The product development team is celebrating. Their latest innovation has received rave reviews from customer focus groups, the engineers have detected and solved every conceivable performance glitch, and production is ready to roll. In short, their innovation is poised to shake up the marketplace. But even as the champagne corks are popping, one crucial issue remains unresolved: what should the price be?
The pricing decision for new products deserves much attention. The decision will not only determine the profitability of the new product, but will also determine the fate of the organization’s existing products, and shape the response of its competitors.
Three approaches to new product pricing are widely used: cost-plus pricing, competition-based pricing, and customer value-based pricing. Only the last can provide new product with the best chance of achieving sustainable, long run success.
1) The cost-plus approach
Cost-plus pricing involves pricing the product to yield an “adequate” return over all costs. Selling price is arrived at by layering a required rate of return or “expected” margin on top of variable and allocated fixed costs per unit.
A recent study revealed that among 350 American manufacturing companies ranging in size from $100 to $500 million in annual revenues, the cost-plus approach to pricing products was practiced by almost 40% of respondents.
The appeal of this approach is evident: cost-plus pricing utilizes readily available information and is relatively simple to administer. The problem, however, is that there is no guarantee that the price yielded by this approach will even approximate the perceived value of the product from the perspective of potential customers.
Managers who have employed the cost-plus methodology have later found themselves plagued by the nagging question: could we have charged more and still achieved the same volume? Unfortunately, by the time this question arises, it is usually too late to affect any changes, as customers have already formed lasting expectations of what they should pay for the product.
2) The competition-based approach
Competition-based pricing involves setting prices at or below those of your competitors, in order to achieve sales and market share objectives. This is an enticing proposition for many managers, particularly those who have been charged with the responsibility of launching a new product, and have a strong desire to guard against slow sales.
However, a “me too” price creates the perception of a “me too” product, immediately encouraging comparison. Moreover, while price-cutting is the fastest and easiest way to achieve sales targets, price cuts are just as easily matched by your competitors and in the end, market share gains that result from using the competition-based approach are usually short-lived.
The customer value-based approach involves first determining what the customer is willing or able to pay for your product, and then managing product attributes and costs to that level. At the core of value-based pricing is a full understanding of the customer‘s value system.
In any purchase decision, customers are explicitly or implicitly trading off product attributes against price. In determining the appropriate price for a new product, the key is to understand which attributes actually drive the customer‘s purchase decision, and to be able to assess the relative importance of each attribute.
There are a host of market research tools that can be employed to understand the customer tradeoff process.
Price metering, is frequently used to establish a price band for new products when no reference price currently exists in the marketplace. Price metering helps managers to determine the perceived value by asking potential customers the following four questions:
· At what price would you consider this product to be so inexpensive that you would have doubts about its quality?
· At what price would you still feel this product was inexpensive, yet have no doubts as to its quality?
· At what price would you begin to feel this product is expensive but still worth buying because of its quality?
· At what price would you feel the product is so expensive that, regardless of its quality it is not worth buying?
Another tool often employed to determine the value equation of customers is conjoint analysis. Conjoint analysis creates a simulation of the marketplace to replicate buying behavior by asking consumers to choose among several product /price alternatives. A series of such choices creates a relative ranking of what is important to the consumer. These rankings are then used to calculate the relative elasticity and value of different attributes.
By employing market research tools such as price metering and conjoint analysis, a manager is now in a position to identify expected volumes for the new product at various price points. This information then becomes the foundation for determining the optimal price levels and structures for the new product.
The major drawback of value based pricing is that it requires much more time, effort, and financial resources than either cost-plus or competition-based pricing. When it comes to pricing new products, however, first impressions usually stick, and organizations are rarely offered a second chance. For most organizations, therefore, the benefits associated with using value-based pricing far o
