Developing a New Product? Start with the Price

It’s usually true that most members of an organization appreciate how pricing has the potential to be used as a strategic tool. Unfortunately, it is also fairly universal that many are at a loss as how to best incorporate pricing into their new product development process for strategic advantage.

At many software companies new products begin with a general awareness of a market opportunity and as the idea grows in shape and potential, managers may assign a team to work together to design a product that they believe will sufficiently meet the needs of the customer.  Once the product is more-or-less market ready, management assesses the current and future costs associated with developing and supporting it. In an attempt to be fiscally responsible, the price is set high enough to ensure that the costs are covered and a profit is generated.

Can you see the flaws in this method?

First, you can’t calculate sales volume and hence, unit-cost, without first taking into account the price. I apologize in advance, but we’ll need to briefly dust off the downward sloping demand curve to illustrate this point.  The greater utility a consumer receives from a product, the greater the demand; conversely, as prices increase (utility falls) and demand decreases. Thus, setting the price impacts the units sold and therefore the unit cost. Simply put, managers cannot assume that they can adjust price without changing the unit cost, which leads to an exercise in circular logic!

Another problem with the cost-based approach is that the investments are made up-front without considering the value that the new product will provide to the customer. In other words, at launch-time, marketing is put to the test of convincing prospects that the new product creates enough value to justify the price needed to cover costs. In the case of products that have overspent on low-value features, this may prove to be challenging indeed.

Value-based pricing solves these problems, but as a product manager, you need to start early! Rather than leaving pricing until the end of the process, pricing strategy should be determined before development is ever started. In this way, you can ensure that a product can be sold profitably at a target price. Think about it this way, once you have identified a market opportunity; determine what potential customers will be willing to pay based on the value that your anticipated product will provide. Determining whether to invest in the product or not then becomes a function of product development’s ability to develop the product at a cost low enough to make the price profitable.

With a firm understanding of the value baked into the product creation process, value-based pricing also makes it a great deal easier for marketing to create sales tools that effectively communicate your product’s value to prospects. Likewise, the sales team will have less motivation to reward the strongest negotiators by giving into pricing discounts.

Sounds great, yes? Well sure, but how do you know how much your target customer is willing to pay? How do measure the value your new product will provide? These are great questions and luckily a concept called Economic Value to the Customer (EVC) is a big help… but that’s a topic for another post (see Unlock Your Product’s Value with Pricing).