Effective Price Segmentation Techniques

In order to fully capture potential profit contributions, a firm must be able to successfully execute price segmentation tactics on a consistent basis.  Faced by a dynamic market, firms require regular price maintenance to ensure segmentation hedges remain effective.  Efficient price discrimination techniques that involve limited cost to identify market segments and mitigate the existence of a secondary market, truly contribute to a firm’s bottom line.  Understanding the theoretical concepts of price discrimination discussed in a standard economics textbook only scratches the surface of the knowledge needed to implement a profit generating pricing strategy.  This article will attempt to provide the connection between pricing theory and where the rubber meets the road.

A challenging, yet fruitful step in creating a long-term strategic pricing plan starts with the alignment of internal incentives.  Executives must thoroughly communicate market segmentation and discount procedures from the top down, establishing relative target prices for offered goods or services.  Sales personnel must understand the value added from charging different price levels to consumers based on their elasticity of demand.  Discounting from a predetermined price allows sales people to evaluate customer’s price responsiveness and segment according to outlined discount tranches.  Even with strict discounting management tactics, sales people will force consumers to reveal their demand behavior.  A common foundation based on symmetric information between the sales force and management is critical in the success of the pricing endeavor.

Identifying consumer’s willingness to pay poses a problem that can be solved through observation over a time series.  The common segmentation hedges, such as age, gender, and income are relatively discernable.  When self-identification and observable customer characteristics are not evident, other pricing tools are utilized.

A net price band or discount band can be constructed to observe the distribution of prices realized or discounts offered in comparison to the percentage of revenue created.  Refer to Figure 1 below for an example.

Figure 1:  Net Price Band

A tight, normally distributed spread indicates either rigid discount management guidelines or homogeneous demand characteristics.  Opportunities for improvement in discounting methods or price discrimination policies exist when a large, skewed distribution is observed.  The creation of a net price band allows executives to hone in on consumers paying higher prices and focus on reallocating sales efforts to capture more customers with similar demographics.

Pigou’s contribution to price discrimination in the second-degree (Non-linear Pricing) offers an explanation to the correlation between the price per unit and volume purchased.  In an effort to further identify consumer behavior according to net price paid and the amount of sales volume generated, scatter plots are constructed.  Refer to Figure 2 below for an example.

Figure 2: Net Price to Volume

Observing the relationship between how much a customer purchases and the net price they receive per unit provides another form of segmentation.  Consumer contributing more sales revenue to the firm generally expect lower per unit prices than consumers only making few purchases during a time frame.  A stair step methodology can be defined from the relationship present on the scatter plot.  As one can observe, the high sales volume a customer has, the lower net price received.  The stair step line allocates consumers into three markets in this case.  Consumers purchasing less than approximately $2,000 in revenue should not receive a price less than $17 and so forth.  By selecting target prices for each market according to volume consumed and preventing resale, firms can effectively price discriminate and garner significant profits.

Another form of market recognition analyzes consumer trends by geographic region or sales territory.  Allocating consumers based on their location’s willingness to pay overall helps identify profitable market segments for the firm.  Refer to Figure 3 below for an example.

Figure 3: Net Price by Sale Territory

In Figure 3 above, the series points represent weighted average net prices, maximum net prices, and minimum net prices indexed by sales volume.  This instrument helps recognize sales territories where consumers have higher willingness to pay or less stringent discounting control.  Both pieces of information are vital in making executive pricing decisions.

The previously discussed tools help identify consumer groups by observing historical data.  Ongoing reports, as the ones above, analyzing changes in the market space keep firms on the frontier of excellence in pricing. Continuing to keep sales incentives aligned with profit measures, identifying market segments, implementing price discrimination tactics, and consistently monitoring the market dynamic ensures the firm’s longevity.