REAPING WHAT YOU SOW

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1 REAPING WHAT YOU SOW BY GEORGE E. CRESSMAN JR. Customer-driven pricing strategies help harvest profits. Pricing strategy is an essential element of new product introductions, and realized price is the harvest for what is often a long and expensive development journey. But many companies fail to capture a pricing and profit harvest from new product and service offerings. Why is new product pricing such a challenge? In managing the development of new offerings, the business objectives should be to (1) establish pricing strategy and policy that ensure optimal profitability throughout the new offering s life cycle and (2) provide a stream of profits to fund future offering developments. Yet mistakes in pricing innovation abound. Consider the market for a widely used piece of capital equipment. Operators for this equipment were highly skilled, and there weren t enough of these operators to satisfy demand. Users of this equipment tried hard to retain their operators. A manufacturer of this equipment invested heavily in ergonomic design capability and innovated equipment that was highly user friendly. This manufacturer discovered that operators strongly preferred the ergonomically designed equipment and was even able to equate the innovative design with operator retention. But instead of pricing to reflect the innovation s impact on operator retention, the manufacturer chose to match the price of a competing brand missing the opportunity to harvest a reward for the innovation. A few companies are starting to evaluate the potential for developing more profitable innovations. Some managers have found ways to make new offering pricing decisions with more confidence and with better results. After exploring why new product/service pricing is so difficult, we ll examine how these companies and managers are successfully harvesting their innovations potential. 34 MM March/April 2004

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3 EXECUTIVE briefing Pricing new products continues to be a difficult challenge for many managers. Traditional approaches frequently result in slow customer adoption and poor profitability. Adopting a customer-driven new product development cycle helps managers increase the odds that their new products and services will win customer favor and deliver profit objectives. This article does not provide new techniques for pricing new offerings. Instead it provides tools and processes we have found most useful in pricing new products. When Pricing Fails Pricing new products often fails because many companies use a destructive product-oriented, approach. (See Exhibit 1.) This approach starts with the creation of a product or service. Manufacturing, marketing, and distribution costs are estimated and, together with a desired profit margin, a price is assigned. Marketing is then charged with finding customers who will buy the new product or service. This is essentially an inside-out approach in which new products and services are thrown over the wall in the hopes they will stick to some customers. Sometimes these new products/services do stick and generate some revenue flow, but more often the offering fails. As failures occur, companies try harder and create more new products. Failures become increasingly frequent and disastrous. The product-oriented approach to new product development produces the best products and services the firm can provide whether customers want them or not. Pricing is cost-driven and the value customers realize in using the new product/service is not reflected in pricing. These new offerings may provide sophisticated features that customers can neither understand nor benefit from. These sophisticated features drive costs up, prices follow, and customers refuse to buy. Ironically, the product-oriented approach to product/service introduction creates a logical fallacy: In effect, it suggests customers value a supplier for the supplier s costs, not the benefits customers receive in using the product/service. This would suggest that suppliers should drive costs and prices higher because customers will value a higher price, driven by higher costs. Iridium phones are an example of a technology-driven, feature-loaded, high-cost, high-price innovation. The phones were billed as a use anywhere mobile phone system. The original developers of the system poured $5 billion into a 66- satellite system. Phones and needed accessories took up so much space they required a special briefcase. Purchase price for a phone system was $3,000, and airtime fees were $7 per minute. At the same time, cellular phones with limited but adequate coverage for many customers were selling for less than $100 and were much more user friendly. While the Iridium system was technologically brilliant, it was clear from its inception that customers would neither pay the high purchase price nor accept the high use fees. Approximately 50,000 customers purchased phone systems, but this was well below the volume required to sustain the business. The original owners sold the system for $25 million in a leveraged buyout. Another reason new product/service pricing fails to be profitable is that much of the advice managers have been given does not help in setting prices that customers can understand and be convinced to accept. Managers have been told that pricing should be set to either skim or penetrate the market. Skim pricing strategies set prices high (although there is no formula to determine how high), resulting in lower customer adoption. Skim strategies are traditionally recommended when development cost is high, in order to recover investment expense. Low adoption levels can be a problem, however. If manufacturing requires higher production volumes to achieve economies of scale, skim strategies fail. Penetration strategies set prices low (again, with no advice on determining the correct price level), intending to drive higher volume. Penetration strategies are frequently recommended when managers fear competitors may quickly copy the new product and want to pre-empt competition by achieving customers. The problem with penetration strategy lies in the life cycle. As products and services mature, com- Exhibit 1 The destructive new product development cycle Drive for new products Let s see what else we can do. Performance shortfall Why aren t we selling more of this? Customers just don t get it. Product idea Something we can do! Search for customers Our prices are reasonable because it s such a great product! Result: The best products and services customers can get, whether they want them or not! Product development Costs Price Margin objectives 36 MM March/April 2004

