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The Psychology of Upfront Pricing

Psychology of Upfront Pricing and Prospect Theory

You ever notice in the bar someone always says to you, “Hey can I buy you a drink?” Say, “no thanks, but can I have the money instead?” Tell him you’re saving up to buy your own goddamn bar. —George Carlin

There is a lot of great startup advice on pricing, but much less about upfront pricing for businesses with recurring billing (subscription businesses) or repeat customers.

There are plenty of reasons why you might want to focus on your upfront pricing and packaging, and not just your month-to-month pricing:

  • Increase profit margin with upsells. If I’m a customer, I’m already taking out my wallet to buy something and squinting at the tiny numbers on the back of my card. If I’m buying one thing, maybe I’ll buy more than one thing. Add-on products and services like accessories, installation, premium onboarding, or insurance can be great ways to add profit margin to the customer.
  • Lower payback period. If you’re a company that doesn’t make a profit on the first transaction, getting more cash upfront can reduce the payback period—the period of time before the customer becomes breakeven— of the customer. This frees up cash sooner, and makes the cash you have tied up with not-yet-profitable customers safer.
  • Reduce churn. The fewer opportunities customers have to churn, the better. An annual payment means that customers are locked in for a year, and won’t have 11 more times to say no. Given the same total price, this increases margin.
  • In some businesses: align incentives. In some cases, upfront payments can help align incentives. If you’re a company that has to issue customers some hard asset (hardware, furniture, whatever), you may want to get customers to pay or deposit money for those assets. In addition to being good for cash flow, this might make customers take better care of the asset.

None of these come for free. A customer would rather hold onto their hard-earned money than trade it away all at once because they’r optimizing their own cash flows, too. The art of optimizing upfront pricing, therefore, is to introduce the right set of tradeoffs to optimize cash flow while making customers excited about what they can get with the right upfront pricing.

The Psychology of Upfront Sales: Prospect Theory and Pricing

By now, you are hopefully convinced that optimizing your upfront pricing can have some incredible upsides to cash flow relative to month-to-month models. Prospect theory articulates some of the ways psychology can make people irrational about economic matters.

Upfront pricing wants you to pay today, for a benefit tomorrow. The problem is:

  • A benefit today is better than a benefit tomorrow
  • A cost tomorrow is better than a cost today
  • Losses harm me much more than equivalent gains (losing $10 is way worse than gaining $10 is good)

The good news is that prospect theory, the psychological theory of how people asymmetrically value gains and losses, presents some ways that upfront pricing options can be designed and promoted for success. 1

Three Principles of Pricing from Prospect Theory

Customers work from a “reference price.”

Perceptions of price are relative. A bottle of wine can sell for a high price at a high-end restaurant, a different price at a low-end restaurant, and a low price still at a bargain retailer. The reference price, in context, affects what customers see as fair value.

If customers are used to paying $6/month for a suite of productivity apps and email, then it might be difficult to sell a related set of products for $16/month unless they are exceptionally valuable. Of course, the reference class—the collection of products the customer is choosing between— can vary wildly depending on context. As Harvard Business School’s Bharat Anand has pointed out, a necktie’s competitive space might include power tools… on Father’s Day.

People are loss averse—a dollar loss is more severe than a dollar gained.

Suppose a product is available for $100.

  • If the price is marked down from $110, you’ll be pleased and perceive it as a gain. Your reference price is $110, so getting it at $100 is a bargain.
  • If the price is marked up from $90, you’ll be displeased and perceive it as a loss because you know that you could have gotten it for $90.

Customers have diminishing sensitivity to changes in price.

Prospect theory suggests that:

  • People would rather win $50 twice than $100 once. The pleasure of winning dollars 1-50 twice greater than winning dollars 51-100 once.
  • People would rather lose $100 once than $50 twice. The pain of losing dollars 51-100 is less than losing dollars 1-50, twice.

