Keep It Simple: The Case for Combining Price Components

So the advantages of price partitioning imply that, as a manager, it’s better to offer a low base price and then hit consumers with a litany of small fees at checkout, right? Not so fast, say researchers who study a phenomenon called “shipping-charge skepticism.”5 Experimental research shows that some consumers strongly dislike paying for shipping. For those consumers, offers that include shipping in the total price are more attractive than offers that partition the price of the product and shipping into separate components. Data from customers using shopping bots (computer programs that search Internet commerce sites for the best prices — Google Inc.’s Froogle, would be an example) — to purchase books online has demonstrated the same effect. Customers were found to be almost twice as sensitive to changes in shipping charges as they were to changes in the price of the books they were purchasing.6 This analysis suggests that combining shipping charges and the price of the books makes consumers willing to pay more for the bundle, making combined pricing more advantageous than partitioned pricing.

Under what conditions do combined prices make consumers more satisfied or willing to pay more than partitioned prices? In contrast to the examples of partitioned pricing (telephone and hotel bills), the prices for two different components of a product or service are often combined: Books or shoes ordered online may be shipped for free, new kitchen countertops are sometimes sold with free installation, and new cars may come with a five-year/50,000-mile warranty. The fact that combined prices are common in the marketplace suggests that, under some conditions, it must be advantageous for sellers to take this approach.

One reason for combining prices is to avoid highlighting components such as shipping charges that consumers would rather not think about, or a warranty that might make reliability more of an issue. For example, research conducted by one of the authors shows that when a consumer is considering the purchase of a refrigerator, partitioning the price of a warranty raises more concerns about the appliance’s reliability — hurting purchase likelihood — than partitioning a different component, such as an icemaker.7

Another reason for combining prices is to be upfront with consumers and avoid surprising them later with fees that may upset them, ruining customer goodwill. A resort stay that costs a lot more upon checkout than the customer expected may not be remembered favorably the next time the customer goes online to make reservations. Resorts like Club Med offer all-inclusive prices to help consumers relax while they’re on vacation. In a sense, this combined pricing strategy decouples the pleasure of consumption and the pain of paying, allowing consumption to be savored more fully.8 The price of a stay at Club Med may be high, but repeat business is good because consumers know the price upfront, and they aren’t reminded of the costs every time they enjoy a resort amenity or surprised at checkout by a long list of charges for the amenities they already enjoyed. This kind of goodwill may be why Southwest Airlines Co. recently advertised its “Freedom from Fees” policy, differentiating itself from airlines that add on fuel surcharges and charge fees for checked baggage. (It also eliminates all that yelling at the ticket counters.)
A Contingent Approach: The Strategy of Benefits-Based Price Partitioning

Although most managers are familiar with the concept of selling benefits — not features — in their marketing communications, this concept hasn’t been adopted as widely in the area of pricing, and particularly price partitioning. In this section, we describe why the approach of benefits-based price partitioning — pricing components based on customers’ sensitivity to the price of each component — can be a win for both managers and customers.

One of the reasons cost-plus pricing has continued to be popular among managers is that it has the advantage of being perceived as fair by consumers. Research indicates that customers believe companies are entitled to a reasonable profit margin and that cost-based price increases to preserve a company’s profit margin are fair, but they feel morally outraged when companies opportunistically increase prices to increase their profits. A classic article by Nobel Prize winner Daniel Kahneman and his colleagues illustrates this principle by showing that customers believe a cost-based increase in the price of snow shovels is fair, but a demand-based increase in the price of snow shovels during a snowstorm is unfair.9 Similar to cost-plus pricing, when managers use cost-plus price partitioning with a uniform profit margin across components, it is straightforward to justify why a specific price is being charged for a particular component.

However, keeping your profit margin constant across price components may not maximize either profit or customer satisfaction. Recent research we conducted shows that customers are more price sensitive for components that they feel provide them with less benefit (“low-benefit” components, such as installation or shipping) relative to components they feel provide them with more benefit (“high-benefit” components, such as auto parts or books).10 In other words, customers are happier to pay for some components (auto parts or books) than for others (installation or shipping). Thus, for customers buying books online, a price partition in which the profit margin on shipping is low — or even negative — and the profit margin on books is high will be systematically more attractive to customers than a partition of the same total price in which the profit margin on shipping and books is the same. Taken to the logical extreme, this strategy suggests that customers prefer combined pricing in which a component they don’t like paying for is included in a single total price, rather than partitioned pricing in which they pay some proportion of the total price for each component.

In contrast to a strategy in which the same profit margin is expected for each price component, benefits-based price partitioning suggests that profit margins should be higher for components for which customers are less price sensitive and lower for components for which customers are more price sensitive. By holding the total price constant, research shows that customers will be more likely to buy when components they don’t like are de-emphasized (either by decreasing their profit margin or by combining them into a total price) and components they do like are highlighted (either by increasing their profit margin or by partitioning them from other components). It’s hard to argue against a strategy that improves outcomes for both the seller (by increasing customer purchase intentions) and the customer (via greater customer satisfaction and perceived value) while keeping the total price constant.