4 petition frequently intensifies and prices decline. Offerings introduced with penetration strategies start from a low price and go down. Both skim and penetration strategies are based on knowing customer price elasticity. If elasticity is low, it would make sense to price high. Within limits, customers will buy regardless of the price level. Alternatively, if elasticity is high, a penetration strategy is more appropriate and lower prices drive greater volumes. For new offerings, the challenge is developing reasonable estimates of elasticity. The newer the offering, the less likely customers will be able to accurately forecast their purchasing intent. This results in elasticity estimates that are little more than guesses creating much uncertainty in setting price. Standard skim and penetration strategy advice also ignores the adoption process common in most markets. Adoption of new products/services is rarely a linear process. Instead, customers with specific characteristics adopt at different rates. For example, some customers will characteristically be the first adopters, for either psychological (they have to be first ) or highly specific needs (they can benefit from the innovation well in advance of the larger market). Other customers the vast majority of the market will wait and adopt well after the radical innovator adopters have purchased. Skim strategies may work with radical innovators, but adoption may never move beyond these initial purchasers unless management has a carefully planned strategy to target the larger market. Alternatively, penetration strategies may result in early adoption by the radical innovators, but the larger market may get no real benefit from the innovation at any price. Seeing the new product/service pricing decisions as a simple choice between skim and penetration strategies creates strategy that misses the opportunity to price innovations for their impact on customers businesses or personal lives. This results in prices that are often too low. New Product Pricing Strategy Standard skim/penetration advice does not provide an adequate framework for pricing innovations. To price innovation processes profitably, managers must adopt an approach that answers the following questions: What complementary product/services/industries must be in place for customers to realize the benefits of the innovation? How will these be developed? What will the adoption rate be? How does this affect project economics? How can the innovation s benefit potential be communicated? Penetration strategies may result in early adoption by the radical innovators, but the larger market may get no real benefit from the innovation at any price. Exhibit 2 describes an alternative development cycle a process manager can use to market profitable innovations. The sequence described in Exhibit 2 reverses the process used in many companies: It starts with customer targets, drives to offering design, and offers the potential to discover new customer needs and new customer targets. Starting with an offer- Exhibit 2 Profitable product development cycle New customer targets What other customers have similar value drivers? Increased customer understanding What other products and services make sense for our target customers? Target customers What is our target customer s business? Customer value drivers How does our target customer make money? Possible product solutions What do customers do now? What is needed? What new benefits can prospective customers acquire with this innovation? Which customer segments will value these benefits the most? What incumbent solution will be displaced? What price(s) will be possible in the segments that benefit most? How will the suppliers of the incumbent solution(s) behave as they are displaced? How will this behavior affect pricing? Product development candidates What specific products and services should we invest in? Affordable costs Given the likely prices, what costs can we afford to incur? Likely prices For our proposed solution and current solution, what price are we likely to achieve? Result: The best products and services customers can get. MM March/April

5 ing concept, the profitable development cycle pursues innovation by addressing the following questions: Which customer targets are appropriate? What are these customers values, and how are these values currently served (the incumbent solution)? What incremental benefits will our offering concept deliver? Given customer values, the current solution, and the incremental benefits of the offering concept, what price is the innovation likely to be able to command? Considering the likely price for the innovation, what costs can the business afford to incur? What offerings can be implemented for the costs? What is the introduction strategy for the innovation? The key to this process is that it delivers the best value offerings to the target customers, not necessarily the best possible offerings. Benefits and Incumbent Solutions The first step to profitable pricing of innovations involves understanding customer values, incumbent solutions for those values, and potential incremental benefit delivery. A traditional approach to assessing customer needs involves surveying respondents using a set of product/service attributes presumed to be important to the target market. In another frequently used technique, respondents are shown sets of product/service descriptions and asked to rate the desirability of each alternative description. These techniques were used to estimate market potential as PCs were just being introduced. Respondents were shown a description of a computer that would fit on their desk and were asked if they would buy this personal computer. Based on results, the world market potential was estimated at about 50,000 units. Of course, the market for PCs turned out to be much larger than 50,000 units and, in fact, the market is still growing. The failure of the PC market potential estimation research illustrates the inadequacy of traditional approaches to understanding what customers need. Customers may not see how the new product/service can affect their businesses or personal lives, and they may then significantly undervalue the innovation. Customers also may not completely understand what they re getting from current solutions or how the new solution will improve their position. In such cases, responses are likely to undervalue key offering elements that significantly improve their businesses and personal lives. Traditional approaches to understanding customers often generate an importance-performance rating for the new product/service features and an elasticity measurement for the innovation. There