Irrational? Yes. Useful? Extremely—it gives us a roadmap for how we can bundle gains and losses to make the customer as pleased as possible.

Using Prospect Theory to Increase Upfront Sales

Loss aversion, reference pricing, and diminishing sensitivity make upfront pricing a double-edged sword. The good news is that taking $120 from somebody can cause less pain than $10 12 times because you’re taking that first dollar fewer times. The other good news is that discounting for upfront payment allows you to set a high month-to-month reference price and discount it with your upfront pricing. The very bad news is that $120 is a lot more than $10—12x more—and a customer is going to scrutinize a $120 commitment more than a $10 one.

Use Semantic Framing to Control the Reference Price and Context

Shocker: Discounts make people happy, surcharges make people mad. If we are trying to motivate people to buy something upfront, it is more effective to position the upfront pricing as a gain, rather than month-to-month pricing as a penalty.

Suppose Dropbox sells services for $100/year paid upfront, or $10/month.

You could position this in either of two ways:

  • Pay 20% extra if you buy month-to-month
  • Save 17%—or 2 months free—if you prepay for 1 year

Unsurprisingly, customers are more motivated by the prospect of a discount than the prospect of a surcharge.

The threat of a surcharge is useful, too. If you have a limited-time discounting window, you might want to emphasize a looming increase in price to create urgency. If you are trying to sell early bird tickets to an event, it may be helpful to position the coming price change as a to create urgency of purchase.

Bundling and Unbundling Gains from Losses

If you are offering a basket of services—hardware, monthly service, premium support, paid apps, premium platform features, premium onboarding, upfront setup services, etc—there are opportunities to create urgent “closers” for sales and create upsell opportunities for the company.

Show Savings from Each Line Item

Suppose you offer a service at the following price points:

  • (Upfront) Hardware cost: $100
  • (Upfront) Installation, setup, onboarding, or other upfront charges: $50
  • (Recurring) Month-to-month SaaS: $30
  • (Recurring) Add-on monthly service: $30

Rather than offering one across-the-board discount, it looks more attractive if we discount these individually.

For example:

  • (Upfront) Hardware cost: ~$100~ $85
  • (Upfront) Installation, setup, onboarding, or other upfront charges: ~$100~ $50
  • (Recurring) Month-to-month SaaS: ~$30~ $25.99
  • (Recurring) Add-on monthly service: ~$30~ $13.95 for the first 2 months

Sell Add-ons Against “The Big Price”

If you’re about to buy a very expensive $20k car, it can seem like a no-brainer to add-on the $500 fancy nice-to-have featur. It is, after all, only 2.5% of the base purchase price of the car…right? That same $500 add-on purchased 2 months later might look like a much higher number—and a much tougher sell— without the $20k reference price next to it.

This insight creates opportunities for product marketers to sell add-on services at the moment of purchase. For example:

  • If you purchase design services right now, we’ll reduce the cost of design from $150 to $100.
  • If you purchase premium onboarding right now, we’ll reduce the cost from $100 to $75.

These are a great way to increase the urgency of sale.

Note that these are discounts, not surcharges. If you go the other way—“we’ll increase the cost by $25 next week”—it looks small compared to $20k.

Announce Price Changes with Quality or Feature Improvements

If you are adding a smaller charge—especially a recurring charge—it makes sense to bundle it with when users are getting a lot of value from your offering. Philo, a company I co-founded, recently introduced a rare and small price increase of $5/month. The (blog post)[] and accompanying press emphasized that:

  • Philo hadn’t raised their prices in three and a half years, unlike large and frequent increases by competitors, and
  • The new price increases come with a sharp increase in DVR functionality, making it a better value than ever.

You can choose from (this list of improvements)[].

Offer a Spoonful of Sugar: Discounts with Upfront Pricing

This is the “silver lining effect.” If you are about to take a large loss—for instance, an upfront price, or buying a larger number of devices, etc—it can be helpful to the customer if you find the “spoonful of sugar” to make the medicine go down.

