Pricing primer for Product Managers
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“How should we price this product?” — somebody posed the question in our weekly product meeting. I had no idea.
It was my very first product launch and I had no experience pricing a real product before. The closest I had gotten to “pricing” something was at a Product Positioning and Pricing course at business school — but again, that was coursework based on hypotheticals, and this was the real world.
The idea was to price the product such that we could maximize profits. The “profitability north star” seemed like a good one to go after. The product launch was still a few months away, so we had some time to finalize our pricing.
Upon returning home that evening, I remember diving into my MBA coursework to refresh pricing basics.
At some point, most Product Managers will participate in or even lead a pricing exercise. So in this post, I will lay out some tips on how to think through pricing your product and some commonly employed Pricing frameworks that you can use as a reference to price your own product.
Where to Start
In my experience, it’s best to start with taking a look at what your product and its competitive environment are before jumping into pricing research.
Is your product a better version of another product that’s already out there? Or, Is it truly New to the world, and nothing like it exists? Is it hardware only, software-only? Is it a professional Service?
What are the competitive dynamics in your industry? Is it a highly competitive commodity business? Or is it an industry where high prices signal quality? Or somewhere in between?
Explore Value-based Pricing
The best way to price any product is to be able to price proportional to the differentiated value it delivers over the next best alternative — as perceived by the customers. This is called “Value-Based” Pricing.
To apply Value-based pricing
- Your Product must have at least one differentiated feature over other incumbents/competitors
- There must be at least one alternative in the market that your target customer segment currently buys from — and you have a fairly accurate idea about the prices customers pay for that alternative
- You need to be able to quantify the perceived value of your differentiated feature. This can be done using techniques like Conjoint analysis, or other Qualitative customer interviews.
Quick Example: Say you are about to launch a NEW microwave oven with an “Auto Clean” feature — and you want to figure out how to price it. Your closest competitor recently launched a new microwave (No Auto Clean) and priced it at $150. Both microwaves otherwise have similar features — capacity, power consumption, size & weights, etc.
From a Value-Based pricing approach, the question you need to answer is — how much more will microwave shoppers be willing to pay for the “Auto Clean” Feature?
This is the hard part, but let’s say you figure that the differentiated Bluetooth feature is worth an extra $75. In theory, the Value-based price of your new Product will be $75 over what customers pay for a regular Microwave oven — or, $225.
The concept of Consumer Surplus
In reality, however, it’s unusual to successfully capture the entire $75. More likely you will end up sharing some of it with the customer — this way customers have a positive incentive to buy your product and upgrade. Maybe you price the product at $200 instead of $225. The difference of $25 is also known as Consumer Surplus in pricing economics.
Net, net — customers buy only when they think they are getting more value than what they are paying for.
Consumer Surplus= Perceived Value of a product - Actual Price Paid
Note: You can also apply Value-based pricing to your own product portfolio as well….much like Apple does.
When Value-Based Pricing doesn’t work
Here are a few scenarios where value-based pricing doesn’t work so well.
If you have an undifferentiated product — you are not generating any additional incentive for the customer to choose your product over competitors.
If you have a truly New to the world product that has no peers — You have no competitive benchmark to work with and quantifying value turns out to be very complicated.
If your competitor’s market pricing is largely opaque. There are several B2B industries (e.g. O&G, Industrials) where unlike CPG industries, market pricing is vague or even confidential. Blind biddings are a case in point where companies do not know what competitor bidding prices are.
If your differentiation isn’t defensible — If it’s not defensible, competitors will simply copy your feature and undercut you in price.
In some ways, I should have talked about Cost Plus pricing ahead of Value-based pricing because Cost+ is what companies mostly end up using to price their product.
This is especially true for Physical products, where dynamic market price testing and figuring out how different customer segments value your product is difficult, compared to software.
