To take an accurate measure of the benefits a product offers -- and thereby find its true price ceiling -- market research must be designed to elicit more open-ended feedback than can usually be acquired through multiple-choice questionnaires or trade-off techniques, both of which can limit responses. For example, a controls maker's revolutionary high-pressure steam valve for nuclear power plants significantly increased the reliability and reduced the complexity of their water-management systems. At first, trade-off techniques were used to research the market: the company described the technical benefits of the new valve and tried to find out how much customers would pay by comparing it with a valve for another application. Most of them felt that a 20 to 25 percent premium was justified.
The company later redid its research to broaden the outlook, this time asking more open-ended questions to establish how much value the valve would deliver to the business systems of its customers. Instead of first asking them to compare the new valve with an existing one, the company now sought to evaluate the cost of planned maintenance shutdowns and the role the new valve could play in reducing their number. Now that the company had a fuller picture of the new benefits -- a picture based on its customers' economics -- it asked how much customers would be willing to pay for them. This time, the customers gave a figure that was several times the price of the existing valve. The supplier had a more accurate picture of its pricing options.
The floor
Cost-plus pricing is often derided as weak, but it plays an essential role in setting the floor for a company's pricing options. An accurate analysis of costs per unit, plus a margin representing a minimally acceptable return on investment, reveals a new product's lowest reasonable price level. If the market can't bear it, the company must rethink the product's viability.
Although the cost-plus model is well-known, companies often trip up in two areas when they use it to analyze their costs. First, surprisingly, they don't account for all costs that should be allocated to products; there is a tendency, for example, to overlook R&D expenses associated with a product category (including expenses for incomplete projects) and goodwill linked to acquisitions that lead directly to new products. As a necessary part of any development program, these are legitimate items to bring into the cost calculation. Second, overly optimistic market projections can create false estimates of costs, particularly fixed ones.4
The range of pricing options is usually smallest for me-too products. Companies using them to play catch-up must therefore be particularly careful to assess their costs correctly and to understand the assumptions underlying these calculations; a small error can permanently prevent products from becoming profitable. If a product's viability relies on cost savings generated by economies of scale, for instance, a false estimate of the size of the market or of a customer segment would be disastrous.
The size of the market
Similar research is needed to gauge the size of the market or market segments for various prices at and below the ceiling. Instinct might suggest that the lower the price, the higher the demand, but that isn't always true. Midrange prices, for instance, might put a product in the dead zone -- too cheap for quality-conscious customers and too expensive for bargain hunters.
One company, for example, offered a new data-management system that it claimed could save large companies hundreds of millions of dollars a year. But to penetrate the market quickly, it released the core software with an enterprise license fee of less than $100,000.5 Potential customers wouldn't take the company's claims seriously; if the claims were true, the software should have been priced in the same range as other enterprise-resource-planning (ERP) packages, which cost $1 million or more.
Estimating the size of a market at various price points clarifies the range of pricing options, suggests which price models to use at any price and volume point, and increases the accuracy of estimates of profitability along the spectrum and of the unit-cost calculations needed to define the price floor.
Setting the release price
After a company has determined the full range of its pricing options and the market's size at various points within that range, it is ready to formulate the release price. Targeting the largest market segment within the range might be tempting, but maximizing volume doesn't necessarily maximize profits (see sidebar "Penetration pricing "). In particular, four aspects of new-product pricing may counsel against targeting the largest market, especially if doing so means setting the price low.
Reference price
The release price minus any discounts or other incentives establishes the market's first reference point for the product's true value as judged by its maker. More than any press release, sales pitch, or catalog description, the reference price tells the market what a company really thinks a new product is worth. An excessively low reference price can handicap its long-term profitability -- the low price might hasten its penetration of the market, but the resulting lower margins forgo the future profits a higher price would have captured once a customer base had been established. A low reference price is particularly damaging if it conflicts with the value position the company is trying to establish or if market demand has been underestimated.
