Monetizing Innovation: How Smart Companies Design the Product Around the Price

Metadata

• Title: Monetizing Innovation: How Smart Companies Design the Product Around the Price
• Author: Madhavan Ramanujam and Georg Tacke
• Book URL: https://amazon.com/dp/B01F4DYY1I?tag=malvaonlin-20
• Open in Kindle: kindle://book/?action=open&asin=B01F4DYY1I
• Last Updated on: Friday, March 8, 2024

Highlights & Notes

When most people hear the word “price,” they think of a number. That’s a price point. When we use the term price, we are trying to get at something more fundamental. We want to understand the perceived value that the innovation holds for the customer. How much is the customer willing to pay for that value? What would the demand be? Seen in this light, price is both an indication of what customers value and a measure of how much they are willing to pay for that value.

Every single feature stood trial before the customer.

Porsche succeeded by designing the product around the price. This is what smart companies do.

Porsche placed customer needs, value, willingness to pay, and pricing in the driver’s seat when it developed the Cayenne; Fiat Chrysler stuffed them in the trunk.

How companies bringing something new into the world can leverage the science of monetizing innovation, increase the chances that their new offerings will succeed, and produce results that can be magical. The odds against successful innovation are always high. But, as you read, you’ll learn how a focus on monetizing innovation can substantially increase your chances of financial success.

New products fail for many reasons. But the root of all innovation evil—what billionaire entrepreneur Elon Musk would call the set of “first principles”—is the failure to put the customer’s willingness to pay for a new product at the very core of product design. Most companies postpone marketing and pricing decisions to the very end, when they’ve already developed their new products. They embark on the long and costly journey of product development hoping they’ll make money on their innovations, but not at all knowing if they will. Price is more than just a dollar figure; it is an indication of what the customer wants—and how much they want it. It is the single most critical factor in determining whether a product makes money, yet it is an afterthought, a last-minute consideration made after a product is developed.

Market and price, then design, then build. In other words, design the product around the price.

How did you arrive at your prices? Did you compare your product to other products in the marketplace, or did you actually ask customers what they’d pay for it? Did you know in advance what would happen if you increased your price by, say, 20 percent—that is, how that would likely affect demand and thus volume?

The most successful product innovators we know start by determining what the customer values and what they are willing to pay, and then they design the products around these inputs and have a clear monetization strategy that they follow through with.

While you might think many types of flaws can cause products to flop in the marketplace, we actually have found that monetizing failures fall into only four categories: Feature shock: cramming too many features into one product—sometimes even unwanted features—creates a product that does not fully resonate with customers and is often overpriced. Minivation: an innovation that, despite being the right product for the right market, is priced too low to achieve its full revenue potential. Hidden gem: a potential blockbuster product that is never properly brought to market, generally because it falls outside of the core business. Undead: an innovation that customers don’t want but has nevertheless been brought to market, either because it was the wrong answer to the right question, or an answer to a question no one was asking.

Have the “willingness to pay” talk with customers early in the product development process.

Don’t force a one-size-fits-all solution. Whether you like it or not, your customers are different, so customer segmentation is crucial. But segmentation based on demographics—the primary way companies group their customers—is misleading. You should build segments based on differences in your customers’ willingness to pay for your new product.

Product configuration and bundling is more science than art. You need to build them carefully and match them with your most meaningful segments.

Choose the right pricing and revenue models, because how you charge is often more important than how much you charge.

Maintain your pricing integrity. Control discounting tightly. If demand for your new product is below expectations, only use price cuts as a last resort, after all other measures have been exhausted.

Which of these missteps you will likely make has a lot to do with your company’s culture. Companies with strong product-driven or engineering cultures tend to be the ones that develop feature shocks. Firms with a culture of playing it safe and avoiding big risks typically suffer minivations. Hidden gems most often afflict companies that coddle the core business. And undeads are born in firms whose top-down cultures discourage feedback and criticism from below.

But they follow patterns that you will recognize if you have ever worked in such a company.

The first danger signal is that the research and development (R&D) team keeps saying “let’s add this,” but can’t articulate the new product’s value to customers.

Customers won’t buy a product if they do not buy your story about why that product helps them. Products that are feature shocks cannot articulate a clear value proposition and tend to be a one-size-fits-all approach to customers.

