Thinking. About Business.
Pricing to Lose?
The don’ts when pricing a new product
By David Chopko
You have an idea for two new products or services. You test both on a small scale and the results look promising. You
tweak both and retest. Now your testers are raving about the products. You’re sure you have two winners. You decide to
survey the market to determine what these new products are worth. You’re careful not to tell those who are completing
the survey too many good things about the products since you don’t want to bias your results. The survey results show the
market is willing to pay only 50 percent more than your cost for one product, something you thought was highly original
and innovative. For the second product, the results show that prospects are willing to pay twice as much as they might pay
for the closest competitor’s product, which in your estimation is nearly as good as your product. You scrap the first product
and launch the second. A year later your new product is losing money and a product similar to the one you scrapped is
taking the market by storm. What gives?
Unfortunately, you’ve learned some tough lessons. As most marketing researchers will advise, survey results are
notoriously unreliable about anything dealing with pricing for quasi-copycat products and are basically useless or, even
worse, can provide misleading information when dealing with the pricing of truly unique products.
Early in my career while working for a Fortune 500 company, I was part of a team tasked to launch a truly innovative
product into the European market. The product had shown remarkable promise in field tests. It was a breathable bed cover
that blocked dust mite feces and, hence, dramatically reduced the asthma attacks suffered by young sleeping children.
When parents of these children were surveyed, they repeatedly told the surveyors that they were willing to pay $500 or
more for the product. When the product finally launched with much fanfare, it totally bombed. Families, who prior to its
launch viewed it as a medical device and seemed willing to pay a hefty price, after its launch, viewed it simply as a glorified
bed covering. Few people were willing to pay $500 for a bed covering, especially for a child.
Another flawed approach business owners commonly employ is to ask people to value (or suggest a price they might pay
for) something they don’t understand or as yet, fully appreciate the advantages it offers. A while ago, we ran the following
experiment. We asked two groups, non-tennis players and professional tennis players, to value two tennis rackets: one, a
standard racket anyone might buy at Walmart, and the other, a racket that a tennis professional might buy at a tennis shop.
The non-tennis players priced the standard racket at $20 and the other at $50. From the professionals, the prices received
were $25 and $200. This difference occurred because the non-players had no idea what professional tennis players looked
for in a tennis racket, and therefore didn’t understand why the better racket should be worth $200. Now let’s assume
we had given the professional tennis players a high-end racket made from a new metal and asked them to price it. We
probably would have received price estimates around the $200 range. However, if we could have shown these potential
customers or, better yet, offered definite proof to this group that this new metal racket would improve the quality of their
play (points won) by 5 percent, they likely would have fought one another to buy the racket for $10,000 (assuming a limited
number would be sold). The moral of this story is that until the target audience understands the full extent of a product’s
1
www.business2businessonline.com
Thinking. About Business.
value, it is impossible for them to value or opine on a fair price for the product.
If it is so difficult to set a “good” initial price for a new product, what should a small business owner with a new product
do? The most common approach, but not necessarily the correct approach, is to price based on cost. Here is what I’ve been
told countless times. “In my business I generally make an X percent (say 50 percent) margin on my sales. I think I do a
little better (or worse) than my primary competitors, so the average margin for products in my general line of business is X
percent plus or minus some small percent. I think this new product is exceptional, so it should command a margin of the X
percent plus or minus this small percent plus 3 percent or 5 percent or sometimes even 7 percent because of its uniqueness.”
If you have read my other columns on pricing, you know that I believe what a product or service costs, although important,
should not be the determining factor for establishing price. This is especially true for a new product, where product value
should drive pricing. Given this position, I am commonly asked the following: “If I can’t determine value by asking
prospective customers, why shouldn’t I use margins to set the price?” Besides the fact that margins don’t reflect people’s
values, since rarely do consumers know or care what it costs you to make your product, margins are based on a quicksand
calculation. The margin formula that most small businesses use is [(price/unit) minus (production/service cost/unit)]
divided by (price/unit). A unit priced at $10, which costs $6 to produce, would have a 40 percent margin ($10 – $6) /
$10). The $6 production cost has two components to it: a fixed cost and a variable cost. In today’s world, especially for a
new product, it is not unusual—in fact, it is typical—for the fixed cost in this equation to be larger than the variable cost
component. Now there is the problem. The fixed cost component is based on someone’s assumption of the number of units
that will be sold over some finite period. If you think business owners/inventors are less than spectacular at pricing new
products, you ought to see their skills at volume forecasting. Volume forecasts being off by a factor of 2 or 3 times is the
norm.
Let’s put some numbers to the above hypothetical and see what happens. Assume (a) the $6 unit cost is comprised of $2
per unit of variable costs and $4 per unit of fixed costs, (b) the total fixed cost for this product is forecast to be $400,000,
and (c) the first year sales forecast is 100,000 units. Now let’s change an assumption and instead of sales of 100,000 units,
because of something unforeseen (and there is ALWAYS something unforeseen happening in a start-up), only 40,000 units
are sold. As such, the actual fixed cost per unit is $10 and the total cost per unit jumps to $12. If the company had correctly
forecast the first period’s sales volume and had used the margin technique to set its price, based on setting its pricing on a
40 percent margin, the price should have been $20 per unit. How does a small business owner, who thought $10 per unit
was a fair price, reconcile in her mind that people should now pay twice that amount? Take this absurdity one step further
and say that after the first year, the company receives critical product endorsements and volume skyrockets tenfold to
400,000 units. Total production costs plummet to $3 per unit. Now that everyone wants the product, why would a small
business owner drop the price to $5 per unit to maintain the 40 percent margin? The answer is that she would not.
Some small business owners contend that what one should do is to only consider the variable contribution margin when
setting a price [(price – variable costs) / price]. Return to the hypothetical and analyze this approach. Based on the above
numbers, the $10 price yielded an 80 percent variable contribution margin. Assume you and your closest competitor both
make a similar product. You have automated your operations, reducing your variable costs to $1, but increasing the fixed
cost component by $0.50. Following the variable cost margin logic, your price should be $5.00, while your competitor’s
price, based on his margin, should be $10. Obviously there is not a logical explanation for your $5.00 price. Likewise, there
was limited (dare I say “no”) logic for the original price based on the variable cost margin.
It is important to understand that costs play a key role in determining one’s initial price and long-term pricing strategy,
but taking a snapshot approach to pricing based on costs is not a winning strategy.
2
www.business2businessonline.com
Thinking. About Business.
As the above highlights, there are certain approaches you should not take when pricing a new product. In upcoming
articles I’ll discuss what information should be collected and the approaches that should be considered when pricing a
new product.
David Chopko ([email protected]) teaches pricing and market planning in the University of Delaware’s Lerner Graduate School of
Business and helps small businesses develop and implement pricing strategies.
3
www.business2businessonline.com