Business management

The pros and cons of two-part pricing

It’s a business practice that has raised eyebrows in the past, so do two-part tariffs take consumers for a ride or offer a great deal for all concerned?

  • This captive-market strategy is based on selling a product at or below cost and then charging for essential supplies, parts or services
  • It is a pricing model used successfully by printer and razor manufacturers but is vulnerable to competitors offering cheaper compatible products
  • It is more likely to succeed if customers are loyal to the brand and the pricing is consistent across all markets

It’s no surprise then that there are hundreds of costing techniques and strategies, all united by one common goal – to maximise profit. This is the Holy Grail of pricing, yet 2014’s Global Pricing Study, which revealed that 72% of all new products fail (mostly because of high price pressure, price wars or low-cost competition), indicates that organisations are consistently getting it wrong.

The model a business chooses depends largely on the sector in which it operates. Companies that have a secondary service or product to sell often use two-part pricing – also crudely referred to as the ‘razor and blades’ strategy after one of the industries that most commonly uses it.

In essence, says economist Dr Dov Rothman, vice president of financial and business consultancy Analysis Group, two-part pricing is a captive-market strategy that is based on selling customers a product at or below cost and then charging them additional – and ongoing – fees for essential supplies, parts or services.

Classic examples include amusement parks, razors, glucometers (which measure blood glucose), games consoles and printers – all of which involve secondary costs on top-up products that far exceed the initial upfront outlay. More recently, car manufacturers have started using this model – often discounting vehicles heavily to bring in new customers and then profiting on parts and service agreements.

A historic precedent

Ivan Segrt is a director at Simon-Kucher & Partners, a strategy and marketing consultancy that is a global authority on pricing. “Businesses have been using two-part tariffs for more than a century,” says Segrt, “though precisely when and how the model originated is not known. The concept gained a lot of prominence in economic theory in the 1970s and 1980s, underpinned by the rise of theme parks, which used it.”

The late Walter Yasuo Oi, Elmer B Milliman professor of economics at the University of Rochester, New York, even wrote a seminal paper on the subject, in which he coined the term ‘Disneyland dilemma’ to describe the choice between having a high admission fee that would include all the rides, or letting people in for free and then charging them for each attraction.

The Button-Fastener Case, which made headlines in 1895, is an early-recorded example. Button-Fastener invented a stapling machine that fastened buttons to shoes. It made little money on the machines, its profits coming solely from the sale of its costly staples. When a competitor started making compatible but cheaper staples, Button-Fastener sued.

Button-Fastener is a perfect illustration of the two-part strategy, showing how the potential for profit lies not in the main product but in the after-market, while highlighting one of the key factors that can threaten its success: cheaper compatible after-market products.

Price is the most powerful economic force in our day-to-day lives and one of the least understood

Dr Hermann Simon, business leader

“This is one of the main threats to businesses that use two-part tariffs,” says Segrt. “Once a patent expires, other manufacturers can step in with cheaper consumables and often there is nothing the makers of the primary product can do about it.”

HP’s recent backtrack over a software update that prevented some third-party cartridges from working is a case in point. The company bowed to pressure from consumer rights champion Electronic Frontier Foundation (EFF) and brought out another update that reversed the block.

“We’ve worked with many clients for whom we’ve ultimately devised a two-part tariff strategy, but there are many factors to take into account before we reach that point,” says Segrt, “including the prospective long-term value of the after-market, patent rights and legislation, plus customer loyalty and the brand’s popularity – is the brand strong enough to keep its customers once generic substitutes come on to the market? Nespresso, for instance, is immensely well liked and has high retention – its capsules cost more than the compatible competitors’ products but people like the product and the company, so two-part pricing makes sense in this case.”

Consistency is key

Internal communication and discipline and the ability to execute a strategy are also critical. “Everyone, from top to bottom, must be aligned and must understand the principles of the strategy,” says Segrt. “It won’t work if one salesman discounts the machine and sells consumables at a high price, while another does the opposite. Today, when online shopping has become the norm and pricing transparent, professional buyers and consumers would simply shop around, and the company would lose out. The pricing policy and commercial discipline must be consistent across all markets, to make two-part pricing viable. People usually underestimate the complexity and effort involved.”

Two-part pricing often attracts negative publicity, mainly because of the high after-market margins: the ink in branded cartridges is allegedly more expensive, per millilitre, than Dom Pérignon, while the mark-up on Gillette razor heads is a staggering 4,750%. It’s no wonder that companies are reluctant to go on the record to defend their pricing, though in an interview with the Daily Mail, a spokesman for Gillette did say that parent company Procter & Gamble determined the price of the razor heads “based on covering our costs – the cost of product development, raw materials, processing, packing, transport, general expenses and marketing. We need to earn a sufficient return to sustain our business and to develop new high-quality products that provide good value in relation to durability and performance in relation to price.”

Despite this, two-part pricing can benefit consumers, most notably because they can try a product for a low initial charge and then, effectively, pay in instalments for subsidiaries on an as-needed basis. “It enables customers to stagger their expenditure,” says Segrt. “Lower after-product costs would inflate the price of the primary product, which would prove prohibitively expensive for many. This model allows people, if not to try before they buy, then certainly to try before they commit: it lowers the cost of getting it wrong, as they don’t have to pay a large sum upfront without knowing whether they’ll like the product.”

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