Customers complain the product has too many “nice to haves” and too few “gotta haves,” and they conclude they don’t need the product, at least at that price. And if they do like some of the “nice to haves,” they can’t afford them.

No one wants to sell his or her idea short. Minivations are products that tap neither a product concept’s full market potential nor its full price potential. Companies that fall into the minivation trap underexploit the market opportunity and the price they could have charged, thereby robbing themselves of profits. Minivations go down as undermonetized products cursed with a “what might have been” tag.

The component company failed to ask this question: “What value does this component bring to our customer and its customers, and what portion of that value can we capture?” Instead, it asked, “What does this component cost to make, and what minimum margin do I need to add on top of that?”

While feature shocks enter the market overfeatured and overpriced, minivations enter the market underpriced or with volume targets that are too low. They are tame, safe answers to the right question.

So how do you spot minivations in the making? (See Figure 2.2.) Your team seems comfortable checking the box and lowballing on targets. You find evidence for lack of ambition and a desire to not “overprice.” When the product is out, your sales team often is the canary in the coal mine. Compared to your other products, the sales force is easily meeting its targets with your new product. Your channel partners are reaping their maximum margins. Sellouts are popping up. Fewer pricing problems are emerging. If the majority of deals are going through the pipeline without price escalations, you may have underestimated the value of your new product and underpriced it. Tracking the number of price escalations, as well as the length of the sales cycle against historical norms, will give you more hard evidence that something new is occurring.

What fuels such minivations? “Good enough” thinking is the culprit here.

Unlike feature shocks, minivations are difficult to guard against because they don’t end in epic failures, just value-limiting ones. Although minivations do not spell catastrophe for a single product, they take a systemic toll across a company as team members tolerate too much “good enough” thinking and too little ambition.

Your company may have hidden gems lying around if you are going through one of these situations: changes in business models; a disruption in your industry; a commodity business trying to differentiate itself; a shift from offline to online business; a change from selling a product to a service; a move from analog to digital; or a move from hardware to software.

Remember, recognizing the hidden gem’s potential is key. But in most organizations, no one is responsible for recognizing them.

How do undeads happen? They occur when a new product is the wrong answer to the right question—or an answer to a question that not enough people care about. These products emerge from organizations that struggle to separate the technically feasible from the commercially practical. Undeads hit the market with an almost audible thud and poor sales.

How do such undead products make it to market? They happen when their proponents wildly overstate the customer appeal and don’t segment the customer base effectively.

By pushing the willingness-to-pay conversation too far out in the innovation process, these companies put themselves in a situation where saying “no” comes too late.

Figure

The reason is the reigning mindset or paradigm about monetization and product development. In that mindset, the work of monetizing a new offering is often viewed as unsavory, dirty, and detrimental to true innovation. According to this sentiment, dreaming up big, bold new product concepts should not be encumbered by asking for a price check.

Myth #1: If you simply build a great new product, customers will pay fair value for it. “Build it, and they will come” is the mantra.

Myth #2: The new product or service must be controlled entirely by the innovation team working in isolation.

Myth #3: High failure rate of innovation is normal and is even necessary.

Myth #4: Customers must experience a new product before they can say how much they’ll pay for it.

Myth #5: Until the business knows precisely what it’s building, it cannot possibly assess what it is worth.

Understanding if customers are willing to pay for your invention, before you commit too many resources to building and launching it, will dramatically increase your likelihood of success.

By designing your product around a price, your innovations will stand a far greater chance of surviving and thriving. Figuring how much customers will pay for your product when it is still in the concept stage will make your innovation process far more reliable. You and your company will be far more likely to succeed.

The bottom line is we will show you that putting monetization front and center in the product development process is not antithetical to innovation by any means.

when we say price we mean it to be an indication of what customers value and a measure of how much they are willing to pay for that value. To build a product around a price, you must engage in deep discussions with potential customers before you design and develop it.

Your dialogue must be specifically about their willingness to pay for the product you have in mind. The term “willingness to pay” is so important for us, and our clients, we refer to it by the acronym WTP.

