Daniel Shefer
Director, Product Architecture
MDRM
DS_PM/delete-this/@spamex.com
“The price point defines the sales model. It has to
be simple, and you have to know how to make money with it…” -- industry pricing consultant
Pricing has far reaching effects beyond the cost of the
product. Pricing is just as much a positioning statement as a definition of the
cost to buy. Pricing defines the entry threshold: who your buyers are and their
sensitivities, which competitors you will encounter, who you will be
negotiating with and what the customers’ expectations will be.
The most important thing in developing any marketing
strategy, including pricing strategy, is to understand as much as possible
about current and potential customers. The more you know about their
motivations, sensitivities, needs, and their own customers, the more likely you
will be to maximize both the effectiveness of your product as well as your own
revenue stream.
The purpose of this article is to explore the interrelation
between product and pricing.
Before delving into details, here are some common pricing
strategies. Note that combinations of these models are possible.
The pricing model sets the framework in which the final product price is calculated. Think of the pricing model as an equation. To get to the price (‘Y’) the value for ‘X’ in the equation needs to be inserted. This ‘X’ is the Price Baseline. An example is the price of a user license for a software program. After entering the Price Baseline into the pricing model and relevant discounts such as for volume, the product’s price point is calculated.
The pricing model should always be tested against sales scenarios. The best fit should be within the target market. Most models will not be optimized for some segments. In some cases, it may cause money to be left on the table or deals to be lost due to too high of a price. One way to test the fit is to list various sales scenarios and compare the effect on revenue caused by changes of the pricing model and the price points that feed into it. This exercise should be repeated at least twice a year. The assumptions used in the comparison should be validated and the model should be tested on the previous quarters’ sales.
Another test for the fit of the pricing model and price point within a market segment is that a comparison with the competitors’ pricing must be made. Take into account the pricing differential based upon positioning and functional differences. If the differences between your price and that of your competitors’ cannot be justified, you will either have to change the model or the pricing factors in it.
The last test is the market. Make sure that your prospects and customers “get it”. The pricing model should be simple to explain. If you need more than a couple of sentences to explain the pricing model, it is too complex.
This section covers vendor approaches to products and
pricing. The vendor's pricing approach may determine the appropriate product
packaging or vice versa. Consider a "one size fits all" approach
versus a specialized product approach, the logic of adding ever-more features
and the impact of product development approaches on the customer’s perception
of value.
The "Divide and Conquer" approach refers to
breaking a whole product into parts and selling these individual pieces
separately.
For example, a PC software application originally cost
$8,000 for full functionality. A consultant investigated the way people used
the toolkit and determined that there were five standard implementations. The
R&D department created compile flags that would only include the features
necessary for each specific implementation. As a result, the company was able
to split the product into five specialized offerings using the same code base
and sell them for $8,000 each. The difference was that each version of the new
products worked out of the box. People will certainly pay for that!
The tool was originally marketed with a "you can do it
all with this toolkit" approach, and afterwards, the approach was changed
to a "we have done it for you" approach with the five main uses of
the toolkit. In other words, the "tool" was reconfigured and made
into five separate "solutions."
In another twist to this approach, a network fault
management company decided to charge for the rules that managed individual
network element types and not only for the tool itself. The developers didn't
understand why this was done. Non-developers created the rules so, of course,
they should be free. Their point of view was that the customer only wants to
pay for things created by developers.
Contrary to this pretentious view, it was “the rules” that made the real
code valuable.
Continuing along this logic with a more familiar application,
Microsoft
could take a look at Word and other MS Office products. Customers pay
hundreds of dollars for an application and beyond the basic functionality, use
very little of it. Microsoft might break off some of the more advanced
functionality such as the Macro Creator and the Mail Merge tools, package them
separately and charge for them. The cost to make these add-ons would be
negligible. These tools are used by professionals and would justify a separate
expenditure. With MS’s market share, they will be able to get away with not
reducing the price for the remaining Word application while charging hundreds
of dollars for each of the above add on packages.
Ask yourself this question before adding any new
feature. “Is adding this feature
worthwhile?” One example where the
answer was “no”, was at OneTouch. OneTouch offers a
satellite based distance-learning product. Its users interact with the
instructor via keypads and customers began asking for them to be wireless.
