Chapter 11
Higher Return: Introductory Pricing Strategies
Let us always meet each other with a smile, for the smile is the beginning of love.
—MOTHER TERESA
Now that your company has a product or service ready for market, how can you use price to attract the attention of buyers and propel them to buy your product?
Two factors determine the success of an introductory pricing plan: knowledge and timing. By its nature, a new product is unfamiliar to potential buyers, and the burden of familiarization is on the seller. Precisely how your company should shape its introductory price will vary with each product, but while the application varies, the framework for success does not.
The good news is that the seller begins with an advantage. Sellers should know more about the product (or service) and its use than first-time buyers, so the seller should be able to shape the introductory pricing to the seller’s advantage. Yet many persist in using introductory price schemes that ignore the advantage. Too many companies use the two-step “discounted trial followed by full price” approach. That begins to reflect the evolution of product knowledge and power, but it is a very crude approximation. What is a better fit?
Three Phases in Customer Product Adoption
Every market exhibits the same uptake pattern for new products, and this pattern must be the framework for introductory pricing strategy. The three-part pattern is:
1. Learn
2. Use and Enjoy
3. Reassess
Learn
The customer product adoption pattern is driven by customer knowledge. For instance, before a customer uses a product, he must learn about the product. Before she knows what benefits the new service provides, it would be pointless to wonder about alternatives. This pattern can be discerned in many ways, e.g., from customer focus groups at different stages in their usage and familiarity with a service or products, or by observable real-world customer behavior.
Stages in familiarity with a new product or service is the key question for new-product development teams considering pricing.
In addition to surveys of new customers, a good barometer of customer mind-set is the use of call-ins. Very typically a new product, particularly a groundbreaking new product, will require explanation and assistance in the beginning, prompting calls. An example of such a pattern of calls for a software as a service (SaaS) product showed that assistance queries dropped off after about 12 days. So, in that case, managers can infer that the learning phase basically ended within two weeks.
Note that there is a big difference between the customer familiarizing himself with the product and the seller’s educating the customer about a product’s full value. The latter task can take much longer and be Herculean in scope. The latter involves much more than introductory pricing. Familiarity is the essential purpose of trial.
Use and Enjoy
If the product suits the market, familiarity will lead to usage. Where usage or enjoyment of the product and service can be measured, usage measures often ramp up toward the end of the learning phase. This is because purchasers have learned how to use the product—and with that ability comes higher utility and satisfaction. Again, this can be measured. Satisfaction, measured directly or by proxy such as usage, is the key to determine when to end a trial and press for commitment. If the product offers real value, the customers will exploit the value with a palpable enthusiasm.
A look at the usage data will frequently show how things are going. At several online information service providers, for instance, customer cancellations were directly inverse to usage. Regression showed an adequate goodness of fit between usage and cancellation during trial—and high confidence levels (more than 90 percent).1
After some period of high usage and satisfaction, most customers will begin to wonder whether they can obtain the same value for less money. This is a dangerous phase of new-product introduction. The trial may have built understanding, but now the value of that understanding may migrate to a competitor or substitute! In some companies, where calls are categorized by type, an early warning of increasing price focus might become apparent by the number of calls inquiring or complaining about price. From the SaaS example, the surge of calls, and with it the reassessment phase, began about four weeks after initial commitment. Ironically, if the product never gets to the phase where price is a concern, that may be a bad sign also: it may suggest that the product is not priced high enough.
Awareness of the three phases has been incorporated into pricing some of the most successful product introductions in history. For instance, AT&T’s consumer data service obtained over 800,000 customers during its initial months of launch. The pricing for this service was carefully tailored to the three phases: low price (actually, five hours free) during the introductory learning phase, a higher-than-market price during the middle high-enjoyment phase, and a competitive market price during the comparison phase. This is diagrammed in Figure 11-1.
Figure 11.1 Three stages of buyer awareness and price level.
A key message in this example is that introductory pricing does not need to mean a loss in revenues. AT&T actually obtained incremental margins during the trial, which of course means that it could afford a larger-scale trial.
Just as a careful analysis of the product and customer can show that trial need not always mean negative margins, we have found that often an introductory pricing strategy need not involve lower prices. When a company has an innovative, unique, and compelling product but may face competition soon, there may be no reason to begin pricing lower than normal. In fact, intro pricing may be higher.
