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Jun 8, 2012

Pricing Similar Products: 2 Tricks

If you have similar products in your portfolio, setting pricing that enable both of them to succeed can be a big challenge. Here's how to do it.

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One of our clients, an airplane manufacturer, was struggling with overlap between two of their models. The newer model had been growing in size and features and was encroaching on the market for the older model. Their fundamental question to us was:  Should we continue to manufacture both models, or should we develop a plan to discontinue the older model?

The issue ultimately came down to pricing. Setting the right price for products and services is one of the more challenging decisions any business faces.

We suggested two complementary approaches to answer this question. These approaches can help any business that has overlapping products in its portfolio:

1. Indifference price analysis

Estimate the price we would need to charge for the older model to make identical profits between the older and newer models. This approach would make the manufacturer indifferent to the customer's choice of model.

2. Value-in-use price analysis

Estimate the older model price point at which the customer is indifferent between the two models (i.e., the value they derive from using either model, less their purchase cost, is identical). We have used this approach at multiple clients.

The logic here is simple:  If our "indifference" price for the older model is lower than or similar to the customer's value-in-use price, then our path forward with the older model is straightforward:

  • Continue to manufacture both models and promote both of them as viable solutions
  • Charge a price for the older model where we are more or less indifferent to the customer's choice of models
  • Let the customer decide which model best meets their needs
  • If customers consistently choose one model, we may need to revisit the value-in-use price analysis and reopen the question of whether to discontinue the other model

Conversely, if our indifference price for the older model is much higher than the customer's value-in-use price, we likely need to discontinue the older model, or at least sharply curtail production to serve only those customers that have the highest value-in-use for the older model.

Estimating Value-In-Use Price

Calculating the indifference price between two overlapping products is a relatively straightforward breakeven analysis. However, estimating customer value-in-use can be challenging. In this case, we were selling to commercial customers, so we needed to really understand their economics in detail.

Luckily we had a longstanding relationship with one of the top airlines and had great visibility into the routes and schedules they flew, their operating costs per seat-mile, their number of passengers per route, and a lot of other useful economic information. We also knew a great amount of detail about the differences in operating costs (e.g., fuel efficiency as a function of route length) between our two models.

As a result, we were able to show in great detail that their cost to operate the older model was about 10% higher than their cost for the newer model. The manufacturer needed a roughly 20% lower list price on the older model just to break even on most routes. At current prices the older model was the more value-creating choice for the airline on only about 30% of the relevant routes.

Note that this analysis was only performed for one customer and was a purely economic analysis; there are several strategic factors that drive aircraft model selection (e.g., long-term predictions of fuel costs can drive different decisions than today's prices might indicate). Nevertheless, it gave us a lot of insight on value-in-use across the customer base and clarified the role of the older model in our portfolio.

Our client decided to keep manufacturing both models, but with reduced expectations for sales of the older model. They also decided to develop new, more fuel-efficient models that reflected the projected growth in fuel costs.

If you have overlapping products or services in your portfolio, analysis of value-in-use and indifference prices can help you clarify the role of each product/service in your portfolio.


Karl Stark and Bill Stewart are managing directors and co-founders of Avondale, a strategic advisory firm focused on growing companies. Avondale, based in Chicago, is a high-growth company itself and is a two-time Inc. 500 honoree. @karlstark