Pricing New Products

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This strategy can be risky, however. If consumer choice is influenced primarily by benefits rather than price, penetration pricing can only be destructive. The media, high-tech, and pharmaceutical industries provide many examples of new offerings and technologies priced aggressively to build share, which was then lost when competitors released newer and slightly better products. In markets focused on technical efficacy, these suppliers needlessly pushed price expectations lower and thus forfeited profits.

Cost-to-serve advances

Another possible occasion for penetration pricing comes when a supplier's cost to serve will decline sharply and rapidly -- often because of economies of scale or a learning-curve effect -- as volume expands and fixed and variable costs per unit drop. If costs fall faster than prices, margins should rise over time.

But as the market share of a company grows, its competitors often react quickly, using low prices to minimize their market loss or to enter the market. The result can be constant downward pressure on pricing that puts target margins out of reach. Remember too that extreme care must be taken if the core driver of a product's acceptance is benefits rather than price.

Limited capacity is another pitfall that can trap a company that is chasing low costs to serve. If penetration pricing ignites demand that can't be met, the supplier is injured twice: margins are lost needlessly because available supplies could have been sold at higher prices, and delivery delays or failures - a factor in the overall perception of a product's benefits -- could undermine customer satisfaction.

Weak competition

Penetration pricing could also be appropriate if a company's competitors have higher cost structures or are locked into channel agreements that limit their pricing freedom. In the basic-materials industry, for instance, Asian and Eastern European suppliers have frequently captured market share through penetration pricing once their purity and logistics standards reached minimally acceptable levels, because producers in developed countries could not match their low labor costs.

A well-known example comes from the US consumer PC market, in which Dell Computer created a lower cost structure (and eliminated costs associated with intermediaries) by selling built-to-order PCs direct to customers over the phone and the Internet. Since rivals couldn't match Dell's low costs, the company expanded its market share rapidly even as it secured higher margins than its rivals did.

Notes:
Mike Marn and Eric Roegner are principals in McKinsey's Cleveland office; Craig Zawada is a principal in the Pittsburgh office.
¹ This analysis is based on average economics for S&P 1500 companies. See Michael V. Marn, Eric V. Roegner, and Craig C. Zawada, "The power of pricing," The McKinsey Quarterly , 2003 Number 1, pp. 26-39.
² See Ralf Leszinski and Michael V. Marn, "Setting value, not price," The McKinsey Quarterly , 1997 Number 1, pp. 98-115.
³ Conjoint analysis examines the direct trade-offs among competing products. Perceptual mapping, which assesses the benefits of different products that may not be direct substitutes for one another, seeks to identify the benefits that no other product offers.
⁴ See Charles Roxburgh, "Hidden flaws in strategy," The McKinsey Quarterly , 2003 Number 2, pp. 26-39.
⁵ The company considered this an at-cost price, but it actually underestimated its true expenses.
⁶ See Robert A. Garda and Michael V. Marn, "Price wars," The McKinsey Quarterly , 1993 Number 3, pp. 87-100.

Copyright © 1992-2003 McKinsey & Company, Inc.

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