Failing to optimally price your new offering can quickly translate to lost profits. In fact, just missing the best price by 1% can mean eliminating about 8% of your new product’s potential operating profit:

Pricing a new product is tricky. A price that’s too high will slow sales—a situation that can be remedied relatively quickly by charging less. Much more risky is asking too little for a new product. By setting a price too low, companies not only forfeit sizeable revenues and profits but also undermine the product’s market value position. And once prices reach the market, companies discover that it’s difficult, even impossible, to increase them. According to some analysts, 80-90% of all badly selected prices are too low.

Companies repeatedly commit this costly mistake even after pouring millions or even billions of dollars into the development or acquisition of a product. They often price their new offerings too low because they feel pressured by customers who have come to expect more for less. Companies also undercharge in response to global competition, greater pricing transparency and lower barriers to entry in many of the most appealing industries. And on top of these issues, many companies charge too little in an attempt to quickly penetrate markets or rapidly realize return on investment.

These concerns compel firms to price products using an incremental approach, which bases pricing decisions on how much current products cost. For example, if a new product is 15% more expensive to manufacture than the previous model, then a company asks 15% more for it. But this approach frequently fails to capture the full value of a new product—as one of the first manufacturers of portable bar code readers discovered. The company used the price of stationary readers as a reference point, increasing it in proportion to how much time customers would likely save using portable readers. But the new offerings turned out to be revolutionary, not only accelerating current processes but also allowing customers to dramatically improve their supply chains. The company ended up undervaluing its own product as well as fixing the market’s price expectations too low. Its misstep easily cost the industry $1 billion or more in potential profits.

To avoid such blunders, companies must take an expansive rather than an incremental approach to pricing decisions. They must figure out both the highest and lowest prices that they could set for a product. It’s advisable to embark on this price-benefit analysis early in the development cycle, when the market is first being studied. In so doing, companies can find out if products are feasible or not due to price barriers as well as discover what features customers value most.

For new products that are comparable to others on the market (“me-too” products) or ones that deliver slight enhancements (“evolutionary” products), the range of pricing options is relatively small. Meanwhile, for products that are so novel that they create their own market (“revolutionary” products), the spectrum is much wider. But remember, even if the pricing range is narrow, there’s still a lot of potential for lost profit if the product is not priced optimally. In fact, asking for just 1% less than the best possible price for a product can mean erasing about 8% of its potential operating profit.

Identifying the Ceiling

Since incremental approaches tend to emphasize the lower reaches of a product’s price range, companies should begin by establishing the highest amount they could charge. To set the ceiling, businesses must explore all the benefits that the product offers customers. While some benefits—including savings on raw materials—have values that can be readily quantified, others—such as brand reputation—are more difficult to measure and must be probed using market research.

The market research must go beyond using known values as reference points, so that companies can address a wide range of possibilities. The research should not be swayed by internal perceptions or limited in scope, or else it could end up simply verifying what the product’s developers have said or what the sales force has gathered from the field. To accurately measure a new product’s benefits and thus identify its price ceiling, market research must be aimed at obtaining more open-ended feedback than what can typically be gathered through multiple-choice questionnaires or comparisons with other products, which can both restrict responses.

Finding the Floor

While often dismissed as inadequate, cost-plus pricing is integral to establishing the lowest point of a new product’s price range. By accurately analyzing costs per unit and taking into account a margin that corresponds to the lowest satisfactory return on investment, companies can define a new product’s floor price. If the market cannot support this price, then the company must reconsider if the product is feasible.

While the cost-plus model is widely used, companies often commit missteps in two areas when they utilize it to assess their costs. First, astonishingly, they fail to consider all of the costs that should be assigned to products. Two costs commonly overlooked are R&D expenses linked with a product category and goodwill associated with acquisitions that pave the way for new products. Second, businesses can make excessively optimistic market projections that can support inaccurate estimates of costs, especially fixed ones.

Establishing the Release Price

Companies must also rely on research to assess the size of the market or market segments for the various pricing levels at and below the ceiling. While it may seem that moderating the price will automatically increase demand, this is not always the case. Choosing to go with a mid-range price, for example, might paralyze sales. While quality-conscious customers will find the new product too cheap, bargain hunters will think it’s too expensive.

After a company has gauged the size of the market at different points within a new product’s pricing range, it can begin figuring out the release price. While it might seem most rewarding to pursue the biggest market segment within the range, this doesn’t always work, as the greatest volume doesn’t necessarily translate to the largest profits. In fact, going after the largest market—particularly if it compels a company to charge moderately for its product—can be dangerous.

With a new product’s reference price—its release price minus any discounts or other incentives—a company is communicating what it believes its new offering is worth. Thus a reference price that’s too low can impede the product’s long-term profitability, as the resulting tighter margins cause the company to forfeit the profits that a higher price would have secured once a customer base had been developed. Second, a low price—especially for evolutionary products—could ignite a damaging price war. Since competitors typically cannot respond quickly by building upon their products’ benefits, they react by cutting prices. A higher reference price, on the other hand, implies that a company is seeking profits rather than market share and might elicit few, if any, immediate responses from rivals.

Companies should consider a product’s lifecycle when setting a release price. A high release price might be acceptable to some early adopters, who will willingly pay for the product’s benefits. The company can thus claim the extra value then reduce the price as time goes on to draw latecomers. This strategy will not only help a company generate more revenue over a product’s life, but also allow it to ramp up production capacity to meet demand. Moreover, setting a higher release price aimed at a narrower segment of customers will ease the problem of cannibalization—new items eating up the sales of existing ones from the same company. However, if a previous product line is being discontinued, then a lower release price for a new product could speed customers’ transition to the new line.

Bringing the Product to Market

The first six months to a year after a new product reaches the market have a huge impact on its value position. Particularly during this time span, companies must tightly regulate their pricing operations, right down to each transaction. Rebates or standard discounts, which could be customary for ongoing product lines, might undermine a new product’s reference price. To penetrate markets quickly without compromising a product’s reference price or perceived value, companies can try other strategies such as giving consumers free samples or providing a free-trial period. Companies can also release the product to select groups of customers who can sway the market. In short, there’s no need for companies to continue their costly habit of charging too little for new products. Instead, they should base release prices on sound market research and cost analysis, thereby capturing a new product’s full value.

Source: Pricing New Products
Michael V. Marn, Eric V. Roegner, and Craig C. Zawada
The McKinsey Quarterly, 2003 Number 3
www.mckinseyquarterly.com