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Conventional wisdom holds that the best time to launch new products is in the early stages of an economic recovery, when demand picks up and customers become less price-sensitive.

While this may be true for some, our experience shows that most companies actually miss a significant opportunity to maximize revenue and profits due to dysfunctional pricing strategies with roots that can be traced to the years before the recovery.

During the recent recession, we frequently saw entire markets consumed by ad-hoc discounting by companies trying to defend their piece of a shrinking pie. In the process, these companies sent a clear signal to customers that price was entirely negotiable and they would give value away if pushed hard enough.

To make the sale, many companies also began bundling additional products and services into their core offering to "sweeten the deal." But by giving away services, these firms drove up their costs and taught customers that their services were not highly valuable.

These shortsighted pricing approaches may have helped maintain sales, but they also taught customers to focus on price and ignore value.

Numerous traps can sidetrack well-intentioned new-product pricing strategies. Our research indicates that there is less than a 50% chance that new products will hit their volume and profit goals. Avoiding these traps will be critical for firms that are depending on successful new product launches to drive earnings and growth in the resurging economy.

Based on our extensive fieldwork, we see three broad categories of "pricing traps" that companies must avoid to insure successful and sustainable product introductions.

Trap No. 1: Pricing Benefits Instead of Value

In a recent study we conducted, 70% of product managers surveyed indicated that their biggest challenge in new product pricing was how to understand (and quantify) the value that their products and services delivered to customers.

We often see companies who grossly overestimate or underestimate the value that their product delivers to customers. A recent example is a medical device manufacturer that had developed a new visualization tool that could speed up certain clinical tests up to tenfold. When the product was introduced to the market, it was highly praised by customers and the press, who recognized the power of the innovation. Despite the kudos, sales fell far short of expectations a few months after launch.

We determined that different segments of the market realized significantly different value from the product. For example, pharmaceutical customers saved enormous amounts of money by reducing the labor required to run thousands of testing procedures per month, while university segments found the productivity improvements actually destroyed value because they reduced the amount of time that students had to learn the testing procedures.

As this example illustrates, understanding the economic value that your product brings to different customer segments is an essential ingredient to launching new products. Moreover, economic value must be understood in relation to the value delivered by competitors, because customers are comparing competitive offerings when making a purchase.

Armed with this data (i.e., the price of the next best competitive offer and the economic value you bring to customers), you can begin to develop a credible pricing approach to help drive and sustain volume and margins growth.

Why do so many companies get this critical step wrong?

In our view, the problem is fueled by an overreliance on traditional marketing research techniques such as focus groups, surveys and conjoint studies that are unable to answer one critical question: How will my product drive revenue or reduce costs for customers?

Focus groups are helpful to understand the types of benefits your product might deliver to customers. Surveys can provide validation for how those benefits vary across customers segments. Conjoint studies can provide statistically significant results for how much customers are willing to pay for a new product.

However, decades of experience has led us to conclude that the most effective way to assess the value that you bring to your customers is through in-depth interviews, which enable you to understand your customer's business model and how your product helps cut costs and drive revenue.

Armed with intimate knowledge of how your product affects your customer's business, you can construct an economic value model that becomes the foundation for your pricing and sales strategy. Taking this step, along with appropriate sales training, has resulted in tens of millions of dollars in additional revenue for our clients.

Trap No. 2: Managing Customer Risk with Price

By definition, new products involve some risk to customers because they represent untested solutions to business needs. For incremental innovations involving minimal changes in technology or customer use, the risk to customers is lower.

It's a far different story for more innovative products, however, because they present customers with a dilemma. They offer the potential to dramatically reduce costs or drive revenue relative to existing solutions (i.e., they create significant economic value). At the same time, it is unproven whether the product can actually deliver on its value proposition.

Although customers may recognize that your product or service has the potential to create significant value, they must weigh that against the possibility that the underlying technology will fail or that the seller hasn't worked out all of its "bugs." The result is sluggish post-launch sales because customers are reluctant to be the first to test a new offering.

When faced with this challenge, many companies make the critical mistake of attempting to help customers overcome the perceived risk by discounting. Their logic is that lower introductory prices will bring customers into the market, creating sales momentum for the new product.

Unfortunately, price discounting rarely works for innovative products, because it fails to address the real problem—customer risk—while creating low price expectations that reduce margins on future sales. When launching innovative products or services, a far better approach is to maintain price levels and develop a separate strategy to manage customer risk.

One firm used this approach with great results when it introduced a handheld computer to help doctors record patient notes and integrate them into an electronic record. The device produced significant time savings for doctors and staff, but hospitals perceived considerable risk—that the device would be lost or stolen—and were reluctant to purchase large quantities.

Initially, the sales force responded to these objections with price discounts. But an analysis of the firm's sales records revealed that less than 1% of orders were to replace lost or stolen devices, indicating that the actual risk was much less than customer perceptions. Instead of steeper discounts, the firm launched a 100% no-theft guarantee, offering replacement of any stolen device.

