Capturing the value of technical innovation

Article by Michael Hurwich, President of SPMG

In many industries, technical innovation is essential in order for companies to remain competitive. But innovation alone is not enough…

Despite their success in creating new products or services, many companies in industries where innovation is a required trait have problems in turning the technical value of their innovations into added profits. The promise of a return on investment for the research and development invested in new products seldom materializes, frustrating both management and shareholders alike.

There are several reasons why this occurs:

1. Focus on market share: There is often a temptation in organizations to use technical innovation solely as a method of capturing market share from competitors. This strategy typically undervalues technical innovation because it fails to recognize that while not all customers will value the innovation, those who do are usually willing to pay a premium for it. As a result, the market share lift usually occurs only within those segments that would have been willing to pay a higher price for the innovation, had a higher price been set. Among other market segments, there is little impact.

2. Misreading customer acceptance: Some organizations are too optimistic about the value of innovation and place a higher value on it than their customers do. This can occur when managers become wrapped up in product innovation and see customers as equally enthusiastic about technological breakthrough, without any grounding in research for the opinion.

Another less common problem lies in underestimating customers' willingness to pay a premium for the value of the innovation. Typically this occurs because a company fails to recognize the ancillary benefits that might arise from using new products, or because they fail to understand all the reasons that customers choose a product or service in the first place.

Take, for example, the case of a major chemical supplier who recently introduced a new product that significantly reduces the quantity of the product that customers have to use in order to achieve the same results as the older version provided. While the pricing formula took into account the reduction in volume required, it did not adjust for changes to transportation or storage costs. Consequently, customers received an added value through lower shipping and inventory costs. This value could have been reflected in the price of the product, leading to higher profits.

3. Ill-advised discounts: Many companies establish inappropriate volume discounts for innovative new products with a premium value. These discounts erode most of the value and reduce the profitability of the innovation. Partition pricing - reviewed below - can provide an answer to the discount dilemma.

4. Cost plus pricing strategies: Companies using cost plus pricing strategies may fail to achieve the higher prices warranted by higher value products. This results when new product innovation leads to lower production costs, but the manufacturer fails to take into consideration that the value of the product to the customer has been enhanced. As companies adopt more effective means of making the product, or achieve the same product characteristics with a smaller package, those who use cost plus pricing strategies will automatically lower the price for the product without considering the increased value of the product. These pricing formulas may also lead to a reduction in absolute profit.

Take, for example, a product that sells for $1.00 per unit, with a current production cost equal to $0.80, and a gross profit equal to $0.20 per unit. Gross margin is thus 20% and mark-up is 25%. Now suppose that a new product is introduced with a production cost equal to $0.60 per unit. If the company applies the same mark-up of 25% to this cost, the price for the new product would be $0.75, with a gross profit of $0.15 per unit. While the gross profit in percentage terms remains the same (20%), actual profits have declined by $0.05 per unit. If the company sells the same number of units, actual profits will have declined by 25%.

Capturing value from innovation

There are several ways a company can ensure that the benefits of innovation include increased profitability. Below are some of the steps to consider in implementing a more effective pricing strategy.

Establish and communicate clear strategic objectives

As with any strategic issue, setting the price for innovation should start with a clear understanding of what it is you want to achieve. In many organizations there will be some internal conflict over the objectives for the new product. These differences of opinion need to be aired at an early stage and resolved before the pricing strategy is implemented.

Once established, the strategic objectives need to be communicated to everyone within the organization, from finance to sales, to ensure that the strategy will be implemented properly. This step, more than any other, is critical to ensuring that whatever the price set for technical innovation, it will be maintained through to the customer.

Measure customer value

Measuring customer values and trade-offs is a key step in the process of determining the value that customers will place on a new technology. Discrete choice analysis can be used to measure specific customer values, and to compare buying decisions against existing products. Having a clear understanding of customer value is often critical to the process of establishing and maintaining premium prices for technical innovation in the field. This research can be used to support and direct the sales organization. Consequently, it is important to communicate clearly the results of any measurements throughout the organization.

Review the advantages of value based pricing

Value based pricing strategies will more often lead to higher profits than either cost plus or competitive based strategies when applied to new products or services. This is because value based pricing is designed to take into account the added value that innovation provides customers and to capture a portion for the innovator. Even where market share gains are a priority, value based pricing is a more effective method of establishing a price that balances market share gains with optimum profits.