Some examples:

  • Upfront discounting. Is there a way to add a “silver lining” to a high upfront cost?
  • The discounts mentioned above to design services and onboarding when you purchase the device?
  • Volume discounting. Volume discounting is discussed elsewhere. What if we give you 1 device free after the purchase of 3 or 4 devices?
  • Bundle discounting. If you choose enough add-on services, we may choose to bundle them for a discounted rate. For instance, if you get Visit, Music, and enterprise features, do we bundle those together for less money?

The “What does this dollar do for me?” Effect

Many of the ideas above involve either bundling or unbundling individual components. By bundling and unbundling these components, you need to actually assign value—and set new reference prices— for each component of your product. This is risky, but also creates opportunities.

Dropbox has had to sustain a price base despite rapidly falling cloud storage costs. As of this writing, Dropbox doesn’t offer add-on pure storage, and this may have to do with them not wanting to create references prices for their storage costs.

By contrast, Everlane uses price transparency to these ends. By showing customers how much they pay in cost and how much they take in markup for each product,

If a customer is contributing money towards each component, . A dollar going toward your local park is likely a more welcome contribution than a dollar generally allocated toward the government treasury—even if that dollar goes right back to the park.

Imagine that you are a startup offering early 5G Internet service to homes. Since your service is early, you need to distribute a $200 piece of 5G hardware to the home. Since you are cash-constrained, you want to find a way to get the customer to pay you upfront for the hardware.

Rather than an opaque upfront price, customers might be more willing to pay an upfront price if they understand that it’s a kind of passthrough price for the hardware. If customers understand why certain items are priced that way—especially upfront line-items—they’ll be better able to justify paying.

Hyperbolic Discounting - Get Started Today, Don’t Pay Until Tomorrow

Many people will take $100 today over $110 tomorrow. Those same people will take $110 in 6 months over $100 in 5 months. When 5 months go buy, they’ll take $100 immediately over $110 in a month. Aren’t people strange? This is called hyperbolic discounting.

Hyperbolic discounting is driven by immediate gratification, procrastination, and delusional optimism. All of these are failures of self-regulation.

Immediate gratification is the phenomenon in which people want the benefits now, and are willing to delay the costs needed to pay for these benefits until later. Tying upfront payments to immediate benefits—either in the form of discounts or added products—can help motivate upfront payment.

Procrastination is the phenomenon in which short-term costs are given undue saliency over long-term costs. If immediate gratification is “get it today,” procrastination is “pay tomorrow.”

Delusional optimism is the phenomenon in which decisions are made based on overconfidence, or a virtuous conscience. You buy a gym membership in January thinking you’ll go to the gym a lot. You buy a boat thinking you’ll be out on the water a lot.

Focusing on the benefits of commitment, or the virtuous aspects of your product (“think of how it will change your life, and be good for your community, and save money, and help the environment!”) can help trigger the overconfidence you need to make an upfront sale.

Tying It All Together

  1. Upfront pricing is an important cash flow tool for many businesses with recurring revenues.
  2. Upfront pricing is hard: people want all of the benefits today, and all of the costs tomorrow.
  3. Prospect theory gives us clues about how to make upfront pricing work.
  4. Semantic framing, context, and reference prices matters. Customers love discounts and hate surcharges.
  5. How you bundle and unbundle products can lead to big impacts on how those products are perceived. You can a. Unbundle gains. For instance, by giving many line-item discounts instead of a top-line discount. b. Bundle losses. For instance, by loading additional expenses onto the biggest bill c. Bundle small losses into larger gains. d. Bundle small gains into larger losses.
  6. If you unbundle, be prepared to answer “what does this dollar do for me?” Where possible, explain what each dollar does for the customer.
  7. Inspire overconfidence and offer something extra immediately. Immediate gratification, procrastination, and delusional optimism cause people to value benefits today and costs tomorrow.

  1. Ideas in this section borrow liberally from this paper.

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