"A company only has two functions: innovation and marketing"
- Peter F. Drucker
The session kicked off with this quote from Peter F. Drucker, an important thought leader in the world of management. It effectively states that the role of a company is to create value and then to extract that value.
Lots of businesses are better at creating value (which is arguably harder), through focusing on highly engineered products, excellent services, customer relationship management or complex logistics to build defensible businesses. These are likely highly systemised and data driven.
However, when it comes to the extraction of that value, this is often done through more ‘finger in the air’ guesswork. This is often driven by companies not knowing how to quantify the value they have created, not monitoring pricing over time, or having conflicting goals between profit and market share.
Pricing for value, not cost
“The moment you make a mistake in pricing, you're eating into your reputation or your profits.”
- Katharine Paine
Price is a powerful creator and destroyer of profits. In fact, a Harvard Business Review found that a 1% improvement in pricing can add up to 11% to profit. Conversely with bad pricing, a company is missing out on profits in every transaction they make, not to mention the deals that are ultimately lost.
Pricing is also a big factor in branding and reputation. Prices that are too high can make companies come off as arrogant, while prices that are too low can call the quality of a product into question.
Despite this, ‘cost-plus’ is still the most common way that companies determine the price of their products. That is understanding how much the product cost to create and then adding a margin above to determine what to charge customers.
Ultimately the customer doesn’t care how much the product cost you to build. They care about the value it provides to them. So why price directly against it? Instead the focus should be on setting prices based on what potential customers’ willingness-to-pay for your product or service is.
Cost-plus is followed closely by benchmarking against competitors’ prices, which may be a useful data point but shouldn’t determine your overall pricing strategy. Remember your company exists to offer customers something different than what is already on the market. You should be offering more value and a better product, otherwise you probably shouldn’t be building it.
The Trade-Off Triangle
"Price is what you pay. Value is what you get"
Price and value have a clear distinction and we will discuss each as discrete concepts. Warren Buffet articulated this well when he said: ‘Price is what you pay. Value is what you get’
As with many functions in a business, pricing strategy will evolve over time, particularly as the product develops and as commercial priorities change. Each corner of the triangle in the graphic below represents a different company objective. We’ll discuss some relevant pricing strategies to achieve each in turn.
In an ideal world all 3 objectives would be achieved but in reality there are inherent trade-offs between them. However the most effective pricing strategies are designed to minimise these.
Often an initial strategy in situations where companies are looking to rapidly acquire new customers. At this point the focus should be on offering lower value options at lower prices.
This is usually paired with lower commitment options to encourage trial and usage. It is important to hold back additional elements for future upsell when prioritising acquisition.
Example -- ClassPass. In its first two years, the business operated with low single digit or negative gross margins and low commitments on their product. They raised over $80 million in funding to get to 15 million cumulative reservations.
KPI -- Number of new customers.
In situations where a company is looking to monetise customers they should focus on offering high value options at higher prices. They should look to systematically cross-sell and upsell additional features and services to increase average order value.
Example -- HubSpot. The business offers its subscriptions loaded with platform features, but HubSpot does place limits on how many contacts you store in its CRM. It also up-sells you on things like ‘premium services’, and essential add-ons like reporting and paid advertising.
KPI -- Average revenue per user, monthly recurring revenue
Where the priority is to retain customers and lock in revenue streams, there should be a focus on offering higher commitment options which is often combined with a discount to encourage tie in.
Example: -- Headspace offers monthly, annual and also lifetime options with discounts accrued at each step.
KPIs -- Average customer lifetime value, churn rate.
Making a market:
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.
However if a company is creating a market, then getting the price right straight off the bat is vitally important.
When launching a product a key trap that companies fall into is to not have in-depth pricing discussions with target customers long before the product development team begins to draw up the engineering plans, and certainly long before any manufacturing resources are committed.
Those discussions need to centre on determining precisely what features customers truly care about, are willing to pay for, and the price they are willing to pay. Simon-Kucher research finds that 80% of companies don’t have this type of discussion with customers early in product development. These companies hope to monetise, but they have no real evidence that they will
Usual strategies are hard to apply to new products and many inputs have to be considered. As we’ve discussed, cost-plus pricing doesn’t consider value (customers don’t care how much a product cost!) - and if there is little or no direct comparables then benchmarking against competitors’ pricing isn’t an option either.
The answer will come from multiple inputs and variables that should be considered when setting a price level.
Below is a list to get you started:
Cost - this should provide the minimum price of the product, not including discounting offers.
Price sensitivity - the importance of price in the buying decision
Value - the value proposition of the product, stated willingness-to-pay
Competition - cost of competitive solutions, cost of DIY solution both in terms of time/monetary costs
Competitive positioning - competitive prices vs value delivered
Historic prices - of similar products
Thanks again to Simon Kucher & Partners for delivering this highly informative session and to all the portfolio companies that attended.