What We Can Learn About Pricing From Menu Engineers

63 Comments

menu_engineerLet’s say that you’re an entrepreneur or general manager about to take a new product to market. How do you price it? Traditional economic theory tells us that the market clearing price is the point at which supply and demand meet, and that consumers always know the utility of any given purchase. So surely pricing your product shouldn’t be that hard, right?

Just as most of us must rely on relative pitch to discriminate amongst various tones, so too must the vast majority of consumers rely on relative price cues in order to determine what they’re willing to pay. What this means, according to behavioral economist Dan Ariely, is that the price of everything is “up in the air.” That’s where menu engineering comes in.

Gregg Rapp, Menu Engineer

Have you ever gone to a restaurant and found some ridiculously priced item on the menu? Of course you didn’t buy it — you’re no sucker. Or are you? This Today Show piece on Gregg Rapp may surprise you.

Rapp is a menu engineer. He helps restaurants maximize revenue by hacking common flaws in human decision-making. For example, by simply removing “$” signs from prices, people are less intimidated by them. And he advises against listing items from least to most expensive, because that focuses the consumer on price. Instead he mixes up items, making it hard to find their price — thereby encouraging the customer to emotionally commit to something before finding out what it costs. But my favorite strategy of his is that of putting some absurdly expensive item on the menu. Rapp doesn’t expect many consumers to buy it, but having it there makes expensive items appear cheap by comparison. Think about it: How many times have you ordered a bottle of wine in the middle of the price range?

Let’s give the strategy a try. We’ll assume that two companies are offering the same product to the same customer, but are using two different price lists to do so.

Company A: Silicon Valley Pricing Model

Widget — Basic : $10,000

Widget — Premium: $20,000

Company B: Menu Engineer Pricing Model

Widget — Silver: 10,000

Widget — Gold: 20,000

Widget — Platinum: 50,000

See the difference? My hunch is that most companies could increase revenue by simply adding a very high-end offering, even if they never sell a single one of those expensive units.

Arbitrary Coherence

Ariely also talks about something he calls arbitrary coherence. He argues that pricing is, at least at first, arbitrary — that we don’t all have some notion of “absolute price” when it comes to the utility we’ll get from every potential transaction. That’s the arbitrary side of his term. He goes on to argue that once we anchor ourselves to the price of something, our expectations with respect to price going forward is relative to our first impression — that’s the coherence bit.

In a seemingly absurd experiment, he showed that simply asking students if they would pay the last two digits of their Social Security number for various things significantly impacted what they were ultimately willing to pay for them:

“Did the digits from the Social Security numbers serve as anchors? Remarkably, they did: The students with the highest-ending Social Security digits bid highest, while those with the lowest-ending numbers bid lowest…. In the end, students with Social Security numbers ending in the upper 20 percent placed bids that were 216 to 346 percent higher than those of the students with Social Security numbers ending in the lowest 20 percent.”

This explains why having high MSRPs is so important. Conventional wisdom is that high list prices allow sales organizations to engage in price discrimination through discounting. There’s definitely some truth to this assumption, but there’s more to it than that. High list prices can actually increase perceived value — even in businesses in which the marginal cost of production is low.

Of all the levers a business has at its disposal, price is often the most powerful. The vast majority of revenue gains from higher prices result in profits (whereas selling more units often carries a commensurate increase in expenses). And the assumption that higher prices will erode loyalty or decrease demand is often just plain wrong. I’ve never seen a business that’s put too much thought into pricing, but I’ve met plenty that haven’t thought about it enough.

Mike Speiser is a Managing Director at Sutter Hill Ventures. His thoughts on technology, economics and entrepreneurship will appear at this time every week.

63 Comments

Sean R

Our firm’s currently helping a client do just this – price their menu. Your article is very timely, and I greatly appreciate your insight. I think this model, within reason, is somewhat genius – simple, but genius. Thanks for sharing as there is certainly proof in this pudding!

Rags Srinivasan

Mike
Nudging customers to pick a version that is most profitable to the marketer is a tactic – a fine tuning knob. There are several such tactics, based on behavioral economics, including prices that end in 9. But all these optimizations will still only result in sub-optimal profits if the marketing strategy is not done well. Marketing is about segmentation and targeting – finding the different customer segments, what they value and positioning versions that best appeal to them. For the restaurant case, the restaurant needs to decide the segment they want to bring in and what that segment values like ambiance, service, wine list, social status, etc.
Profit maximization requires the marketer to understand the core value proposition and what unique value they provide to their customers over alternatives. If a business fails to understand this, then any number of tactics applied will not help.