Consider using partition pricing

Partition pricing is the practice of separating elements of a total price from one another. For example, technical fees or other charges might be separated from the base fee of the product or service. This approach is particularly useful when there are existing discount programs that may apply but which may erode profitability if applied to a product/service innovation. By using partition pricing, a company can reduce or eliminate the negative impact of discount programs on the profitability of new technological innovations.

With partition pricing, companies separate the technology from the base product or service only on the invoice, where a technology fee or other charge is added to the base price. These fees are based on the value of the new technical innovation that has been added to the product and are not subject to discounts.

DIAGNOSING THE PRICE FOR A NEW DRUG: THE PHARMACEUTICAL INDUSTRY'S GREATEST CHALLENGE by Michael Hurwich

An aging population, technical innovation and more informed patients with better access to medical information are driving the demand for new and innovative therapies.

While many companies put more and more resources into the back-end of R&D, they often ignore opportunities to increase profitability through the front end by using a value-based approach to new product pricing. The challenge is to alleviate pricing pressures by establishing customer-perceived value for the drug before establishing a new product line.

STEP 1: Target and Focus. 

Examine the value the product offers and determine how this will benefit customers. Careful analysis of the new drug should be undertaken in order to establish a realistic prediction of revenue and profitability for the company. To determine the expected value the product offers, the attributes that comprise the product value need to be confirmed and evolved. These attributes will help determine the drug's value, which in turn will perform as a predictor of future sales. Many methods are used to identify these attributes, such as customer surveys, conjoint measurement, focus groups, internal forecasting, historical regression, reference and price metering.

STEP 2: Competitive Environment. 

A close examination of the retail competitive environment aids in determining the price placement of a new product. Customers considering similar products or alternatives will scan their product options or non-product options, in developing a consideration set. Within this consideration set, customers will develop a hierarchy of brands/products based on their assessment of value towards relieving various symptoms. In addition, a reduction of side effects most commonly influencing quality of life contributes to a value weighting. Typically, customers will choose the brand or product at the top of their hierarchy, if it's available. Perceived competition, therefore, assists in the evaluation of product pricing and positioning.

STEP 3: Price Metering. 

A price metering survey should be an initial step in determining the optimal price of a new drug. Price metering provides a range of prices customer may be willing to pay for the drug, depending on a series of tradeoffs:

-	Will the product decrease the time spent in the hospital?
-	Will the product eliminate the need for surgery?
-	Will the product permit more days on the job rather than off?
-	Does the product have minimal side effects?
-	Does the product increase quality of life?

If the majority of these answers are positive, it can be assumed that customers will be willing to pay a higher price for the value the product offers, to the extent it alleviates all or most of their symptoms.

STEP 4: Value/Price Mapping. 

The information acquired in the price metering survey is used to present the value of your company relative to that of your competitors, as well as the value the company is perceived to offer by the key customer set for each of your product offerings. A series of value maps are created that reflect customer value perceptions of different features and bundles relative to price.

STEP 5: Discrete Choice Analysis. 

Our elasticity tool and methodology effectively provides a snapshot of your customers' willingness to give up something in return for something else. It's often used to predict the choices that a consumer will make between drug attribute alternatives. This is an optimum methodology to sue for predicting price and the likely outcome in the marketplaces in a competitive situation.

STEP 6: Pricing Methodology Alternatives. 

Providing several strategic pricing and product attribute alternatives will assist in clarifying your company's goals and objectives for market share, profitability, revenue growth or ROI. Benefits, risks, advantages and disadvantages of various alternatives are provided to determine which approach meets your corporate objectives. Pricing these alternatives helps identify opportunities for increasing profitability and minimizing risk with your chosen customer segment and channel strategy.

STEP 7: Pricing Approach. 

The pricing strategy alternative selected must be consistent with your corporate, marketing and sales objectives.

What was once seen as a challenge is now an opportunity to build value perception in order to set a new product price. This step-by-step methodological approach provides your company with the tools and structure to effectively price the new drug. Utilizing this value-based pricing technique will help your company achieve optimal revenue and profitability.