How to increase your margins using delayed repayments

Discover how hyperbolic discounting could enable you to charge 50% more for your products or services with “buy now, pay later”

Hyperbolic discounting, discovered by psychologists in the 1960s and examined in economics research in the 1980s, says that people put much less value on money in the future than in the present.

Of course this is part of how we all manage our finances – £100 this month is worth about £105 this time next year, if interest rates are 5%. But when you bring the payment forward right into the present moment – as most retail purchases do – the effect is much stronger than that.

Paying tomorrow for what you get today

Essentially there is a resistance to spending money – and a corresponding desire to gain money – in the present moment, which is much stronger than the normal interest rate effect.

If someone offers me £100 next week, or £110 in two weeks, I will almost certainly prefer the £110 in two weeks. It’s 10% more and I only have to wait an extra week to get it – that’s quite logical. I quite rightly believe that 10% is a very generous interest rate for waiting a whole week.

But if they offer me a choice between £100 right now and £110 in one week, my decision changes. Suddenly 10% doesn’t seem such a good compensation for waiting a week. The impulse of getting money now versus the uncertainty of what might happen between now and then makes me more likely to choose the £100 today.

The exact amounts, the lengths of time and the interest rates all vary. But this technique works effectively across many different consumer products and industries. It’s all about deferring payment while offering the benefit of the product today.

Offering your consumers or clients credit

Furniture shops are famous for this. Not only do they win customers who would otherwise not buy at all with their interest-free credit deals, but they get people to spend a lot more than they otherwise would. There’s even some rational logic to this – I get the benefit of a sofa over its lifetime, so why not pay for it over at least part of that timescale? But the effect isn’t really about rationality. It’s about deferring the pain of payment. For £899 out of my pocket, I can probably live with the old sofa for a bit longer. But for £38 a month over three years – with the payments not even starting for two months – why not indulge in a bit of luxury now? After all, it’s been a hard week and I’d just love to sink into that new sofa with its fresh smell while I load up a DVD and a glass of wine.

This method can be applied to any industry, for example if you sell a service to small businesses. Many of them are always short of cash – and may indeed be into their overdraft. Offering payment terms or credit is a good way to get people to buy now despite their uncertainty about paying next month’s wages.

If you sell to consumers, any way you can get them to commit to buying a high volume without having to pay for it up front is likely to increase volumes and reduce price sensitivity.

Making the idea of payment less tangible

Another effect contributes to this: the idea of psychological distance. Psychological distance applies to any object, or decision, or experience that you think of in a way displaced from your current experience. This distance could be in time, if you are thinking of something that will happen in the future. It could be in space, if you think of something that is happening far away. Or it could be conceptual distance – an experience that is more abstract or vague, less concrete.

All of these kinds of distance make the idea of payment less tangible, while the benefits do not diminish correspondingly. The cost–benefit trade-off is changed, and people become willing to pay a higher cost for the same benefit.

There are risks to delayed payment, of course: some clients may fail to pay the bill, or at least part of it, and others may cancel their subscription soon after taking it out. Depending on the details of what you do, you may legally have to offer a cooling-off period of a week or two (allowing people to cancel the payment plan if they change their minds – though of course in this case they must also return the product). For certain things you might also need a consumer credit licence, though this would be unusual if you sell to businesses. Worth checking with a lawyer – and don’t let them make you pay up front!

All these costs are probably worthwhile, though. Experiments and informal experience indicate that some consumers will pay up to 50% more for a product if they can pay for it later rather than handing over the cash now. That’s a huge extra margin you can access with a simple change of timing.

How to apply hyperbolic discounting to your business

Consider the time period over which your customers will use your product.

If you have a one-off purchase, if the consumer buys and uses your product immediately, then it is hard to use this technique. But if they are buying it to use in the future, or if they are going to make repeat purchases, or if they are buying something whose benefits they will experience over a long period, then you have a good opportunity to use this approach.

Draw a chart like this, graphing benefit received from your product against time.

GraphMark the horizontal axis according to an appropriate time period and highlight the key benefits or values of your product on the vertical axis. Many products will have an initial period of high value, followed by a gradual slow decline of value over time. Imagine when you first get a new car, or move into a house – you will have a surge of pleasure and novelty over the first weeks or months, and once you get used to it this will decline. After a while the value becomes fairly steady, though over a long period the value reduces as the car or house becomes older – the bumpers get scratched or the boiler starts to make funny noises when it starts up.

Work out how you can link what the customer pays to the benefit they get. And once the value declines below a certain level, think about how you can offer them something new – a new car, an extension to the house, or a different flavour of tea – to restore that surge of initial value they once had, and get them to pay you again.

The Psychology of Price: How to use price to increase demand, profit and customer satisfaction, published by Crimson Publishing is available on Amazon now.

Comments

(will not be published)