are business owners who have an optimistic attitude coupled with a pessimist's viewpoint and rationality. Having an ever-present "glass is half full" mentality is dangerous and might very well lead your start-up or business down the toilet.

Mind you, I'm not advocating that you need to walk around acting as if there is a rain cloud following you. Nor am I telling you to be a Debbie Downer when it comes to growth opportunities. However, from a purely decision-making perspective, I advise you to be a cautious closet pessimist instead of an eternal optimist as you guide your business toward success - and your business will be better and stronger as a result.

Kevin L. Brown - www.kbsinsight.blogspot.com 

MANTRA! MANTRA! MANTRA!

It's more important to know where you are going than to get there quickly. Do not mistake activity for achievement."--Mabel Newcomer

Cannibalize Yourself Before Someone Else Does

Nov 22, 2010 -

American Express OPEN Forum  http://ow.ly/3h3af
When someone proposes a new product that is similar to an older one (“old reliable”), the question is always asked: “How much will this cannibalize ‘old reliable’?” Someone makes an estimate, and then the games begin.  You see, the wrong question was asked.  It should have been, “Who will cannibalize ‘old reliable’ and how soon?”

I saw how cannibalization can damage a powerful company when done wrong.  Rubbermaid, circa the early 1990’s, was the leader in plastic housewares.  It dominated many categories, especially at the mid and upper price points.  Wastebaskets were one such category.  But wastebaskets do not wear out very often.  Still, Rubbermaid rightfully felt it must “cannibalize” its own dominant category with new and more fashionable designs.  And it did.

The problem that occurred was that there is a finite demand for wastebaskets, and Rubbermaid was dominant in the market.  Its new stylish designs cost more to produce and thus sold for higher prices than the older, more mundane products.  When it sold new wastebaskets, they were often treated as additions to the retailers’ assortments at higher retail prices.  The retail spots for older, plainer and cheaper products remained, but competitors who focused on low-cost functionality cannibalized these. In allowing this to happen, Rubbermaid lost considerable market share—and its dominant position.

In its zeal to cannibalize its own low end products, Rubbermaid ignored an important segment of the market—the low end, value price—to its detriment.  Some years later, Harvard Professor Clayton Christenson generalized an explanation for this in his book, The Innovators’ Dilemma. This same problem afflicted many industries, including Christenson’s memorable example of steel making.  Nucor steel started making the most mundane and low precision steel products and then methodically kept moving upscale gaining in competence until it virtually owned the U.S. steel market’s premier position.

Contrast this to Apple computer, a company that has masterfully contained proliferation and yet regularly “cannibalized” its products with newer, better ones.  Apple, however, innovated in such a way that the “older product” was still “state of the art,” and the newer one, introduced at times just one year later—“advanced the state of the art”—just about the time competitors were trying to copy and compete with the old one.

The key point here is that cannibalization by older products is important, but how it is done, is even more important.  There is an attractive trap in the product life cycle curve, which tracks a product’s life from inception to growth to maturity and then to decline.  Wise companies begin to “knockoff” their own products before they have reached the late stages of maturity or, worse yet, moved into decline.  Rubbermaid waited too long, and then ignored the part of the market it once “owned.”  Apple timed its moved earlier, and in doing so, this forced competitors to always be playing “catch up.” 

Consider how product life cycles have shortened as technology has accelerated and it can easily be sent around the globe to find the lowest cost, highest quality sources of supply, wherever they might exist.  Plan that life cycle carefully, and never ignore the entry-level segment of the market.  U.S. automakers conceded that part to the Japanese, and with this foothold, they simply moved up-market with remarkable speed.  Like Nucor, they soon occupied leadership positions, and companies that erred like Rubbermaid and U. S. automakers like GM, never fully recovered.

I’ll close with a “formula” that will serve as a reminder of this:  PP x 2 ≠ FF. 

Translated, this means that Preserving the Past (PP) and Perfecting the Present (PP) does not equal Finding the Future (FF).  In fact, the first two PPs consume the scarce resources of Time, Talent and Money, and there is not enough left to either Find the Future (FF)—or Fund the Future (FF).

Either “knock-off” (cannibalize) yourself, or someone else will do it to you! 

John L. Mariotti is President and CEO of The Enterprise Group. He was President of Huffy Bicycles, Group President of Rubbermaid Office Products Group, and now serves as a Director on several corporate boards. He has written eight business books. His electronic newsletter THE ENTERPRISE is published weekly. His Web site is Mariotti.net.    

Kevin L. Brown-www.kbsinsight.blogspot.com 

3 Ways To Use Twitter for Excellent Customer Service

Alyson Shontell 

(Business Insider) American Express OPEN Forum  http://ow.ly/3h2tJ

Nov 24, 2010 -

The best customer service is an instant, helpful response. Twitter is a real-time, direct line to customers and as a business owner, you should take advantage of it. Poor customer service has become the norm, so most people expect an annoyingly lengthy process when they give companies feedback. If you surprise them with promptness, you'll create a lasting, memorable experience between customers and your brand.

Here are five examples of Twitter being used for excellent customer service, and how your company can do the same:

1. Use Twitter to break down walls between unhappy customers and yourself, like JetBlue.
   Airlines seem to make everyone angry these days. A few years back, customers were especially upset with JetBlue for extreme delays and poor service.
   
