Pricing Innovative
Products and Services
By
Dennis E. Brown
Atenga Inc.
January 2007
Profits are lost when new products are priced incorrectly. Strategic pricing techniques, adapted to
the special requirements of innovative products and services, will spell the difference between
success and failure. As 80% of new product introductions fail, nothing could be more important.
1 Introduction
New product introductions are the most important and risky activity of any growing business.
Blockbusters such as RIM’s Blackberry and Apple’s iPod will redefine markets and companies for
years to come. The first company to recognize a new marketplace, a new value proposition, and
to fill it can earn outsized profits and build substantial competitive advantages, which can last for
years. This is not only valid for consumer goods companies. Websense, the first company to
recognize the need for Internet security filtering, has grown to a $200 million company with gross
margins in excess of 92%, selling its products to corporations all over the world. In high tech
companies, new products introduced in the prior 18 months often contribute more than half of
current revenues.
Given the importance of new products to companies’ success, the lack of attention paid to
pricing is shocking. In many cases, pricing is a more of a determinant of corporate success than
product design, cost control or even sales volume. Yet most companies focus on these three and
pay minimal attention to pricing.
Even when they focus on pricing, many companies fail to
optimize it. In this failure, they forego funds that could be used to educate new customers, improve
the product, or provide incentives for dealer channels. According to the research company AMR,
23% of new product failures involved failures in pricing.
But there are success stories as well. Many companies follow a disciplined process that flawlessly
introduces new products, prices them optimally and earns them outsized returns. This paper will
describe that process, and how it differs from price optimization for existing or competitive
products and services.
2 Value Optimized Pricing
Managers rarely discuss pricing with enthusiasm. Pricing is often the center of strained relations with
good customers. Competitors use pricing to steal market share. Within the company, product
managers, financial managers and customer-contact managers clash over the structures and
levels of prices.
Many companies have given up. Managers declare that “We know our costs, and we take our
industry’s traditional margins.” Or, they say, “We know our customers and we know what they will
pay,” skipping the all-important data collection step altogether. One commentator has called this
approach “winging it.” These managers may talk to a few salespeople and a few customers and
get some feedback to justify their decisions. But they fail to research adequately the customers’
perception of the new value proposition or their features and attributes.
Some companies think about pricing differently. They have discovered the highly leveraged effect
of pricing on their business success, and they have built the capacity to practice pricing in a way
that transforms the bottom line.
A process called Value Optimized Pricing turns price strategy into a formidable instrument for
growth and competition. Companies using this process perform extensive, focused market
research of a particular kind before setting their pricing strategy. They manage their price structure
aggressively. The price structure is the focus of their ongoing activity to serve their most profitable
customers. Value Optimized Pricing enables companies to define service levels and bundles of
products and services targeted to well-defined specific markets. Value Optimized Pricing provides
ongoing efficiencies in product development, marketing, sales and operations. Value Optimized
Pricing aligns your company’s offerings with the perceptions of value of your prospects and
customers. Value Optimized Pricing is also a framework for managing your relations with customers
and with competitors.
186 managers around the world (57 from the United States) responded to a survey in which they
rated the severity of their various problems. As can be seen in Figure 1, below, pricing decisively
topped the list, and pricing in the business-to-business sector was even more problematic.
