by Babak Hafezi, M.A., M.B.A
As every entrepreneur will tell you, one of the key elements that entrepreneurs have issues with is how they set the right price for their product/service. Many entrepreneurs do not understand pricing formulas and many un-willingly price themselves out of the market, either by undercharging or by overcharging. However, your pricing strategy correlates directly with your corporate strategy. Is your company attempting to increase market share, create a luxury product, make a profit, or just survive?
What is the right price for my product or service?
Based on your corporate strategy, your pricing model will be different. This is one of the key failures of technology firms in that they want to go-to market rapidly and unconsciously underprice or overprice themselves to their detriment. A great example of a pricing blunder and its implication was Netflix’s price increase in July of 2011. Unfortunately, Netflix did not ask itself what is the right price for my service? The company was focusing on further expansion in its streaming content and DVD mailing and it could no longer be profitable by providing both services at the $9.99 rate a month. The company decided to provide pure streaming services for $7.99 or pure Mail delivery service $7.99 without a discounted bundle price. The 60% price increase lead to Netflix loosing 800,000 clients in one quarter and a loss of stock valuation of 40% in one day. Netflix’s corporate strategy and pricing strategy had diverted through time and Netflix was eager to increase the price, but did not invest its time and resources in finding the right price for its customers. Netflix has not been the same company ever since the incident and its stock has yet to recovered from that blunder. The right price changes with time and companies that have been previously successful must also adapt of die, such is the case of Wendy’s.
What happens if you underprice?
If companies underprice themselves they leave a lot of money on the table, and in many cases become cash flow negative without knowing it. HafeziCapital recently advised a client whose model proved to be financially unsustainable in its third year of business given its specific market condition. Had HafeziCapital not modeled the income based on very specific bespoke parameters the company may have lost all its value in its second year. Imagine how crippling this could have been for a software company that was trying to actively raise capital. Based on our analysis we changed the income model and subsequent long-term viability of the company and established the parameters to raise capital.
There is a science behind product pricing. Mathematical formulas exist that calibrate the best pricing power based on income, price of goods and other variables that affect the market. Competition has an effect on the market but remember that the market has room for both a $10 Seiko watch and a $250,000 Patek Philippe watch.
How can both high and low-end products exist in the market space?
Well the $10 Seiko watch may be a great an accurate watch, however it is built for mass volume. The Seiko will have cheaper materials and internal mechanics that are fairly simple to assemble, whereas the Patek Philippe will have very complex movements and precious metals and stones that increase the intrinsic price. Furthermore, the value increases due to the man-hours that are required and special talents of the watchmaker to assemble the watch, its cache, history, product rarity, its secondary market value and specific target market, namely the wealthy. The volume is also a part of the consideration, given that Patek Philippe only makes about fifty thousand watches a year globally versus the Seiko that makes tens of millions.
The point is that most entrepreneurs do not know how to price their product/service adequately because they do not know their customer, their cost structure, their revenue targets, where the market is heading, and their competitors. Many entrepreneurs enter a new market and look at their competitors alone and price their product below or about the same as their competitor. Yet, they go into the market claiming the product is superior. That may be true but what is the reason behind your pricing strategy?
What can we learn from the tablet wars?
The tablet wars exemplify the diverse pricing strategies from one company to the other. Apple’s iPad tablets are generally more expensive than those of its competitors. However, Apple’s pricing strategy entailed making money on the tablet itself (37%-49% profit margin per tablet) and on the distribution of books and music versus that of Amazon’s Kindle whose first generation table was a money looser (average -1.1% profit margin) and the second generation has an estimated profit margin of 13% with the distribution composing the largest part of its income.
However, Amazon and Apple have two distinct pricing strategies, in that Amazon used the Kindle to defend its market share of book’s and music (CD) sales via digital distribution. Whereas, Apple was entering a new market, namely the book distribution and publishing business and further using its distribution tools to generate further income. Amazon and Apple could not have the same pricing strategy given that each has a different corporate strategy.
Entrepreneurs rarely correlate their corporate strategy with that of the pricing strategy, leading them to make money in the short term at the expense of long term survivability. Companies whose corporate strategy does not align with the long term goals become financially crippled. Developing a corporate strategy that correlates directly with the pricing strategy is critical to corporate success and long-term viability. Furthermore, developing a feasibility study that models short, medium and long-term incomes with the strategic objectives of your organization is empirical to your overall success.
Who needs right price auditing?
- Technology firms
- Application firms – Answering Freemium vs. Premium question
- Software as a Service (SaaS) firms
- Retail firms
- Profesional Services firms
- Technical Services firms
- Wholesale firms
- Biosciences firms