https://pragmaticmarketing.

com/resources/articles/product-and-pricing-
strategies

Product and pricing strategies

By Daniel Shefer | Daniel Shefer is Director, Product Management at

Warp Solutions. Contact him at DS_PM@spamex.com.

'The price point defines the sales model. It has to be

simple, and you have to know how to make money with
it.' -- industry pricing consultant

Pricing has far reaching effects beyond the cost of the

product. Pricing is just as much a positioning statement as
a definition of the cost to buy. Pricing defines the entry
threshold: who your buyers are and their sensitivities,
which competitors you will encounter, who you will be
negotiating with and what the customers' expectations will
be.

The most important thing in developing any marketing

strategy, including pricing strategy, is to understand as
much as possible about current and potential customers.
The more you know about their motivations, sensitivities,
needs, and their own customers, the more likely you will be
to maximize both the effectiveness of your product as well
as your own revenue stream.

The purpose of this article is to explore the interrelation

between product and pricing.

Pricing Models
Before delving into details, here are some common pricing
strategies. Note that combinations of these models are
possible.

 Per Unit
Also known as the 'per seat' model in software. This
is the way most people buy their material objects:
home, car, software licenses, etc.

 Concurrent Users
Cost is determined by the number of users that can
access the service, application, etc. at the same time.
The concurrent user model is common with server
based applications such as databases.

 Per Usage
In the per usage model, the cost is proportional to
the extent of usage. The most common example is
long distance calls and home utilities such as
electricity and gas. Depending on the product, an
initializing or installation fee might be tied in.

 Per Unit of Infrastructure

The product, such as a database, is licensed per the
number of CPUs on the machine that runs the
application.

 Revenue Share
The customer pays a percentage of the additional
revenue achieved when utilizing the product. The
 revenue share model works best when the vendor
manages the collection of the revenue.

 Costs Savings
The customer pays a percentage of the savings
achieved when utilizing the product. This can cause
customer antagonism because the need to open
books and share financial information will be seen as
an intrusion.

 Site License
The customer pays a flat fee. Site Licenses are used
mostly when usage is wide-spread in large
companies. A site license saves customers the trouble
of managing licenses when the number of users
fluctuates.

Price Baseline

The pricing model sets the framework in which the final

product price is calculated. Think of the pricing model as
an equation. To get to the price ('Y') the value for 'X' in the
equation needs to be inserted. This 'X' is the Price Baseline.
An example is the price of a user license for a software
program. After entering the Price Baseline into the pricing
model and relevant discounts such as for volume, the
product's price point is calculated.

Testing the Validity of the Pricing Model

The pricing model should always be tested against sales
scenarios. The best fit should be within the target market.
Most models will not be optimized for some segments.  In
some cases, it may cause money to be left on the table or
deals to be lost due to too high of a price. One way to test
the fit is to list various sales scenarios and compare the
effect on revenue caused by changes of the pricing model
and the price points that feed into it. This exercise should
be repeated at least twice a year. The assumptions used in
the comparison should be validated and the model should
be tested on the previous quarters' sales.

Another test for the fit of the pricing model and price point
within a market segment is that a comparison with the
competitors' pricing must be made. Take into account the
pricing differential based upon positioning and functional
differences. If the differences between your price and that
of your competitors? cannot be justified, you will either
have to change the model or the pricing factors in it.

The last test is the market. Make sure that your prospects
and customers 'get it.' The pricing model should be simple
to explain. If you need more than a couple of sentences to
explain the pricing model, it is too complex.

The Vendor's Side

This section covers vendor approaches to products and

pricing. The vendor's pricing approach may determine the
appropriate product packaging or vice versa. Consider a
'one size fits all' approach versus a specialized product
approach, the logic of adding ever-more features and the
impact of product development approaches on the
customer's perception of value.

Divide and Conquer Approach to Productizing

The 'Divide and Conquer' approach refers to breaking a

whole product into parts and selling these individual pieces
separately.