The early WTP talk will help you in three essential ways: It will tell you right away whether you have an opportunity to monetize your product—or not. It will help you prioritize features and design the product with the right set of features. It will enable you to avoid the four types of failures.

But the CEO was skeptical and asked the team: “How do you know our customers will value these specific features? How do you know which features they’ll pay for, and which they’ll figure they can do without?”

So the CEO pushed the team to prove customers would be willing to pay for the service—and would find value for each of those 25 features—before they embarked on a long journey of turning it into a product.

First, you want to understand your customers’ overall WTP for your product—the price range they would consider reasonable (if, in fact, they would pay anything at all). Then you have to ask yourself whether that price range would work for your company. It may not if you can’t deliver a market-acceptable product at a price that makes you a profit.

Second, you must understand how much value customers place on each feature and what they’d be willing to pay for that value. In this step, you dig a level deeper to understand exactly which features customers value most and would thus be most willing to pay for. This step will help you create your product roadmap—what features to develop first, next, and so on. What’s more, it will focus your team on the features that generate the most customer interest and help avoid a feature shock.

This sounds counterintuitive: Fewer features create more demand? But it was true in this case. Piling too many features into the product was killing demand by hiding the features that truly mattered. The company had created something that many customers thought excessive and thus actually reduced their WTP.

A company guesses what customers will value about its product and what they’d pay for it. Don’t just hope; find out!

Validate feature value and willingness to pay, and you’ll build far more successful products.

The simplest way is to ask direct questions about the value of your product and its features, for example: “What do you think could be an acceptable price?” “What do you think would be an expensive price?” “What do you think would be a prohibitively expensive price?” “Would you buy this product at $XYZ?” Then follow each question with the most powerful question of all: “Why?”

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More sophisticated methods for getting at pricing include simulating purchase scenarios that ask customers to pick an option. For instance, you could show a product lineup with different price points and feature combinations and then ask which ones they would choose (including not choosing any option). Again, ask “why?” Then you change the scenario (for example, the feature and price combination) and ask them to choose again.

In Figure 4.3, we detail the five methods we have found most useful that you should use when you have the conversations with your prospective customers. Your conversations will typically take one of three forms: one-on-one conversations, focus groups, or large-scale quantitative surveys. Figure 4.3 Top Five Methods for Having the Willingness-to-Pay Conversation (from Easiest to Most Advanced)

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CEO Questions Does our product development team have serious pricing discussions with customers in the early stages of the new product’s development process? If not, why not? What data do we have to show there’s a viable market that can and will pay for our new product? Do we know our market’s WTP range for our product concept? Do we know what price range the market considers acceptable? What’s considered expensive? How did we find out? Do we know what features customers truly value and are willing to pay for, and which ones they don’t and won’t? And have we killed or added to the features as a consequence of this data? If not, why not? What are our product’s differentiating features versus competitors’ features? How much do customers value our features over the competition’s features?

The reality is your customers are different, whether you like it or not. They have very different needs, differing abilities to pay, and they vary by the degree to which they value your product’s key benefits. The only way to cope with this variance is to embrace customer segmentation.

when it comes to innovation, there is only one right way to segment: by customers’ needs, value, and their willingness to pay for a product or service that delivers that value.

What features and services really mattered most to customers, and what were they willing to pay for them?

The paper company used segmentation to drive the way it designed new products based on the needs, value, and willingness to pay data.

The simple rule for product design is to base segmentation on your customers’ needs, value, and WTP for features you are developing. Period. Revenue size (for business-to-business), age (for consumer segments), ethnic background, and other observable characteristics are often purely uncorrelated to what matters the most in product design.

Successful innovators build the right product for the right segment at the right price. They use segmentation as a guiding influence, starting with the R&D stages of an innovation. They constantly explore how customer needs, value, and WTP differ in the market, and how they can act differently to shape products and versions differently for different segments. If there’s capacity to build only one product (for example, in a startup), the company prioritizes and builds that product for the segment with the biggest opportunity (either in terms of size or revenue potential), while creating a plan to introduce future products for other segments. In all these ways, successful companies avoid building a one-size-fits-none new product.

Segmentation gives you the power to serve customers better by catering to their specific needs. Segmenting in the early stages of your innovation process will help you build products that resonate with customers. Plus, your sales and customer support teams will know how to service them better.