Furthermore, quantifying Willingness to pay for people is easier said than done. Not only does it require employing complicated & theoretical market research methods such as Conjoint — it doesn’t help that real customers will negotiate — and won’t readily reveal how much they value a certain product (lest the price goes up).
So what do you do when you aren’t really sure of how much people will pay for your product? You take the easy way out — and use the COST + model.
You simply add up all your costs, and then put a markup on top to price your product to get a selling price such that you are always in profit.
Sell Price = Costs + X% Mark-up over Costs
We love to hate Cost + pricing
“Cost-plus pricing is a lot like the romance novel genre, in that it’s widely ridiculed yet tremendously popular” — Utpal M Dholakia, Rice University
Most Product Managers rightly hate it, after all, it’s an inward-looking pricing strategy. It ignores market pricing levels and what competitors are doing. All you care about is your costs. You are, by definition, disconnected from what customers are willing to pay!
But what really sucks about Cost + pricing is this.
You need to be VERY sure of what your costs are — and yet you can almost never be sure of your costs in the beginning.
If you’ve ever built a physical product in a factory — you’ll know what I am talking about. Your material and overhead costs estimations are linked to future volume expectations — which by definition are just that — expectations.
Say it costs you $5 of material & labor to build 1 unit of product. You build it in a factory where you pay an yearly rent of $10000.you guesstimate that you can build and sell 5000 units every year.So your total cost for each unit will be $5 in Material & Labor
+ $2(=$10000/5000) in rent allocated to each unit produced.= $7/unitNow say you want to make a 50% profit margin your Sell Price works out to be $7+$3.50 = $10.50.
See what happened there? You guesstimated an annual volume of 5000 units when you started production.
But what if after you launch, your demand is only 1000 units? As managers, we are often guilty of overestimating volume estimates.
At 1000 units, your real cost of the product balloons to $15/unit! (Material & labor — $5/unit + Factory Overhead -$10/unit ). Worse still, Your market price is pegged at $10.50. In the real world, it is VERY hard to increase prices up without losing customers to your competitors. Not a pretty picture. So you see, Cost + pricing is not guaranteed to cover your costs and turn guaranteed profits.
But Cost+ Pricing isn’t always bad — in fact it can be the right thing to do
First off, Cost+ pricing is easy to understand — anybody from the company CEO to the guy at the sales counter can apply a markup to the costs and come up with the price.
Your customers will appreciate the simplicity and transparency especially when you are raising prices on them. Your salespeople will have a much easier time explaining that prices are rising because costs have increased rather than haggling with them on perceived value. Typically, customers will accept the arguments as fair.
Many product managers go with Cost + pricing in the beginning since they simply cannot have all the information they need to understand customers’ willingness to pay or their perceived value. But as long as you buffer your costs enough — Cost + is sort of a hedge against incomplete market information.
Pricing Strategies to Position your Product
Value-based and Cost+ pricing strategies form the core of how to of think through pricing any product. But Pricing can also be used strategically, given an industry and product category.
Here are some commonly employed pricing models that you might want to be aware of:
NOTE: The quadrants are depicted as Price vs Quality — but low quality here doesn’t necessarily mean a poor quality product — maybe the product has limited variety or maybe is a relatively new/unproven product.
You employ this pricing strategy when you believe your product is very high quality and/or exclusive — and you put a price tag on it to signal that high quality or exclusivity. Examples are high fashion, luxury brands such as LVMH, Rolex, etc.
Pulling this strategy off is difficult for new products without an existing brand reputation but it can be done — either via signaling the high costs involved in the production (e.g. Handmade, exquisite materials, limited edition, small-batch) or selling to an exclusive group of people that will buy your product at high prices.
Your high pricing means you’ll most likely cover all your costs — but your volumes will be limited. Expect a lot of competitors springing up to undercut your price but you must stick to your premium pricing levels or your value proposition to your customers will dilute significantly.
In this strategy, you price your product at a premium, only selling initially to a select group of people or early adopters (similar to the premium pricing model) but over time you introduce product variants that cater to the wider market.
