The subject of pricing makes most people uncomfortable – including those involved with new products. No surprise there since many organizations keep the responsibility for pricing in either finance or product management. But not including pricing strategy as a key, early element of your new product process is a serious mistake that leaves money on the table at best. And what’s worse – it can squander your constrained R&D resources. Quite simply, the best time to get pricing right is at the start – sometimes it’s the only chance you get.
The first question I ask B2B or industrial companies is whether they price for value or for margin – Note: We’ll cover consumer markets in a later article. I find that the majority of industrial companies price for margin. That’s unfortunate because pricing for margin is all about you instead of the customer. It starts with estimating your cost to manufacture; it finishes with setting a price to deliver either your target or minimum acceptable margin. The process isn’t quite as slavish as it sounds though. Some companies look at the competitive situation and tweak the price up if they can. Others start somewhere above their target margin in order to provide themselves a cushion.
On the other hand, pricing for value is all about what’s in it for the customer. Starting with the value created for the customer you can then determine whether there is anything in it for you. Pricing for value means starts with spending the time to understand what the customer’s problem is costing them and how much your solution will help them. The best way to quantify value is to estimate the impact in terms of increasing their sales Throughput (cash flow), reducing their Investment in working capital or reducing their Operating Expense. Those familiar with Goldratt’s Theory of Constraints will recognize this as ∆T, I, & OE.
But pricing for value is not a selfless act of charity. Once you understand the value created, your next step is to determine what percentage of that value you can expect to share in. The best way I’ve found to do this is from the customers’ perspective. Pretend you’re the customer and evaluate the new product based on the financial gain it’s going to give you. That usually means doing a cost in use analysis and then calculating either a payback period or a return on investment (ROI). Most companies expect to see a fast payback – 12 to 18 months – before they’ll buy. With a little trial and error, you can quickly determine the highest price that gives customers the payback they require. Of course, now that you know what’s in it for them, you can estimate the margin and ROI that’s in it for you.
Pricing for value helps better exploit your constrained new products development resources. Doing the upfront work to understand the value created and what price delivers an attractive payback for the customer defines commercial feasibility. It also helps you to evaluate, beforehand, whether the new product project is a good investment. If that works shows the value created also generates a margin at or above your target and a return on development resources that is equal to or better than your other opportunities, then the project deserves a place in your new product pipeline.
The argument for simplicity. Doing up front value work is an investment in itself. So, some will argue that pricing for margin is simpler and that you can still plug your price into a customer value in use model to see if it is attractive. But pricing for margin doesn’t include the customer’s perspective so it can leave margin on the table. Why settle for a 35% target margin, when your value work shows a 65% margin would give the customer a 12-month payback? Furthermore, pricing for margin fails to evaluate feasibility and weed out the products that will ultimately fail to deliver the margins you desire.
So what’s your pricing strategy? Join the conversation and let us know what you think.