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Is pricing science, art, maths or psychology? How to set the right price for a product

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Setting the right price for a product is one of the most important decisions that a founder must make. The markers for success are happy customers who see value in the product, and a thriving business that makes a profit. But pricing is not an exact science and data alone is not enough to decide the numbers. Psychology, art, maths, science and a little intuition are all key ingredients to successful pricing.

Founders are often seeking to answer questions such as, when is it too early to begin charging customers for my MVP, will I scare customers away if I begin charging them too much, and how do I increase or decrease prices without upsetting my existing customers?

But the single most important rule for pricing is being deliberate about pricing and without paying too much attention to one single question.

How stretchy is your pricing curve?

The starting point is to understand elasticity of demand. If a product is very elastic, then even the smallest increase in price will reduce demand drastically. People generally want things a little less when the price goes up but exactly how much they are put off depends on the elasticity.

Price elasticity varies between products so founders will need a good understanding of the level of price elasticity specific to their product. This is influenced by factors such as the availability of substitutes, whether there is tough competition, if the product is a necessity or a luxury, the cost of the item and the proportion of income required to buy the item, the economic environment, how long the product will last and whether this is a permanent or temporary price.

Customer-centricity is key

A customer-centric view of the product is essential to understand the impact of the factors above on the brand and its products, and how this affects price. The mobile phone industry in Australia earned an estimated revenue of $25.2 billion in 2017-18 according to Deloitte. It is a fiercely competitive market and the price elasticity of a lower-end mobile phone is almost always more elastic than luxury alternatives such as the latest Apple iPhone or Samsung Galaxy.

Last week Apple changed its pricing strategy with the launch of its new iPhone SE. This is the cheapest iPhone yet. But rather than welcoming the launch of an affordable product, critics are questioning the wisdom of devaluing the brand and alienating luxury customers when the SE’s features closely mirror the iPhone 11, including even the A13 bionic chip. Many speculate that traditional high-end customers of the iPhone 11 and 11 Pro may feel duped having paid a high price for a very similar product.

Undoubtedly the iPhone SE is a pricing gamble. But it is a product that has been developed and launched for this unusual moment in time. Competitive pressures have slowed growth in the market as new entrants such as Oppo, Xiaomi and Huawei have launched offering cheaper products, and macro factors such as unemployment and loss of earnings suggest that those who are looking for a new phone may be more prudent in their spending.

Apple has adapted its pricing strategy to reflect these pressures by making the product accessible. The jury is still out as to whether this move will impact the take-up of its next premium product but Apple has removed features such as Face ID and large screen size in the new iPhone SE in the expectation that loyal customers are willing to pay a premium for these features in the future.

Strategic principles of good pricing

Understanding price elasticity will enable founders to form a hypothesis and to test this through their pricing strategy. In their book Monetizing Innovation, consultants Ramanujam and Tacke suggests there are three generic pricing strategies that startups consider.

Maximisation is where customers are charged the highest maximum price before they’ll switch to an alternative product. This recognises the importance of the price elasticity curve. In adopting this strategy, founders need to understand what customers will pay for similar products, perhaps with a different use case, and benchmark their product against these.

In setting the strategy the startup generally launches with a higher price to test acceptance and reduces the price if take-up is low and customer feedback is that the product is too expensive. This relies on understanding the customer and their views of the marketplace and gathering feedback.

Penetration applies deep discounting to gain market share quickly. In this strategy there is generally a basic “freemium” product where 80% of the product features are given away.

Many businesses who have sold billions of dollars in products using this strategy – LinkedIn, Gmail, Evernote and Doodle to name a few. The assumption for this pricing strategy is that most large companies want to pay for support and large-scale heavy users will be willing to pay for premium features. The fundamental premise of this strategy is that price will not be a barrier to take-up.

LinkedIn is a great example of success using this strategy. It withdrew 10% of previously free features with the expectation that heavy users would be prepared to pay for these features which included power search and the ability to contact other people. This strategy paid off for LinkedIn and its Premium accounts became a major source of revenue.

Skimming targets early adopters and leads with a premium product at a top price before later launching a more affordable version for the aspirational mass market. The expectation is that a sophisticated and affluent audience will have a halo effect on the rest of the product line. But this can of course backfire and alienate existing customers if the business launches a mass market product that is too similar to its high-end early product. Whether Apple has fallen victim to this trap, remains to be seen.

If take-up of a product is lacklustre, this doesn’t necessarily mean that it is priced incorrectly, and founders shouldn’t rush to slash prices. This often happens when a company launches into a new geography and fails to understand the factors that are unique to that market influencing price elasticity.

Slow take up might also be a job for marketing. How much awareness is there about the product and does this need to be boosted through a more concentrated marketing effort targeting the right audiences? Additionally, price is often a proxy for quality so it could be that a cheap product is perceived as poor quality.

Again, getting close to customers, potential customers and gaining feedback will help identify this issue. If a startup is able to adapt pricing so that customers can buy the features they want and need, this means that customers can create their own product. This has the additional benefit of giving the founder feedback on the perceived value of particular elements of the product.

When pricing strategy is determined, a degree of flexibility is important. Customers are driven by value and but can also be unpredictable. Typically, customers fear making the wrong decision so a ‘get out’ clause can ensure buyers’ remorse is not a factor influencing take-up.

If a founder can manage these requirements while providing a product that it knows to be genuinely valuable, then they will be well on their way to building a loyal following of their business.

Benjamin Chong is a partner at venture capital firm Right Click Capital, investors in high- growth technology businesses.

Benjamin Chong, Right Click Capital
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