The best example of the Price Skimming strategy is Tesla Motors. Tesla’s first car Roadster was at a premium price — over a hundred thousand dollars at the time — targeted towards early adopters that believed in an Electric future and the company.
Over the next decade, Tesla built its brand reputation for fantastic Electric cars and has since introduced several different lower-priced models available for different segments of the market.
Things to consider when pursuing a price skimming strategy — don’t disappoint your early adopters by diluting the value of the product they paid a ton of money for. The way Tesla handled it was not to dilute the Roadster brand — but by introducing MODEL X, Y, S & 3 to capture the wider market.
Another thing that Tesla is very careful about is not discounting its cars. Discounting is rampant across the car industry especially during year end inventory sales — but Tesla never discounts its cars. This not only helps Tesla maintain its margins on new cars — but Teslas on the road also are able to retain their re-sale value much better than other cars.
Penetration Pricing :
If you still recall how this post started — our team discussion on how to price our product — this is the pricing strategy that we ended up going with.
With a penetration pricing strategy, you launch your product with “Special Introductory Pricing” for a “limited time”. Once the special pricing period expires, you go back to offering your actual price (Competitive/Value-based or Cost+ models).
The goal is to get people to try your product for a low price — and then raise prices once the introductory period expires. Penetration pricing is mostly used to price software and services — as you can easily start/stop service if customers choose to opt-out after the introductory period is over. The ubiquitous “Freemium” business models are another manifestation of penetration pricing.
A few things to consider
If you are launching with the goal of getting people to switch from your competitors to your product — penetration pricing is a good way to do that. But this will only work if
- Switching costs for customers are low in that industry
- Your product is at least at par or higher quality than competitors
If #1 isn’t true — then people won’t switch. If #2 isn’t true, people won’t stay.
Another reason you might want to go with this strategy if you have a new to the world product that people have never used before. Penetration pricing allows people on the fences to try the product for a while (at a low/no cost to them) — experience the magic — and hopefully convert to a full price paying customer once they see the value in it.
Economy Pricing :
This is a pricing strategy that most of us are familiar with. You walk into a Walmart or a large grocery retail chain — you have the brand Name Kleenex tissues and you have another No-brand/ Private label tissues for 30% cheaper. That’s economy pricing in action and stores do this to drive market share and capture the large segment of grocery shoppers that doesn’t care about the brand of their toilet paper.
But Economy pricing isn’t for everybody.
First off, it’s a manifestation of the Cost+ pricing abstract — and your costs must be very competitive such that you are able to sustain low prices. But the issue is you need volumes to reduce costs — and you need lower costs to drive volumes. It’s sort of a chicken or an egg issue for most small businesses.
Economy pricing also comes with the expectation that the quality isn’t going to be the best out there. Again quality here doesn’t necessarily mean “product quality”, although it could — It may also mean for instance, that customers can only choose from a few standard models.
If you are a small business or starting up, you’ll struggle to be profitable with the Economy Pricing strategy.
If you are want to create a brand or value that customers recognize and pay for — Economy pricing isn’t what you should do.
In sum, stay away from the Economy pricing game unless you are a large deep-pocketed conglomerate that can afford to lose money until competitors are forced to quit.
This has been another long post but hopefully, these concepts will help you think about your product pricing in a more structured fashion. The reality is that there is no pricing strategy that works for all products. But knowing several strategies gives you a good sense of what you can go with.
Start thinking about how to price your product right from the word go instead of at the very end. Progressively Test different strategies to see what works best for you. Understand your cost position vs competitors, the perceived value of your product to the customers. Think about how much of that perceived value can you capture? How would competitors respond? What would your response be? Finally, Pricing isn’t a one-time decision, you must constantly evaluate your pricing against new market realities.
Pricing your product will be one of the most important decisions you’ll make as a PM.
Do the research, Make it count.