Everyone saw the benefit of the increased ease of use but when customers were
asked, they were only willing to pay 15% premium for wireless keypads. Making
the keypads wireless would have cost much more. So OneTouch never offered a
wireless keypad. Despite this requirement on many RFPs, OneTouch never lost a
sale over this issue.
This begs the question, is it worth adding a unique feature
if a single customer pays for it? A prospect recently asked that we develop an
integration with a caching server product they use. After a short
investigation, it was clear that none of our other customers needed this. In a
nutshell, if a company builds a targeted product for a well-defined market, it
can rarely, if ever, cost-justify a one-off project. Can you imagine Proctor
and Gamble developing anything without a business case or building a product
for a one-time purchase? In the software industry, we tend to ignore the
lessons of other industries. Agreeing to these "one timers" rarely
gets the deal, if ever, despite even after agreeing to what
is basically bad business.
Furthermore, the
real cost of adding features is not easy to calculate. Most product focused
software companies have difficulty estimating the real cost for developing,
testing and supporting a feature over time. In many cases, they will
underestimate the direct costs. To reach the real cost of adding a feature,
vendors must consider the resources that are tied up for the project over time.
This is probably the most painful aspect that makes most special feature
developments destructive.
Perceived value is the additional value that the prospect
attributes to your product regardless of its intrinsic value. Perceived value
is subjective and heavily influenced by the company and product image, word of
mouth etc. If given a choice between two similar products, customers are
frequently willing to pay more for the one with greater perceived value. For
example, when given a choice between Benedryl and a generic house brand,
consumers will often pay substantially more for Benedryl even though the two
products have the exact same active components. Customers will pay extra for
the familiarity and confidence that the brand name instills in them.
Creating perceived value is an excellent defense against
product “commoditization”. Successful brands are able to prevent price
erosion and demand a price premium by creating and maintaining brand
value. Tom Peters has said, “In an
increasingly crowded marketplace, fools will compete on price. Winners will
find a way to create lasting value in the customer’s mind”.
If your price point is above the price the customer sees as
the value point, you will either have to enhance the value of the product (an
important part of the sales process) or lower the price. When the product is
priced above the perceived value, prospects will be reluctant to buy or will
tend to haggle on price. OneTouch used to sell its keypads for $235. Customers would
constantly bargain with them over their price. Once they lowered the price to
$100, the bargaining stopped.
How a product is packaged and delivered can impact its
perceived value. Assume your software application fits onto a diskette but it
costs several hundred dollars or more. Sending it out on a diskette will be
counterproductive. Also, allowing clients to download an application that costs
thousands of dollars can have a negative impact on its perceived value.
One way to relieve
the pressure for discounting is to offer the customer a discount in exchange
for flexibility of features, terms and speed of implementation, level of
support etc. This approach will work best with a modular product. The ability
to be flexible with functionality and terms will allow you to negotiate
discounts for appropriate customers and justify cost inequities to current
customers.
Computer
Associates (CA) is an expert
at taking advantage of high switchover costs. They have made an art form of
buying companies with mature products and using them as cash cows. The
customers of these companies are many times “Main Streeters” and are reluctant
to replace the applications that work for them. CA can then charge a premium
for services and support.
One way to fight
price sensitivity is to increase the switch over costs by creating more contact
points between the customer and your service. Some call this the “Velcro”
approach. By decreasing price sensitivity, suppliers can increases the prices
they charge customers. By improving customer intimacy, suppliers reduce price
sensitivity and increase the amount they can charge customers.
For example, by
offering their customers overdraft protection, banks increase the utility
credit card holders see in staying with them. Another advantage is that credit
card companies cannot offer the same type of insurance.
Another familiar
example is
AOL’s strategy. AOL distributes thousands of CDs
with their software and 6 months of free service. Their correct assumption is
that once a customer has an account with their own email, a buddy list and
other features, the willingness of customers to switch Internet provides is
significantly reduced. Low incremental costs by user registration automation
and a great out-of-the-box experience are what make the “Velcro” approach
possible.