For example, a PC software application originally cost

$8,000 for full functionality. A consultant investigated the
way people used the toolkit and determined that there
were five standard implementations. The R&D department
created compile flags that would only include the features
necessary for each specific implementation. As a result, the
company was able to split the product into five specialized
offerings using the same code base and sell them for
$8,000 each. The difference was that each version of the
new products worked out of the box. People will certainly
pay for that!

The tool was originally marketed with a 'you can do it all

with this toolkit' approach, and afterwards, the approach
was changed to a 'we have done it for you' approach with
the five main uses of the toolkit. In other words, the 'tool'
was reconfigured and made into five separate 'solutions.'
In another twist to this approach, a network fault
management company decided to charge for the rules that
managed individual network element types and not only
for the tool itself. The developers didn't understand why
this was done. Non-developers created the rules so, of
course, they should be free. Their point of view was that
the customer only wants to pay for things created by
developers.  Contrary to this pretentious view, it was 'the
rules' that made the real code valuable.

Continuing along this logic with a more familiar

application, Microsoft could take a look at Word and
other MS Office products. Customers pay hundreds of
dollars for an application and beyond the basic
functionality, use very little of it. Microsoft might break off
some of the more advanced functionality such as the Macro
Creator and the Mail Merge tools, package them separately
and charge for them. The cost to make these add-ons
would be negligible. These tools are used by professionals
and would justify a separate expenditure. With MS's
market share, they will be able to get away with not
reducing the price for the remaining Word application
while charging hundreds of dollars for each of the above
add on packages.

Adding Features--Is it worth it?

Ask yourself this question before adding any new feature:

'Is adding this feature worthwhile?'  One example where
the answer was 'no', was at OneTouch. OneTouch offers a
satellite based distance-learning product. Its users interact
with the instructor via keypads and customers began
asking for them to be wireless. Everyone saw the benefit of
the increased ease of use but when customers were asked,
they were only willing to pay 15% premium for wireless
keypads. Making the keypads wireless would have cost
much more. So OneTouch never offered a wireless keypad.
Despite this requirement on many RFPs, OneTouch never
lost a sale over this issue.

This begs the question, is it worth adding a unique feature

if a single customer pays for it? A prospect recently asked
that we develop an integration with a caching server
product they use. After a short investigation, it was clear
that none of our other customers needed this. In a
nutshell, if a company builds a targeted product for a well-
defined market, it can rarely, if ever, cost-justify a one-off
project. Can you imagine Proctor and Gamble developing
anything without a business case or building a product for
a one-time purchase? In the software industry, we tend to
ignore the lessons of other industries. Agreeing to these
'one timers' rarely gets the deal, if ever, despite even after
agreeing to what is basically bad business.

Furthermore, the real cost of adding features is not easy to

calculate. Most product focused software companies have
difficulty estimating the real cost for developing, testing
and supporting a feature over time. In many cases, they
will underestimate the direct costs. To reach the real cost
of adding a feature, vendors must consider the resources
that are tied up for the project over time. This is probably
the most painful aspect that makes most special feature
developments destructive.

Perceived Value

Perceived value is the additional value that the prospect

attributes to your product regardless of its intrinsic value.
Perceived value is subjective and heavily influenced by the
company and product image, word of mouth etc. If given a
choice between two similar products, customers are
frequently willing to pay more for the one with greater
perceived value. For example, when given a choice between
Benedryl and a generic house brand, consumers will often
pay substantially more for Benedryl even though the two
products have the exact same active components.
Customers will pay extra for the familiarity and confidence
that the brand name instills in them.