Smart segmentation creates a win-win situation for your company and customers. Like the paper manufacturer we mentioned earlier in this chapter, you make it easier for your customers to find the right product, make the purchase, and get the right level of services from your company.

Pressure-test your findings: Have you defined a customer group to which you can sell? Are there clear “fences” between segments—features one segment strongly wants but others don’t? The acid test is asking a group of salespeople whether they can sort their clients into the segments you’ve come up with. Practicality and common sense are as important as statistical indicators.

Serving each new segment adds significant complexity for sales, marketing, product and service development, and other functions. Smart companies start with a few segments—three to four—and then expand gradually until they reach the optimal number.

Don’t try to serve every segment. You’re not obligated to serve every possible customer. The products and services you develop should match your company’s overall financial and commercial goals. A segment must deliver enough customers—and enough money—to make the investment worthwhile. This part of segmentation is called market sizing. Market sizing doesn’t mean simply counting the segment’s customers. It means estimating how many of them you can acquire and keep, and at what prices—separating the attractive segments from those that don’t make business sense.

In writing TV commercials, Internet banner ads, or any other marketing and sales messages, companies must describe their target segments as precisely as possible.

The message here is clear: You need to create segments in order to design highly attractive products for each segment. And you must base your segmentation on customers’ needs, value, and WTP. This way, segmentation becomes a driver of product design and development, not an afterthought. The following tips are among those that have helped numerous companies do segmentation right: Begin with WTP data; let common sense be your guide; create fewer segments, not more; don’t try to serve every segment; and describe segments in detail in order to address them. Understanding customers’ needs and WTP will give you segmentation power. And segmentation power, in turn, is what gives you monetization power.

Now you’re ready to get down and dirty into the design of what you’ll offer each customer segment—exactly what features and functions to deliver. There are two core design decisions you will need to make here. One is product configuration, and the other is bundling.

Doing product configuration right means you design a product with the right features for a segment—that is, just the features customers are willing to pay for.

Too many features lead to feature shock products, especially if your customers are not wild about those features. If they are wild about them and you didn’t realize it, you design a minivation. Products with features that customers won’t pay for wind up undead.

By having their feature sets tailored to each segment’s needs, value, and WTP, each offering finally had a distinct value proposition. The design of these products also minimized the chances they would cannibalize one another, since customers clearly saw what they gave up at the lower price points. The way we like to put it is that the company established clear “fences” between its products. Customers only get a low price if they go without extra product or logistics services; the company can offer a low price on this product because value and costs are lower.

To maximize the monetization potential of new products, companies should curb their instincts to please customers by giving away value-added functionality—unless those customers will pay for it. These firms must get comfortable with the idea of giving their low-price segment only basic quality and service levels, rather than giving them everything. In other words, product configuration requires the guts to take away features.

Bundling helps you determine whether your products and/or services should be sold together or separately.

You and your customers win when a good bundling decision is made. It not only boosts your revenue, it increases your customers’ satisfaction because you’ve made the purchasing decision easier. They didn’t have to choose between A or B; they got both, and generally for less than they would have paid separately for A and B.

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Two Key Principles of Product Configuration and Bundling When you configure and bundle your new product, you may get overwhelmed with deciding which features to include in each segment offer. In a different way, it is easy for customers to become overwhelmed trying to decide which offer is right for them. Designing your product with leader, filler, and killer features in mind will help you with that first challenge. Creating good, better, and best options will address the second.

To determine what features you should bake into which product configuration, you should start by separating the must-have features from the nice-to-haves. On their own, nice-to-haves won’t convince customers to buy a product.

It’s equally important to think about which features might turn off customers. Critical features—what we call leaders—are what drive customers to buy a product. Customers have high WTP for such leader features. Fillers are features of moderate importance or nice-to-haves. In contrast, killers are features that will blow the deal if the customer is forced to pay for them.

A killer feature should be eliminated from the offering, but it could be sold à la carte to the few who want it.

Here’s an easy way to identify killer features: Look for those that are valued by less than 20 percent of your customers and are not valued at all by more than 20 percent.

Customer segmentation is your tool for identifying these distinctions—that is, which features each segment considers to be leaders, fillers, and killers.