Another version of
“Velcro Pricing” can be seen in the printer market. By requiring unique
cartridges, printer companies lock in their customers after the purchase of a
printer. Due to this lock in, HP
and Lexmark can afford to
lower the prices of their printers. Their profits don’t come so much from the
printers they sell but from the toner and ink cartridges. The printer companies
can charge a premium for these cartridges. Once generic refills become
available, smaller premiums are still possible because of the perceived value
that these brand names offer. There is a tension between the desire for
creating unique types of ink cartridges and distribution costs. While the
printer manufacturers would like to see a unique cartridge for each printer,
resellers would balk at the overhead of carrying so many cartridge types.
For the purpose of this article, standards will be divided
into two groups: Proprietary and Open. Embracing, extending, or creating
standards impacts pricing as well.
Owning a proprietary standard and a strong market share
allows the vendor to raise prices when they own a significant share of the
market. The proprietary standard increases switchover costs for the consumers.
Familiar examples are Microsoft’s Office products. Most computer consumers use
MS Word so the switchover costs to another word processor that is not fully
compatible with Word would be too high.
By constantly changing the standard, vendors with large market shares
can pressure customers to upgrade once the people they exchange files with have
upgraded themselves.
When a company creates and owns a standard,
even if the standard is openly accessible, they place all other vendors at the
disadvantage of playing catch up. This is not only a marketing advantage but a
practical one as well. Microsoft’s ActiveX technology is very common on web
sites. The Netscape
and Opera
web browsers have trouble keeping pace. If users want to utilize ActiveX
components, they need to stick with the Internet Explorer. This approach works
only if the standard becomes widely adopted. Microsoft tried this with its LRN
(Learning Resource iNterchange) standard but failed to get industry buy-in and
now seems to be abandoning it.
Open Standards refer to standards that are controlled by
public bodies such as TCP/IP, HTML etc. In contrast, Open Standards such as
TCP/IP, XML, and HTML have both an upside and a downside for vendors. By
supporting an open standard, vendors decrease the customers’ switchover costs.
Newcomers to the market can take advantage of this. For example, switchover
costs for customers to another networking card vendor are very low. By
supporting the open TCP/IP standard, vendors can make their products
interoperable with current equipment and thus more attractive to potential
customers.
The more difficult it is to compare between products, the
less price will be an issue in the purchasing process. To make it more
difficult for customers to compare products vendors can add features (good for
differentiating), obfuscate the function of common features with creative
naming, sell the product in a way that makes it hard for consumers to compare
as well as create complex pricing models (see below).
Have you ever wondered about all those stores that announce
that they will not be undersold? Large retailers with massive product sales can
receive a unique model of a product from the vendor. No other retailer will
have this EXACT model. This is very easy to do and in consumer electronics, the
uniqueness is many times not much more than a different label or box.
One example of products that are hard to compare are
mattresses. The comparison criteria are subjective and are based on customers’
subjective memories. Retailers can therefore rely on their consumers to have
limited capacity to compare items between stores. By the time they go to
another store, the previous mattresses they saw are only a vague memory.
Disruptive technologies allow vendors to create products
with a new approach to solving current market needs. To capture a beachhead in
the market, disruptive technologies tend to offer only part the functionality
the incumbent offers better addressing the needs of a niche market and for a
significantly lower price. A disruptive product poses two challenges to
existing vendors. The first one answering the needs of niche markets becomes
harder and harder as products grow with the maturing of the technology and the
second is that incumbents find it impossible to compete with the price.
One way to better deal with disruptive technologies is to
have an entry level offering that can be priced competitively so as to
discourage competition and that is flexible enough to refocus it to address
competitive threats. An entry-level product built specifically with flexibility
in mind is the best option. Due to lack
of resources, companies often create a scaled down version of the main product.
Another advantage of having an entry level product is having an upgrade path for
customers that are not willing to make a commitment out front or that are not
big enough to purchase the full-featured product.
Case in point: In 1996, Cimatron, a CAD/CAM software vendor was selling $30,000 plus CAD/CAM software seats. That year, Solidworks announced a product based on a new design technology with a starting cost of $5,000. Initially, Cimatron scoffed at the new product. It only addressed one part of the market and at its price point it could not support professional services, a technician to install it, etc. It didn’t need them. However, Solidworks had clearly identified an unsolved problem in an underserved market segment. After losing a significant part of their market share, Cimatron eventually responded, with their own “light” product. Their delay in identifying the market trend cost them dearly.