Creating perceived value is an excellent defense against

product commoditization. Successful brands are able to
prevent price erosion and demand a price premium by
creating and maintaining brand value.  Tom Peters has
said, 'In an increasingly crowded marketplace, fools will
compete on price. Winners will find a way to create lasting
value in the customer's mind.'
If your price point is above the price the customer sees as
the value point, you will either have to enhance the value of
the product (an important part of the sales process) or
lower the price. When the product is priced above the
perceived value, prospects will be reluctant to buy or will
tend to haggle on price. OneTouch used to sell its keypads
for $235. Customers would constantly bargain with them
over their price. Once they lowered the price to $100, the
bargaining stopped.

How a product is packaged and delivered can impact its

perceived value. Assume your software application fits
onto a diskette but it costs several hundred dollars or
more. Sending it out on a diskette will be
counterproductive. Also, allowing clients to download an
application that costs thousands of dollars can have a
negative impact on its perceived value.

Feature Flexibility

During price negotiations, the most common pressure is to

lower the price of the product. Lowering the price is a lose-
lose proposition for the vendor. In addition to the direct
loss of revenue, the existing customer base will eventually
discover the pricing inequity. New prospects will get wind
of the discount and expect it as well. Competitors might
feel that they are in a price war and retaliate with discounts
or in other ways--creating a cycle of price reductions.
One way to relieve the pressure for discounting is to offer
the customer a discount in exchange for flexibility of
features, terms and speed of implementation, level of
support etc. This approach will work best with a modular
product. The ability to be flexible with functionality and
terms will allow you to negotiate discounts for appropriate
customers and justify cost inequities to current customers.

Switchover Costs

Products with high switchover costs are always a boon to

vendors. The higher the cost to change to another product,
the more loyal the customer will be. High switchover costs
can be achieved by using proprietary formats and
hardware, by creating a product that requires a large
investment such as training, or by requiring a large
investment in equipment. High switchover costs will also
allow vendors to be more flexible in the product price. The
profits will be realized once the customer is locked into the
new product. The flip side is that not all prospects are
ignorant to such issues and the switchover costs can deter
them from buying.

Computer Associates (CA) is an expert at taking

advantage of high switchover costs. They have made an art
form of buying companies with mature products and using
them as cash cows. The customers of these companies are
many times 'Main Streeters' and are reluctant to replace
the applications that work for them. CA can then charge a
premium for services and support.

'Velcro' for Reducing Price Sensitivity

One way to fight price sensitivity is to increase the switch

over costs by creating more contact points between the
customer and your service. Some call this the 'Velcro'
approach. By decreasing price sensitivity, suppliers can
increases the prices they charge customers. By improving
customer intimacy, suppliers reduce price sensitivity and
increase the amount they can charge customers.

For example, by offering their customers overdraft

protection, banks increase the utility credit card holders
see in staying with them. Another advantage is that credit
card companies cannot offer the same type of insurance.

Another familiar example is AOL's strategy. AOL

distributes thousands of CDs with their software and 6
months of free service. Their correct assumption is that
once a customer has an account with their own email, a
buddy list and other features, the willingness of customers
to switch Internet provides is significantly reduced. Low
incremental costs by user registration automation and a
great out-of-the-box experience are what make the Velcro
approach possible.

Customer Lock In
Another version of Velcro Pricing can be seen in the printer
market. By requiring unique cartridges, printer companies
lock in their customers after the purchase of a printer. Due
to this lock in, HP and Lexmark can afford to lower the
prices of their printers. Their profits don't come so much
from the printers they sell but from the toner and ink
cartridges. The printer companies can charge a premium
for these cartridges. Once generic refills become available,
smaller premiums are still possible because of the
perceived value that these brand names offer. There is a
tension between the desire for creating unique types of ink
cartridges and distribution costs. While the printer
manufacturers would like to see a unique cartridge for each
printer, resellers would balk at the overhead of carrying so
many cartridge types.

Standards

For the purpose of this article, standards will be divided

into two groups: Proprietary and Open. Embracing,
extending, or creating standards impacts pricing as well.