An example of this comes from the early days of America Online. While AOL was famous for its up-front discounts, this was not always appropriate. When preloaded onto a computer, AOL actually faced less competition than after a user was connected to the Web. Thus, rather than discount up-front, AOL tried an alternative approach: full price up-front, then various discounts after getting the contract. This made complete sense because it matched discounting to the reassessment (third) phase when users could learn to search for lower-priced alternatives.
Introductory pricing strategies must reflect what the customer knows—and what they do not know.
The three-phase framework provided an incisive means for understanding customers and their decision logic. When a computer buyer initially opened the computer box, his immediate goal was to begin to use the Web. In that instant, AOL faced few competitive comparisons and enjoyed unrivaled awareness. Management knew this, but it was the framework that facilitated the pricing conclusion: no need to discount in phases one and two. Only after extended usage, in phase three, would users consider moving to a lower-priced alternative.
Reassess
The third phase, reassess, posed a problem for AOL. While it offered a rich array of services, the $23.99 monthly price was well above competitors’, which were as low as $5 a month. Therefore, the third phase was the focus of pricing. AOL designed a pricing scheme that reflected this danger:
First phase: full price, but option to cancel to reflect customer uncertainty
Second phase: full price and contractual commitment
Third phase: full price, but with a random month free
The power of promising an unspecified month free was that it reduced pricing transparency. It was designed to make users ask: would the next month be free? In which case, would switching providers squander a free month? As it turned out, this was an effective way of preventing new-subscriber drop-off.
The reassessment phase should always include an appraisal of switching costs. Switching costs can include new learning, contact cancellation penalties, and switching end-customer interface. Switching costs should play a major role in designing introductory prices. Where switching costs are high, companies should look for ways to induce customers to “buy into” several contract elements that would require switching should they choose to leave.
Be careful of cost factors that offset switching cost barriers. For instance, customers may buy more than one class of service, such as simultaneously using both Microsoft Windows and Apple OS in a corporate department. This is known as multi-homing. Multi-homing can be very burdensome, and individual purchase switching costs may be ignored as customers rush to shed the burdens of multi-homing.
Breadth versus Depth
We find that introductory pricing should only rarely involve a discount, particularly when facing an incumbent service vendor. Here is why:
Inevitably, incumbents have spent considerable time and effort developing their product so that it covers a range of customer needs, frequently adding additional applications (e.g., video game players that add in online gaming, online movies, video editing capabilities, or cross-platform mobility; their objective is to capture incremental audiences).
While the rich product functionality and integration typical of incumbent offers may benefit some customers, often it comes at added cost or added complexity—so that ease-of-use suffers. Such complexity has repeatedly caused products to under-index in some segments (e.g., often women refuse to buy complex technological consumer services such as satellite television, so Dish and other satellite vendors markedly under-index among women).
This means that overextended products provide an opening for competitors. Such products are ripe for the possibility of an effective introductory pricing attack.
Therefore, overextended products can be attacked by a narrow and segmented product. Why? Because customers hate paying for features they don’t use (even if, as in software, it adds little to cost).
An interesting example of this kind of introductory pricing involved a market for desktop computing support, which is characterized by high switching costs (relative to margins). In this case, switching costs ran about 15 to 25 percent of the annual operating costs because of installation and training of users to move from one company’s service to another’s. The case involved finding an attack offer that funded switching costs without cutting too deeply into vendor margins to be viable.
The solution lay in the data provider making an offer that included a flat charge service warranty for two years. The scope of the bid was only basic services setup and maintenance, with all other services (e.g., training) as extras. This dramatically undercut the incumbent price, which included many add-on services, for which they had negotiated high-margin surcharges.
In contrast, the entrant’s terms meant that after-sales support calls (within limits) would add no charges for the buyer, allowing the challenger to amortize switchover costs. The narrower scope reduced costs further. The result was a price offer almost half that of the incumbents. The incumbents thought that the new price was a loss-leader, but in fact it was the more lucrative service contract.
The reason the economics worked was that the seller was risking only its costs per hour (about $45 per hour) while the buyer was avoiding full price charges (about $110 per hour). It was a mutual win owing to differences in cost context.
Calls to Action and Lifetime Value
A call to action (purchase) is particularly important if the benefits of using a product are slow to accrue and there are switching costs to consumers. Frequently this is the case with “me too” products. Examples of commodity products with some switching costs include financial services such as brokerage and banking accounts, or cell phone accounts (especially before number portability). Even worse, some products may never actually offer any benefit (e.g., most insurance products don’t pay out unless there is a loss).