Unlike Cimatron,
Mercury Interactive, a provider of enterprise testing and
performance solutions, was able to take a threat from upstarts and turn it into
a hands-down victory. In 1998, when selling into large accounts, they found
that two new upstart competitors were already present in many of them. These
competitors offered only web based testing but for a quarter of the price of
Mercury’s testing suite. During that timeframe, Mercury recognized that the
dynamics of web testing had changed, (e.g. downloadable, lower entry level,
less technical users etc....) and developed a new product - Astra. The
advantages Astra offered customers were: the security that comes with buying
from a market leader, an upgrade path (all test scripts were compatible with
their enterprise level application) and any customer that upgraded within a
certain timeframe would get a refund for their purchase of Astra. With this
strategy, they were able to not only stop their competitors but also increase
their own market share.
A side note: While not Mercury’s largest source of revenue,
Astra has become a significant part of their lead generation efforts.
Another way to look at pricing models is from the Technology
Adoption Cycle. Where you are with your product in the cycle bears heavily on
the approach to pricing you should take.
The early stage buyer is interested in the technology, often
in the form of toolkits. They enjoy being on the “cutting edge”. Since a lot of their motivation involves ego
gratification and gaining some kind of competitive edge, this audience may not
see a difficult implementation as a bad thing. This means someone else with
less fortitude will not be able to follow his or her trail – at least not
easily.
One mistake vendors make with Early Stage Buyers is assuming
that a lower price will drive the business – it won’t. It will probably leave
money on the table. Lower prices will lower margins, but not raise volume
significantly with these buyers.
Main Street Buyers purchase products. Vendors can take two
approaches with Main Street Buyers. They can differentiate to keep prices at a
maximum or inadvertently enter a price war with competitors.
The Late Stage Buyer buys the #1 (read: safest) company or
the cheapest product. These are people who want to know what “the thing” will
do for them, whether it really works, and what is involved in running it. This
is much more a “mainstream” set of issues. They are hesitant to buy unless they
can speak with someone from their industry that uses the product successfully.
When you have reached this point in the product cycle, you should be well into
introducing the next generation of your product as well as cutting back on your
product’s R&D expenses as prices go down. See Defending Against Disruptive Technologies
above.
Groucho Marx is quoted as saying: “I do not care to belong
to a club that accepts people like me as members.” Groucho Marx pricing refers
to the situation where the pricing can deter ideal customers and attract
undesirable ones. The credit industry has this problem where its ideal
customers (those that pay their bills), are the ones that need credit the
least. This creates a situation where the consumers willing to pay for expensive
credit are people that badly need it because they have a bad credit history and
are high high-risk customers. This way, a high- end product might inadvertently
attract “bad” customers. Or as a paraphrase on Groucho Marx: the credit cards
offering is inviting to those that they do not want to sell to in the first
place. To avoid this problem, credit companies created a somewhat unique
mechanism: They use credit histories to decide whom they want to sell their
product to. The customer expresses a desire to buy but the credit card company
decides if they want to sell. This model is rare outside the financial services
industries.
Some of the best-known examples of variable pricing models
are eBay, Priceline,
the airlines and the stock market. In these markets, the price is set
dynamically with little restriction. The nature of the markets limits the type
of products that can be sold on them.
eBay is the case exemplar of the “ideal” marketplace.
Geography is not an issue prices are set by supply and demand. Consumers know
what they are looking for and there is no need for anything beyond a spec
sheet. eBay might be one of the cheapest selling channels but this type of
marketplace is only good for products that are sold “As Is” with easily defined
features. Products that require complex service contracts, professional
services or pre sale work are not good candidates for this eBay.
Priceline is similar in the bidding aspect but is
fundamentally different in another. It adds an uncertainty in the purchase such
as the date for the airline tickets or the exact hotel as a trade off for lower
prices. This uncertainty can be seen as a “flaw” in the offered product. In
exchange for this “flaw” and the ability to sell last minute vacancies, vendors
are willing to reduce prices.
