Developing a Pricing Strategy: Part 2
How much will people pay for your product? What price point is likely to maximize profit? Following on his discussion of margins last week, Aaron takes a look at other factors that influence pricing.
This is the second of two articles on developing a pricing strategy for Internet products and services.
In the first article, we covered the role of margins in determining your pricing strategy (what they are, why they matter, and how to measure them). Understanding margins is crucial to the development of a pricing strategy.
Margins Reviewed
- A margin is the ratio of profit to revenue for a given product.
- Margins set the “floor” for pricing. For example, if your product can’t meet company margin goals, it’s probably a crappy investment.
- To measure a margin effectively, you need to use the net margin (includes fixed and incremental costs).
- For new Internet products, the breakeven should be under one year.
Market Variables
While margins are important in determining the floor in pricing a product or service, understanding market variables is critical to setting the ceiling, or likely price. These are key questions in crafting the overall strategy for setting your price:
- What is the potential size of the product’s market?
- What are customer expectations for pricing?
- What is the competition charging for similar services?
- How do you want to position the company?
Customer Demand
Revenue = Number of Customers x Product Price
So the smaller the market for your product, the higher the price for the product will need to be to achieve your revenue goals. OK, that is the easy part.
In reality, few Internet companies put much effort into sizing the market for a product. “Build it, and they will come,” product managers typically proclaim. Management regularly accepts this as a satisfactory answer, reasoning:
- This is the Internet. We don’t have time for market sizing.
- There will always be more potential customers than can possibly be acquired, so why bother accurately sizing the market?
- Jupiter analysts proclaim that this is a $100 billion space. There is clearly enough demand.
- We only need 1,000 customers to break even, and there must be at least that many potential customers out there.
- We were the ones who told the product manager to build this product, so it has to be a big opportunity.
- We already have three customers who have asked for this product, therefore, there must be 300,000 more.
The bottom line is that it is a pain to properly size a market for a product. You need to be able to define who your target customer is (another thing few Internet companies do) and then do the necessary research to see how many people/companies out there fit this description. This can be expensive and time consuming.
If you are 90 percent sure that the market is big enough to supply the revenue you need for a few years and you are in a crunch to introduce a product to market, it is probably safe to skip this exercise. However, you should still clearly define your target customer. You will need to know your customer to understand his or her expectations for pricing.
Customer Expectations
Customers have expectations for pricing that they use when they make purchasing decisions. Understanding these expectations is key to setting a successful pricing strategy.
Typically, customers associate a product type with a price range. For example, CDs cost from $10 to $20. It costs $7 to $10 to see a movie. Even if your product is first to market, you will likely find that the majority of potential customers have a sense of what it should cost based on what the product or service is replacing. For example, the price of Web-based training is associated with the price of classroom training.
Defining this price range is particularly useful when you are looking for ways to price products for immediate sale. If customers expect a CD to cost $10 to $20, you know that at $9, you are likely to see a lot of transactions.
Competitive Landscape
Competitors are typically the largest driver of customer pricing expectations. If customers are accustomed to seeing your competitors selling CDs for $10 to $20, they will expect you to offer your CDs in the same price range.
Even if there are no other companies offering the exact product as you, clues for pricing can always be found by looking at other companies. No product is unique or without peers.
Positioning
Positioning adds a little twist to the pricing game. Because customers have expectations about pricing, the price that you charge for a product affects a customer’s impression of your company or the product line. Do you want to be known as a premium company or a “good value for the money” company? Both have advantages.
Defining your positioning for pricing goes to the very core of your organization. Like margin goals, positioning goals need to be considered at a company level for they have a significant influence on the overall success of the company.
In looking for the right positioning, seriously consider the strengths of your product and organization. If you can’t provide a premium-quality product or service, don’t try to price your products as premium, or your customers will have a negative experience. Likewise, don’t waste resources building a premium product if you aren’t planning to charge for the added value.
