Pricing Revolution

I wrote this briefing for some of our clients a few months ago when the rate of UK VAT increased from 17.5% to 20%. I’ve decided to share it publicly as it may be useful for some of you when other increases take place (for instance raw material costs which have to be passed through) or if tax rates change again. And if VAT is going to increase in Greece, Ireland and other indebted EU countries, this could be a useful reference.

So, how should you update your prices if the rate of VAT goes up?

The simple answer, the one you’ll get from your accountant, is: increase all the prices you charge by 2.13%.

However, the more interesting question is a psychological one: how will your customers respond to the changes? There is room for some creativity here.

Here are seven things to consider. I’m using a case study of a local pub in order to give concrete examples with each point, but the same principles apply to any retailer and indeed to most business-to-consumer operations:

1. Fairness is important to customers. They understand that prices have to go up if VAT goes up, but will appreciate it if you appear to “share the pain”. A good way to do this is to promise to hold prices steady on a few key products – this could be “our most popular beers” or just “a selection of our best value drinks”. This gives you the moral high ground if you need (or want) to increase prices on some other products by a greater amount than just the VAT increase.
2. Changing your product selection. You might decide to freeze prices on your existing products while introducing a range of new drinks. This way nobody has any point of comparison for the new products, so you can set the price however you wish. If you are keeping the majority of your products the same, this doesn’t help much. But many retailers change their product mix frequently, so they can easily hide any increases in this way. It is more likely that you will be able to do this on some products than others: in the pub example, food changes more often than drinks and it will be easier to make wholesale changes.
3. Differentiate by market segment. You probably have some customers who are very price-sensitive and others who are not. For example, locals might be more price-sensitive than tourists. And people who buy the cheapest beer (let’s say Carling, or your low-end bitter) are probably more price-sensitive than those who buy more expensive products (those fancy Belgian lagers) This means you can more easily raise the prices of products that are already more expensive. You could combine this with approach number 1, to hold prices steady on the cheapest item in each category (the cheapest lager, ale and wine for example) while increasing the prices of the others. But if so, I’d recommend you also freeze prices on at least one premium beer, so that you don’t encourage too many people to trade down to the cheaper option. You might want to freeze the price on one of the currently less popular beers in order to see if it boosts demand.
4. Most people won’t notice which prices have changed, unless they are regulars. So you can highlight the ones which you have frozen, to show how generous you are being, while not mentioning the others. The occasional thoughtful customer may assume that everything has been increased except the ones specifically promoted as frozen. So you may want to freeze the prices of one or two other items without promoting it – so that if anyone ever asks, you can say “no, we have frozen lots of prices – e.g. this lovely Crabbies ginger beer which nobody ever buys – it’s just that we are only promoting a few of them”. You don’t need to specify exactly what proportion of your prices are frozen, of course! In fact, it might be more convenient to forget which is which so that if someone really wants to know, you can’t exactly remember right now…
5. You can raise prices more if you give customers something to “compensate”. For example you could raise the price of a pint by say 8%, but give everyone a free extra 50ml of beer (in a shot glass?) in return. Most people won’t know the exact amount of the VAT increase so they will not be able to calculate if this is a better or worse deal…but who would say no to an extra mouthful of beer? Better yet, you could say that the extra taster has to be from a different beer, so that you increase people’s temptation to try a different brand. Two people who are being sneaky might each order a “taster” of the other person’s beer and then just swap. But if people want to be like that, let them. They will probably end up buying more in order to “take advantage” of their own cleverness.There are lots of other additional extras you can do – Wetherspoons and similar chains usually have some kind of beer-and-hamburger deal and you could have a more upmarket version of that; if you have gig nights in the pub, you could do something with music tickets – e.g. a loyalty card to get a free gig ticket, or an entry into a draw for a free ticket with every premium beer. In general, these type of offers are more complex and may raise further psychological points: for instance, if this applies only to the beers where you have not frozen the price, it may not work so well in combination with suggestion number 1. If you combine the two, this may actually encourage more people to buy the cheaper beer with the frozen prices and reduce demand for the others.

And two general principles to remember:

1. You’re not providing a public service. Don’t have any fear of raising prices, as long as it doesn’t drive customers away. And if you have a good reason for it, and make some gestures of fairness, people will understand.
2. Remember that market forces will still work – so whatever you do is just a temporary measure. Competition, inflation and the costs from your suppliers, will influence your prices in the long run, so whatever you do now is just about optimising your revenue in the next 3-9 months. In that period you will probably think of lots of other promotions, and the effect of the VAT rise will disappear in the noise.

Rounding

A note on rounding, as many retailers prefer to keep prices rounded to even numbers.
In our pub example, they may want to keep drink prices at multiples of 10p. This is fine – in fact it probably means that you can increase the prices by a bit more than the VAT rise. e.g. a £3.50 pint going up by just the VAT rise would be £3.57, so if you put it up to £3.60 you’ll get nearly an extra 1% in revenue. Even better on a half pint.

You may want to offer a couple of specific brands at £3.55 or £3.58 just to make people think the prices are being very carefully worked out – many customers will assume they are getting a better deal when they see prices like this.

And one other change businesses can consider [in the UK case, the increase was just after Christmas] is to increase their prices before Christmas instead. Demand should be high at Christmas, so a price rise may be a natural decision anyway. Then, simply keep the prices at the same level in January (perhaps tempered with a few judicious post-Christmas sales promotions).

And finally, the biggest problem of a tax increase: the 99p price point. There’s not much you can do about products at 99p or £1.99 – you may simply have to swallow the 2p reduction in margin. But other 99p/95p points are more flexible. For example, sales of an item at £4.95 are unlikely to be seriously impacted if you go to £5.95. And even with the VAT increase, your margin will still be significantly higher.

A nice brief analysis from Eric Barker of different strategies when you’re negotiating one-on-one with a buyer, versus when you are auctioning something off.

In negotiations:

the final selling price tends to be higher when the seller makes the first offer and lower when the buyer moves first. This phenomenon is known as anchoring.

while in auctions:

in auctions starting low can often produce a higher selling price…in auctions the number of bidders is determined by the features of the auction. Maximizing the number of participants in an auction benefits the seller—a greater number of participants will usually result in a higher ending price

So if you have multiple buyers of what you’re selling and you can only sell to one of them, the auction strategy may let you achieve a higher price if you start with a low bid and let people drive each other’s willingness-to-pay upwards through competition.

While if you are selling to several customers and you can sell to all of them (for instance if you are a lawyer selling your legal advice) individual negotiations are the way to go; and be sure to make the opening offer!

The article is here.

Procter & Gamble and Unilever have been fined 315 million euros for price-fixing.

There are much more imaginative (and legal!) ways to maintain a price premium than this. Product innovation enables price differentiation; increasing the perceived value of your product allows you to charge more; and bundling your products in innovative ways can reduce commoditisation.

I know that Unilever at least is engaging in some of these things, and I’m sure P&G must do too. Naturally I am available to assist with behavioural pricing research if either company is interested in a chat…