The new pricing model does not fit all products such as
perishables. Imagine for example a bakery that offers slightly stale bread from
yesterday at a discount. Most people would not be interested in such an offer.
Airlines have made variable pricing into an art. By
segmenting their market, they have created a complex, confusing model. They
sell a basically identical product at different prices all depending on when
you buy and who they think you are. The first parameter is the time of
purchase. The price of ticket is significantly lower if you purchase it at
least two weeks ahead of time. Airlines assume that anyone buying a ticket
at the last moment or that is not staying over the weekend is a businessman and
therefore, they can change more. The reasoning here is that the cost will be
covered by the employer so the customer is not as price sensitive as those who
are paying out of their own pocket. The second parameter is the “Saturday night
stay over”. Airlines assume that business people want to return home for the
weekend and will charge more for itineraries that do not include the next
Sunday. This confusing approach also infuriates the airlines' customers,
particularly the business traveler.
The customer needs to be able to compare apples to apples
especially when they need to sell the solution internally. If your offering has
a unique pricing model, any internal effort to justify buying your solution
will be all that more difficult because the prospect will find it hard to
compare your offering to that of others.
This issue was brought up when a large online content site
convened advertising buyers in an attempt to find ways to increase sales. The
buyers complained that the online industry’s terminology, pricing and, ROI
models were not standardized and that this was causing a great deal of
problems. Creating an industry standard would probably have benefited all the
players in the online advertising market.
When this discussion took place in early 2001, the market
was mature enough from a technology perspective.
Prospects abhor a proposal that is not capped. If a service
costs $10,000 to set up plus 50 cents per minute, prospects will be concerned
about what the final cost will be for them. No one wants to exceed their budget
so prospects will appreciate a cap to the variable costs. If you have control
over the variable costs, you will gain from capping them as long as you can
guarantee that no damage will be done to your company if they exceed usage.
Imagine the first-time cell phone customer who receives a $200 usage bill
instead of the expected $45 one.
To look at another aspect of open ended pricing let’s assume
your company resells a product such as conference calls together with value
added services that you add on. You purchase the conference calls at a
per-minute cost that varies by the location of the caller. You have no control
over the actual cost of the call. If the prospect asks for capped price, you
should think very carefully about this. The costs that you do not control may
come back to bite you…
Earlier in the article, the relationship between the functionality of the product and the pricing model was discussed. Proper product planning and positioning can help prevent a price war by allowing the vendor to charge a premium. However, if the products are similar and as the market matures, price becomes a bigger factor in the buying decision. Pricing wars start once the differentiation within the market space has eroded. Unless the vendors can extract themselves from the price war by better positioning, the vendor that is able to offer lower prices over time will win the price war.
In essence, a price war is not fought with pricing models. If a battlefield analogy is to be used, the pricing model is the transportation device. It is the tool the vendor used to arrive at a price point for the product. The showdown of a price war is focused around the price point, not how the vendor arrived at it. If the vendor chooses to lower prices to fight a price war, the pricing model must be calibrated at a lower price point or discarded all together and the product features must be adjusted as well.
For example, current ERP systems require endless adjustment and configuration. In theory, should the ERP vendors enter a price war, the vendor whose product has the lowest incremental costs during the sales cycle and the installation and configuration is in a better position to survive.
While the price of a product might be a differentiating factor, the pricing model in itself is not. For a pricing model to offer a vendor an advantage in the market place it must be backed up by a unique product, technology or business model. This is because differentiating is done in the prospect’s mind and at the final stages of negotiating the deal; the customer must weigh the difference in price vs. the different positioning and functionality. If the customer is unable to “see” the differences between the offerings, the way the vendor arrived at the price point (by way of the pricing model) has no relevance.
Where can a combination of technology and a pricing model be a differentiator? A good example is Interwise. Interwise offers an enterprise communications platform for live events over the web. Its technology lets customers install local servers that will save them the need to use Interwise’s infrastructure when conducting events behind their firewall. This technology lets Interwise offer its customers unlimited usage behind their firewalls without imposing additional load on Interwise’s hosted network. Lacking this technology, Interwise’s competitors would have to incur additional costs to offer the same free usage.