Figure 1
Managers’ Rating of Marketing Issues
Advertising
Enviroment
After Sales Problems
Distribution Probelems
Internal Staffing/Traning
Market Saturation
Governement Regulations
New Competition
Selling Cost
Product Quality/Warranty
Product Differentiation
New Product Introduction
Price: Services
Price: Consumer Goods
Price: Industrial Goods
Price - Overall
0
1.125
2.250
Problem Pressure
3.375
4.500
3 Pricing Successes
Consider the following three scenarios:
A manufacturer of specialized wiring harnesses priced his new model at $150. This was a
replacement product, designed to obsolete its predecessor. It substantially simplifies the
connection of a particular broadcast camera to a particular video capture device. Instead of
using a rat’s nest of wires and confusing plugs, the new harness was a simple bundle with a
diagram of the camera’s socket configuration printed on its jacket. It clearly labeled which plugs
went into which sockets. The company’s normal cost-plus formula would have priced it only
$137.50. Raising the price to $150.00 created a mirror for the attributes of simplicity and usability
that the company wants to communicate. Surveys showed that the $150.00 price would be wellaccepted by the users. At 10,000 units sold the first year, the results are shown in the table below:
Price at $137.50
Price at $150.00
Units
10,000
10,000
Revenue
1,3750,000
1,500,000
Cost
1,100,000
1,100,000
Profit
275,000
400,000
Difference
125,000
The simple 9% difference in price realization drove a 45% improvement in profits!
A drug manufacturer introduced a new ulcer medication after the market incumbent was
already established. This was an enhancement product. Conventional wisdom said that as a late
entrant, the drug should be priced at least 10% below the incumbent’s price. But surveys showed
that doctors were concerned about drug interactions and side effects, and the dosing of the new
product was more convenient. So the attributes of the product enabled the company to charge
more for it, and the product was released at a premium price over that of the incumbent. The
pricing became a way to communicate the product’s superior attributes in the marketplace, an
active part of the marketing mix. The product became the volume leader in its category.
An industrial chemical is successfully marketed at a price fully ten times that of competitive
products in its marketplace. By surveying the market, they were able to identify a market segment
which is not price sensitive. This was a breakthrough product, offering a value proposition never
before available. They guaranteed elimination (not just control) of the problem they focused their
marketing and sales efforts on this particularly quality-sensitive segment of the market and gave
them what they wanted. Recognizing the superior value provided to this chosen segment, the
company let that guide their price. This enabled the firm to train and compensate service
technicians in a way that allowed them to deliver on the promised level of service. Thus the
customer’s value perception drove the price, which in turn funded the activities necessary to
provide the value.
These three success stories have several elements in common. First, the companies went beyond
mere cost-plus and competitive analysis. They used their cost data to establish a floor for their
prices. Then, by surveying their customers, they successfully looked beyond their cost data, and
segmented their markets based on each market segment’s willingness to pay. Furthermore, the first
company used price to communicate a very distinct message. The firm reinforced the price with
other renditions of the same message in their product descriptions and marketing, and in the
guidance they gave their sales force.
The result was a business success, as they went on to
dominate their marketplace. The second company surveyed their marketplace and understood at
a profound level what was important to their customers and what they would pay for it. Again,
they went on to dominate their market. The third company was able to define and isolate the most
profitable portion of their marketplace. Once they had done so, they configured the entire
company to serve only that portion, and they were able to dominate it. They denied the richest
profits to their competitors and captured them for themselves.
4 Pricing Challenges
If the rewards of doing a good job in pricing are so rich, what stops most companies from
optimizing their pricing structures? The answer is that pricing has become much more difficult over
the past few years, because: a) The mantra for the business community over the last 25 years, at
least, has all been about decreasing costs and improving operational efficiency, b) Products have
become interdependent, and c) Customers have access to more information.
4.1
The mantra
On the Forbes list of the 20 most influential business books 1981-2000 there are only two books that
even mention pricing as a strategic method for improved business results. Of these two, only one
describes to how to achieve optimal pricing. Many tell you to “listen to the customer,” but only one
relates that to pricing. Is there then any wonder why most businesses fail leverage the power of
strategic pricing?
4.2
Products have become interdependent
Single products have proliferated into product “lines” with nuances designed to appeal to different
marketplace segments. This is called “horizontal proliferation.” Marketing literature today endlessly
emphasizes the “marketplace of one,” the idea that ever-smaller market segments exist to be
served with ever-more-specific messages and services. But vendors need to provide these different
market segments with more than just different messages and services. Vendors need to provide
customers with pricing structures aligned with their perceptions of value as well, and vendors need
to build “fences” around each market segment. The fences prevent customers in a premium
marketplace from purchasing lower-priced renditions of the products. The same product sold in
multiple marketplaces is another level of interdependence.
