Reflections on market driven pricing, Financial Times 26 October 2005

"The latitude you have in setting prices depends on how obscure or obvious the value of your product or service is," says Jaideep Prabhu of Imperial College's Tanaka Business School.

Reflections on the wonder and woes of a new inkjet printer
By Jonathan Guthrie and Jonathan Guthrie - on Entreprise
Published: October 26 2005

I experienced an apotheosis recently when I bought a new Hewlett-Packard inkjet printer. It scanned! It photocopied! It even printed! And all for £50! I felt as if the roof of the store had lifted off and the god of retail, who I'd guess resembles Philip Green in a white robe, was bathing me in radiance.

But as the poet Keats remarked, Joy's hand is ever at its lips bidding adieu. I left the shop gripped by the impotent fury us middle-aged guys do so well, having paid £52 for a couple of print cartridges to go with my "bargain" printer. What precious elixir could they contain, I had asked the bored teenager at the till. Pearls dissolved in vintage Krug?

Then anger gave way to admiration. I surmised that manufacturers such as HP lure buyers with cheap printers, clawing back the discounts later with expensive cartridges. That got me thinking about pricing strategies. Setting prices can be pretty nerve-wracking. Pitch them too low, and you could forfeit margins. Pitch them too high, and turnover could disappoint. How do you reach a profitable compromise?

Michael Pollitt of Judge Business School told me that about 35 per cent of businesses simply set prices in line with the market, while 25 per cent aim to undercut it. Another 35 per cent add a mark-up to costs. A final 5 per cent "let their customers set their prices" - and presumably end up weaving baskets under the supervision of strong, patient men in white jackets.

Naufel Vilcassim of London Business School added that most products and services are also set relative to a "reference price", which is what customers expect to pay for average quality. This may reflect the experience of the customer rather than the real costs to the supplier. For example, some internet users remain aggrieved that data businesses no longer dish out scads of free content via the web as they once did.

The latitude you have in setting prices depends on how obscure or obvious the value of your product or service is. There are huge opportunities for profit in "credence goods" where, according to Jaideep Prabhu of Imperial College's Tanaka Business School, "The customer cannot tell the value even after consumption." A good example, he chuckled, would be management consultancy.

Margins are less malleable in "experience goods", such as food and drink, where quality can be gauged through consumption. The worst pricing squeezes occur in "search goods", where customers can find out what a given outlay will buy them. PCs belong to this category because computing power is easily compared.

The political correctness in business is that competition is bracingly healthy. So is cod liver oil, which is equally horrid for recipients. If transparency depresses margins, then a pricing strategy that increases opacity may raise them. Selling cheap printers and costly cartridges has this result, even if that is not what manufacturers such as HP intend. Customers, especially retail ones, tend to focus on initial rather than subsequent costs. Prof Prabhu calls it the "razors and blades" strategy. Mobile phone companies, opticians and insurers all deploy it.

A weakness of the razors and blades strategy is that a rival may start selling cheap blades to fit the low-cost razor you hoped would lock customers into your brand. In printers, this competition comes from makers of cheap generic cartridges and from cartridge recyclers, such as the Cartridge World chain.

Reputational risk is another problem. I am not the only person to fume about the high cost of printer cartridges. Both the Office of Fair Trading and the Consumers' Association have criticised manufacturers in the past. Thomas Zackor of Hewlett-Packard told me wearily: "It is enticing to look at cartridge costs on a price per millilitre of ink basis, but it does not make much sense." Developing a new cartridge type can cost as much as $1bn (£563m), he said.

Mr Zackor added HP was helping to set up a new standard for comparing the output of different cartridges, which should improve price transparency. However, he declined to say whether margins were significantly lower for printers than for cartridges. "We look at it from the perspective of the whole system," he said firmly.

HP's imaging and printers division generated decent rather than disproportionate earnings of $2.8bn on net revenue of $18.4bn in the nine months to July 31. Those figures dispelled any lingering resentment I felt about pricey ink cartridges. They make HP's pricing structure look like a sensible way of protecting margins, rather than a rip-off. Perhaps HP can learn from the insouciance of businesses that represent price opacity as a badge of exclusivity, such as management consultants. I called a McKinsey official, hoping he might twitch aside the customary veil of secrecy. Did the company, for example, copy plumbers by charging according to the swankiness of clients' cars and houses?

"I couldn't possibly comment," he said, sounding gratifyingly appalled.

"Come on," I wheedled, "I'm only asking for a flash of your ankles."

"Our heritage means we tend not to discuss internal processes," he said.

"Some girls do and some don't?"

"You might say that," he purred.

Later, Fiona Czerniawska of the Management Consultancies Association told me 60 per cent of its members worked for a fixed charge, 30 per cent for costs plus a margin and 10 per cent for contingency fees. But I could not help feeling she was ruining the magic for me.