Proprietary Standards

Owning a proprietary standard and a strong market share

allows the vendor to raise prices when they own a
significant share of the market. The proprietary standard
increases switchover costs for the consumers. Familiar
examples are Microsoft's Office products. Most computer
consumers use MS Word so the switchover costs to
another word processor that is not fully compatible with
Word would be too high.  By constantly changing the
standard, vendors with large market shares can pressure
customers to upgrade once the people they exchange files
with have upgraded themselves.

When a company creates and owns a standard, even if the

standard is openly accessible, they place all other vendors
at the disadvantage of playing catch up. This is not only a
marketing advantage but a practical one as well.
Microsoft's ActiveX technology is very common on web
sites. The Netscape and Opera web browsers have
trouble keeping pace. If users want to utilize ActiveX
components, they need to stick with the Internet Explorer.
This approach works only if the standard becomes widely
adopted. Microsoft tried this with its LRN (Learning
Resource iNterchange) standard but failed to get industry
buy-in and now seems to be abandoning it.

Open Standards

Open Standards refer to standards that are controlled by

public bodies such as TCP/IP, HTML etc. In contrast,
Open Standards such as TCP/IP, XML, and HTML have
both an upside and a downside for vendors. By supporting
an open standard, vendors decrease the customers?
switchover costs. Newcomers to the market can take
advantage of this. For example, switchover costs for
customers to another networking card vendor are very low.
By supporting the open TCP/IP standard, vendors can
make their products interoperable with current equipment
and thus more attractive to potential customers.

The Difficult Comparison Effect

The more difficult it is to compare between products, the

less price will be an issue in the purchasing process. To
make it more difficult for customers to compare products
vendors can add features (good for differentiating),
obfuscate the function of common features with creative
naming, sell the product in a way that makes it hard for
consumers to compare as well as create complex pricing
models (see below).

Have you ever wondered about all those stores that

announce that they will not be undersold? Large retailers
with massive product sales can receive a unique model of a
product from the vendor. No other retailer will have this
EXACT model. This is very easy to do and in consumer
electronics, the uniqueness is many times not much more
than a different label or box.

One example of products that are hard to compare are

mattresses. The comparison criteria are subjective and are
based on customers' subjective memories. Retailers can
therefore rely on their consumers to have limited capacity
to compare items between stores. By the time they go to
another store, the previous mattresses they saw are only a
vague memory.
Defending Against Disruptive Technologies [1]

Disruptive technologies allow vendors to create products

with a new approach to solving current market needs. To
capture a beachhead in the market, disruptive technologies
tend to offer only part the functionality the incumbent
offers better addressing the needs of a niche market and
for a significantly lower price. A disruptive product poses
two challenges to existing vendors. The first one answering
the needs of niche markets becomes harder and harder as
products grow with the maturing of the technology and the
second is that incumbents find it impossible to compete
with the price.

One way to better deal with disruptive technologies is to

have an entry level offering that can be priced
competitively so as to discourage competition and that is
flexible enough to refocus it to address competitive threats.
An entry-level product built specifically with flexibility in
mind is the best option.  Due to lack of resources,
companies often create a scaled down version of the main
product. Another advantage of having an entry level
product is having an upgrade path for customers that are
not willing to make a commitment out front or that are not
big enough to purchase the full-featured product.

Case in point: In 1996, Cimatron, a CAD/CAM software

vendor was selling $30,000 plus CAD/CAM software seats.
That year, Solidworks announced a product based on a
new design technology with a starting cost of $5,000.
Initially, Cimatron scoffed at the new product. It only
addressed one part of the market and at its price point it
could not support professional services, a technician to
install it, etc.  It didn't need them. However, Solidworks
had clearly identified an unsolved problem in an
underserved market segment. After losing a significant
part of their market share, Cimatron eventually responded,
with their own 'light' product. Their delay in identifying the
market trend cost them dearly.

