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Maximizing Value through Effective Pricing Strategies and Tactics
Introduction to Product Pricing
Warren Buffett said it best: “Price is what you pay. Value is what you get.” The difference between value and price has a lot to do with the problem your product solves for customers. Whether your product is paint sold in a web shop, your interior design skills, or guitars manufactured by your company, it’s all about the problems to solve for customers. Classic guitars, for example, are a combination of wood and strings. When you ask owners of Fender and Gibson guitars about what value is to them, however, you’ll likely get many different ideas and opinions. These two brands offer and sell different experiences, although both sell a similar product. The same could be said for the Harley-Davidson brand. It doesn’t just sell motorcycles; it sells a way of living.
“So what? Why does it matter?” you may wonder. Well, let’s take the product water as an example (see Figure 13.1). Plain and simple tap water is a fine way (in most countries) to resolve your thirst. It’s also a very cost-effective solution to resolving thirst. The price of tap water in the Netherlands, for example, is around 0.60 to 0.70 cents per 1,000 liters. The pricing strategy used by water companies is cost-plus pricing, meaning that all the costs for the product are calculated, a small margin is added, and that’s the price for customers.
Figure 13.1 Different price levels of water. What is the perceived value?
With such an affordable product on the market, why would there be a need for a competing product? Well, there are plenty of competing products when it comes to water. Mineral water, for example, is sold in bottles at roughly 40 times the price of tap water and has a mind-boggling market cap of $350 billion.1 Prices from various suppliers are within a close range, between $1.20 and $1.60 per bottle. The pricing strategy used is market pricing.
1. 2021 estimate from Grand View Research.
Another sector of the drinking water industry is reserved for sparkling water and distilled water. This represents roughly 20% of the total market size in terms of revenues but only 10% of the market in terms of the number of bottles sold. Companies like Perrier focus on this part of the market specifically. They apply the pricing strategy of market skimming or price differentiation with their exclusive bottles of water. This price “skimming” of the market originates from the processing of milk. The best, fattest, and creamiest part of the milk rises to the top of the milk churn during milk processing and is then skimmed off to be sold at a higher price than the rest of the milk.
The last commonly used pricing strategy is value-based pricing. With value-based pricing, there is no direct correlation between the actual costs and the price of the product. It is often difficult to apply value-based pricing to a commodity market or product. However, if there is no alternative available, the value is determined by the pains and gains of the customer, and their willingness to get those resolved.
2. https://www.productfocus.com.
What we often find is that Product Owners don’t have anything to do with pricing. Pricing products and services is often done by the pricing department or by sales and marketing, who define the prices for all products and services of the organization. This is strange to us. If Product Owners are supposed to maximize the value of a product, shouldn’t they also think about the product’s price? Isn’t price a lever that can be adjusted to deliver value (e.g., revenues and margins) for the organization? Let’s find out.
The Product Pricing Process
Let’s define product pricing first:
Pricing is a process where a business sets the price at which it will sell its products and services. In this process, the organization considers the costs of time and materials for producing the products or services, supply chain costs, marketplace, competition, market conditions, brand, and quality of the product.3
3. Wikipedia, s.v. pricing, 2022, https://en.wikipedia.org/wiki/Pricing.
An important piece in the definition is that pricing is a process. Processes are usually a series of activities or jobs that occur regularly, at least more often than once. In other words, pricing is a process that should happen regularly. The pricing process activities are illustrated in Figure 13.2. Whether this regular basis is yearly, quarterly, monthly, weekly, daily, or even hourly, depends on the company, its products and services, and the industry, amongst other factors.