A second level of interdependence is the reliance of one product on another. The sale of ink-jet
printers is one example of this. The sale of cartridges is so profitable that in many cases a price of
zero for the printer can be justified. A second example is the sale of highly profitable services
around a software product. The expectation of future service revenues must be considered when
pricing the base software product. The opposite is also true; many companies discount their
services in order to insure the successful sale and implementation of the core product. A third
example is medical diagnostic equipment, where some companies give away the equipment in
return for the revenue from the purchase of supplies. In all of the cases above, the profits of the
product line must be viewed as a whole. In fact, there is an entire methodology for pricing product
lines, whereby each product is assigned a role in the portfolio, and the pricing for the entire
product line is set as a structure.
“Vertical” proliferation and differentiation are also at work. Many companies differentiate their
products by designating them as “good,” “better” and “best,” (“standard,” “gold” and “platinum”
is another common designation). In these cases, the pricing strategy is designed to highlight and
capture the value propositions of a diverse customer base. In too many cases, these designations
are based strictly on features of the product, rather than on the value perceptions of their
customers.
5 Innovative Products and Services
Innovative products and services may be divided into four categories:
Enhancements or extensions of existing products
Complement existing products
Replace existing products
Breakthrough products
Enhancements
and
Extensions.
These
improve
the
performance
of
existing
products,.
Enhancements improve performance of a feature (e.g. a faster processor, a higher-capacity disk
drive, a higher- or lower-dose medication). Extensions add new features to an existing product.
New editions of software are often extension products. Prices should be set relative to existing
price, based on customers’ perception of the value of the enhancement or extension.
Complement. These are products that reach previously unavailable market segments, utilizing
variations of existing products. For example, a Windows version of a Unix product would serve a
different audience – those customers running Windows – and complement but not compete with
the older product. The iPOD Shuffle complements the older iPOD by introducing a different
technology, lower price point, and reduced capacity, making the iPOD available to a market
segment that is satisfied with the lower performance. Price complementary products according to
the value perceptions of the customers, but be certain that “fences” will prevent customers willing
to pay more from purchasing these lower-priced complements. Reduced or increased capacity,
distribution methods, packaging, policies, and warranties should all be considered as potential
fences.
Replacement. These are products that render their predecessors (your own, or your competitors’)
obsolete. New versions of software, new generations of computers or peripherals, new
medications, are all examples of replacement products.
These products should be priced to
communicate the improved performance, but care must be taken. Intel’s introduction of the
Itanium was designed to replace the older Pentiums in server marketplaces, but the improved
performance was insufficient to induce customers to do the work necessary to adopt it. The fact
that competitor AMD was able to approach Itanium’s capabilities, but run existing Windows and
Unix software enabled customers to meet their needs for increased performance without having to
convert or replace their software. If customers do not switch, they may be lost.
Breakthrough. Breakthrough products meet a need previously unmet, a need which cannot be
met with any alternatives. Breakthrough products are enormously rewarding if they succeed, but
there are enormous risks. Examples of breakthrough products are cellular networks, Ethernet,
employee leasing, personal computers, the Internet, the polio vaccine, recent diabetes
medications, Windows, and Astro-Turf.
Breakthrough products introduce capabilities that were never available before. They introduce an
entirely new value proposition. Setting the price for such a product is very challenging. Where other
products joust for market share against known competitors, the very concept of competition is
different for breakthrough products. In established marketplaces, products compete based on
positioning, features (attributes, brand value, distribution methods, price, etc.) and the value
perceptions of the customers. They compete against companies in the same market space, and
they generally (but not always) know their competitors. But breakthrough products and services
must identify, articulate and establish an entirely new value proposition. They do not compete
based on the features and benefit of their product, but on their ability to articulate and promote
their new value proposition in competition with other clearly-defined propositions that customers
have already accepted. The dollars for the new purchase often come at the expense of some
other need. There is always the option of doing nothing; your potential customers have survived
and prospered until now without ever having addressed this new need, nor ever having solved this
particular problem. Marketers of breakthrough products and services must first elevate the problem
set they solve to the level of executive action. Only then can they get their product’s features
considered by potential buyers.