If a new product falls into this category, a call to action may be indispensible. There are many potential calls to action, but they usually cost money if the call to action is not trivial. To see how much can be invested in a call to action, a manager must know the lifetime value of the customer. Lifetime value is dependent on expected churn and spending. One factor in boosting both inputs to lifetime value, often overlooked, is the permanent price structure. If the permanent structure is very ordinary, then the lifetime churn will be ordinary.
Introductory pricing should mesh with the permanent price structure since price structure should reflect market price drivers.
Because price structure is a major driver of churn and lifetime value, a better structure can improve the “budget” for the call to action. So a better permanent price structure allows better introductory offers. There are many ways to determine the best price structure (see Chapter 6), but frequently new products are tougher to give an exact price architecture. An effective way to address this uncertainty is to offer customers a choice of structures and prices. If you are unsure whether they want to buy flat rate “all-you-can-eat” or “by-the-drink,” give them a choice. With self-selection, customers will generally take the best option for their needs—and can switch to a better structure if their perceptions change.
Allowing buyers a choice of price structures and levels will reduce your market acceptance risks.
Retention Tactics
Retention tactics need to be considered in any product launch. For instance, offering discounts in arrears, rather than up-front, naturally has the effect of discouraging churn. An example of this is reward points which accrue with usage, not purchase. While it is usage that builds up airline miles or credit card reward points, it takes some time for points to cumulate to something worthwhile. Until customers redeem them, such points are an effective means to discourage defection because generally the points are cancelled upon closing the account (e.g., if a customer cancels her American Express card, all points are lost).
Structural retention tactics apply to industrial situations also, where contingent volume discounts are paid at the end of a contract term. For instance, industrial plastic packaging contracts producers use volume discounts in a very tactical way, adjusting discounts to gain share and placement for new products. “Tactical” means that discounts might be specific to geographies or even warehouses. An added advantage to many layers of product discounts is that where discounts are geared to future orders, it is very difficult for buyers to disengage. This is one reason that packaging manufacturers did not suffer as badly as other sectors in the recent downturn.
Free
A quick word about “free.” This is a powerful word, but sadly it appears to be accepted by consumers without a lot of thought. When applied with less than a concern for honest communication by sellers, the stage can be set for damage to the brand.
What is free? In some cases the appeal for free is really for pricing simplicity combined with the usual desire for lower prices. For instance, when L.L. Bean, the venerable mail-order house, decided to offer “free” shipping, customers understood that the cost of shipping would have an impact on the product costs. But while L.L. Bean says that their customers find this approach less annoying, it is likely that what the customers really like is a simplified understanding of the price.2
Another use for free applies when there is some question in the customer’s mind about the value of the product or service. In some cases, this value must be demonstrated through direct experience (e.g., a sample or trial offer). The rule here is:
The utility of free = (Experiential value/Apparent value) × (Perceived risk – Guidance on sale) × (1/Cost of free)
Therefore, the more unknown the good and the more its purchase represents a risk (because of price or other factor), the more useful free will be. This is why there are food samples in grocery stores: a new taste is conveyed in only a limited way via advertisement. For some categories of goods, interestingly, the cost of free samples has come down sharply, as in the case of simulator software for fashion goods and configurators for cars. In some cases, sampling means using the actual product, such as long trial periods for SaaS services like salesforce.com.
Guided Sales
One reason for the existence of a sales force is that buyers often want advice on a prospective purchase. Again, understanding customer knowledge is key for determining if your product requires a guided sale. Therefore, guidance on sales goes hand in hand with more complex goods (e.g., automobiles, houses, medical procedures, etc.).
In general, the more guidance, the less need for free samples, notwithstanding the risks or need for experiential value. This is why airliners are purchased (or, at least, options for purchase are taken) before the first one rolls off the production floor. Yes, it’s important to know how an airplane will fly; yes, it’s risky to buy a new generation of an airliner—but there is a lot of guidance by Boeing and Airbus on the airplane. Plus free samples would be expensive.
Guidance is an underrated element to introductory pricing. Every product can benefit from some advice from the maker, but in many cases the product’s margin or distribution does not allow it. With the advent of the online purchase, the ability to offer inexpensive guidance has increased. Most online selling could benefit from more guidance to help outline options and set context. For instance, even simple guidance like the Amazon.com advice that “People who bought this book also bought …” is a superb source of guidance. Reviews by purchasers can also serve this purpose.
