Price Optimization for Innovative Durable Goods
Ben Kluge, Stefan Herr
In the durable goods sector, it is an illusion to believe profitable pricing results from cost analysis and target margins. The optimal launch of a product in this sector relies on more. The following article will show how profit potential can be increased through the effective use of market information. The price information presented here is based on real data. However, due to reasons of confidentiality, it has been slightly modified and does not allow any conclusions to be drawn about the original case. All data was obtained through expert interviews that were carried out during the last year with leading companies in the electronics and machinery industry.
Companies today are spending millions of dollars on development of new technologies. Investments of this sort present an enormous risk. For this reason, the launch of a new technology is often controlled by a company’s top managers. But in order to execute a market launch successfully, a manager has to have more than broad experience: He or she must also have a particularly good feel for the market and for future customers.
But determining the optimal price for an innovative technology requires more than just experience and instinct. Even the smallest pricing mistakes can lead to devastating effects with losses in the millions. Sub-optimal prices are extremely difficult to correct after market launch.
The following example illustrates just how little room for failure there is in pricing new technologies. Company X has developed a new generation of machine technology that can better satisfy customer needs. The new machine should thus be offered at a premium price. A potential 500 machines could be sold worldwide within the next two years. Based on intensive internal discussions and previous experience, management decides on a launch price of 800,000 Dollars.
Assuming that Company X’s management is very good at determining market launch prices and 800,000 Dollars is only five percent below the profit-optimal market price, the result would be a loss of potential profits of 20 million Dollars within the first two years. Likewise, if the price were set five percent too high, the potential profit loss would be considerably higher. Many potential customers would probably not switch to the new technology due to the higher price.
This example shows just how important an optimal market launch price is. Even small pricing errors can lead to enormous financial losses, or, in the worst case, to the failure of the launch all together.
Determining the optimal launch price requires fundamental market information and strategic decisions.
Determining the optimal launch price requires fundamental market information and strategic decisions. Diagram 1 gives an overview of the important information basis.
Diagram 1: Information basis for determining market launch price
Three pieces of information are absolutely necessary to determine the optimal market launch price for a new technology: accurate knowledge of potential customers’ willingness to pay, the preference of the customer for regional or global purchasing, and the individual buying intentions of potential customers. A focused customer analysis is useful for closing in on this information.
Before introducing a new product, the goals for the market launch strategy have to be defined. There are two possible strategic options: the maximization of profit or the maximization of turnover. It is also necessary to decide on the exact specifications of the product or service, determine the variable costs for various product specifications, and define the target regions and regional preferences.
This information can be joined together with the help of a decision support model. In the following, we will use a real example, the global market entry of an automatic production machine for electrically-engineered high-end products, to illustrate the main steps involved in price optimization. Endowed with a new technology, this product has significant advantages over other production machines currently on the market. The goal is to maximize profit. Three steps must be taken to optimize the price of the new machine: the simulation of sales and profit; the development of a global price corridor; the creation of a customized discount policy in order to implement the pricing policy.
By simulating sales and profit, companies can determine optimal prices without having to risk financial failure in the market.
The information on potential customers’ willingness-to-pay and buying intentions can be used to simulate machine sales and profit development in relation to price. Diagram 2 shows the relationship between machine price /sales and machine price /profit for the regions Japan and Europe. The same simulation can be conducted for every region defined in the sales strategy. The profit-optimal machine price lies at the apex of the profit function.
Diagram 2: Simulation of sales and profit in relation to price
Markets with globally operating customers need a global price corridor.
As the example shows, the optimal price can vary considerably from region to region. This can be due to several factors, including regional differences in the acceptance of the technology or the varying competitive intensity of the markets. These differences can become a problem if customers purchase machines globally for their regional branches, or if they require globally uniform conditions. In the latter case, a lower price level in a less important region would negatively affect a higher price level in more important regions. Global purchasers would pay the lowest prices, thereby destroying the expected higher price level in the important sales regions. If there are large discrepancies between the price levels in the individual regions and if the profit-optimal price of a less important region is below that of the more important sales regions, a globally feasible price corridor should be defined based on the simulation of the regional price optima.
Diagram 3: Global price corridor
Diagram 3 shows the necessary adjustment of regional price in Europe. Marketing strategists had already determined that this region was less important for the launch of new machine technology. As a result, the low price derived from the price simulation needs to be adjusted to the higher prices, otherwise the anticipated higher price level in Japan and North America could be jeopardized. Diagram 2 shows that by raising the market entry price in Europe, only 80 percent of the profit potential in this region is exploited. By forfeiting profit gains in Europe, however, a higher price can be established in the regions more important to the sales strategy, namely Japan and North America.
Optimized prices are not standard prices. The appropriate actions must be taken to implement them in the market.
Optimization of market entry prices does not mean that all customers in a region have to pay the same price. A uniform price would not be feasible since customers differ greatly from one another in sales volume (number of machines) as well as in market power. Moreover, some customers enjoy special conditions due to strategic partnerships with suppliers. In order to take advantage of the differences between customers, a list price is set which is higher than the desired end price. An individualized discount policy takes customer-specific characteristics into account. The size of the discount depends on the industry the customer is in. The previously determined profit-optimal price must be achieved on average for all customers within a region, in order to reach the desired optimal price level in that region. Diagram 4 illustrates the relationship between list price and individual price per customer.
Diagram 4: List price and rebate policy
By simulating the profit-optimal price, defining an adequate price corridor and determining the list price and rebate policy, the pricing strategy for the global market launch of the new machine technology is optimized.
Reaction to competitive activity must be planned before it becomes acute in the market.
After the launch of a new machine technology, the competition could respond in one of two ways: either by lowering prices, or by improving/innovating their own machines. Therefore, before launching a product, a company needs to plan how they would protect their position from these actions and how they would react to these scenarios quickly and appropriately.
Scenario 1
Competitors react to the launch with price reductions, but not with any substantial technical improvements to their machines. This means that your newly introduced machine technology has a considerable and lasting competitive advantage.
Reaction: In this case, no quick reaction to competitors’ price reductions is necessary. Customers who prefer the performance advantages of your new technology will be influenced by price reductions for the competitors’ older technology only for the short term. By hastily reducing prices, you would only destroy the established price level for the new technology.
Scenario 2
Competitors react by making technical improvements to their machines, but fail to reach the performance level of the new machine technology. The performance level differs by more than 30 percent.
Reaction: This situation is similar to Scenario 1. Customers who prefer the performance advantages of an innovative technology will allow their buying decisions to be influenced by marginal improvements in older technology only for the short term. As in Scenario 1, hastily reducing prices would only serve to destroy the established price level.
Scenario 3
The relevant competitors react with considerable technical improvements/innovations in their machines and achieve the performance level of the new machine technology.
Reaction: In this case, the price level of the new machine technology needs to be adjusted to the entire market. If competitors retain the old price level despite considerable improvements in performance, a reduction in the previously established premium price level for the new technology is necessary. If competitors raise the price level due to the considerable improvements in performance, price reductions for the new machine technology should be implemented only to a limited extent.
Scenario 4
The relevant competitors react with the market launch of their own innovative machines and achieve a higher level of performance than your new machine technology.
Reaction: In Scenario 4, the competitors’ price levels set the standard in the market. Lower performance levels must be compensated by lowering prices, in order to retain current customers.
This sort of competitive activity and the best possibilities for reaction can be analyzed by conducting comprehensive market simulations already at the time of market launch. By doing so, you will be in the position to respond quickly and appropriately to changes in the market.
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