Loss Aversion and Why Owners Will Not Raise Prices

Why this matters

Most shop owners who are underpriced know it. They have watched parts and wages climb for three years, and they still do not move the price, because every time they picture the increase they picture the customers who will leave. That picture is not a forecast. It is a well-documented quirk of how people weigh losses, and it makes a price increase feel roughly twice as dangerous as it is. The fix is arithmetic you can do on the back of an invoice: how many customers you could lose before the increase stops paying, and how many you actually tend to lose.

The idea, and where it comes from

Loss aversion is the finding that a loss of a given size feels worse than a gain of the same size feels good. Daniel Kahneman and Amos Tversky built it into prospect theory in 1979, and their 1992 follow-up estimated the ratio at a little over two: losing something hurts about twice as much as gaining the same thing pleases. The ratio varies by person and situation, and later work has argued it is smaller for routine, low-stakes amounts, but the direction holds up well, and it holds most strongly when the thing at risk is something you already have.

A customer list is exactly that. The customers who might leave are names you know. The extra margin from the ones who stay is an abstraction spread across a year of invoices. So the decision is lopsided before any numbers are run:

• The loss is concrete and attributable. A customer who leaves after an increase often tells you why, sometimes loudly.
• The gain is diffuse and silent. Nobody calls to say they noticed the new price and are staying anyway.
• The status quo carries no visible cost. Being underpriced costs you every day, but it never shows up as an event. See related: Status Quo Bias With Software and Suppliers.

That combination is why owners who are comfortable making a high-stakes diagnosis on a roof or in a panel will sit on a price for years.

The arithmetic: how many customers you can afford to lose

Start from gross margin, the share of each sale left after direct costs (tech labor, parts, materials). Call it m, as a fraction of the old price. Raise the price by p, as a fraction of the old price. Your direct costs do not change because the price went up, so the whole increase lands in margin: each job now earns m + p where it used to earn m.

To keep total gross profit the same, the volume you keep has to satisfy:

kept share = m / (m + p), so the share you can lose and break even = p / (m + p).

The base here is job volume, and it assumes the customers who leave are average-sized. If they are your smallest or most discounted accounts, you can lose more than this; if they are your biggest, less.

Read across a row and the point lands: at a 40 percent gross margin, an 8 percent increase still breaks even if you lose one customer job in six. Very few owners believe an 8 percent increase will cost them one in six. Their fear is closer to one in twenty, and at one in twenty the increase is clearly profitable. The fear is real, and it is still smaller than the room the arithmetic gives.

The counterintuitive column. Read down instead. The lower your margin, the more customers you can lose. At 30 percent margin a 10 percent increase survives losing a quarter of your volume; at 50 percent it survives a sixth. The shops that are thinnest, and so most frightened, are the ones a price increase helps most, because each point of price is a bigger share of what they keep.

Worked example: a maintenance-agreement renewal

A residential HVAC shop carries about 1,000 maintenance agreements and renews them annually. Gross margin on agreement revenue, after the tech time and materials for the visits, is 48 percent. The owner has not changed the agreement price in three years and is weighing a 7 percent increase at renewal.

His fear, stated as a number. Asked to put a figure on it, he says "a tenth of them will walk," meaning a tenth of the book on top of the people who leave every year anyway. That is the loss-aversion picture talking, but write it down anyway, because you will check it later.

Break-even loss. p / (m + p) = 0.07 / 0.55 = 12.7 percent of whatever volume would otherwise have stayed. So even his fearful guess of an extra tenth of the book leaves the increase ahead. That alone usually unsticks the decision.

What actually happened. The shop's normal non-renewal rate, from the previous two years, runs about 9 percent: people move, replace equipment with another company's, or simply let it lapse. After the 7 percent increase, non-renewal came in at 11.5 percent. So the increase cost roughly 2.5 extra points of the book, about 25 agreements, not the 100 he feared.

Gross profit, indexed so the old price per agreement is 1.

• Without the increase: 91 percent of agreements renew, each earning 0.48. Index: 91 x 0.48 = 43.7.
• With the increase: 88.5 percent renew, each earning 0.48 + 0.07 = 0.55. Index: 88.5 x 0.55 = 48.7.
• 48.7 against 43.7 is a rise of about 11.4 percent in agreement gross profit, from a 7 percent price change, after paying for every customer it cost.

