Posted by: Patrick Lefler | February 11, 2010

Loss aversion…and why it matters

Loss aversion refers to the tendency of people to strongly prefer avoiding losses as opposed to acquiring gains. And this emotional difference between gains and losses is so strong that some studies suggest that losses can be twice as powerful as gains.  Psychological researchers Daniel Kahneman and Amos Tversky were the first to document this tendency in their 1979 research article titled, “Prospect Theory: An Analysis of Decision Under Risk”.

As highlighted in the 2008 book “Yes – 50 Scientifically Proven Ways to Be Persuasive”, loss aversion explains quite a bit of human behavior in a number of different areas.

Take the case of investors who prematurely sell stocks that have gained in value because they simply don’t want to lose what they’ve already gained. It is the complete opposite of what rational investors are taught – ride your gains for the long run but cut your losses early. And while personally, none of us would even put ourselves in that “inexperienced investor” category, I don’t think there isn’t one of us who hasn’t said over the past year, “Even though I hate the market, I’m not selling my “xyz” stock until it reaches my break-even level.” We like to think that we’re rational investors, but as soon as our portfolio reaches some psychological (or real) “break-even” point, we can’t sell quick enough. We won’t admit it, but there is a bit of loss aversion in each of us.

Insurance is another area where the concept of loss aversion hits home. Insurance companies don’t frame their marketing message in terms of what customers have to gain by buying their product, but rather they focus their message strictly on what will happen (the loss) if you don’t buy the policy. Insurance policies mitigate losses – whether it’s for your auto, your home or your life – it’s how they sell so many policies. And on a personal level, I find that the really good insurance agents are masters at this technique – they are relentless at it…and in my case, it worked.

So why does this matter? It matters because most businesses today fail to incorporate loss aversion techniques into their sales and marketing messages. Most are really good at crafting messages that highlight what prospects have to gain from buying their product. Far fewer take that next powerful step and also highlight the losses that could occur if that same product is not purchased. It could be as simple as changing your message from: “If you buy this product, you could save 50 thousand dollars” to “If you fail to buy this product, you could lose 50 thousand dollars.” To an economist, the two messages are identical. To a psychologist familiar with loss aversion theory, the messages couldn’t be any more different.

Here’s the takeaway. Loss aversion is a powerful and proven concept. When you market your product or services, you need to incorporate the psychological aspects of loss aversion into your message (when appropriate). If done correctly, the gains can be significant…or said a bit differently, if you fail to incorporate loss aversion into your message, your revenue losses can be significant.

More on this and other topics next time…

Posted by: Patrick Lefler | February 9, 2010

How do you measure your bottom line?

Here’s a story that I’ve run across a number of times in slightly different versions over the past few years. I first encountered it while reading Jack Trout’s book, “In Search of the Obvious”. The story is simple yet profound.

An American businessman was at the pier of a small coastal Costa Rican village when a small boat with just one fisherman docked. Inside the boat were several large yellow-fin tuna.

The American complimented the Costa Rican Tico on the quality of his fish, and asked how long it took to catch them.

“Only a little while,” the Tico replied. The American then asked why he didn’t stay out longer and catch more fish. The Tico said he had enough to support his family’s immediate needs.

The American then asked, “But what do you do with the rest of your time?”

The Tico fisherman said, “I sleep late, fish a little, play with my children, take siesta with my wife Maria, stroll into the village each evening, where I sip wine and play guitar with my amigos. I have a full and busy life, senor.”

The American scoffed, “I am a Wall Street executive and could help you. You should spend more time fishing, and with the proceeds buy a bigger boat and a Web presence. A scalable, go-forward plan would provide capital for several new boats. Eventually, you would have a fleet of fishing boats. Instead of selling your catch to a middleman, you would sell directly to the processor, eventually opening your own cannery. You would control the product, processing and distribution. You would need to leave this small coastal fishing village and move to San Jose, Costa Rica, then to Los Angeles and, eventually, New York City, where you would outsource tasks to third-party clients to help run your expanding enterprise in a vertical market.”

The Tico fisherman asked, “But senor, how long will all this take?”

To which the American replied, “15 to 20 years.”

“But what then, senor?”

The American laughed and said, “That’s the best part. When the time is right, you will announce an IPO and sell your company stock to the public and become very rich. You will make millions.”

“Millions, senor? Then what?”

The American said, “Then you will retire, move to a small coastal fishing village where you can sleep late, fish a little, play with your kids, take siesta with your wife, and stroll to the village in the evenings, where you will sip wine and play your guitar with your amigos.”

Here’s the takeaway: Understand your bottom line and how its measured. In many cases, changes that may sound good, end up adding little or no actual value to bottom line results. Continue to focus on what adds value and eliminate everything that doesn’t.

