Pricing – Your Path to Profits

True, we build products to serve customer needs, and sometimes even to change the world. But unless you work for a non-profit organization, you need to keep in mind that at the end of the day, a product must generate profits for your company. Yes, there are cases where products are sold at a loss (i.e. loss-leaders), and some products are given away for free. But I am referring to the majority of cases, where a product either becomes profitable, or gets terminated.

There are many factors that impact a product financial success and the amount of profits it generates. The price of the product is one of those key factors. Price it too high – and few customers will buy it. Price it too low, and you are leaving money on the table, or worse – losing money on every sale.

I remember the epiphany I had during an introductory economy class I took at business school. The professor explained the concept of the “demand curve” and the “supply curve”. It was brilliantly simple: as you increase the price of a product, fewer people buy it and aggregate demand diminishes. Conversely, as you increase the price, manufacturers are incentivized to increase production and aggregate supply increases. The right price for the product is determined by the intersection of the supply and demand curves. If only life were so simple…

There are few real-life situations where a product manager has visibility into the “supply” and “demand” curves. So while the theory has some merit, it is hard to put it to practice when trying to determine the optimal price for a product. So how do you determine the right price for the product? Let me count the ways:

Cost based pricing:

This is one of the simplest, yet effective approaches I came across. The general idea is to calculate the cost of producing the product, and then add an appropriate margin. The question is what is an “appropriate margin”? If you work for a company with some product history, or in a reasonably mature industry, then desired margins can be derived from analysis of past products performance.

Let’s assume you know what the desired ‘gross margin’ is (i.e. the margin before taking into account other expenses such as G&A, headcount, taxes, etc.). And you know the raw cost of your product, often referred to as COGS (cost of goods sold). Then you can use the formula:

GrossMargin=(Price-COGS)/Price → Price=COGS/(1-GrossMargin)

For example, if your COGS=$100 and your desired GrossMargin is 60%, then your product should be priced at $250.

I realize this looks like a rather simplistic way to determine the price of a product, but in many cases, this approach gives the product manager a first good estimate of what the target price should be. Then he/she can apply other consideration to refine the actual price point.

Competitive based pricing:

If there are other vendors who offer similar products to yours (i.e. competitors), then you can analyze their pricing and determine your product price relative to theirs. But first you need to assess how your product stacks against its competition. For example, how do your product capabilities (or features) compare to competing products.

Once you have completed the product comparison, you should map the various products on a “price/performance” chart. The use of the term “performance” represents more than just “speed”. It is supposed to represent the relevant capabilities of the analyzed products. But let’s start with a simple case, where speed is a key function.

Let’s say that you wish to price a new communication device, and you know that customers judge these type of products by their connection speed – in Megabits per second (Mbps). Then a price/performance chart for products in your market will simply have speed in Mbps on one axis and price on the other.  As you determine your product price, you need to ensure it “fits” into the chart properly next to other products.

This was indeed a simple example. In many cases there are several capabilities to take into account when doing a “price/performance” comparison. This is where some creativity in chart building comes into play. For instance, you could rate the respective capability of every product (e.g. 1-10), then calculate a weighted average as the “performance” of the product (i.e. SumOf [CapabilityWeight * ProductRatings]). This synthesized product “performance” can now be placed on a price/performance chart, and help determine how to fit your product into the competitive landscape.

There is no fixed formula how to do competitive based pricing. But you get the general idea: compare your product to existing products in the market and make sure the price you set fits the perceived “performance” of your product relative to others.

Value-based pricing:

The idea is simple: price the product based on the “economic value” it delivers to the customer. However as with other pricing methods, the implementation of this method can be a bit tricky. How do you actually determine the “economic value” of your product? There are various methods to approach this problem, and they all depend on the type of product (or service) you offer, as well as your customer environment.

A common approach to calculating the ‘economic value’ of a product for a customer is to assess its impact on the customer top and/or bottom line. The assumption here is that a product either helps reduce expenses (i.e. saves money), and/or increase revenue (i.e. makes money). What’s left to do is to calculate that impact… In order to do that, you need to have reasonable understanding of your customer business processes.

