Chapter 5:

Exploring Business Models:

Pricing and Revenue
Management

Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 1
 Overview of Chapter 5

 Effective Pricing Is Central to Financial Success

 Pricing Strategy Stands on Three Legs

 Revenue Management: What It Is and How It Works

 Ethical Concerns in Service Pricing

 Putting Service Pricing into Practice

Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 2
 Effective Pricing Is Central to
Financial Success

Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 3
 What Is a Business Model?

 Use of effective pricing mechanism to:

 Transform sales into revenues
 Recover costs
 Create value for owners of business

 Must clarify business logic that explains how firm can

deliver value to customers at an appropriate cost

 Not all business models require end user of specific

service to pay full cost—consider third-party payers:
 Advertisers
 Health insurers
 Donors to nonprofit organizations
 Tax subsidies for public services
Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 4
 What Makes Service Pricing Strategy
Different and Difficult?

 Harder to calculate financial costs of creating a service

process or performance than a manufactured good

 Variability of inputs and outputs—how can firms define a

“unit of service” and establish basis for pricing?

 Customers find many services hard to evaluate—what

are they getting in return for their money?

 Importance of time factor—same service may have more

value to customers when delivered faster

 Delivery through physical or electronic channels—may

create differences in perceived value

Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 5
 Alternative Objectives for Pricing
(Table 5.1)

 Revenue and profit objectives

 Seek profit
 Cover costs

 Patronage and user-based objectives

 Build demand
- Demand maximization
- Full-capacity utilization
 Build a user base
- Stimulate trial and adoption of new service
- Build market share/large user base

Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 6
 Pricing Strategy Stands on
Three Legs

Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 7
 The Pricing Tripod
Fig 5.1

Pricing strategy

Competition
Costs Value to customer
Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 8
 Three Main Approaches to Pricing

 Cost-based pricing
 Set prices relative to financial costs (problem: defining costs)
 Activity-based costing
 Pricing implications of cost analysis

 Competition-based pricing
 Monitor competitors’ pricing strategy (especially if service
lacks differentiation)
 Who is the price leader? Does one firm set the pace?

 Value-based pricing
 Relate price to value perceived by customer

Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 9
 Cost-based Pricing:
Traditional vs. Activity-based Costing

 Traditional costing approach

 Emphasizes expense categories (arbitrary overhead allocation)
 May result in reducing value generated for customers

 ABC management systems

 Link resource expenses to variety and complexity of goods/services
produced
 Yields accurate cost information

 When looking at prices, customers care about value to

themselves, not what service production costs the firm

Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 10
 Value-based Pricing
Understanding Net Value (Fig 5.2)

 Value exchange will not take place

unless customer sees positive net
value in transaction
 Net value = Perceived benefits to
customer (gross value) minus all
Perceived outlays (Money, Time,
Mental/Physical effort)

 Monetary price is not only perceived

outlay in purchasing, using a service
Effort Time
e
 Consumer surplus: difference Perceived
benefits
between price paid and amount Perceived
outlays
customer would have been willing to
pay in absence of other options

Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 11
 Value-based Pricing:
Strategies for Enhancing Net Value

 Enhance gross value—benefits delivered

 Add benefits to core product
 Enhance supplementary service
 Manage perceptions of benefits delivered

 Reduce outlays—costs incurred by customers

 Reduce price and/or other monetary costs of acquisition and usage
 Cut amount of time required to evaluate, buy, use service
 Lower physical and mental effort associated with purchase and use
 Reduce perceptions of amount of cost, time, effort required

Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 12
 Value-based Pricing:
Enhancing Perceptions of Gross Value
 Reduce uncertainty
 Service guarantees
 Benefit-driven—pricing aspect(s) of service that create value
 Flat rate (quoting a fixed price in advance)

 Relationship pricing
 Nonprice incentives
 Discounts for volume purchases
 Discounts for purchasing multiple services

 Low-cost leadership
 Convince customers not to equate price with quality
 Keep economic costs low to ensure profitability at low price

Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 13
 Paying for Service:
The Customer’s Perspective

 Customer “expenditures” on service comprise both

financial and nonfinancial outlays

 Incremental financial outlays

 Price of purchasing service
 Expenses associated with search, purchase activity, usage

 Nonmonetary costs
 Time costs
 Physical costs
 Psychological (mental) costs
 Sensory costs (unpleasant sights, sounds,
feel, tastes, smells)

Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 14
 Determining Total Costs of a
Service to Customer (Fig 5.4)

Money Purchase
Search costs*
Time Operating costs

Physical effort Incidental

expenses
Purchase and Psychological
service encounter burdens
costs

Sensory
burdens

Necessary

After costs* follow-up

Problem * Includes all five

solving cost categories

Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 15
 Trading Off Monetary and
Nonmonetary Costs (Fig 5.5)
 Which clinic would you patronize if you needed a chest x-ray (assuming all
three clinics offer good quality)?

