Building Block #1: Set Clear Goals

Without a clear goal, you won't have an effective pricing strategy. It's that simple. A clear, overriding goal is a prerequisite because different goals can lead to contradictory strategies and actions. For example, if you want to maximize market share, you must choose strategies and price levels that will be different from the goal of maximizing total profit.

So which goals are most important for your new products? Revenue? Market share? Total profit? Profit margin? Customer lifetime value? Average revenue per unit? Something else? Whichever goals you choose, you cannot maximize all of them at the same time. In setting goals, you must make trade-offs.

Here's an example: Assume you could sell your product at either $10 or $15. Further assume when you sell your product at $10, you get 100 customers, and when you sell it at $15, you get 80 customers. So how should you price your product? Will you take 20 percent fewer customers in return for a 20 percent increase in revenue?

Now let's say the cost to make your product is $7. If you sell it at $10, you have a 30 percent margin. If you sell it at $15, you have a greater than 50 percent margin. So which goal do you want now? Is your answer different?

This is a simple example, but it proves our point that it is a difficult choice. Most new-product pricing strategy trade-offs are far more complicated than this. If you don't prioritize your goals and define your strategy, you will be in hot water when you take your product to market. You won't know how to act in the face of customer and competitive pressures.

Forcing trade-offs in goals is crucial. A workshop task we call Goal Allocation Exercise helps companies do that. Every workshop participant is ideally from a company's C-suite. We ask them to allocate 100 points to a series of goals. That puts each executive in a trade-off mindset. “Should I allocate 20 points to this goal, or should I allocate 60?” The more points an executive allocates to a given goal, the more important that goal is relative to the other goals.

Figure 8.2 shows the output from one of our recent client workshops. It's easy to see the massive differences in each goal's importance among the CEO, CMO, head of sales, CFO, and head of procurement. This executive team was shocked. Walking into the room, they thought they were aligned on the purpose of the new product. The problem was they never put themselves in a situation to make trade-offs across goals. After the workshop, they had deeper and more objective discussions. Eventually, they agreed on the product's priorities: Maximize market share but ensure an overall profit increase of at least 10 percent.

Building Block #2: Pick the Right Type of Pricing Strategy

Forcing trade-offs in goals is critical, but it won't be enough. Your goals must be in line with your pricing strategy. The good news is only three types of pricing strategies matter: maximization, penetration, and skimming. Let's look at each.

Maximization: This strategy maximizes your goal (such as profit or revenue) in the short term. Most companies choose this strategy for new offerings. You determine the optimal price—the point on the price elasticity curve at which the profit or revenue curve reaches its maximum. (We explain this in the sidebar later in this chapter.)

Companies typically choose a maximization strategy when their customer segments don't have early adopters with disproportionately more WTP. Or they choose this strategy because gaining a huge market share rapidly is not worth the expense of lower revenue or profit. In other words, these companies see little difference between the optimal short-term price and the optimal long-term price.

In choosing a maximization pricing strategy, you must have a number of options in mind. Senior executives often don't see the connections among price, volume, and profit. They believe these numbers are independent of one another; for example, they believe that if they raise price, volume will stay the same and profit will increase. If only that were the case! With a price response curve that shows the elasticity of your product, you can show these linkages. Later in this chapter we describe in detail the power of the price elasticity curve and how you can use it to arrive at the optimal price point.

Doing this kind of homework helps you avoid driving blind. Let's assume your team recommends a $100 starting price. Your CFO wants to raise it to $110. With the price elasticity curve you have proof in your hand. You would be able to say “We can certainly raise the price to $110, but then we lose X percent volume. Can we take that risk? Is that the better option?” By quantifying each price option's revenue, volume, and profit implications, you can be sure not to veer off the pricing strategy.

Penetration: With this pricing strategy, you intentionally price your product lower than in a maximization strategy to rapidly gain market share. This is also known as a land-and-expand strategy. When should you choose it? In some markets you must gain share quickly, especially in those dominated by network effects or where customers are highly loyal to the first brand they choose. If you gain customers early in such markets, you are better positioned to maximize customers' lifetime value from future sales and upsells. With a penetration pricing strategy, you make a grab for market share and then expand. This has been Samsung's pricing strategy in the smartphone market; cloud software companies have used this strategy after introducing freemium models. E-commerce market maker Ariba provides a great example. When the firm opened its online doors, it made all its money from buyers, not sellers. The service was free for sellers, and sellers typically brought buyers to the system. Over time, though, the company started monetizing its offerings to sellers. Today, Ariba generates as much revenue from sellers as it does from buyers.

Facebook is another great example of a hugely successful penetration pricing strategy. Most advertisers couldn't be bothered with the social network in its early days—until the free-to-users service had amassed hundreds of millions of eyeballs. But by 2014, with more than 1 billion Facebook members, advertisers were spending $12 billion annually on Facebook ads. That's huge revenue. Facebook has become immensely profitable as well, generating $7 billion in profits in aggregate from 2009 to the first half of 2015.

A penetration strategy might be right if you also plan to hike prices in the future. For example, Toyota's luxury car brand Lexus raised prices in the U.S. market more than 40 percent five years after it entered the market with a penetration strategy.¹

A penetration strategy might also be the right strategy for you if you are in a position to rapidly gain share, bring down unit costs, and purposefully price low to create barriers to entry. In such a case, even if you operate at a laser-thin margin, you might still make up for it because of your very high volume of sales. Think Amazon. Think Uber. More on the Uber case study in Chapter 13.