Rags Srinivasan

Steven Forth

Great metaphor. I know from my own experience how hard it is to price offerings as a start up. Note that “market clearing” prices are only relevant for traded commodities. If you are selling a traded commodity you are probably not a start up. The key to B2B pricing is differentiated value. I have a post on this at http://leveragepoint.typepad.com/leveragepoint_perspective/2009/09/what-do-we-mean-when-we-say-value.html
In my experience psychological factors (and your pricing strategy) determine how much of the differentated value you create you can reasonably claim.

Gregg Rapp

Thanks, Mike! I have notes from people all over the country from your article! You sure have a great reach! Yes, Dan Ariely’s book “Predictably Irrational” really goes into the concept of pricing and gives some great examples for many industries. I do agree to be honest with your customers and always give them a hug when they come into your restaurant! Trying to trick your customer will only loose you freinds and creditablilty. In my 27 years as a Menu Engineer I have found Restaurant People as great warm friendly business owners. I have fun with the high priced items, too! It can put a smile on the customers by coming up with crazy items and having some fun! Thanks again for the mention! Gregg Rapp, Menu Engineer, Palm Springs, CA

Mike Speiser

Thanks for the comment Gregg. And for the remarks about being honest with your customers. If you’re ever in Silicon Valley, please look me up. Would love to learn more about what you do.

mcmackin

Interesting insights.

The discussion at the end re: MSRPs spurred a couple of thoughts I think are worth exploring.

I believe there is a fine line between MSRP and street value. If the difference is too large, the MSRP is perceived as a dream price by the manufacturer. It indicates that there should have been a bit of market research to understand the true value to the consumer – regardless of price to produce. IF there is a significant difference between production price + acceptable markup and consumer value, perhaps the time is not right for the product. It is important to be able to walk away from those endeavors that don’t fit with today’s market environment.

The second thought, however, revolves around “Sale” pricing. I remember shopping with a group of friends, and picking up a kitchen gadget. We liked it, wanted it, but felt it was overpriced at $24. As we walked away, I began to wonder if we had appreciated its value more if it had been ticketed at $30, and on sale for 20% off (net $24 price.) I believe that the perceived value would have increased, in this case, because of the discount – but this too needs to be applied in moderation.

Retailers do have an initial markup, and a target markup at that they anticipate once sell-through is achieved. This would be regular price, plus any sale pricing, plus any liquidation/clearance pricing – until it is gone. If they start with a 50% initial markup, they may have a targeted markup of 40%, which allows for some reg price selling, some sale price selling, and some liquidation selling.

Great post – worth some consideration regarding pricing, as well as our own behaviors as consumers.

Tyler

How do restaurants/all businesses measure the success of a strategy like this?

scottwheaton

Great post.

Though the example should say:

Company A: Silicon Valley Pricing Model

Widget — Basic : Free

Widget — Premium: $20,000

I

RestaurantZoom

Great post but found the menu engineer to be particularly interesting. We have all seen menus with no dollar signs. Personally when I see no dollar signs, my reflex is to assume that the prices are going to be higher than the norm. It instantly puts me on guard and makes me price sensitive. Does anyone else feel this way?

Steve G.

I disagree, with regard to the wine-pricing idea. That assumes that the buyer doesn’t know the value of (or how to value) what they’re getting and that the buyer has a price-first mentality.

Mark B

Great post – this kind of good- better-best-“absurd” structure is second nature to marketers of consumer products. Just walk into any BestBuy to see what I mean. But it is often difficult to get B2B marketers to think this way. This is particularly true with technologists who often get started with a passion for a particular technology or solution and don’t want to see their efforts diluted and thus overlook the opportunity to serve low, medium, and high-value segments. Furthermore the idea of using a “staking horse” – an over-the-top-of-the-line product to create a halo and also frame other prices as being reasonable – is rarely employed

enchantedpeddler

My husband has been a chef for 20 years…and yes, in some ways you are right. Giving the customer an option is always good and doing it this way they feel like they have a deal. I still feel though that honest pricing and marketing is always the best.

