Setting Prices

To an outsider, how a company sets prices for new-to-the-world products may resemble black magic coupled with company politics. However, sound pricing practices are rarely a matter of mysticism or bravado. Rather, like other managerial business decisions, appropriate pricing is accomplished through direct qualitative and quantitative approaches. And, in overcoming this sales and marketing challenge, the prices enable the business to both capture and share value with its customers.

Price Levels and Pricing Mechanism

Strategic pricing can be separated into a two step process. The first step is to determine the appropriate price level; the second step is to determine the pricing mechanisms. Price levels set the quantity of money transacted for a product or service with a given customer, market segment, or overall market. Pricing mechanisms are the step function used to set prices to the appropriate price level.

For instance, it might be determined that a customer’s willingness-to-pay for a product is at $500 while the company can profitably sell the product at $450. Anywhere between $450 and $500 would be an appropriate price level for that customer. However, the pricing mechanism might be to set prices based upon the number of “licensed seats” at $200 per seat. If the customer only requires one licensed seat, the company pricing mechanism would yield a price of $200 resulting in unnecessarily leaving money on the table. Alternatively, the customer might require 5 licensed seats. In this case, the pricing mechanism yields $1000 which is above the customer’s willingness-to-pay resulting in a lost sale that could have been profitable.

Clearly, a business must both determine the appropriate price level and the pricing mechanism. In the remainder of this article, we will examine some of the most common methods of determining an appropriate price level. These qualitative and quantitative methods concentrate on understanding the customer’s willingness-to-pay (WTP).

Qualitative Methods

Qualitatively, price levels can be determined by comparable benchmarks. The closer the benchmark resembles the actual product or service being offered, the more informative it is in setting prices.

A simple benchmark is revealed by examining the industry average spending within a product category. For Instance, IT spending is at 3% of revenues, according to AMR Research, July 2002. Thus, a software product or service designed to serve businesses with $50 million in revenue should be priced well below $1.5 million on an annualized basis. Yet this benchmark leaves much to be desired. Some businesses routinely spend more than 3% of their revenues on IT while others spend much less. Also, this benchmark is for a host of IT products and services where one company’s products must fit within the portfolio of purchases that the company will intend to make.

Another qualitative benchmark for pricing is set by examining similar purchases made by customers within a target market. For instance, if small manufacturing customers are known to purchase enterprise accounting systems at a price of $3 million, then an enterprise customer relationship management system may be expected to cost somewhat near this amount. Pricing based upon similar product types however raises many difficulties. Comparing accounting systems to sales and marketing systems is more like comparing apples to oranges than Red Delicious to Granny Smiths.

Substitutes and competitors clearly provide the best qualitative metrics for setting prices. Substitutes and competing products or services have already established an expected level of expenditures for addressing a specific type of challenge. EMNS utilized this method well in establishing its price levels. The key to qualitatively setting prices according to substitutes and competitors is in understanding how the business’s offering is superior or inferior to other offerings and setting prices according to that value differential. This may involve an examination of comparable ROI dependent upon the purchase decision.

Qualitative price setting methods have the advantage of being relatively easy to accomplish. Research into industry spending levels, comparable offers, and substitute pricing can usually be accomplished with a review of existing literature. However, Qualitative price setting methods suffer from lack of specificity. Using qualitative methods to uncover customers’ willingness-to-pay will provide guidelines to price setting, but may leave a wide price band that requires further narrowing before the business establishes its pricing levels. Target market specific quantitative methods pick up where qualitative methods leave off.

Quantitative Methods

Two commonly used quantitative methods to uncover the customers’ willingness-to-pay are conjoint analysis and price sensitivity metrics.

Conjoint analysis methods attempt to directly reveal how a set of customers make tradeoffs between different bundles of features, benefits, and prices. It relies upon asking potential customers simple questions such as “Which do you prefer, a $1,250 contact management product for five people that captures customer data and provides minor business process automation OR an $8,000 customer relationship management system for five people that does the above but has the added benefit of sharing contact information between the team and automating several business processes?” From this and similar questions, an analysis will reveal the price level and product features desired by a customer set. The main value of conjoint analysis over other tradeoff methods is the ability to reduce the number of questions by creating a minimal set of linear combinations of the features required to span the entire feature space.

Conjoint analysis is a very powerful tool for setting prices. To its credit, it directly quantifies the customer’s willingness-to-pay and sets the requirements for product management. However, conjoint methods suffer from requiring customers to explicitly make tradeoffs. With new-to-the-world products and services, most customers lack the understanding of the offering necessary to make informed tradeoffs. A different approach is taken using the Price Sensitivity Meter.

The Price Sensitivity Meter (PSM) uncovers customer price expectations for new products or services. In the PSM method, a researcher describes to the potential customer the product or service and its features and benefits. Then, the researcher asks four questions: (1) At what price would you consider this offering to represent a good value? (2) At what price would you say this offering is getting to expensive but you would still consider it? (3) At what price would you say this offering is so expensive that you would no longer consider it? And (4) at what price would you say this offering is so inexpensive that you would begin to question its quality? The price is set by examining intersections of cumulative distributions for these independent questions.

PSM method benefits from its simplicity. It uncovers both what the customer believes the product is worth and what they are willing to pay for the product. Its downfall, however, is that it routinely yields prices somewhat below the market efficient pricing.

Striking the Price Balance

As a business creates its price levels, it can utilize all or some of the above methods. Moving from a broad qualitative approach of understanding industry purchase behavior, through a more specific qualitative approach of comparing an offering to substitutes and competitors, and finally to a quantitative approach that directly assesses customer’s willingness-to-pay, sequentially narrows the price band at which the product or service should be offered. Price Sensitivity Meters and Conjoint Analysis require direct market research usually with the aide of a specialist while the more qualitative approaches are relatively simpler to execute.

The selection of a price setting method should involve managerial tradeoffs that reflect the importance of accuracy in setting the price. In general, greater accuracy is provided by the quantitative methods. Each of the above methods provides insights into the customers’ willingness to pay, and each has its limitations. The best pricing strategies reflect considerations from many of the above methods.

For further informaion on pricing, see the Wiglaf Journal EMNS article.