The comparison is like for like: both lines are renewing agreements times margin per agreement, at the same starting book, in the same year. The baseline churn sits in both, which is why the extra loss is 2.5 points and not 11.5.

What his fear would have had to be for this to fail. Break-even means keeping 43.7 / 0.55 = 79.4 percent of the book, so extra churn of more than about 11.6 points on top of the normal 9 (that is 12.7 percent of the 91 percent who would have renewed anyway), meaning more than a fifth of the book walking in total. Nothing in the shop's history, or in anything he had heard from other owners, suggested a 7 percent change does that to a renewing book.

How to say it so fewer people leave

A share of the customers who leave after an increase are leaving because of how they heard about it rather than the size of it. A short notice ahead of renewal, a plain reason, and an office that does not apologize do most of the work. When a customer calls about it, the exchange that keeps them sounds roughly like this:

CUSTOMER: I see the plan went up. Why?
OFFICE:   Parts and wages are up, and we held the
          price three years. This keeps the same
          two visits and the same priority line.
CUSTOMER: The other guys advertise cheaper.
OFFICE:   They might be. Ours includes the
          priority booking you used in July.
          Want me to keep you on for this year?
CUSTOMER: ...Yeah, fine. Keep it.

Notice what the office does not do: offer a discount on the spot, explain the shop's finances, or say "sorry." A discount on request teaches every renewing customer that the new price is a starting bid, and an apology frames the increase as a wrong the customer is entitled to have corrected. See related: Anchoring: Present the High Option First, for how the order of options changes what a price feels like.

What changes the answer

The break-even formula is honest only when its assumptions hold. Four conditions bend it:

• The customers most likely to leave are not average. In most books, the customers who leave over a modest increase skew toward the ones who already booked on a coupon or argue every invoice. Losing them costs less than the formula assumes, and sometimes frees a slot for a better customer. If instead your price-sensitive segment is a handful of large commercial accounts, the formula overstates how many you can lose, because one of them is worth dozens of average jobs. Run the arithmetic on revenue share, not customer count, in that case.
• You are capacity-limited. If your schedule is full three weeks out, a lost job is not lost volume, it is a slot the next caller fills at the new price. The real cost of churn is then much lower than the table shows.
• The price is a bid, not a list price. On competitively bid work (new construction, property-management contracts), each job's win rate responds sharply to price, and the "customer" is a different one every time. The renewal arithmetic above does not transfer; you need your own win-rate history at different price points. See related: The Expected Value Habit.
• The contract governs the change. Agreements that auto-renew may carry their own notice terms for a price change, and some states regulate automatic renewals directly. California's automatic renewal law (Business and Professions Code section 17600 and following) is among the strictest and requires clear notice of a material change in terms before it takes effect, while other states have narrower rules or none. Read your own agreement's price clause first, and if you auto-renew customers in more than one state, have an attorney look at the notice before it goes out. This is not legal advice.

The failure mode

The failure is not usually a price increase that goes badly. It is the increase that never happens, compounded. A shop that holds price for three years while its direct costs rise 4 percent a year watches those costs climb about 12.5 percent, and its gross margin falls from 48 percent to about 41.5 percent without a single customer leaving. Nobody notices, because no event marks it, which is the same asymmetry that made the increase feel dangerous. The second failure is the panic increase: after years of waiting, a 20 percent jump all at once, which does cause the churn the owner feared and confirms the fear for the next cycle.

The habit that prevents both is a standing review date, once a year, when the owner writes down the break-even churn for a proposed increase next to his honest guess of actual churn, and then records what happened. Two cycles of that record usually retire the fear. See related: Keeping a Decision Journal.

References

• Kahneman, D. and Tversky, A., "Prospect Theory: An Analysis of Decision under Risk," Econometrica, 1979
• Tversky, A. and Kahneman, D., "Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, 1992 (the roughly two-to-one loss aversion estimate)
• California Business and Professions Code section 17600 and following (automatic renewal law)
• See related: Status Quo Bias With Software and Suppliers; Anchoring: Present the High Option First; Keeping a Decision Journal