The experts at Simon-Kucher & Partners--the world's largest pricing consultancy--hear such bluster from entrepreneurs all the time. And they think it's nonsense. After more than 30 years in business, they have encountered their fair share of founders who fail to properly price their innovations. In a recently released book called Monetizing Innovation, partner Madhavan Ramanujam and co-CEO Georg Tacke provide several examples of how the science of pricing is more nuanced than you think.
One of these examples involves a quiz about the smartest way to maximize revenue by bundling pizza and breadsticks. Fewer than 10 percent of executives who take the quiz figure out the best bundling formula. Think you know better? We'll see about that. Grab your calculator. Here's the setup:
You own a pizzeria. Like any smart entrepreneur, you've studied your customers' spending habits, and divided them into segments on the basis of what they're willing to pay for certain products. For the sake of easy math, assume each segment has exactly 100 customers.
Segment A loves pizza. They'll pay $9 a pie. But they don't love breadsticks quite as much. They'll pay $1.50 for them.
Segment D (yes, D) loves breadsticks. They love them so much, they're willing to pay $9 for them. And yet, incredibly, the customers in this segment are not crazy about your pizza. But they will reliably pay $2.50 a pie.
As for the two other segments--B and C--they are between these two extremes, in terms of what they're willing to pay for both pizza and breadsticks. All told, then, here's what your segments look like:
Segment A: 100 customers, willing to pay $9 for pizza, $1.50 for breadsticks
Segment B: 100 customers, willing to pay $8 for pizza, $5 for breadsticks
Segment C: 100 customers, willing to pay $4.50 for pizza, $8.50 for breadsticks
Segment D: 100 customers, willing to pay $2.50 for pizza, $9 for breadsticks
Now consider this: Since you own a pizzeria, you can't alter your price from customer to customer. The menu price is the menu price. In other words, you can only set one price per item or bundle.
Your goal is to maximize revenue, under the assumption all 100 people in the segment will buy the pizza or breadsticks or both if your price is equal to or less than their stated willingness-to-pay price. So, for example, if you sell the pizza at $4.50 and the breadsticks at $5, you will make $2,850, since at $4.50, segments A, B, and C will buy the pizza ($1,350, from 300 customers at $4.50 each), and at $5, segments B, C, and D will buy the breadsticks ($1,500, from 300 customers at $5 each).
Got it? Good. Now here's the actual quiz: What is the maximum revenue you can make? (Figure it out on your own before you read any further; the spoilers commence in the next paragraph.)
If you're not bundling the products, the maximum revenue you can generate is $3,300. You can do this if you charge $8 for pizza (segments A and B would buy it) and $8.50 for breadsticks (segments C and D would buy them). At these prices, you'd generate $1,600 in pizza revenue (200 times $8) and $1,700 in breadstick revenue (200 times $8.50).
But what if you could bundle the pizza and breadsticks under one delicious price? Surely some of you have already made such calculations. If you have, you've likely reached $4,200 as your answer for maximum revenue. You've done this by bundling the pizza and breadsticks at $10.50. At $10.50 for both products, all four segments will happily buy the bundle, since their combined willing-to-pay prices are all $10.50 or higher. So, with 400 customers paying $10.50 each, you'd make $4,200.
So, the first lesson here is a simple illustration of the power of bundling. Without bundling, the maximum revenue was $3,300. But by bundling, you generated $4,200: a revenue increase of 27 percent.
If your answer to this quiz of maximizing revenue was, indeed, $4,200, you are probably patting yourself on the back. But you shouldn't be. In actuality, the answer is $4,400. Here's how:
Imagine a scenario in which you sell the pizza and breadsticks as a $13 bundle. In that scenario, segments B and C would still buy it. From them, you would make $2,600, selling 200 bundles at $13 each. Now imagine that you're also selling the pizza and the breadsticks individually, each at the price of $9. Segment A would still buy the pizza. Segment D would still buy the breadsticks. From these segments, you'd make another $1,800: 200 buyers of $9 items.
Your total? $4,400. The concept in play here is called mixed bundling, where you sell products both as standalone entities and in a bundle. If your original answer to this quiz was $4,400, then you really do deserve credit for your prizing savvy. Fewer than 10 percent of the execs who take this quiz come up with the $4,400 answer.
Of course, if you're going to apply this to your own business, the first step is conducting serious research to segment your customers by how much they are willing to pay for certain items. "The right way to do this is to look at what people need and value," says Ramanujam, "and to learn how it differs across the customer base."