Increasing profit through upgrades

In the beginning, there was Dell.  Dell was the pinnacle of what you strived for as an eCommerce site.  Dell had it all and we all copied them.  They had one of the most progressive eCommerce sites in the world and pushed concepts further like configuring, setting pricing based on future supply contracts, gigabuys for accessories, and an outlet store.  One of the things Dell pioneered was gap pricing.  It may sound intuitive now, but it wasn’t back then.  Early on, Dell figured out that if you showed the customer the actual price of the upgrade, they’d balk, but if you displayed it as an incremental price, they were more apt to buy.  In high tech, we dubbed this ‘gap pricing’ which means the practice of dynamically pricing upgrades based on the differential price between your current configuration and a configuration with the new selection.

The math behind gap pricing is straightforward, but cumbersome.  The foundation of gap pricing is the ability to dynamically price a configured system.  This is done by summing the prices of the components in the product.  For example, if you have a computer that includes the following components:

  • Processor
  • Memory
  • Hard drive
  • Optical drive

The first step is to provide a base price for the system.  Let’s call it System X.  Next, you would need to assign a price to each of the possible selections.  Taking it further, let’s say the component types had the following selections available:

Component Option Price
Processor Gen1 $50
Gen2 $75
Memory 8GB $100
16GB $150
Hard drive 500GB $100
1TB $200
Optical drive DVD $25
BlueRay $50

 

And System X has a base price of $500.

Now, you have the foundation for pricing the system.  Consider you start with a basic configuration of System X plus Gen1, 8GB memory, 500GB hard drive, and a DVD.  The price of the system would be $500 + $50 + $100 + $100 + $25 = $675.

Now, the gap price on the following components is:

Component Option Gap Price
Processor Gen2 $25
Memory 16GB $50
Hard drive 1TB $100
Optical drive BlueRay $25

 

This is what you would show the customer and they are much more likely to upgrade to a Gen2 processor if it is only $25 more rather than accepting the true cost of $75.

Once you have this foundation, you can start building other starting points for customers to buy.  For example, you could have System X plus Gen2, 8GB memory, 1TB hard drive, and a DVD.  This mid range system would cost $800 and finally you have the high end system with System X plus Gen2, 16GB memory, 1TB hard drive, and a BlueRay priced at $875.

With this, you would have your good, better, and best systems and it’s time to start merchandising them.  Say you are running a promotion and would like to discount the Basic system.  You do this by assigning a discount of $50 off on the Base price of System X.  So, the new price of System X is $500 – $50 = $450 and all the upgrade pricing is preserved.  But now the total price is displayed as ‘Starting at $625’.

Component Option Base Price Discount Price
System X Base Price $500 $50 $450
Processor Gen1 $50 $50
Memory 8GB $100 $100
Hard drive 500GB $100 $100
Optical drive DVD $25 $25
Total $625

 

Many sites price like this and show the list price as $675 and a savings of $50 for your price of $625.  The Your Savings is key because there is a sense of urgency to purchase since there is the possibility that the discount will go away at some point.  Additionally, customers will go through their own ‘What If’ analysis to determine the best product for the price by comparing different configured systems to each other.  Maybe there’s a $50 discount on the Best computer, but not on the Better computer and it convinces the customer to buy the Best computer which ultimately costs the customer an additional $25 and it’s a little more than they needed, but its only $25 more!

Why is this important?  Because upgrades are where the profit is!  The incremental cost of components like a hard drive is negligible, and if you can entice the customer to buy the larger hard drive your profit grows significantly.  For example, say the cost of the system is the following:

Component Option Price Cost Profit
System X Base Price $500 $450 $50
Processor Gen1 $50 $15 $35
Gen2 $75 $30 $45
Memory 8GB $100 $50 $50
16GB $150 $80 $70
Hard drive 500GB $100 $50 $50
1TB $200 $60 $140
Optical drive DVD $25 $15 $10
BlueRay $50 $40 $10

 

In this scenario, you can see that a processor upgrade provides a profit bump of $10, a memory upgrade is $20, hard drive is $90, and optical drive is $0.  The biggest bang for the buck is to have them upgrade the hard drive.  Given this, a discount on the hard drive of $50 would still yield a profit of $40.  You could do it as a system discount of $50 or a $50 discount on the individual hard drive.  In either scenario, you’re securing $40 more in profit.

One caveat, when you set the good, better, best configurations, you don’t want to allow the customer to downgrade from the initial configuration.  The reason is twofold, once you start offering discounts to the gap price, you could be losing profit on downgrades and if you have a certain profit target on the machine based on the cost of the components you could drive yourself into unprofitable territory if you allow customers to remove the parts that brought you the profit in the first place.

The ideas Dell pioneered in the early days of eCommerce are still with us today and gap pricing is one of the more powerful concepts that help companies increase their profit per order.  Even if you aren’t in high tech, these concepts can be applied to any customizable or semi customizable product offering whether its upgraded service offerings, packaging options, or add-on accessories.

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