Setting the Right Price, at Internet Speed
By Hermann Simon and Ulf Munack
New product development cycles have been shortened so significantly that new products often are technologically obsolete the day they are introduced to the market. That's why companies need precise predictions of future revenue and profit streams at much earlier stages of the product development process, so they can allocate their limited resources to the most profitable projects. Although product pricing is never easy, it is made more difficult when the industry is moving at "Internet speed". Delaying a product introduction by four to six weeks to properly research the profit-maximized optimal price is a luxury that many product managers feel they can no longer afford. While it may be difficult to see it that way at first, this is actually good news.
It is good news because it forces managers to understand that the traditional product pricing paradigm is faulty. In the traditional new product development process, the pricing decision is relegated to a point when the product has already been completely designed and positioned for the marketplace. The product can then be sold only in its current configuration and "as is." Unfortunately, the product in this scenario is only in rare, fortuitous cases configured to achieve a profit-optimized price. Invariably, products are either over- or under-engineered and do not match the features, functionality and performance levels wanted by customers. In this environment, the company's profits can never be optimized, regardless of the price.
Delaying a product intro by weeks to research
the profit – maximized optimal price is
a luxery many can no longer afford.
Certainly, the product manager could try to improve the overall profitability by launching an initially not-profit-optimized product in order to optimize profits from future product-line extensions. This strategy is risky and our experience in various markets shows that it fails on a regular basis. It fails because the initial product, especially when it is not merely a slightly improved product but a new-to-the-market/new-to-the-world product, sets a reference point with potential customers. As all marketers know, some perceptions are set in stone and almost impossible to surpass with improved line extensions. Placing pricing research earlier in the process, concurrently with the research and development phase, is a much better alternative to the traditional approach. If the R&D staff is unaware of the market value of the features they are developing (as measured by customers' "willingness to pay"), how do they know which design features to include and/or strive for?
Not only would this approach optimize the profits made with the individual product, it would also improve the resource allocation among all R&D projects. Product managers are under increasing pressure from the finance department to deliver precise forecasts while the product is still in development. In most companies, the resource allocation is made on the basis of hard quantitative data, such as net present value or internal rate of return. For all given decision criteria, it is necessary to know the optimal product profile as well as the prices and future sales volumes. As stated, pricing research at early stages improves the profitability not just of a single product but also of the whole portfolio.
Every product is, by nature, a composite of many attributes. For instance, laptop computers differ from each other in weight, size, speed, software, RAM memory and other factors. To find the total "value to customer" of a multi-featured product, the value of each attribute needs to be understood.
In the industries we have worked in, two truths hold universally:
First, the higher the performance level, the more it costs to improve that performance.
And second, the higher the performance level, the smaller the premium customers are willing to pay for even better performance.
One universal truth: the higher the product’s
performance level, the smaller the premium customers are
willing to pay for even better performance.
As part of a thorough pricing study, the actual "value-to-customer" of each attribute can be estimated using both direct and indirect market research methodologies. R&D and the production department must be able to supply the manufacturing costs at each attribute level.
The target profit optimizing point is where the difference between the value-to-customer and the cost-to-manufacture curves is maximized. For points above the target level, any improvements cost the manufacturer more than the extra value the customer places on it. Similarly, for points below this level, the resulting price reduction will be greater than the firm's cost savings.
Several research methods provide data about the profit-optimal product profile for the average customer and preference differences among customer segments. This information can easily be used to target attractive niches through future product-line extensions. This advantage allows the results of early price research to be used over the lifecycle of the whole product line.
Many leading firms are moving product pricing research forward in the development cycle. At BMW, product planners utilize this "valuing-target" technique to develop their new car lines. Also, product-line extension involving not only the size of the engine but also the time and order of the launch of the convertible, station wagon or coupé can be profit-optimized with precise and early pricing research.
This technique can also be used for new-to-the-world products like the Transrapid, new magnetically levitate train being developed to run between major cities in Germany at a speed of 300 miles per hour. The engineers were thinking of a system to accommodate trains departing every 10 minutes. Research indicated, however, that the value-to-customer increased significantly when planned departure frequency went from every hour to every half-hour to every 20 minutes. The value was only slightly increased if the departure interval was further decreased to the planned 10 minutes. At the same time, costs increased dramatically due to more complex electronics in the track, more train units, more personnel, and so forth. The result: Transrapid has now been re-engineered for scheduled departures every 20 minutes. The resulting design simplifications and scheduling of fewer trains per hour result in savings of hundreds of millions of dollars.
The same analysis is also valid for services. For example, we helped a medical technology company to develop its after-sales service by optimizing the response time of the service (next day, within four hours or within two hours) and the service availability (9 a.m-5 p.m., 7 a.m.-10 p.m. or 24 hours). Performances above a response time of four hours and availability from 7 a.m. to 10 p.m. had a marginal impact on the value-to-customer but major increases in the investment and the operation costs. You can see, then, that profit-optimizing the design of products and services at early stages of the product development process can benefit all industries.
The technology markets of today are fast-paced. It is in these markets that we see the pricing research being moved forward in the planning cycle, resulting in better and more profitable products and an optimized resource allocation and portfolio management. This proves to be a nice additional benefit of being rushed for time.
Hermann Simon and Ulf Munack are chairman and consultant, respectively, with Simon-Kucher & Partners, Cambridge, Mass, an international strategy and marketing consulting practice. Simon is co-author with Robert Dolan of Power Pricing: How Managing Price Transforms the Bottom Line (The Free Press).
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