Unlike Cimatron, Mercury Interactive, a provider of

enterprise testing and performance solutions, was able to
take a threat from upstarts and turn it into a hands-down
victory. In 1998, when selling into large accounts, they
found that two new upstart competitors were already
present in many of them. These competitors offered only
web based testing but for a quarter of the price of
Mercury's testing suite. During that timeframe, Mercury
recognized that the dynamics of web testing had changed,
(e.g. downloadable, lower entry level, less technical users
etc....) and developed a new product--Astra. The
advantages Astra offered customers were: the security that
comes with buying from a market leader, an upgrade path
(all test scripts were compatible with their enterprise level
application) and any customer that upgraded within a
certain timeframe would get a refund for their purchase of
Astra. With this strategy, they were able to not only stop
their competitors but also increase their own market share.

A side note: While not Mercury's largest source of revenue,

Astra has become a significant part of their lead generation
efforts.

Pricing and the Technology Adoption Life Cycle

Another way to look at pricing models is from the

Technology Adoption Cycle. Where you are with your
product in the cycle bears heavily on the approach to
pricing you should take.

Early Stage Buyers

The early stage buyer is interested in the technology, often

in the form of toolkits. They enjoy being on the ?cutting
edge?.  Since a lot of their motivation involves ego
gratification and gaining some kind of competitive edge,
this audience may not see a difficult implementation as a
bad thing. This means someone else with less fortitude will
not be able to follow his or her trail--at least not easily.

One mistake vendors make with Early Stage Buyers is

assuming that a lower price will drive the business--it
won't. It will probably leave money on the table. Lower
prices will lower margins, but not raise volume
significantly with these buyers.

Main Street Buyers

Main Street Buyers purchase products. Vendors can take
two approaches with Main Street Buyers. They can
differentiate to keep prices at a maximum or inadvertently
enter a price war with competitors. Main Street buyers
expect service, reliability, integration with existing systems
etc. They will not tolerate what Early Stage Buyers did.
With proper planning, the product can spearhead the
differentiating effort.

Late Stage Buyers

The Late Stage Buyer buys the #1 (read: safest) company or

the cheapest product. These are people who want to know
what 'the thing' will do for them, whether it really works,
and what is involved in running it. This is much more a
'mainstream' set of issues. They are hesitant to buy unless
they can speak with someone from their industry that uses
the product successfully. When you have reached this point
in the product cycle, you should be well into introducing
the next generation of your product as well as cutting back
on your product's R&D expenses as prices go down.

'Groucho Marx' Pricing

Groucho Marx is quoted as saying 'I do not care to belong

to a club that accepts people like me as members.' Groucho
Marx pricing refers to the situation where the pricing can
deter ideal customers and attract undesirable ones. The
credit industry has this problem where its ideal customers
(those that pay their bills), are the ones that need credit the
least. This creates a situation where the consumers willing
to pay for expensive credit are people that badly need it
because they have a bad credit history and are high high-
risk customers. This way, a high- end product might
inadvertently attract 'bad' customers. Or as a paraphrase
on Groucho Marx: the credit cards offering is inviting to
those that they do not want to sell to in the first place. To
avoid this problem, credit companies created a somewhat
unique mechanism: They use credit histories to decide
whom they want to sell their product to. The customer
expresses a desire to buy but the credit card company
decides if they want to sell. This model is rare outside the
financial services industries.

Variable Pricing Models

Some of the best-known examples of variable pricing

models are eBay, Priceline, the airlines and the stock
market. In these markets, the price is set dynamically with
little restriction. The nature of the markets limits the type
of products that can be sold on them.

eBay is the case exemplar of the ideal marketplace.

Geography is not an issue prices are set by supply and
demand. Consumers know what they are looking for and
there is no need for anything beyond a spec sheet. eBay
might be one of the cheapest selling channels but this type
of marketplace is only good for products that are sold As-Is
with easily defined features. Products that require complex
service contracts, professional services or presale work are
not good candidates for this eBay.