The guarantee was a big hit with customers and turned a major negative into a significant driver of the product's value proposition. Moreover, the cost of the program was miniscule compared with the lost revenue the company would have experienced had it tried to fix the problem through discounting.

Companies should look at risk-management strategies such as performance guarantees, beta testing and free trials to help drive adoption of new products. A powerful technique gaining momentum in the software industry is usage-based pricing, which ties the price that customers pay directly to the amount of the product used. The more customers use the product, the more they pay for it.

In technology markets, usage-based pricing metrics are rapidly becoming the norm as customers balk at paying for a fixed number of licenses, many of which don't get used and become shelfware. A usage-based metric that tracks the number of users, degree of functionality used and/or the time of use removes the customer's risk of overbuying and helps control costs.

The challenge of usage-based metrics is that they force sellers to really understand the economic value that they bring to customers in order to set the right price level. For many firms, this is a daunting task; but if the seller has done its homework and assessed the economic value it brings to the customer, then setting the right price metric becomes fairly routine.

As the examples illustrate, creative risk management strategies can help support higher prices and encourage trial.

Trap No. 3: Failing to Manage the Post-Launch Price Trajectory

The cold reality of today's marketplace is that the value of your new product begins to erode the second it hits the marketplace as competitors copy your features and cut price to defend market share.

Instead of proactively managing these predictable market dynamics, too many firms adopt reactive, short-term pricing strategies that drive down industry price levels and reduce profits for everyone. Although price levels for any new product or service will eventually fall as competitors begin to catch up, it is possible to reduce the effects of competition with a few simple steps.

The key is to make sure that you don't give away price in the heat of battle. A manufacturer of mass spectrometry devices recently introduced a new model that offered significant performance improvements over its major competitor.

Happily, sales exceeded the target, and the marketing team felt that it had had a successful launch. But after a few months, the sales force began to report that customers were beginning to push back on price, demanding significant discounts to close the deal.

When the price pressure continued, the team performed an economic value estimation (EVE) to better understand what was happening in the market.

The results were telling. At launch, the product offered significant economic value relative to the major competitor. However, in an effort to grow share, the team had conservatively priced the product—just above the competing product—creating a strong inducement for customers to switch. The competition perceived this as a threatening move and responded with a price cut of its own, which only encouraged customers to seek similar cuts in the price of our client's product.

By failing to carefully think through its post-launch pricing strategy, the firm lost hundreds of thousands of dollars in revenue and accelerated the commoditization of its own product.

Fortunately, there are steps you can take to delay price decay:

  • Upgrade value—not features. A commonly applied strategy is to periodically refresh products with new features. The theory is simple: the only way to stay ahead of competition is to enhance the product through added features. The problem is that this approach often leads to overbuilt products that don't necessarily solve your customers' business problems. Instead, we recommend prioritizing those features based on the economic impact they have on your customers' business. Firms adopting this approach typically find that some of the features they planned to include are eliminated while others that weren't even considered receive a high priority.

  • Plan your service rollout over several stages. One of the most powerful ways to augment the value proposition of your product and resist price pressure is through carefully planned service enhancements. Augmenting your product with service solutions enables you to present a "fresh" solution to customers at a time when they are ready to buy. But be careful. The goal is not to provide the most services, only the most valuable ones. Well-planned services can be rolled out to coincide with the maturity of your product offering and become an important part of creating loyal and lasting customer relationships.

  • Focus on share of wallet. One of the chief reasons for the decline of new product prices is the mismanagement of competitive pricing interactions. Companies launching products and targeting new accounts often run the risk of starting price wars with the entrenched competition. An alternative approach (especially in mature markets) is to shift the focus from acquiring new accounts to capturing a bigger share of current accounts. Focusing on share of wallet instead of market share enables you to capture new sales in a less threatening way and is less likely to invoke a significant competitive response.

Pulling It All Together

New products are critical to future revenue and profit growth for all companies, and it is critical to avoid the traps that undercut price integrity. At best, getting snagged by these traps will reduce profits and hurt sales; at worst, they will put you at a significant disadvantage when negotiating with customers and help accelerate the commoditization of your markets.

The good news is that these traps can be avoided if you have a clear understanding of the economic value that you bring to customers and know how to leverage that understanding in a proactive pricing strategy.

Our experience is that a value-based new product pricing strategy can be worth millions to the bottom line. After several years of a down economy, most companies need to prove that they can grow steadily with a recovering economy. You simply can't afford to squander the success of any new product launch with poor pricing decisions.

Continue reading "How to Avoid New-Product Pricing Traps" ... Read the full article

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ABOUT THE AUTHOR

John E. Hogan is vice-president and director of research in the Boston office of Strategic Pricing Group. He can be reached at jhogan@spgconsulting.com. To register to receive SPG Insights, visit www.strategicpricinggroup.com.