What Is Strategic Pricing For New Products?
There are 3 outcomes when determining how to price a product and set a pricing strategy for a new innovation:
- Too High
- Too Low
- Just Right
If the price is too high, you simply then bring down the price until you hit your target. If the price is too low, you are left with a fixed (anchored) value position than can be next to impossible to increase, leaving significant revenue, profits, and value on the table for your competitors to swoop up with competition sales. Two notable examples of products that were significantly underpriced are:
- 2017 Paw Patrol My Size Lookout Tower: This was 2017’s hot new toy item for toddlers. The Paw Patrol tower toy's retail price was $99.99, however, prices in the resale market staggered up to $250.
- 2006 Audi Q7 Launch: Gasoline prices were high, and Audi decided to play it safe with a price of €55,000. Short stocked inventory analysis determined that the optimal price should have been €58,000 leaving which left €210M on the table.
Like Audi, unfortunately, up to 90% of innovative products are not strategically priced, and therefore have too low of a price point to achieve a return on the product.
The five steps below outline a simplified process to develop an optimal innovation pricing strategy.
1. Set a Price Range For Your New Product
Chances are that you will not get the right price immediately; as such, it is best to first establish a range (the highest and lowest price) and continually narrow the range until you reach an optimal price point. This approach mitigates the risk in pricing below the optimal price. A 1% pricing below the optimal can result in up to 10% of potential loss in profit!
A. Lowest Price
This is the “cost-plus pricing approach”, which is typically driven by finance and is how 98% of companies price. To be successful, companies must have a deep understanding of the unit cost of their new product. Companies typically ignore spreading R&D costs and any additional resources needed once production has begun. Companies that are good at using a cost-plus model will also bake in any anticipated discounts in product pricing.
B. Highest Price
This method is all about value. You may be wondering, "what is value-based pricing?"
Here, value can be determined in two ways:
When a purchase decision is based on a purely financial basis (emotional customer inputs are not a factor) companies should employ financial value. For example, if your product will last twice as long as its closest competitor, then the consumer will be willing to pay up to twice the competitor’s price. Companies can quantify the financial value of their products with metrics such as longer life, maintenance cost savings and conversion costs. Manufacturing companies have significant opportunities to practise financial value pricing for example:
- Tire Repair – A certain manufacturer demonstrated that their tire repair product reduced the number of times a tire becomes flat. They calculated the costs associated with downtime of a flat tire (i.e. number of workers idled, cost of replacement time and production lost). They showed that their product saved $1,000 per tire, while their product was priced at $100 per tire. On a pure cost basis, the foam used to fill the tires could not be more than 10% of this price.
Here the difficulty is in quantifying customer perceived value your product and its value attributes compared to the competition. Start by identifying the value attributes that consumers will consider when purchasing your product. Although a product/company may have upwards of 9 or 10 attributes, a consumer typically considers only 3 or 4 when making a purchase decision. To quantify how the consumer value these attributes, the best route is using external research, as internal conceptions can significantly skew results. Tools that can quantify attributes include max diff analysis, conjoint and mapping. Airlines are experts on pricing based on value:
- Direct Flights: Direct flights are more expensive than a connection. The value-add here is the time saved and the simplicity of your travel experience.
- First Class: There is a significant value add perks when travelling upfront (free drinks, more bags, larger seats, lounge access, meals, etc.). Airlines capture the opportunity by pricing for the perceived value.
Know your consumers:
What is the trade-off between value and price your consumers are willing to afford? This is about knowing your consumers’ price sensitivity and how much they are willing to pay for your value attributes. The output of this step is a relationship (trendline) between the price and value of your consumers, known as the fair value line. It is important to note that the fair value line can differ between consumer segments; as a result, you must correctly identify your segment and price accordingly.
Your value-based price is where your value (perceived or financial) crosses the fair value line. To price an innovation, determine the perceived or financial value of the product/service and see where that value crosses the fair value line. Items to the right of the fair value line are value advantaged (the consumer receives more value than their expected price); whereas items to the left are value disadvantaged (consumer receives less value for their expected price).
2. Know your New Product's Environment
While the previous section focused on creating a price range internally based on the new product, this section aims to look externally to narrowing your range. Apart from knowing macro factors such as the state of the economy and consumer trends (these should be considered during the development phase!), knowing your environment is all about your competition.
Know Your Competition
Companies have difficulty understanding what other products are considered when consumers are making a purchase decision involving their offering. If a product is not in the consumer's mindset, it is not a competitor! Once you have assessed your competitive risk, capturing prices and their value attributes (same process described in the perceived value section) will allow you to favourably compare your offering versus competition.
3. Set Your New Product's Objectives
What do you want to get out of your new product? The answer may not seem as straightforward as “make as much money as possible”. Some firms may use a new product to:
- Gain market share
- Disrupt the market with a low price to create demand (a price war)
- Diversify its offering to become less dependent on a core product
- Establish a new type of offer (i.e. a luxury or no-frills business unit)
Once you know the goal of your new price, you can then continue with the appropriate pricing strategy for your new product.
Plot competition’s price and value offering to determine the consumer choice. Afterwards adjust your price such that you are the furthest from to the fair value line, such that you will be the consumer choice. Once you release your price, that will become the reference/anchor of your product. Additionally, the following should be considered:
Reaction from Competition
Since value attributes cannot quickly be matched (if at all), the competition will lower prices instead. It is important to focus on value and avoid competing solely on price.
Introductory offers or trials may offer methods to test your consumer's price sensitivity or how they value your attributes versus competition.
How will this offering affect other products in your portfolio?
Product Life Cycle
Matching pricing to product life cycle will ensure monies are not left on the table.
4. Evaluate Your New Product's Pricing Strategy
It is important to monitor and update key assumptions made when initially pricing the new product. The timing here is key and, as a rule of thumb, one should gather at least 12 months (a full business cycle) of data to accurately evaluate a new product pricing.
A significant amount of resources is placed on developing a new product. However, and ironically, not enough time is spent on strategically pricing a new product.
Use the above and incorporate it as a guide in pricing your new product to ensure you are adequately compensated for the value conveyed to the customer.
ABOUT THE AUTHOR Avy Punwasee is a Partner at Revenue Management Labs. Revenue Management Labs help companies develop and execute practical solutions to maximize long-term revenue and profitability. Connect with Michael at [email protected]