But a word of caution: A penetration strategy is the riskiest from a profit and revenue standpoint. You must focus as much on expanding revenue from customers as you do on landing them in the first place. Or you need to gain huge market share rapidly. And you'd better be able to follow through on those future price increases if you had planned them while deciding on this strategy. We have seen many companies, especially in Silicon Valley, incessantly talk about future revenues as a justification for picking this strategy but hardly come close to achieving it, even years after they launched! One such firm is LivingSocial, which had raised more than $900 million in venture capital to create a business that sent e-mail coupons to consumers to shop local businesses (similar to Groupon, taking a cut of the transactions). But by 2015, LivingSocial was struggling. Four years of losses had piled up to more than $1 billion. Said a New York Times story: “No one paid much attention to how the company would ultimately make money.”²

Skimming: Here you first cater to customers with a higher WTP—the early adopters. Then, you systematically decrease price in order to reach other customer segments with lower willingness to pay. Your initial price needs to be higher than the price you would have charged had you chosen a maximization strategy. A skimming strategy is especially appropriate if you have a significant number of customers who are willing to pay a higher price than others for your product. Put another way, your customers' WTP varies greatly between early adopters and late followers. Some prime examples are buyers of movies, music, online games, high-definition TVs, gaming consoles (such as Microsoft's Xbox video game console), smartphones (Apple iPhone, for example), and some automobiles. These customers won't wait for a product to become mainstream. It gives them bragging rights; they want to show it off to their peers.

Two other scenarios make skimming the right choice. One is when the product represents a breakthrough—an offering that delivers far superior value. The other scenario is when you have production capacity constraints in the initial launch periods but must mass produce in the future.

A classic way to implement skimming is by combining product and pricing actions. Here's how this works: You launch the higher-end product first, skim the market, and then launch lower-end products. A great example of this is when Porsche launched its four-door car, the Panamera. It first debuted the eight-cylinder model to skim the market, then released the lower-priced six-cylinder model a year later. (More on Porsche in Chapter 13.)

Building Block #3: Develop Price-Setting Principles

Now that you've chosen the right pricing strategy type, the next step is to create rules for the tactics you'll need to execute your strategy. By determining your price-setting principles early, you can keep your overall pricing strategy on track and avoid knee-jerk reactions after your product launch. (More on this in Chapter 12.) These are the top five operational parts to consider:

1. Monetization models: We showed you many monetization models in Chapter 7. Which one or ones will you use for your new product? Will your monetization model be the same across all customer segments? Will it change over the life cycle of the product? You must put the answers to these questions into your price strategy document.
2. Price differentiation: Will you differentiate your price? If so, what are the differentiating factors (for example, by channel, industry vertical, and region)? Will you maintain a maximum spread for your range of prices (say, all prices must be within 200 percent of the average price)?
3. Price floors: Will you have a price floor below which you will never price? Will you have a floor below which you will never discount (such as 50 percent maximum discount)?
4. Price endings: Literally speaking, how would you “end” all your prices? What will the numbers on the price tags and catalog look like? From our vast project experience, the most common price endings are 0, 0.50, 0.99, and 0.95 (that is, $30, $29.50, $29.99, or $29.95). These endings are more important in business-to-consumer (B2C) than business-to-business (B2B) markets. In B2B, whole numbers typically are better.
5. Price increases: Will you increase price over time? If so, how much and at what frequency?

Figure 8.3 is an example of what your price-setting principles might look like in practice.

Building Block #4: Develop Principles for Reaction

You should plan not only what your launch price will be, but how you'll react once your product hits the market. Here again you will need a set of principles to guide your actions.

Price reaction principles come in two varieties: those based on how customers behave (such as promotional reactions due to lower-than-expected demand) and those based on how competitors behave with their prices. Planning your reactions is much like playing chess and thinking a few moves ahead. Companies that don't think ahead react spontaneously and make unintentional yet avoidable mistakes. We say more about this in Chapter 12.

Competitive Reactions

These principles help you think through countermoves against your rivals. Before you react, you must anticipate competitors' moves, understand the reasons behind their moves, and prepare for possible counterreactions to your moves. To do so, you should conduct war-gaming sessions prior to launch. These sessions should include questions such as:

• How might the competitors react, and why?
• Are competitors likely to react only once?
• If we match a competitor's price, what will be the impact on our revenue and profit?
• What counterreactions do we expect to our reactions?

From the outcome of these war-gaming sessions, you should distill the key principles that defined your reactions to competitive moves. We say more about this in Chapter 12 on how to avoid knee-jerk reactions. Figure 8.4 is an example of a few promotional and competitive reaction principles.

We have shown you the four building blocks for developing an effective pricing strategy. Properly done, this strategy will become the tool that gives you pricing power. And pricing power is exactly what you want to have with your great new product. As Warren Buffett nicely summarized, “The single most important decision in evaluating a business is pricing power.”³ Companies that have a well-defined pricing strategy are 40 percent more likely to realize their monetizing potential than those that don't have one.⁴

It's hard to beat those odds.