Mark E

[Please post this edited version:]

I saw the MSRP bit in action. My girlfriend was shopping new cars to lease, and was comparing the Volvo S40 against the BMW 1-series. Ultimately she wanted the BMW, but she fixated on the MSRP, even though the lease price was probably less due to higher-than-average Volvo depreciation. Thus she ruled the BMW out as “too expensive,” even though she never compared the two cars based on her cost (not the MSRP). Given the theory, one might expect that the higher MSRP would have attracted the buyer and cinched the sale, who might have felt greater value given the lower lease cost, but in her case the higher MSRP worked against the BMW sale. She perceived a higher value good, perhaps, but her generally cautious nature prompted her to chose based on a mistaken notion of value (in my opinion).

tom

i have designed restaurant menus and priced many other types of products myself. the super high priced items seems to work best when everything else is in a medium to high price range already compared to competitors. i have not seen it help at all other than to create curiosity as to what could possibly make it worth so much if the business was primarily catering to a ‘value minded’ customer base who typically bought from the low end of the menu.

so while i can see in your example how you sell more $20,000 widgets, I also believe the sales upotake would be very minimal if there were also a $1000.00 widget on offer that dominated sales.

p.s the best example in the tech world of this sort of marketing is from apple. they price the highest capacity ipod ridiculously high considering the small cost of the additional storage and sell more mid range models as a result.

Cheese

A good article, but menu-engineering, as explained, works in certain contexts only, not all. For example, it fails in the context of “food courts” – a common, large dining area surrounded by a variety of restaurants, offering several different food options. In general, menu-engineering works (and works great!) when a customer is committed to your brand, but has not decided on the exact product (from within the range you have on offer).

However, when the customer is not committed to a brand yet, “real marketing” needs to step in, to entice the customer towards the brand in general or towards a specific product of the brand. Choosing a brand (including the restaurant) is probably a combination of rational and emotional thinking. Often, menu-engineering in such situations is still applicable, but needs to deal with it in other ways,and is part of the larger “marketeer’s pitch”.

Several companies follow menu-engineering with brand-loyals amongst the target. However, note that the “ridiculously expensive” item on the menu must still deliver value. It is the brand ambassador. It is the true differentiator of the company. It generates “valued” opinion and the company can not afford to ignore any small aspect of this product. At this point, menu-engineering dissolves into the ocean of brand marketing.

As

It’s called goldilocks pricing… the little one is too small, the big one is too big but the middle one looks just right.

macdad

That restaurant menu analogy has its flaws with those who read over a menu and order only an appetizer, realizing they can prepare a much more economical dinner at home in less than the wait time in the restaurant. Scottish!

What will be the death knell of some of these restaurants is the fact that even their appetizers are being so over-priced that we won’t return to them. And don’t even talk about the price of alcoholic drinks.

My mother-in-law would buy only brand names; she would not buy / shop at Sears. When Sears began carrying many various manufacturers’ brands, she really was in a quandary. Grocery stores have turned the tables – store brands are bought more often than the name brands.

If that new product can not fill a need because other products already exist that do much the same task, then there is no way I would buy a new product just because it is new, especially if it is at a premium.

Linda

How can I effectively apply these principals to my retail business? I sell handicrafts, southeast Asian antiques and jewellery. Often it seems that the higher the price, the more my goods are perceived as being better quality and more desirable, but then you run into the problem of affordability (versus desirability). I guess the answer is to set the price and then discount to close the sale?

macdad

Too large a discount and customers want to know what’s wrong with the product. Too small a discount and customers won’t consider the product because the discount isn’t enough of a decrease in the price. Another dilemma.

sfmitch

I think the folks at Microsoft were listening to this type of advice when they created Vista Ultimate.

The lesson here is that the expensive item ‘on the menu’ needs to deliver the goods not just be expensive.

Erick Herring

Great article, Mike. The Economist did a similar thing when they rolled out online access to their magazine – they had one price for online-only access and a second, higher price, for the print version. The “menu engineering” they engaged in was to have a print+online bundle at the same price as the print version. Predictably, they sold most of the bundle, thereby enabling online access without taking a huge hit. I wonder if it’s still working for them?

