Earlier this month there was an article in the Wall Street Journal, Why Gadget Warranties Are (Almost) Never Worth It, pointing out the disadvantageous math behind most extended warranties and chastising sellers for offering them. From my perspective extended warranties are good examples of when multi-part pricing makes sense, and they can be a win for both buyers and sellers. Conversely there are times when the better option for your pricing strategy is to create a bundled price, and it is worth discussing when each option makes sense.
The idea behind multi-part pricing is to capture additional money from customers when there is a wide range of value to customers for certain complementary products or services. In addition to extended warranties, examples of multi-part pricing include parking fees at concerts and sports venues, premium fees for exit row seats on airlines, travel insurance on vacations, and fees to drive in the fast lane on a highway. Multi-part pricing is most logical when there is significant competition on the base product resulting in fairly low margins, a limited supply of the complementary item like parking spots or exit row seats, and a wide range of value by customers for the complementary items.
In the sports and concert examples, there tend to be clearly defined demand curves. The higher the price of the base ticket, the fewer attendees in each section. When deciding to buy tickets, the potential attendees pay the most attention to the ticket price, and less attention to parking, food, etc. Typically parking is limited, so some customers will carpool, and walk a long way to minimize cost, while others will pay a premium to be close. Multi-part pricing enables the venue to capture the value from those who value parking and other extras most, and allocates limited supply.
Similarly airlines have learned that customers pay most attention to the price of the ticket when deciding to buy. Some passengers prefer extra leg room and will pay for it. Other passengers are willing to take small seats for a low price, but will pay extra to check a bag rather than wrestle with the overhead bins.
Drivers pay for access to roads and highways through taxes, including fuel taxes. During busy periods some drivers place a higher value on getting where they are going more quickly, and they are willing to pay fees to use uncongested lanes. To other drivers, a fee to get there more quickly is not worth it. The ability to separate the drivers with toll lanes is simply using multi-part pricing to capture more value.
Extended warranties and travel insurance are also good examples of multi-part pricing. The customer has already made the decision to buy the product or the vacation, but some customers worry more than others about things that could go wrong. The more worried customers do not want to have to pay again when their product breaks in a year, and they don’t want pay for medical care if they get sick while traveling. Some type of insurance gives them peace of mind. The providers of the vacation or the product can predict actuarially how often something is likely to go wrong, so they can come up with an insurance offer that is both profitable and gives comfort to the more worried customers.
The idea behind bundles is to entice customers who are likely to buy a certain product to also buy one or more products they might not otherwise purchase. The keys to making bundles work are anchor products, an unconstrained supply of complementary products, relatively higher price sensitivity on the complementary products, and a predictable cost to the seller for the complementary products. Examples of logical bundles are the value meals at fast food restaurants, The Microsoft Office package, and option packages on new vehicles (groups of individual options).
In each of the examples, there are one or more anchor products that drive the customer to an initial purchase decision. The sandwich at Subway, MS Word and MS Excel in Office, and the car are the focus points for the customers. They may not want chips with their sandwich, but as part of a meal they buy it. They may not need Outlook or Publisher, but for a modest incremental cost they are willing to try them.
Auto sales are a more nuanced example because they represent both multi-part pricing and bundled pricing. First and foremost, a car buyer decides which vehicle to purchase. The car has a base price with optional extras available for incremental fees (multi-part pricing). However, bundles of options are also available. The buyer may primarily want chrome alloy wheels and a chrome grill, but for not much extra decide to get the appearance package which includes chrome exhaust tips and body-colored fascias.
Bundles are successful when more customers buy more products than they otherwise would, the bundles don’t cannibalize sales that would have already occurred, and the bundle does not create new shortages. Conversely, multi-part pricing is most effective when there is limited supply of the complementary products and a wide range of value to customers. Both tactics can be parts of your pricing strategy, but make sure you use them in the proper situations.
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