Guidance can also help simplify a long list of product options. For instance, if there are 25 options for adding to data security, a single question (“On a scale of 0 to 5, how concerned are you with data security?”) can replace a longer list. When seeking “simple pricing,” often buyers are really asking for short and clear menus of choices.
Negative Usage Pricing
If your company is faced with potential customers who are stubbornly resistant to trial and adoption, try a tactic called negative pricing. Applied typically to measurable services (e.g., SaaS applications), this approach provides a strong incentive to users to frequently utilize the service. The idea is to offer a reduction to fixed monthly price every time that a customer use or event occurs.
An example of this is a disaster-recovery service located in Oregon. This service charges a fixed fee of thousands of dollars per month to provide emergency backup computing capabilities and work facilities. Every time one of its clients refreshes the data being backed up, however, there is an offset to the charge. For instance, every time a client tests its backup systems, it gets a $50 credit.
In this case, everyone gains by this structure. The more frequently data is backed up, the less trouble it will be to recover data after a disaster or other computer problem. This reduces the provider’s costs. It also ingrains the habit of backing up among customers, often driven by office managers who harass computer users into doing what they otherwise would be uninterested in: using the service.
There is also a subtle upside to the structure. Note how more price-sensitive customers will be very meticulous in backing up—to save money. Less price-sensitive customers will be more haphazard. They won’t care about the savings. Thus, this structure is a self-regulating way of price discriminating among customers who vary by concern for costs.
An innovative introductory pricing approach, when customers refuse free trial, is negative-use pricing. It can provide incentive to potential users and build support for purchase.
How to Analyze a Nonexistent Product
All the requirements for effective price structures for existing products apply to products under development also, but the obvious problem is that the proposed products do not have available proven customer behavior under different contexts—or do they?
Routinely managers charged with new product development will use customer research (e.g., focus groups, surveys, etc.) to gather insights on how customers will view and value the proposed new product. This makes sense, but in many cases it is not enough. Many products are hard to envision or understand by focus group participants and survey respondents. Also, we still face the gaming of answers described earlier.
A very useful technique for exploring new product development is to create a “synthetic product” that matches the one under development. In essence, the synthetic product is a sophisticated analogy drawing upon like characteristics of existing products. The synthetic analogy allows quantitative analysis of behavior to supplement qualitative investigation.
A leading soft drink company that was considering offering flavored ice cubes at fast food restaurants went through something similar. In test groups, qualitative feedback was favorable: the flavored ice cubes (in a range of flavors such as raspberry, cherry, and lime) were found to be fun and even exciting complements to standard soft drinks. The question was how to examine potential pricing.
By considering the different components of the proposed offer, analogies were found. For instance, the beverage company already offered bottled flavors for use in drinks and related foods. The company had experimented with different insulated containers and ice options. Other elements of the proposed offers all had some analog in history. Together they formed a complete synthetic model that provided the means for testing price against actual market behaviors.
Very few products, no matter how revolutionary, have no analog or precedent. Through the use of these analogies, managers can build very accurate models of likely buyer behavior. For instance, the beverage company knew that previous purchases of (liquid) flavors had been driven by specific segments and contexts—and close examination suggested the same would be true of the ice. In this manner the volumes, types of buyers, drivers of purchase and price, and the impact of context were all captured and even proved statistically.
More important, even if the product does not exist, typically the context does already exist. Consider that when a rigorous test of price is performed for existing products often the product characteristics (throughput, accuracy, durability) are not the primary drivers of price. Instead, context (buyer decision process, organizational mission, brand, etc.) are often the primary drivers of price. Since these more important factors are already known, there is no reason not to do most of the pricing work ahead of actual prototype creation. Don’t wait until the last minute to do the pricing, as important product charter lessons can often come from pricing analysis.
Synthetic models of proposed products, based on analogies, are helpful in many new-product development aspects, not merely pricing. Product feature and configuration choices can be addressed simultaneously with price questions. Finally, synthetics allow much more detailed rollout and channel planning.
For nonexistent products (still under development), there is usually plenty of evidence on potential price drivers. Don’t forget, even if the product does not exist, typically the context already does.