are two challenges in using such information to price innovations. First, when customers don t understand the innovation, they frequently compare the features of the innovation to the products/services they currently use. When the innovation s unique features are poorly understood, customers often discount them and become more price sensitive. To help customers appreciate the offering, innovators must communicate the impact of the innovation. Helping customers understand unique benefits and their economic impact is essential to getting rewarded for an innovation s value. Testing for feature importance performance without communicating benefits and economic impact typically results in higher customer price sensitivity and lower prices at introduction. The second challenge is that elasticity measurements based on feature testing share similar problems. Measuring price elasticity often provides inadequate information for determining innovation price points for two reasons. First, when introducing a new product to an existing market one with known incumbent products/services elasticity measurements may overestimate price sensitivity, sometimes dramatically. The reason is customers familiarity with the incumbent solutions: They use current offering features as a proxy for benefit and economic value delivery. But they don t see the benefit and economic impact of the innovation s unique features and thus don t see why they should pay for these unique features. And second, for introductions in new-to-theworld markets where a product/service variety is totally unknown to customers elasticity measurement may also dramatically overestimate price sensitivity. This occurs for the same reason feature importance-performance measurements undervalue innovations: Customers cannot see how unique features create benefit and economic impact. As with importance-performance measurement, companies must create a benefit and economic impact context or frame for customers in order to understand what customers are likely to pay for an innovation. The key then to pricing new products/ services is in understanding the benefit and economic impact the innovation will create for customers. Strategy for introduction of the innovation should be driven to capture a portion of the economic impact in pricing, providing a share for the customer and a share for the innovator. 38 MM March/April 2004

6 Innovations can be designed to deliver different kinds of benefits, reducing the customer s operating costs and increasing the customer s revenue flow. To drive adoption, the innovation must deliver benefits and economic impact or value beyond those provided by the incumbent solution. The customer s incremental gain from the innovation must exceed the cost of adoption and compensate for the risk of adoption. Equally important to understanding incremental benefit delivery is knowing how benefits vary across groups of customers across segments. Depending on business strategy, the innovator may choose to target segments where the economic impact (value) is very high, and where pricing can be set to capture a higher portion of the delivered value. Or an innovator may target multiple segments with offerings providing different levels of benefit and value. To succeed with this approach, the innovator must provide real differences in value delivery between target segments, thus preventing customers who will pay higher prices for more value from migrating to lower value, lower price segments. Price Potential The next step is to determine what price is possible for each target customer segment. (See Exhibit 2.) The foundation for determining price potential is benefit and value delivery Helping customers understand unique benefits and their economic impact is essential to getting rewarded for an innovation s value. the economic impact of the innovation. This value delivery is segment specific and the best customer targets are those where value delivery is higher. Selecting specific price points involves judgment that considers the following: Unique value delivery. The higher the unique incremental economic impact, the higher the price potential. Innovators should avoid targeting customers where economic impact is low. Pursuing segments where value delivery is low is likely to involve aggressive price competition. Sustainability. The duration of the innovation s unique value delivery is critical. If the unique value can be sustained over a longer time period and there is a large market potential, lower prices may drive larger and faster adoption. On the other hand, if competition is likely to match the unique value delivery in the shorter term, higher introductory prices may be better as prices are likely to decline (but from a higher point) as competitors enter. Customer risk. If customers are likely to incur substantial risk in adopting an innovation, innovators may choose to select lower price points. Be careful, though, because some innovators introduce at low price points intending to raise price as adoption proceeds. This is rarely possible! If there are significant risks, look for alternative ways to indemnify the customer, such as refund agreements. Often low introductory prices even when customers are told the price is low only in the introductory period drive customer price sensitivity and result in prices that stay low. Cost Issues Introductory price points drive allowable costs. In order to achieve profit objectives, innovators must specify what level of costs can be incurred given the likely market prices. A process called target costing is often employed at this point. Target costing principles are well-developed elsewhere. For a discussion of this, see Target Costing and Value Engineering by Robin Cooper amd Regine Slagmulder (1997, Productivity Press). The key point for managing new product pricing is to ensure target costing is based on prices the business can achieve. Achievable pricing is based on incremental benefit and value delivery. The critical concern for the innovator is assuring the costs assigned to offering development are costs associated only with the innovation process. There are two problems commonly encountered in innovation efforts: The allocation problem. Innovations often attract costs fixed costs that would exist whether the innovation was taken to market or not. Of course, all costs in the business should be routinely examined to ensure they are justified. But for innovation profitability assessment, costs should only flow to the innovation if they will actually change if offering development is pursued or the innovation taken to market. Managers must be careful to avoid adding cost burden to innovation developments that threaten potentially profitable business opportunities. The sunk cost problem. Often the language surrounding innovation developments says much about management philosophy. Innovations frequently carry an investment charge intended to recover development costs. Of course, once development costs are incurred, they cannot be recovered. (When introducing an innovation to market, development costs are sunk.) The only relevant costs are those yet to be spent, such as any additional development expense marketing and manufacturing expense typically. The important question is whether the innovation is generating sufficient profit to re-invest in future developments. Charges from past expenditures are not relevant to the reinvestment decision. Allowable costs drive what can be included in the offering. Management should drive development activities to provide MM March/April