   The solution: JetBlue, which was one of the first major brands to use Twitter, turned to social media to appease customers. Their CEO explains, "Our routes mean we’re really susceptible to weather issues, so if there’s a rash of delays, I can say [on Twitter], Heads up, everybody.When travelers have more knowledge, it helps them keep calm. That affects their dealings with people in the airports, which reflects back to them. It can change the dynamics in the airport, and that makes all of our lives a lot easier."
   
   In one particular situation, JetBlue responded to Twitter complaints about lack of heat on an airplane and a missing desk attendant. The airlinetweeted a reply in real-time, coughing up a delightfully helpful response within minutes.
   
   The lesson: Since Twitter is real-time, use it to respond to inquiries quickly. Says JetBlue's CEO, "“That’s a clichéd phrase, but Twitter really is about tearing down the artificial walls between customers and the individuals who work at companies.”

2. Get a positive conversation started about you, like Toyota
   Toyota has had a tough year.  In late 2009 and early 2010, Toyota had to recall millions of vehicles for safety reasons.  This resulted in a negative public opinion and decreased sales. To fix the damage, they turned to Twitter.
   
   The solution: According to TechCrunch, "The Japanese auto giant has launched a branded channel on TweetMeme, in partnership with Federated Media, which aggregates and organize Twitter conversations regarding Toyota.
   
   "Called Toyota Conversations, the site brings together the top stories being Tweeted about Toyota, from news articles to press releases. The site also shows visitors the most popular videos and images being shared about Toyota on Twitter. And the channel includes a Featured Tweets from Toyota’s Twitter account and press room as well as AdTweets, which are Tweetmeme’s retweetable ads for Toyota."
   
   The lesson: Don't shy away from conflict. It's often a good idea to start the conversation and let people vent. Plus, when you start the conversation, you get to be the moderator and control some of the information being discussed.

3. Respond to complaints instantly, like Comcast
   Sports fans are passionate, so imagine sitting at home, eagerly waiting to see the Celtics play in a championship game, and realizing your cable is messed up. Not good. This happened to a well-known podcaster, CC Chapman, who Twitter blasted a complaint about Comcast.
   
   The solution: Comcast handled the situation with urgency and timeliness. They sent a cable man to Chapman's house and repaired the signal before the tip off of the next game.
   
   The lesson: Set up digital alerts. When a customer needs something, you'll know immediately and can be there to assist them. It sure made a great headline when The Globe wrote about Comcast's excellent Twitter customer-service.

Kevin L. Brown www.kbsinsight.blogspot.com 

Why Acquisitions Fall Apart

Serial entrepreneur John Warrillow speaks with Beringer Capital's Perry Miele about what drives a buyer to walk away from a deal. By John Warrillow

Sep 24, 2010 http://ow.ly/2JsUG
Recently I wrote about how the private equity firm Riverside Company closed on only 15 of the 4,228 acquisitions it considered last year. That means there were a lot of deals that fell apart.  Why such a high failure rate? I turned to Perry Miele, the chairman of Toronto-based Beringer Capital, for his opinion. Miele makes his living buying, selling and occasionally investing in companies in the marketing, communications and media industry.

Missing your numbers

“The number one reason deals fall apart is missing your numbers leading up to closing day,” he says.

Miele shared the story of a client who was keen to fetch top dollar for his company. The founder and CEO put together an ambitious set of growth projections for the year, forecasting his company would generate $2 million in pre-tax profit on $7 million in revenue.

Beringer shopped the company to a number of buyers. Given its recent growth and profitability, Miele had several interested companies make attractive offers. The CEO agreed to one offer and entered a 90-day period of due diligence during which the acquiring company had exclusivity to investigate the CEO’s claims without other companies making bids.

As it turns out, the CEO was well behind on his numbers and was actually on track to deliver just $1.3 million of profit on roughly $6 million in revenue. Surprisingly, the acquirer was still interested but adjusted down its offer price to reflect 35 percent less profit than was promised in the CEO’s forecast.

The seller had already become attached to the higher offer and was insulted at the last-minute discount. He walked away. By that point, the other bidders were long gone. And so the deal died.

What is Miele’s advice to sellers? “Leave yourself a cushion when doing your forecasts for the year you are planning to sell. The only surprises a buyer should have when they dig into your numbers are pleasant ones.”

Gross margin erosion

Next up in deal killers: shrinking margins.

“Top-line revenue growth is often the price of admission in selling a company,” says Miele.

But in Miele’s view, it is not acceptable to grow at any cost. You need to grow sales while simultaneously maintaining or growing your profit margin.

Miele shared a story of a client of his running a successful company generating $2.4 million in pre-tax profit on $12 million in sales.

The company generated lots of initial interest when Beringer put it on the market, but one thing in the financials stopped each buyer short of making an offer: the company had been buying new business. Despite growing revenue at an annual rate of 5 percent per year, its profit was stuck.

The prior year, the company had generated $11.5 million in sales and $2.4 million in profit. In fact, despite growing sales each year, the company’s profit was frozen at around $2.4 million for six straight years.

Potential buyers saw the profit margin erosion and walked away, reasoning that the industry had become too competitive to grow and the company had not differentiated itself to the point of having any pricing power.

Perry’s advice? Make sure your top line is growing but also ensure your profit margin holds up in the process.

John Warrillow is a writer, speaker and angel investor in a number of start-up companies. He writes a blog about building a sellable company at http://www.BuiltToSell.com/blog. You can also follow him on Twitter at @JohnWarrillow

Kevin Brown - www.kbsinsight.blogspot.com

When Should You Nickel-and-Dime Your Customers?

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