Capabilities
Beyond the actual strategy, tactics, and price levels, superior introductory pricing requires building solid capabilities to determine price and rollout strategies. If your company lacks pricing capabilities, it cannot develop a strategy to develop pricing or leverage insights based on product knowledge and timing.
To understand value, managers must understand what customers know about their company’s good or service, and how customers propose to use it. It sounds obvious, but we find that often observers at focus groups, or designers of surveys, do not focus on what the customer knows and at when in the adoption process the customer reaches a judgment on value. This is because generally marketing is fixated on the product and perhaps secondarily on channel and promotion. Price often seems to be a distant afterthought, which is often why introductory pricing strategies are threadbare and haphazard.
In some sense, the ability to develop a powerful introductory pricing strategy is a microcosm of overall pricing capabilities. Management must know the customer, must know the product, and must know the competition and your company’s economics. This understanding may be meshed with overall objectives—or may shape overall objectives. It will not happen by itself; it needs to be part of the organizational design.
In some cases, a market launch is not the end of new-product pricing. In some industries, offers are fluid; there are many offers with only slight differences introduced to the market, so the introductory pricing is iterative (or should be). That pattern may be best practice: in many cases we find that companies fail to experiment with prices and launch price trials (e.g., launch a product with more than one price structure or price point). The benefits can be material, as in the consumer packaged goods industry, where trial is common. Procter &Gamble and others have well-developed test market procedures and measures, and the consequences of skipping that process are dire: one Colgate-Palmolive CEO lost his job (in part) due to market disasters from skipping test markets.
“Gettin’ the Hogs off the Truck”
After management has defined the ideal introductory strategy, various thorny issues always remain. The farming expression just mentioned characterizes these last obstacles very well. For instance, how to account for introductory pricing? How to compensate the sales force? Sometimes most dire: how to bill according to your introductory strategy? Billing is often a limitation because at established large companies, where billing systems have been built and optimized for existing products. At many companies capabilities are often limited, and the IT department believes it will have enough trouble implementing the permanent price structure, let alone a distinct introductory pricing structure.
Some introductory pricing decisions will probably alienate influential functional groups within your company. Your sales, marketing, and IT functions must be willing to support needed introductory pricing programs. To ensure this support, top management must take a role in this. Fortunately, top management is increasingly becoming involved in new-product development and pricing because, in many cases, this represents the future of the company. This involvement prevents crippled product launches through poor cooperation. Equally important, with direct involvement, top management can shoulder the burden of taking risks on new approaches that are difficult to justify without hard evidence. It is well known that some leading technology companies such as Apple often have new-product pricing specified by top management, (e.g., the price structure of iTunes was directly controlled by Steve Jobs).
Of course, creativity is helpful in launching a new-product introductory price strategy when infrastructure might not be ready. There are work-arounds to most problems. For instance, there are highly adaptable off-the-shelf billing systems—such as FTS—that can be configured by events, usage, and other factors that play a role in introductory pricing. These systems do not scale to millions of customers, but they do increasingly scale beyond 300,000 invoices and more. In many cases, this is more than adequate! If your introductory pricing strategy generates too many customers, this is the kind of problem you want to have.
Creativity in building infrastructure to support new pricing (e.g., billing) is often necessary.
Summary
Introductory pricing is the smile that can propel customers to trial and to buy new products and services. Introductory pricing is more effective when it mirrors buyers’ stages of understanding and product experience.
The three stages of introduction—learn, use and enjoy, and reassess—suggest the framework for new-product introductory price structures. Applying this framework requires understanding what customers know about your product or service, and when they are ready to move to the next phase.
Introductory pricing often bumps into constraints on billing, sales compensation and rollout support. This will require creativity in working around constraints, and this often calls for senior management support. Strong leadership and application of the three-part framework will lead away from low-return conventional introductory pricing and to superior results.
Notes
1. While confidence levels on usage were very strong, the goodness of fit (R2) suggested that there is often more to the story. Further statistical regression analysis often tells an interesting story, linking back to channel issues and product issues, but for pricing purposes looking at usage is often a good start. Incidentally, often you may wish to ignore customers/cohorts with zero usage because they have forgotten all about buying the service and so are not evaluating their usage or utility from the purchase—hence quite stable.
2. “Will Free Shipping Spread?” The New York Times, April 2, 2011, p. B4. See Chapter 6 for a discussion of customer preferences for simple pricing and when it must be heeded. In this case, apparently L.L. Bean decided it was subject to customer defections.