Jake Kaldenbaugh

Great post Mike but I’d add another behavioral behavior to the mix here: Studies have shown that people often use price as a cue to quality (of course Ariely has been involved in these as well). http://www.carlsonschool.umn.edu/Assets/71779.doc
In your example, I’m willing to bet that some companies will buy the Platinum version because of a corporate culture of being/investing in the best or out of fear that they’ll expose themselves to some future unknown risk by not getting the best.
However, all of these points to a trend that I believe is a negative for corporate innovation. I personally rather that most companies spend time on innovating and creating value. Menu engineering is not an activity that increases value, it is essentially a form of psychological manipulation. I’m actually a fan of Umair Haque in this regard in that types of “innovations” create “thin” value as opposed to “thick” value. http://blogs.harvardbusiness.org/haque/2009/07/the_value_every_business_needs.html While pricing manipulation can provide some hacks for optimizing a company’s potential cash flow, I believe that consumers will trend away from these companies in the long-run. As consumers become exhausted through this type of activity, they will revert to products that leave some of the pricing on the table to ensure the customer experiences value over time. I know that I personally seek alternatives to vendors that rely on manipulating the buying experience rather than delivering great product at a great price.

Mike Speiser

Great comments Jake. On innovation — I don’t think innovation suffers because of smart business moves. In fact, more cash flow can lead to more innovation (as Google demonstrates). Having said that, a company that innovates on business model alone is not interesting — which, I believe, is the risk that you are pointing out?

Jake Kaldenbaugh

If by business model you mean employing psychological and behavioral tricks to manipulate the buying process, then yes, I think innovations based on these types of advances promote hollow value for the consumer. I’d like to think that consumers see through this type of activity but the reality is that they are very successful tactics. I’ve often argued that the strongest secular trend at work in the market today is the decline in the average consumer’s critical thinking capabilities. And a true market approach argues that if it’s exploitable, it should be exploited. Hence, the housing bubble.
I believe that these types of strategies can be very effective at transferring wealth from consumer to producer, but they don’t provide much of a transfer of utilization value from producer to consumer. If this is the case, then I believe what happens is that at some point, consumption can become discontinuous. If the market sees a compelling new alternative, it quickly migrates away from the behaviorally engineered value towards the alternative with higher core value (i.e. CDs > iTunes).
I’m a believer that start-ups should focus on creating alternatives with much higher core value. Existing market leaders will rely on “menu engineering” to perpetuate their existence based on their inability to perform real innovation. As a VC, I would think you could use these tactics to help you find good start-ups but probably not in the way you imply: it seems to me that industries where market leaders are relying on “menu engineering” will be the areas that are ripe for start-up disruption!

Mike Speiser

You made an impassioned argument, but I don’t think you addressed my point. Because a restaurant takes the “$” off the menu doesn’t mean the food sucks.

Stephen Webb

Excellent point, Jake, and I tend to agree with you. However, there’s a fine line between strategy and manipulation. Consumers may eventually get tired of these specific activities, but the underlying principles will guide all future activities.

Linda

This is what I call “cargo cult” mentality. I see a lot of it in third world countries where I do my stock buying. The idea is that if you produce a cardboard cutout of a product or service, you can then charge a huge amount of money for the concept of it…without necessarily having to produce the goods. This sort of thinking works quite well in industries like tourism and hospitality where there is a high turnover of one-time-only customers

Glen Campbell

I recall reading (years ago) that Sears used this principle since the early 20th century. For each product, they had a Good, Better, Best option. About 10% of sales are in the “Good,” and about 5% were in “Best,” with all the remainder at “Better.”

Indus Khaitan

Good analogy.

Would also point to ‘ladder pricing’ where each new step on the ladder gives you an additional relevant feature for a few dollars (or it’s multiple) more. Hosting providers & a lot of SAAS vendors use this technique where people tend to use the last step which has everything for a “slightly” more price than the previous one.

Cheers!

Mike Speiser

Thanks Indus. You make a great point. This is a function rich with opportunity. Yet companies with 4000 software engineers and 1000 sales professionals often have <1 person working on pricing. Crazy, really…

Thanks again for a great comment.

S.Meinardi

Yeah, from both “Predictably irrational” by Dan Ariely and “The science of fear” by Daniel Gardner

Mike Speiser

Thanks. Was at the Left Bank Brasserie last night and noticed that they followed all of the rules… Oracle has also managed to put these ideas to work for years in enterprise software…

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