Figure 13.2 The pricing process
In some organizations, pricing is a manual process, where individuals or groups of people set prices for new products, and where they inspect and adapt prices regularly. In other organizations prices are set automatically. For example, think about websites where you can book a hotel or a flight. Such companies typically change their prices automatically, based on predicted demand, availability, and the season amongst other factors. When taking a high-level view of a typical pricing process, the following steps can be identified:
Inspection of various inputs, sources, documents, and numbers
Inspection of current company goals
Selection and setting of the pricing strategy
Selection and setting of the pricing tactics
Adaptation of product prices, including supportive tools, and communicating changes
As the definition shows, pricing is a process. But more important, as you’ll notice in the steps illustrated in Figure 13.2, pricing is an empirical process. This is important to notice because it means that the pricing process and its outcomes need to be inspected and adapted regularly. To optimize the value delivered, feedback from customers, competitors, and the market is needed to validate prices and learn if they’re right. But what makes a price “right”? We explore the pricing process in more detail in the rest of this chapter and share practical advice and examples. Hopefully, this will enable you to bring some great ideas to the table the next time prices are being updated in your company.
Step 1: Inspection of Inputs
The first step in the pricing process, before setting or changing product prices, is gathering information. Information about the marketplace, information about competitors, and information about costs of time and materials, for example. You can also think of other sources, like how many products were sold, or how many deals were made, and why those deals were successful or not. Let’s explore some commonly used sources of information in this first step of the pricing process:
Win/loss analysis: If you work for a commercial company, there is likely a sales team or department in the company. This team’s job is to get new customer orders and assignments, and make deals for the company. They probably create quotes for customers to get those orders in. There’s also a chance that the company participates in tenders (Requests for Proposals) now and then. Tenders and quotes can be great sources of information during the pricing process. Analyze them and try to learn why the organization has won or lost certain tenders/quotes. Why did prospective customers decide to work with your company? Why did they select one of your competitor’s products or services? Was their decision based on prices, or did they believe they got more value from the selected party?
Competitor offering: Another great source of information that can be found outside of the company: your competitors’ offerings. If you want to set or change the prices of your products or services, then you better know what your competitors’ offering is. Learn more about their pricing model, if possible, but also make sure to understand where they differ from your company. Create a Strategy Canvas, for example, to compare products and services. Find your unique differentiators and know about your competitors’ unique selling points.
Costs: Think of the costs of designing, building, maintaining, servicing, and improving products and services. Consider the costs of raw materials, labor, transportation, shipping, and more. As a Product Owner, you should know what the total cost of ownership of the product is. Once you do, you will also know how much revenue or cost savings your product should produce at minimum to have a positive balance.
Predicted demand and availability: Predicted demand and availability of alternatives are also big influences on a product’s price. It’s basic supply and demand. Obtaining insights about market trends, product usage, sales trends, customer trends, and other market information is useful. Seek to understand how demand and supply are likely to change.
Value proposition: Another source to inspect is the value proposition. Does the value proposition still align with customer needs? Are key customer problems still being solved? Do these problems still exist? What alternatives are available? You can use, for example, the 5Ps (Problem, Pervasiveness, Pay, Position, and Possible) to validate the value proposition. You could also use various canvases like the Business Model Canvas, Lean Canvas, or Product Canvas. The thing is, if there is a mismatch between your product and customer needs, or if there is only little value in solving the customer problem, that will influence the prices.
Step 2: Inspection of Current Company Goals
Every organization has goals to be achieved. Products also strive to achieve certain goals, such as improving revenues, reducing costs, or increasing customer satisfaction. The company and product goals usually influence product prices. Therefore, when setting your product’s prices, consider what goal needs to be achieved. Following are a few typical examples of goals:
Increase revenues: For many products and organizations, there is a goal of increasing overall revenues. When managing your product, this can also be your Product Goal. Increasing revenues can be done in many ways, including bringing in new customers, improving customer churn, and up-selling and cross-selling products.
Increase margins: When the company and product goal is to increase margins, organizations often focus more on reducing costs, optimizing processes, and improving overall efficiency. Alternatively, prices can be increased, which tends to be more difficult to explain to customers.
Increase market share: This company goal is mainly focused on getting new customers in, which may contribute to increasing revenues at present and/or in the future.
Reduce churn: This company’s goal is about keeping the customers that the organization has. It is usually more difficult and costly to attract new customers than it is to keep current customers.
Achieve survival: Achieving survival is not the ambitious and inspiring goal that organizations want to be chasing, of course. No company or person wants to fight for survival. However, companies sometimes end up in a crisis. Sometimes they lose customers, and sometimes a disruptive innovation comes along, putting them in survival mode. If this is the situation a company is in, it will most likely influence their pricing strategy.
