VideoHow much should you charge for a new product? Charge too much and it won't sell — a problem that can be fixed relatively easily by reducing the price. Charging too little is far more dangerous: a company not only forgoes significant revenues and profits but also fixes the product's market value position at a low level. And as companies have found time and again, once prices hit the market it is difficult, even impossible, to raise them. In our experience, 80 to 90 percent of all poorly chosen prices are too low.
Companies consistently undercharge for products despite spending millions or even billions of dollars to develop or acquire them. It is true that businesses and private consumers alike are demanding more for less; the prices of personal computers, for example, have been pushed downward despite their higher processor speeds and additional memory. Global competition, increased pricing transparency, and lower barriers to entry in many of the most attractive industries have contributed to the trend. But these are not the only problems. Many companies want to make a quick grab for market share or return on investment, and with high prices both objectives can be harder to achieve.
These concerns encourage companies to take an incremental approach to pricing: they use existing products as their reference point. If a new offering costs 15 percent more to build than the older version does, for instance, they charge about 15 percent more for it. Particularly in consumer markets, they might set the price slightly higher or lower than that of their main competitor.
The incremental approach often underestimates the value of new products for customers. One of the first makers of portable bar code readers, for example, calculated how much more quickly its customers would be able to assemble their own products if they used portable readers. The company then took the price of the older, stationary readers and raised it proportionally, solely to account for the time savings. This strategy also fit in with the company's desire to penetrate the market quickly.
But by using an existing product as the reference point, the company undervalued a revolutionary product. The portable reader not only improved existing processes but also enabled companies to redesign their supply chains. Portability and instant access to information prepared the way for real-time inventory control, vastly improved logistics planning, and just-in-time deliveries, thus eliminating the need for large inventories. Buyers quickly recognized a bargain and flocked to the low-priced product. The company, which couldn't keep up with demand, not only failed to capture the full value of its reader but also set the market's price expectations at a very low level. A single bad decision easily erased $1 billion or more in potential profits for the industry.
Analyses based on cost differences and process improvements are parts of the puzzle, and so is an understanding of the competitive landscape. But good pricing decisions are based on an expansive rather than an incremental approach. Before zeroing in on a price that promises the greatest long-term profitability, companies must know both the highest and the lowest prices they could charge. Price-benefit analysis should begin early in the development cycle, when the market is first being probed, for it not only shows companies whether price barriers might make products unfeasible but can also guide their development by indicating which attributes customers are most willing to pay for.
Exploring the Full Range of Pricing Options
For products that replicate others on the market ("me-too" products) or that offer small improvements (evolutionary products), the room to maneuver is relatively narrow, and incremental approaches may come close to the optimal price (see "Launch Position," at the end of this article). Even then, however, a lot of money can be left on the table. Charging just 1 percent less than the optimal price for a product can mean forfeiting about 8 percent of its potential operating profit. (This analysis is based on average economics for S&P 1500 companies. See Michael V. Marn, Eric V. Roegner, and Craig C. Zawada, "The Power of Pricing," The McKinsey Quarterly, 2003 Number 1, pp. 26—39.) And the more novel a product may be, the more important it is for companies to take a broader view of the pricing possibilities.
The highest price. Since incremental approaches tend to focus on the lower end of the price range, companies should start by defining the opposite end of the spectrum. Such a price ceiling, based on a product's benefits, may ultimately prove to be unrealistic: there may not be a sufficient market at that level, it may leave too much room for competitors, or customers may be strong enough to demand a greater share of the value the product creates. (See Ralf Leszinski and Michael V. Marn, "Setting Value, Not Price," The McKinsey Quarterly, 1997 Number 1, pp. 98—115.) But establishing this ceiling will ensure that each and every potential price point is brought up for discussion.
To establish a price ceiling, a clear understanding of a product's benefits for its customers is essential. The value of some benefits, such as savings on raw materials, can be measured easily. But others, particularly process and relationship benefits such as on-line purchasing options or brand reputation, must be evaluated through market research.
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