6 Six Steps to Pricing Success
Excellence in pricing can be achieved by any company, in any industry and with any product or
service. This includes the difficult-to-price “breakthrough” products. As opposed to what many
managers currently think, good, profit-maximized pricing is not black art; it is simply a process that
accurately defines the customers willingness to pay based on the perceived value of your product
or service compared to competitors and alternatives in your marketplace.
The six steps below illustrate a proven methodology for pricing success.
1 - Assessment
Begin by documenting the internal perceptions of your executives, marketing, product
management
and customer-facing staff (sales, customer service and other frontline team
members). Document their perceptions of the attributes and values your company delivers to its
customers, how you are differentiated from your competitors, what is your core competence.
Document their perceptions of your pricing policies and procedures, roles and responsibilities.
Document conversion ratios, marketing processes, bid success rates, and sales cycle. Document
also any barriers to growth they may perceive (examples: capacity, market position, sales
processes and capabilities, information technology or other infrastructure issues, training, data
deficits, competitive positioning, or industry issues).
2 - Internal Research
Create a questionnaire that can validate, confirm or reject, extend, support and refine the value
perception results of the assessment. Administer the questionnaire to the internal staff to confirm
their perceptions and document them carefully.
3 - External Research
Identify a research set representing your marketplace. These should be names representing
customers, prospects, lost-business contacts, channel partners (if any), contacts who never bought,
and representatives of companies who have never heard of your company. Administer the same
questionnaire. If appropriate, administer the Van Westendorp Price Sensitivity Meter and a Conjoint
Measurement. For each respondent, capture enough metadata (industry, position, size of
company, location, any other relevant data) to be able to segment the marketplace, showing
which segments place higher and lower values on the various elements of the value perceptions.
4 - Analysis
Determine the perceived value of your product, product line or service. Produce a profile that
shows how your company, and your competitors, is perceived in the marketplace and the value of
your brand and how the attributes of your product or service stack up. Further, examine how your
self-perception may differ from the market’s perceptions. Also examine how your channel, if
appropriate, perceive you and the needs from your customers.
By comparing the profiles of all the different segments involved; you, your channels and your
customers, you may finds gaps in the perceptions. These gaps will make your sales efforts and your
price realization strategies less efficient, and knowing if and what they are, enables you can take
corrective action.
5 - Optimized Price
Determine the price levels that optimize profitability, market penetration or increased valuation,
depending on your corporate objectives. Identify price realization strategies – discounts, channel
management, documentation, packaging, bundling, options, and specialized and general
services oriented towards market segments where you can dominate and earn superior profits.
Examine the barriers to growth identified in Phase I, and deal with them.
6 - Price Training for Sales
Train your sales force on the value perceptions of your customers including their perceptions of the
competitors. Equip them to defend your prices, reduce discounting, and leverage negative
perceptions of the competitors.
7 Conclusion
Innovative products and services present a unique challenge to the manager or executive
responsible for setting their prices. The challenge lies in the nature of competition, the absence of
historical data and the importance of price as a measure of the new product’s value. Disciplined,
careful research, however, can provide the data to support sound judgments about the
customer’s perceptions of value and willingness to pay. The research must include internal as well
as external perceptions, and it must collect enough metadata to enable judgments about which
market segments are the most likely to adopt the new products quickly and profitably.
Atenga is a strategic pricing company, helping companies optimize the prices they charge for
their products and services. Atenga developed the Six Steps to Increased Profit method and
provides the educational, research and analytical services that support Value Optimized Pricing.
For more information, visit us at www.atenga.com, write us at [email protected], or call us at
888-280-8251.
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