Use this framework to determine an the price for a new product
A well thought-out pricing strategy is crucial for optimizing both sales volume and profit. It is surprising therefore, according to data from the Professional Pricing Society, (the world’s largest organization dedicated to pricing) that fewer than 5% of Fortune 500 companies have a full-time function dedicated to pricing. Every company needs to ask itself the question "Am I charging optimum prices that will generate the maximum profits for my sales?”.
The consulting group McKinsey carried out a famous exercise that determined a price rise of 1% at an average company in the S&P 1500 index (which covers small through to large companies) would generate an 8% increase in operating profit if sales volume stay steady. With just a 1% price increase, sales are unlikely to waver much and the extra profit flows directly onto the bottom line.
The leverage of price is substantial. All overhead costs have been met and so the additional gross margin that is obtained (somewhere between 40% and 60% depending on the product or service) contributes completely to net profits. It does of course raise the question "why not increase prices by 5%, 10% or even 15%?".
Launching a new product and pitching it at the right price is critical. A price that is too high will kill sales and a price that is too low will jeopardise profits. Many companies set the price of new products by looking at competitive products already on the market and make a judgement as to where the new product fits.The sales teams have a strong contribution in this discussion and there is more than a possibility that they will push for a price that is relatively low on the grounds that it will make their job easier. It is worth using independent research and tried and tested pricing tools to make sure that the optimum price is chosen.
The only sure way of obtaining an accurate and realistic understanding of how price works for a new product is to carry out a test market – in other words to create a situation where customers are exposed to real price changes with real demand pressures. However, it would be still necessary to decide on what price to launch into the test market and in any case, test markets are expensive and difficult to organise. For this reason, we turn to pricing models that simulate buying situations.
Establishing the price of a new product is critically important as it determines the success of the launch and the profitability of sales. Two tools from Gabor Granger and Van Westendorp have proved to give realistic price levels for new products. The Gabor Granger tool can be used to test concepts before prototypes are made. Once a prototype is developed and can be shown to respondents, the Van Westendorp tool will indicate the optimum price.
Clive Granger and André Gabor, professors of economics at the University of Nottingham in the UK developed their pricing tool for new products and services in the 1960s. Peter van Westendorp, a Dutch economist developed his Price Sensitivity Measurement tool in 1976.
The Gabor Granger pricing tool is often used to establish price perceptions of new products. It was developed in the 1960s by two economists (Gabor and Granger). The proposed new product is shown or described to target customers who are asked if they would buy it at particular prices. The prices that are presented to customers are changed and on each occasion respondents say if they would buy or not. In theory customers should be given random prices but in practice the first price they are presented with starts high and subsequent prices are lowered. Levels of demand can be calculated at each price point (the demand curve shown below). Using this estimate of demand, the price elasticity (or expected revenue) can be calculated and so the optimum price-point is established.
A more sophisticated variation of the Gabor Granger technique is a tool developed by Van Westendorp. Respondents are shown or told the features and benefits of a product (or service) and the Price Sensitivity Measurement (PSM) tool determines pricing options based on four questions:
At what price would you consider this product/service to be cheap?
At what price would you consider this product/service to be too expensive?
At what price would you consider this product/service to be priced so cheaply that you would worry about its quality?
At what price would you consider this product/service to be too expensive to consider buying it?
As with the Gabor Granger tool, Van Westendorp is often used to set the price of a new product or service and can also be used for price testing existing products. Analysis of the data yields four demand curves as shown in the following diagram. The various intersections on the curves describe the pricing options:
In both cases you will need to:
Have a sample of potential buyers of the product who will complete the survey (if possible at least 30 completed surveys and ideally over 100)
Have a facility for suitably describing the new product (the questions can be asked after a product trial or respondents can be shown a description of the product before being asked their likelihood of buying at certain prices). The new product could be shown to people in an online questionnaire or if the interview is by telephone, via a web link (which assumes that the respondent will be able to access it through a computer, an iPhone or an iPad).
Some things to think about:
Establishing the price of a new product is critically important as it determines the success of the launch and the profitability of sales. The Gabor Granger tool can be used to test concepts before prototypes are made. Once a prototype is developed and can be shown to respondents, the Van Westendorp tool will indicate the optimum price.
Both Gabor Granger and Van Westendorp have proved to give realistic price levels for new products. It is worth considering launching at a slightly higher price than that which is suggested by the tool if it is a market which expects discounts.