Step 3: Selection and Setting of the Pricing Strategy
The objectives of setting the price of a product are typically to maximize profit, meet target sales, and market share targets, and maintain a price that is stable in relation to competitors’ prices. There are many factors (internal and external) that influence a product’s price. Internal factors include the cost of creating the product, marketing strategies, product specifications, distribution, production plant capacity, and promotion, for example. Some external factors influencing the price include market competition, legal factors, target audiences, data, personalization, and of course, supply and demand.
There are various pricing strategies you can employ. We explain five common ones:
Cost-plus pricing: Cost-plus pricing is a pricing strategy in which the selling price is determined by adding a margin or buffer to a product’s costs. This means that an organization must deliberately maintain a product cost breakdown, to prevent selling the product below cost price. Cost-plus pricing is a common pricing strategy for government contracts, utilities, and single-buyer products that are manufactured to the buyer’s specifications.
A taxi runway of Schiphol Airport in the Netherlands crosses one of the Dutch highways via a flyover. This airport used to do maintenance on this bridge and the tarmac every four years, to keep it safe and in good condition. This maintenance work was very costly, so the airport asked one of its vendors to develop a software product to calculate the wear and tear of the bridge and tarmac. Inputs for this included the actual tonnage of planes that crossed it. The vendor calculated how much it would cost to build the product and they added a nice margin to that cost. They then delivered a quote to the airport, which seemed very profitable. Sometime later, the project was executed, the product was delivered, the customer was happy, and bottles of champagne were opened to celebrate. When the Product Manager asked the client, “It’s great to learn that maintenance can be done every six years rather than every four. But, just out of curiosity, how much money does this save for the airport?” The answer to this question was a factor of 1,000 of the price he had calculated! Perhaps it would have been more beneficial to have chosen a different pricing strategy.
Competitive pricing: Competitive pricing, or competition-based pricing, is a pricing method in which the price of your product is based on competing products in the market, which function as a benchmark for your products’ prices. Typically, your product is then sold at a price just above or below the benchmark of your competitors.
Setting a price above the benchmark will result in higher profit per unit but might result in fewer units sold as customers would prefer products with lower prices. On the other hand, setting a price below the benchmark might result in more units sold but will cause less profit per unit. In competitive markets, selling organizations have little control over their prices, which are mostly determined by supply and demand.
One of the advantages of competitive pricing is that no complex calculations are required. Selling organizations follow the common market price or a price set by market leaders. In addition, in competitive markets, the burden of price-based marketing is lifted. However, other forms of marketing efforts might be needed.
The downside of competitive pricing is that when most competitors adopt roughly the same prices, price is no longer a differentiator. This means that organizations typically must make additional marketing efforts to attract customers. Additional marketing efforts might include aggressive advertising, better customer support, market saturation, and others.
Value-based pricing: Value-based pricing is a pricing strategy wherein prices are based on the buyers’ perceived value. Value-based pricing is a strategy that is often used by companies that offer unique or distinguishing products or services in comparison to competitors.
Value-based pricing is rarely used for commodity products but is more applicable for products and services such as attorney fees, architectural design, car customization, and other custom products and services. Another form of value-based pricing is to take a small percentage of the costs saved or extra profits made by the customer (e.g., a consultancy company taking 5% of the cost savings that a company gets after helping them with their Agile transformation).
The following example from Accountingverse illustrates value-based pricing:
Mr. Davis wishes to have his car, a 1969 Cadillac Coupe, restored. It has been sitting in his barn for a while and rust has eaten most of its parts. He approaches KustomKars Company to do the job. Based on the value it would give the owner, the company quotes an all-in price of $30,000. Mr. Davis agrees to the price as he believes that it is a fair measure of the benefit he will receive.
KustomKars now must work within a budget and make sure that the total cost it will incur will be within $30,000 if it wishes to make a profit. If the company wishes to earn at least $2,000, then target costs must be set at up to $28,000. However, the satisfaction of the customer must not be sacrificed. The perceived value must be met.4
4. https://www.accountingverse.com/managerial-accounting/pricing-decisions/value-based-pricing.html.