Priceline is similar in the bidding aspect but is

fundamentally different in another. It adds an uncertainty
in the purchase such as the date for the airline tickets or
the exact hotel as a trade off for lower prices. This
uncertainty can be seen as a flaw in the offered product. In
exchange for this 'flaw' and the ability to sell last minute
vacancies, vendors are willing to reduce prices.

The new pricing model does not fit all products such as
perishables. Imagine for example a bakery that offers
slightly stale bread from yesterday at a discount. Most
people would not be interested in such an offer.

Airlines have made variable pricing into an art. By

segmenting their market, they have created a complex,
confusing model. They sell a basically identical product at
different prices all depending on when you buy and who
they think you are. The first parameter is the time of
purchase. The price of ticket is significantly lower if you
purchase it at least two weeks ahead of time. Airlines
assume that anyone buying a ticket at the last moment or
that is not staying over the weekend is a businessman and
therefore, they can change more. The reasoning here is
that the cost will be covered by the employer so the
customer is not as price sensitive as those who are paying
out of their own pocket. The second parameter is the
Saturday night stay-over. Airlines assume that business
people want to return home for the weekend and will
charge more for itineraries that do not include the next
Sunday. This confusing approach also infuriates the
airlines' customers, particularly the business traveler.

The Prospect's Side

Comparing Apples to Oranges

The customer needs to be able to compare apples to apples

especially when they need to sell the solution internally. If
your offering has a unique pricing model, any internal
effort to justify buying your solution will be all that more
difficult because the prospect will find it hard to compare
your offering to that of others.

This issue was brought up when a large online content site

convened advertising buyers in an attempt to find ways to
increase sales. The buyers complained that the online
industry's terminology, pricing and, ROI models were not
standardized and that this was causing a great deal of
problems. Creating an industry standard would probably
have benefited all the players in the online advertising
market.

When this discussion took place in early 2001, the market

was mature enough from a technology perspective.

Open-Ended Pricing
Prospects abhor a proposal that is not capped. If a service
costs $10,000 to set up plus 50 cents per minute, prospects
will be concerned about what the final cost will be for
them. No one wants to exceed their budget so prospects
will appreciate a cap to the variable costs. If you have
control over the variable costs, you will gain from capping
them as long as you can guarantee that no damage will be
done to your company if they exceed usage. Imagine the
first-time cell phone customer who receives a $200 usage
bill instead of the expected $45 one.

To look at another aspect of open ended pricing let's

assume your company resells a product such as conference
calls together with value added services that you add on.
You purchase the conference calls at a per-minute cost that
varies by the location of the caller. You have no control
over the actual cost of the call. If the prospect asks for
capped price, you should think very carefully about this.
The costs that you do not control may come back to bite
you?

Other Issues

Pricing Models During a Price War

Earlier in the article, the relationship between the

functionality of the product and the pricing model was
discussed. Proper product planning and positioning can
help prevent a price war by allowing the vendor to charge a
premium. However, if the products are similar and as the
market matures, price becomes a bigger factor in the
buying decision. Pricing wars start once the differentiation
within the market space has eroded. Unless the vendors
can extract themselves from the price war by better
positioning, the vendor that is able to offer lower prices
over time will win the price war.

In essence, a price war is not fought with pricing models. If

a battlefield analogy is to be used, the pricing model is the
transportation device. It is the tool the vendor used to
arrive at a price point for the product. The showdown of a
price war is focused around the price point, not how the
vendor arrived at it. If the vendor chooses to lower prices
to fight a price war, the pricing model must be calibrated at
a lower price point or discarded all together and the
product features must be adjusted as well.

For example, current ERP systems require endless

adjustment and configuration.  In theory, should the ERP
vendors enter a price war, the vendor whose product has
the lowest incremental costs during the sales cycle and the
installation and configuration is in a better position to
survive.

The Pricing Model as a Differentiator?

While the price of a product might be a differentiating

factor, the pricing model in itself is not. For a pricing
model to offer a vendor an advantage in the market place it
must be backed up by a unique product, technology or
business model. This is because d