7 offerings that deliver the required benefits and value within the cost constraints dictated by achievable pricing. The Introduction Introducing innovations requires special marketing strategies. There are three issues that affect achieving value driven pricing. First, in order to price for benefit delivery, customers must be able to realize the benefits. Frequently, innovations require complementary products and services to support the innovation. For example, larger adoption of PCs required the development of software to allow users to realize the full potential of the computer. VCRs had limited benefit until movie copyright holders permitted licensing for in-home viewing. Some innovations have been placed in the market before full development of the complementary products and services, resulting in limited adoption. If management misreads lack of complements as a pricing problem, they may reduce price and see no impact on adoption. In order to realize prices proportional to value, innovators must ensure the availability of any required complementary products and services. Second, adoption of innovations follows characteristic patterns. This pattern is slow at first, accelerates, and slows again as full market adoption is reached. Managers sometimes mistake the initial slow adoption period as a problem with marketing, often believing this slow adoption is the result of high price. The real problem is rarely price and it is much more often an issue with market communications. The majority of the market is unaware of the innovation. Even when the larger market is aware of the innovation, it remains unconvinced of the benefits of adoption. In many markets, early adopters are somewhere between 3% to 10% of the total market; innovations face a characteristically small potential where price is rarely the issue. But if managers respond to low adoption by cutting price, they establish pricing problems for the rest of the innovation s life cycle. Prices for mature products almost always decline: If price is lowered in the introductory phase, it will typically move even lower in maturity. Third, innovative offerings typically have no in-kind competition, but they do have functional competition. In order for innovations to become more widely adopted, they must displace incumbent solutions. For example, jet aircraft had to displace dominant prop-driven aircraft. The competitive battle against an incumbent solution can be incredibly intense, sometimes even more intense than the competitive battles of mature markets. This is because the majority of the market knows and understands the incumbent solution, but not the innovation. Like a rookie on a sports team, there is no record to rely on. The rookie must demonstrate competence while more veteran players are assumed to have competence. The key for innovative offerings to win these competitive battles lies in getting trials that have successful results and can be publicized. Price dealing won t achieve trials and, because incumbents often have more favorable cost structures, innovators typically cannot price compete successfully. Managing pricing for innovative offerings should consider these guidelines: Ensure complement availability. Make sure customers can realize the promised benefits and value, especially when some benefit/value is delivered by complementary products and services. Don t compensate for missing complements by cutting price. Plan for the adoption period. Recognize that the introduction period has low adoption rates. Don t panic; the game in the introductory period is typically driven by market awareness and almost never by price. Create multiple offerings some with higher levels of benefit/value and corresponding price, others with lower levels of benefit/value/price to deal with customer segments that emerge as markets develop. Price offerings for benefit/value delivery and force customers to accept lower levels of benefit/value in order to get lower price. Manage the competitive battle. Don t try to out-price an incumbent solution. You need trials, and price cutting won t win them. Identify customers where trial is likely and has a high probability of success, then help these customers succeed in their trial. Get on with the market communication effort, stressing how customers will benefit from the innovation and the economic benefit of the innovation. Reaping the Harvest Profitable pricing of offering innovations requires driving the development process from customer targets. Traditional product-driven development processes typically result in technically superior products, cost driven pricing, and low customer acceptance. By switching to a customer value driven development cycle, managers can increase customer adoption and drive more profitable pricing. To adopt a customer-driven new product cycle, managers must develop new organizational skills. Units such as R&D, marketing, sales, and manufacturing must work cross-functionally to deliver products and services that have economic benefits for target customers. Market research must move beyond more traditional performance measures to careful assessment of customer business models, competing solutions, and unmet needs. Competitor strategy analysis must be based not on offering feature comparisons, but on competing benefit delivery and competitor intent. And finally, they should forecast and track adoption rates, and build organizational discipline to avoid lowering price as a response to slow adoption. Managers who institute customer driven new product cycles find their new products and services achieve greater adoption and increased profitability. About the Author George E. Cressman Jr. is senior pricer at Strategic Pricing Group Inc. in Waltham, Mass. He may be reached at gcressman@strategicpricinggroup.com. 40 MM March/April 2004