When writing this article, I came upon many examples of
hard- learned pricing lessons. While not directly related to the product, they
are nonetheless interesting.
"The fact that our
customers probably didn't understand our licensing as well they might have
earlier makes the transition and the perceived pain higher than it actually is
…” -- Microsoft’s Steve Ballmer admitting that the shift in Microsoft's
complex volume licensing practices, which it introduced in 1997, had sown some
confusion, July 2002.
Prospects do not like complex pricing models. They need to
be able to not only understand the pricing but also be able to understand it
thoroughly. They need to be able play out “What If” scenarios when the sales
rep is not around. They also need to be able to explain it when they are
selling the solution inside their organization.
Here's a bad scenario: if your pricing model requires that
you have to explain your technology to the prospect before they can understand
your pricing, you are in a very bad spot. The problem can be compounded if the
prospect tries to explain the pricing to the decision maker.
Prior to 2002, Broadvision
pricing was set across 10 different product lines generally split between
back-end (administration, databases etc.) and user facing, front-end
applications. For back-end tools, the cost was per developer; for user facing
tools, by the number of end users or administrators. All of this created a complex pricing matrix
that was hard to understand and compare, flexible across the sales force as
well as outdated compared to the competition. To address these issues, the
company moved to a much simpler pricing model. Each application had a pre set
cost per CPU regardless of the number or type of users accessing it. Everything
would be bundled in the price of the CPU (deployment, development, and tools),
and the CPU cost would be the same across all environments.
Hubris is the only way I can begin to explain sharing savings. NetManage developed a support tool and priced it as a percentage of the software revenues of the customer. Assuming that a company spent 10% of revenue on product support and that the product would save 30% of that, NetManage priced the product at 1% of the customer's revenue. No one was willing to take the pricing model seriously regardless of whether the price point was cheap or not. Prospects did not like the model and were not keen on having to have to open their books to NetManage. Prospects felt this pricing model was like a tax. Sales reps were laughed out of more than one account. Even though customers are along for the ride, they don’t want it to feel that way. Revenue sharing is a legitimate proposal; sharing savings, seems not to be.
If your company’s
name is not IBM, Microsoft or another
industry giant, be VERY careful before you create a new pricing model. And if
you do try to invent one, make sure you have a fall back plan.
A large database company once priced its software by the
speed of the computer’s CPU that it was running on. This upset customers,
mostly IT people, who were penalized for upgrading the hardware. It is always
in the vendor’s interest that the clients use the fastest performing hardware
possible. The faster the application, the happier the customer is. By charging
customers more money when they upgraded their hardware, the company increased
the cost of the software and reduced their motivation to keep the application
at peak performance. The model did not last long.
When selling a product that offers cross-departmental
benefits, beware of situations where more than one department will need to pay
for the product. It raises huge internal issues about internal allocations. The
expenditure is made for one department, but all departments “pay” for it. If you were in Sales, would you for instance,
raise quotas to “pay” for the software? Not likely.
Ways to work around this issue:
When offering a free trial of your product, be sure that the
trial period cannot be extended or that it becomes compelling for the user to
purchase. For example, a famous online dating service started by offering a
free trial of its services for $149 per a subscription. It realized that every
time users’ accounts expired, they obtained a new email identity and created a
new account with the service. Since their profile could be recreated so easily,
customers had little motivation to purchase subscriptions. Another interesting
tidbit is that this company found that by lowering the price point to $30, the
abuses were reduced significantly. While a technical solution to prevent
creating multiple accounts would have been better, it seems to have been an
option. Thus the problem is eliminated by aligning the service's price with the
customers' perception of "fair value."
The product and its pricing model are co-dependent and must be developed with an
understanding of how each affect one another, the market that is being
addressed, who the customer is, the sales approach and how customers will relate to all of these.
Proper pricing entails understanding and addressing these issues from the very
beginning of the company’s positioning as well as from the initial product’s
design stages. Pricing is a continuous effort and should be reexamined as the
product goes though its life cycle to ensure congruency between all elements.
This article and its contents copyright (c) 2002 by Daniel Shefer.