More on this and other topics next time…

Posted by: Patrick Lefler | February 7, 2010

And you thought airline price wars were bad?

Here’s a great story that highlights a pricing war than even the airlines couldn’t replicate. It comes from Rafi Mohammed in his Book: “The Art of Pricing”.

“The intense rivalry between Jay Gould’s Erie Railroad and Commodore Cornelius Vanderbilt’s Central Railroad in the nineteenth century illustrates the pivotal role that competition plays in determining value. These adversaries battled to control livestock transportation between Buffalo and New York City in 1867. The standard price for the route was $125 per carload. Vanderbilt incited a price war by reducing his rate to $100; Gould responded with a another $25 price cut. The Commodore reciprocated; Gould struck back by dropping his price to $25. When Vanderbilt set his price to $1 per carload, Jay Gould’s cars ran empty, and Vanderbilt celebrated his victory – given that both railroads offered virtually the same service, why would customers pay more to Gould?”

“The Commodore’s merriment ended abruptly when he discovered that Gould had purchased every steer in Buffalo and sent them to slaughter in New York on Vanderbilt’s rail cars – yielding large profits for Gould, quite literally at the Commodore’s expense. Moreover, in the process, Vanderbilt’s aggressiveness wiped out a profitable business”

Two points here. First, if you want to avoid price wars, have a product or pricing model that is not viewed as a commodity by your buyers. Second, if you can’t differentiate your product or pricing strategy, you need to understand that your prices will be heavily influenced by the competition.

More on this topic and others next time…

Posted by: Patrick Lefler | February 4, 2010

Aligning pricing with customer value

When one thinks of what customers value most, pricing strategy is probably not high on the list. And on the surface, it makes perfect sense because in most cases, pricing strategy is designed to extract the most revenue dollars possible from customers. I’ve even heard some folks make the analogy of customer pricing to “playing poker” with your customers; complete with hidden cards, bluffs from both sides of the table and a winner-take-all mentality. Not exactly a key selling point or value proposition.

So here’s a slightly different way to look at your pricing strategy. On a regular basis, step back from the tactical aspects of pricing and look at it from a strategic point-of-view. Look to see if there ways to change the competitive landscape by changing the strategy – not just tweaking your existing policy but radically changing the industry model. One way to look at this is from your customer’s perspective. Does your pricing strategy align with what matters most to them? Make sure you understand what the business drivers are for your customers and how might that change in the next few years? Are there ways to change your strategy that anticipates the needs of your customers?

One of the best examples of game-changing pricing strategy innovation came from General Electric and their commercial-aircraft-engine business. According to a 2003 Boston Consulting Group (BCG) Article titled; “Pricing Myopia”, engine manufacturers had traditionally used engines as a loss leader to secure the lucrative business of selling replacement parts. GE changed all that when it offered airlines the option of buying power by the hour – in essence, purchasing as a package engines, parts, along with maintenance, repair and overhaul services and paying on the basis of per hour of use. The strategy not only allowed GE to make the most of its competitive advantages, but more importantly, it aligned pricing with customer value (by tying prices to airline up-time) and aligned their customers’ interests with its own. According to BCG, GE’s strategic use of the power-by-the-hour concept helped it transform the competitive position and profitability of its commercial-aircraft-engine business.

I’ve said this before and I’ll say it again…We spend far too little time thinking about our pricing strategy. I used to joke that for every 100 hours we spent building our products, we were lucky to spend 10 minutes thinking about the actual pricing strategy. Sad but true.

More on this topic and others next time…

Posted by: Patrick Lefler | February 2, 2010

The first of many…

A little introduction…First of all, my name is Pat Lefler and I am the founder of The Spruance Group – a management consultancy that provides strategic solutions to growing firms in both the financial services and software sectors. The Spruance Group empowers companies to grow faster by focusing on what creates value for your customers and eliminating everything that doesn’t. There is a direct relationship between focusing on what clients value and bottom line results and the competitive advantage is enormous for companies who concentrate on these types of activities.

Second, I believe that in today’s world – a world where the global competitive forces are squeezing businesses from every angle – your number one priority should be to focus on what delivers value for your customers – activities that are not only valued by the customer but ones where the customer is willing to pay for them. The corollary to this is that processes that exceed what customers value (and offer no other benefits) are waste and should be eliminated.

Third, I believe that focusing on customer value extends from not only the product (or manufacturing) side of the business, but it also extends to the customer support, marketing and sales sides of the business. It’s not enough to focus all your efforts on delivering a product that customers value and will pay for – you must also apply this same methodology to the “soft” sides of the business where it’s much more difficult to identify what matters (and what doesn’t) for your customers, but where the waste and inefficiencies are substantial.

More on this topic and others later…