What is the right price for your new product?
Choosing the price for a brand-new product is one of the most challenging tasks for a pricer. When making a change in the pricing of an existing product, you can work from data you already have: how much of the product you sell at the current price, how much it costs you to make, feedback from customers about your pricing
Setting the price for a new product feels much more like a leap into the void. And yet, getting the price right is very important. When you introduce a new product, the price can define how customers see the product and how successful the launch is. While you can always adjust the price later, there’s never another chance to make a first impression.
While one post is certainly not exhaustive, here are three of the most common ways to choose the price for a new product or service.
Price to Deliver Your Target Margin
One of the simplest ways to set a price is to base it on how much money you want to make on the product. Let’s say you’re going to sell a new product via mail order. You believe it will cost you $40 to make the product, $5 to mail the product to the customer, and you will typically need to spend $5 in marketing to reach each customer, so your total costs are $50/each. You have fixed costs to meet and want to make some money for yourself, so you price your product at $100, a product margin of 50%.
This is called “cost plus” pricing in the industry, and while professional pricers sometimes scorn it as simplistic, it is one of the most common ways for businesses to actually price products.
The good thing about this approach is that it makes sure that you are covering your costs and your profit needs. Thinking carefully about what price you need to sell your product for in order to actually make a profit is an important exercise. Doing this can help you figure out if your planned product is even viable. If covering all your costs and the amount of profit you need to make results in a price you don’t believe is realistic, you know that you are not able to sell the product, at least as currently planned.
However, the limitation of this approach is that it only considers your needs. It is possible that your customers will consider this price too high. It’s also possible they would have been willing to pay considerably more for your product, and you could end up leaving money on the table.
Still, if you lack other reference points, pricing your product or service at a level which meets your needs allows your potential customers to let you know whether they are willing to pay you what you want to make. And if they are, you will have the business you want.
Just make sure that you really do have realistic estimates of all your costs. Often business owners think only about the costs of making the product and not the costs of delivering it to the customer, paying for their marketing and sales expenses, and other non-product related costs. Sometimes (as we saw with the retail distribution costs of guitar pedals) the cost of getting the product into a store and in front of the customer can actually be significantly more than the cost of making the physical product.
Nonetheless, those distribution and sales costs are real costs, and it’s important that you take them into account when pricing your product on a “cost plus” basis.
Price Based on Competitive Products
Another extremely common way to price products is to identify a competitive product and price your product based on that competitor’s price.
The obvious advantage of this is that you are pricing against a known reference point which customers are already familiar with.
The equally clear problem is that your product may not be the same in cost or in value as the competitive products available.
Small differences are easy to bridge. Say that you are selling a high quality blend of tea, and you are comparing the price of your product to Lipton and to Twinings. You might consider that your product is so far superior to Lipton that it doesn’t matter if you are 4x or 5x the price, but you think that you’re only about twice as good as Twinings Tea, so you price your tea at twice the price of Twinings.
Whole companies sometimes take this approach. For instance, other grocery stores often price their key products a specific percentage above the same product at Walmart, based on their assessment of how much customers are willing to pay to visit their store rather than Walmart.
But sometimes what might at first look like a competitive product is a difference in kind rather than degree.
For instance, a hand-made quilt (even sewn and quilted on a sewing machine) might be similar in warmth to a mass market quilt made in China, but the difference in the cost of production is so huge that it would not make sense for a quilter to price her creations in relation to a blanket she saw on sale at Target.
She might price her quilt in comparison to other hand-made quilts or custom textile products. But trying to manage a specific relationship with mass-produced blankets would be nonsensical.
Other times, the difficulty is simply that there is not a very similar product already in the market. When Apple launched its iPad, I heard an executive at Dell tell a large audience, “This product doesn’t know what it is. It’s too big to be a good phone, too small to be a good laptop, and too expensive to be a good ereader.”
He was wrong that the iPad didn’t have a niche, but right that pricing it in direct comparison to a phone, a laptop, or an ereader would have been overly simplistic. Sometimes a new product needs to be priced in a more imaginative way. That can involve picking a strategic price point, pricing based on a desired margin, or trying to estimate how much value it will produce for the customer.
Price Based on Customer Value
Value-based pricing is an approach designed to arrive at a price based on how much value your product delivers to the customer. This can be particularly important when your product is significantly different from other offerings available in the market, and when you may be delivering benefits to your customers far in excess of the cost of making the product.
This is an approach best suited to business-to-business sales, because businesses so clearly quantify value in most circumstances. However, you can apply a less formal version to pricing consumer products as well.
Say that a company has developed a set of automated sensors to be used in one of the giant barns in which commercial egg-laying hens are housed. There are so many chickens in these barns that if the air circulation system breaks down, the chickens can overheat and die as a result of the collective body heat within a couple of hours. The company’s system of sensors monitors all of the air circulation fans and the temperature inside the barn. It will automatically call and text the farmer if there is a problem. It also regulates the fans to keep the chickens as comfortable as possible while not wasting power. The company has studies showing that in barns using the system, the average egg production increased by $10,000/yr, the loss of chickens was reduced by $30,000/yr, and the consumption of electricity was reduced by $4,000/yr.
The total savings the company is delivering to its customers is $44,000/yr. How much can they charge for their system?
If they charge the customer more than $44,000/yr, the customer is worse off. However, if they pick some lower number, they and the customer are dividing the extra value.
Say they charge $10,000/yr. That means that the company selling the sensors gets $10,000 of the additional value produced and the customer gets $34,000. Assuming the sensor company has covered their costs, they are both now better off. They have split the incremental value provided by the product.
This same approach works when there is a competitive product which delivers greater or lesser value than your product.
Say you are selling a high speed cutter which will perforate paper towels on a production line. Your cutter will last twice as long as the competitive cutter. It costs $5,000/hr in lost production to shut down the production line, and replacing a cutter takes two hours.
The competitive cutter has to be replaced every 10,000 hours of usage, while yours is good for 20,000 hours of usage. That means that during a year of continuous production, your product saves 6 hours of shut-down time, which cost $5,000/hr. $30,000 in annual savings. This means that so long as your product is less than $30,000 more than the competitive product, you are saving your customer money.
These are comparisons which are very easy to make because they are all about money. With a consumer product, it can be much more difficult. Say you are selling a genuine horse-hide WW2-style A2 aviator jacket, while Walmart sells one made from synthetic leather for $40. For what price can you sell your high quality jacket which costs $200 just to make? It’s much harder to calculate this because there’s not a rigorous way to calculate how much incremental value the customer will perceive from your much higher quality product.
Pricers and marketers sometimes conduct studies in which they show potential customers a series of different products with different prices and ask them which one they would buy, and then calculate the incremental value which, on average, customers assign to various attributes.
It’s tricky to successfully pick a price for a consumer product this way, but it’s possible to at least get some hints.
The three approaches to pricing a new product outlined above are all broad. Between the three, it’s possible to price for many different situations. None will give you guaranteed success in pricing a new product, but they do give you some good frameworks for thinking about the question.
Have you been enjoying my writing here at PricingEvolution? As the new year approaches, I’m hoping to add some additional features to the site, including a community chat for subscribers where people can ask pricing questions and get answers.
I’m also considering a paid tier which offers monthly live discussions about pricing issues and the opportunity for one-on-one advisory calls on pricing.
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