Let’s say that your product helps reduce expenses associated with a certain business process. You should compare the expenses a customer incurs without your product, to those with it. Presumably your product will significantly reduce those expenses. Put in a spreadsheet the difference in the customer’s periodic expenses (i.e. monthly, quarterly, or yearly) before and after using your product. That difference represents the positive cash flow your product will generate for the customer. A similar process can be applied to products that help increase revenues. You calculate the difference in the customer’s periodic income before and after using the product. That difference represents the positive cash flow your product will generate for the customer.

Having calculated the positive cash flow generated through using your product, add the actual product cost to your spreadsheet. It will be represented as an investment (i.e. negative cash flow) that drives the positive cash flow you calculated above. Now choose your favorite investment analysis method, for example: Return on Investment (ROI), Breakeven Point, or Net Present Value (NPV).

For example, let’s assume that your product generates an extra income of $500 per year for the customer – either through cost savings or additional revenues. We can now examine different options for pricing the product. Let’s try a price point of $1000.

Table 1: Cash Flow from Product use

If we look at breakeven point, then the product will pay for itself by the end of the second year of use. If we look for return on investment over a period of 3 years, then the product generated $1500 and cost $1000. That translates into a 50% ROI in nominal terms. You could take into account the time-value of money and calculate the value of future cash flows based on the cost of capital (i.e. interest rate). If the customer’s cost of capital is 5% annually, then the present value of future cash flows and ROI are:

Present value of cash flow: $1362=$500/1.05+$500/1.05**2+$500/1.05**3

Discounted 3yrs ROI: 36%=(($1362-1000)/1000)*100%.

You can examine options to price your product so that its economic value meets or exceeds customer expectations. In our little example, a 36% adjusted ROI may be fine, but if the customer expects a higher ROI, you may need to lower your product cost.

While value-based pricing seems like a perfectly rational approach, real life calculation of customer value can be far more complicated. Actual business processes and costs aren’t always clear even to the customer himself. And the impact of a particular product on future revenues is a conjecture at best. Customers often differ from one another in terms of business processes, costs and efficiency.

But don’t let all these caveats deter you from attempting to use the value-based approach. Developing a general model for your product ROI is a very useful exercise. It can generate a descent estimate for what the product price range should be, and will serve as a powerful justification tool when negotiating price with customers.

Alternate pricing models:

The pricing methods discussed above pertain to “traditional” pricing strategies, where customers actually pay for products they purchase or services they use. There are several alternate pricing methods that have been adopted by some companies. Let me touch on those briefly.

Freemium pricing:  this is a model that combines a free basic product (typically software or service) with the option to upgrade it to a ‘premium’ product for a fee (Free+Premium=Freemium). The difference between the free and the premium product is usually based on capacity, performance and capabilities. The ‘free’ product is a marketing/sales tool designed to lure customers into using the company product/service. The ‘premium’ product is the actual revenue generator. Pricing strategy and analysis should be applied to the premium product.

Alternate revenue source: a model where actual users of the product/service get it for free. Revenues are effectively generated from an alternate source. A prime example is advertising-based model, where advertisers pay the company for the rights to “reach” its product/service customers.

Let me summarize this short discussion about pricing.

Setting the right price for your product (or service) is critical; after all it is one of the key “four P’s” in marketing (Product, Price, Position, Promotion). There are multiple approaches to determine the target price for a product. I briefly described a couple here – Cost, Competitive, and Value-based. Whether you choose one of these, or any other method, it is important to do the analysis early on. I recommend you analyze the product price using multiple approaches. For example, start with a cost-based analysis, then look at competitive pricing and finally build a value-based model. If you are getting reasonably consistent results across multiple approaches, you are probably aiming at the right price point.  I know it sounds like a lot of “mundane work”, but remember that a solid pricing strategy could make the difference between a successful, profitable product line and a dud.