Clinic A Clinic B Clinic C

 Price $45  Price $85  Price $125

 Located 1 hour away  Located 15 mins away  Located next to your
by car or transit by car or transit office or college
 Next available  Next available  Next appointment is
appointment is in 3 appointment is in 1 in 1 day
weeks week
 Hours: Mon-Fri, 8AM-
 Hours: Mon-Fri, 9AM-  Hours: Mon-Fri, 8AM- 10PM
5PM 10PM
 By appointment—
 Estimated wait at  Estimated wait at estimated wait at
clinic is about 2 hours clinic is about 30 to clinic is 0 to 15 mins
45 mins

Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 16
 Increasing Net Value by Reducing
Nonmonetary Costs of Service

 Reduce time costs of service at each stage

 Minimize unwanted psychological costs of service

 Eliminate/redesign unpleasant/inconvenient procedures

 Eliminate unwanted physical costs of service

 Decrease unpleasant sensory costs of service

 Unpleasant sights, sounds, smells, feel, tastes

Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 17
 Revenue Management:
What It Is and How It Works

Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 18
 Maximizing Revenue from
Available Capacity at a Given Time

 Price customization
 Charge different value segments different prices for same product

 Useful in dynamic markets

 Different price buckets based on price sensitivity to different
usage times, flexibility, other factors

 RM uses mathematical models to examine historical data and

real-time information to determine
 What prices to charge within each price bucket
 How many service units to allocate to each bucket

 Rate fences deter customers willing to pay more from trading

down to lower prices (minimize consumer surplus)

Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 19
 The Strategic Levels of
Revenue (Yield) Management
Price
Fixed Variable

Quadrant 1 Quadrant 2

Predictable Movies Hotel rooms

Stadiums/arenas Airline seats
Function space Rental cars
Cruise lines
Duration

Quadrant 3 Quadrant 4
Unpredictable Restaurants Continuing care
Golf courses Hospitals

Source: Fig 1 from Kimes and Chase reading (p. 212)

Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 20
 Dealing with Customer Conflicts
Arising from Revenue Management
Customer conflict can arise Marketing tools to reduce
from: customer conflicts:
 Perceived unfairness and  Fenced pricing
perceived financial risk  Bundling
associated with multitier pricing  Categorizing
and selective inventory  High published price
availability

 Unfulfilled inventory commitment  Well-designed customer recovery

program for overbooking
 Unfulfilled demand of regular  Preferred availability policies
customers

 Unfulfilled price expectation of  Offer lower displacement cost

group customers alternatives

 Change in nature of service  Physical segregation and perceptible

extra service
 Set optimal capacity utilization level
Source: J. Wirtz, S.E. Kimes, J.H.P. Ho and P. Patterson, “Revenue Management: Resolving Potential Customer Conflicts,” Journal of Revenue and Pricing
Management, 2003, Vol. 2 (3): 216-228.
Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 21
 Price Elasticity (Fig 5.6)

Price per
unit of Di
De
service
Price elasticity =
Percentage change in demand
Percentage change in price

De
Di

Quantity of units demanded

De : Demand is price elastic. Small changes in price lead to big changes in demand
Di : Demand for service is price inelastic. Big changes have little impact on demand

Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 22
 Key Categories of Rate Fences (1)
Table 5.2

Rate Fences Examples

Physical (product-related) Fences
Basic product  Class of travel (business/economy class)
 Size and furnishing of a hotel room
 Seat location in a theater
Amenities  Free breakfast at a hotel, airport pickup, etc.
 Free golf cart at a golf course
Service level  Priority wait-listing
 Increase in baggage allowances
 Dedicated service hotlines
 Dedicated account management team

Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 23
 Key Categories of Rate Fences (2)
Table 5.2

Nonphysical Fences
Transaction Characteristics

Time of booking or  Requirements for advance purchase

reservation  Must pay full fare two weeks before departure
Location of booking  Passengers booking air tickets for an identical
or reservation route in different countries are charged different
prices
Flexibility of ticket  Fees/penalties for canceling or changing a
usage reservation (up to loss of entire ticket price)
 Nonrefundable reservation fees

Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 24
 Key Categories of Rate Fences (3)
Table 5.2