Price skimming: With the price skimming strategy, selling companies set high prices after the initial launch of the product so that they can quickly recover a large part of the costs made and generate large profits quickly. Price skimming is a common strategy in technology markets, such as games, videos, mobile phones, gaming consoles, and laptops.
The idea with price skimming is that once the upper-class market has been served (product units sold are decreasing), the price is lowered to also attract another target audience and increase the customer base. This is interesting for the groups of potential customers who were not able to afford the product or were not willing to pay the higher price after the initial launch. Price skimming results in a larger market share and continuous sales.
The biggest advantage of price skimming is that the organization generates higher profits in the earlier stages of the product’s lifecycle. This is useful because R&D and development costs for technology products are high. By setting high prices, these high expenses can be recovered quickly. Another benefit of high prices is that customers often associate high prices with high quality.
The downside of price skimming is that organizations will limit their sales volume because prices may be too high for the majority of the potential market. Another disadvantage of this strategy is that when the prices are reduced, later customers might not be as happy as the initial group of people, who bought the new product right after the launch.
Penetration pricing: Penetration pricing is the exact opposite of price skimming. With this strategy, the company first sets low prices for the new product, intending to quickly capture market share. The goal is to attract customers away from competitors by initially offering low(er) prices. After the product has been accepted and adopted by customers, and once it becomes an established brand in the market, prices may be increased. Many people are enticed by low(er) prices, and it is an incentive for many people and organizations to switch between suppliers.
The benefits of penetration pricing are typically a high volume of sales, getting many new customers quickly, and therefore quickly getting more market share. Another benefit of setting low prices is that possible startups will be discouraged to enter the market and current competitors may be forced to leave if they cannot keep up with low prices.
The downside of this pricing strategy is that the margins and revenues per product unit sold are quite low and might cause customers to question the quality of the product. Also, customers may not be willing to extend contracts or repeat purchases when the prices are increased.
Step 4: Selection and Setting of Pricing Tactics
Pricing tactics differ from pricing strategies in the sense that they are easier to change and can often be combined. Simply said, pricing tactics help you to communicate how you will support the pricing strategy, and it will help to improve pricing effectiveness. The ten most popular pricing tactics are as follows:
Charm pricing
Anchoring
Tiers
Bundle
Unbundle
Variable
Luxury
Dynamic
Personalized
Subscription
As you scan the tactics illustrated in Figure 13.4, you’ll probably recognize most of them and that a combination of various tactics is used for your product.
Figure 13.4 The ten pricing tactics
Step 5: Adaptation of Prices, Tools, and Communicating Changes
Many people don’t realize that pricing is a process and that setting great prices may be complex at times. As illustrated in this chapter, setting prices for products and services is much more than picking a random number. Pricing doesn’t end just after selecting the strategy, applying the tactics, and setting a number. Setting or changing prices often requires a lot of adaptation in the organization. Here are some examples of what is typically needed to set or change your products’ prices:
Market communication: Newly set or changed product and service prices need to be communicated to the market. Customers need to be made aware of price changes before the actual price change happens, which probably means communication to customers via a printed letter, digital newsletter, advertisements, or other forms of communication.
Internal communication: Besides customer communication, your internal colleagues need to be aware of the price changes as well. For example, think of sales, account management, marketing, website, or web shop team, developers of calculation/quote tools, and so on. Your colleagues will probably need some time to process the price changes, so make sure to communicate this in time.
System changes and tools: In most organizations, we use all kinds of tools and systems that help us to do pricing. For example, price calculation tools, price explanation tools, websites and web shops, invoicing software, financial systems, and more. Organizations use a lot of different tools; we’ve encountered some organizations that had up to 20 different finance-related tools, all of which were influenced by every price change made.
Market feedback on price: When all the adaptation is done, the Pricing process still isn’t over. This is when it starts all over again. Because the market might respond to your new prices in unexpected ways. Customers might start complaining about the new prices or maybe they even want to leave you and go to a competitor. Of course, it is a great idea to do price experiments. Don’t wait for feedback from stakeholders and the market until all the work is already done and all communication and tools are adapted.