Nonphysical Fences (cont’d)

Consumption Characteristics

Time or duration of  Early-bird special in restaurant before 6PM

use  Must stay over on Saturday for airline, hotel
 Must stay at least 5 days
Location of  Price depends on departure location, especially
consumption in international travel
 Prices vary by location (between cities, city
center versus edges of city)

Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 25
 Key Categories of Rate Fences (4)
Table 5.2

Nonphysical Fences (cont’d)

Buyer Characteristics
Frequency or volume of  Member of certain loyalty tier with the firm
consumption get priority pricing, discounts, or loyalty
benefits
Group membership  Child, student, senior citizen discounts
 Affiliation with certain groups (e.g., alumni)

Size of customer group  Group discounts based on size of group

Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 26
 Relating Price Buckets and Fences to
Demand Curve (Fig 5.7)
Price
per
seat
1st class

Full fare economy (no restrictions)

1 - week advance purchase

1 - week advance purchase, Saturday night stay

3 - week advance purchase, Saturday night stay

3-week advance purchase, Saturday night stay,

$100 for changes
Specified flights, book on Internet, no
changes/refunds

Late sales through

consolidators/Internet,
no refunds

Capacity of 1st No. of seats demanded Capacity of aircraft

class cabin
* Dark areas denote amount of consumer surplus (goal of segmented pricing is to reduce this)
Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 27
 Ethical Concerns in Pricing

 Customers are vulnerable when service is hard to evaluate

or they don’t observe performance of work
 Many services have complex pricing schedules
 Hard to understand
 Difficult to calculate full costs in advance of service
 Unfairness and misrepresentation in price promotions
 Misleading advertising
 Hidden charges
 Too many rules and regulations
 Customers feel constrained, exploited
 Customers unfairly penalized when plans change

Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 28
 Designing Fairness into
Revenue Management

 Design clear, logical, and fair price schedules and fences

 Use high published prices and present fences as

opportunities for discounts rather than quoting lower
prices and using fence as basis to impose surcharges

 Communicate consumer benefits of revenue

management

 Use bundling to “hide” discounts

 Take care of loyal customers

 Use service recovery to compensate for overbooking

Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 29
 Putting Service Pricing
into Practice (1)

 How much to charge?

 The pricing tripod model provides a useful departure point
 A specific figure must be set for the price
 Need to consider the pros and cons, the ethical issues

 What basis for pricing? (How define unit of service?)

 Completing a task
 Admission to a service performance
 Time based
 Monetary value of service delivered
(e.g., commission)
 Consumption of physical resources
(e.g., food and beverages)

Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 30
 Putting Service Pricing
into Practice (2)

 Who should collect payment?

 Service provider or specialist intermediaries
 Direct or nondirect channels

 Where should payment be made?

 Conveniently located intermediaries
 Mail/bank transfer

 When should payment be made?

 In advance
 Once service delivery has been completed

Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 31
 Putting Service Pricing
into Practice (3)

 How should payment be made?

 Cash
 Token
 Stored value card
 Electronic fund transfer
 Charge card (debit/credit)
 Vouchers
 Third-party payment

 How to communicate prices?

 Relate the price to that of competing products
 Ensure price is accurate and intelligible

Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 32
 Chase’s Blink Service (Fig 5.10)

 Chase advertises its fast

new credit card scanning
service, “Blink”

 “Blink” can be read by a

point-of-sale terminal
without being physically
touched

 Simplifies and speeds

payment transaction, saves
customer time and effort
Courtesy of JP Morgan Chase & Company
Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 33
 Frequency of Health Club Use
Relates to Timing of Payments (RI 6.1)

Annual payment plan Quarterly payment plan

health club visits
Frequency of

Semiannual payment plan Monthly payment plan

health club visits
Frequency of

Time line Time line

Source: John Gourville and Dilip Soman, “Pricing and the Psychology of Consumption,” Harvard Business Review, September 2002, 90-96.

Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 34
 Summary of Chapter 5:
Exploring Business Models (1)

 Pricing objectives can include

 Generating revenues and profit
 Building demand
 Developing user base
 Three main foundations to pricing a service
 Cost-based pricing
 Competition-based pricing
 Value-based pricing
 Cost-based pricing seeks to recover costs plus a margin for
profit; includes both traditional and activity-based costing
 Firm must be aware of competitive pricing but may be harder
to compare for services than for goods
 Value-based pricing should reflect net benefits to customer
after deducting all costs

Slide © 2007 by Christopher Lovelock and Jochen Wirtz Services Marketing 6/E Chapter 5 - 35