The classic approach to product configuration and bundling is to create a three-tier model, sometimes referred to as good, better, best or G/B/B. Typically, the good version has the most important core features, and the best has all the bells and whistles (the all-in product/bundle).

Ideally, no more than a quarter of your customers should opt for the good option, while 70 percent should opt for the better or the best.

Why does a well-crafted G/B/B configuration/bundle work? Because you can steer customers to a choice based on whether they are price conscious (good), quality conscious (best), or somewhere in between (better). The core philosophy behind a G/B/B is that a significant portion of people avoid extremes when they are presented a choice; they choose the compromise option. Playing on this psychology, G/B/B configuration/bundling maximizes sales.

Don’t make it too big. Once you go beyond nine benefits or four products, your product configurations and bundles run the risk of exceeding psychological thresholds. Your product will start making customers’ heads spin, and you will be heading toward producing a feature shock product!

Make sure you and your customers both benefit. The right product configuration and bundling provide benefits to both you and your customers (not just one or the other). The benefits to you should include more revenue (through increased acquisition and cross-selling), decreased price transparency, and higher customer loyalty (or increased switching costs). The benefits for customers include the added convenience of buying from a single provider, discounts, and an integrated experience from the bundle.

In many industries, companies focus first on acquiring customers and then upselling. This strategy is often called land and expand. To increase customer acquisition, many companies pack too much into their entry-level product. But then they struggle to upsell customers since the functionality difference in the better or best product is marginal at best. Consequently, these companies land but don’t expand. If more than 50 percent of your customers have bought your entry-level product, you most likely have this problem. If so, you should seriously consider removing features from your entry-level product. The ideal distribution of customers for a G/B/B product configuration strategy is 30 percent in good and 70 percent in better and best, with best being at least 10 percent.

Hard bundling works when you have market power and are the dominant player. In almost all other cases, you should go with a mixed bundling approach.

Individual prices need to be higher with mixed bundling. If you create a mixed bundle and individual products are also sold separately, the à la carte price within the mixed bundle must be higher than the stand-alone optimal price in the unbundled situation.

Bundle with integration value so that 1 + 1 = 3. Bundling is not always about discounting. In certain industries, such as software, you can sometimes charge a premium for bundling products together because customers are willing to pay for integrated product experiences (such as common user interface and seamless interoperability between products). In these situations, if you offer a discount on the bundle, you will hurt your bottom line two times over!

Exploit inverse correlations. This is an advanced tip. If you find two customer segments with inverse preferences, you can bundle products together to serve both segments. For example, if one segment finds Product A a must-have and Product B a nice-to-have, and another segment finds Product B a must-have and Product A a nice-to-have, your best strategy may be to bundle A and B and sell one bundle to both segments.

The overwhelming reason Ryanair’s unbundling strategy was successful is because customers paid far more attention to the base fare than to surcharges.

Product configuration and bundling are your key building blocks for designing the right products for the right segments at the right price points. Product configuration is about putting the appropriate features and functionality—those customers need, value, and are willing to pay for—into the product; this process has to be done for each identified segment. Systematic product configuration prevents you from loading too many features into a product and producing a feature shock. Bundling means selling your products and/or services together. If done right, this will increase total profit because customers end up buying more than if the products were sold stand-alone. Also, customer satisfaction will go up because the buying decision is easier. Successful bundling benefits both you and your customer. There are two key elements of the product configuration and bundling process: establishing which features are leaders (must-haves), fillers (nice-to-haves), and killers (features that will nix a deal if customers are forced to pay for them), and creating good/better/best options. While these might sound easy, they are two of the most difficult challenges. Savvy product configuration and bundling decisions have propelled many new product launches, as firms like Microsoft and McDonald’s can attest.

What are the product configuration/bundles we plan to offer? Why did we pick these offers? Do they align with our key segments? If not, why not?

What are the leader, filler, and killer features for the new product or service our company is developing? How did we find out?

Have we explored a good/better/best approach to product configuration and bundling? What do we expect sales to be for each product configuration? Is the share of the basic product configuration lower than 50 percent? If not, why not?

This is no small matter. In fact, establishing a favorable monetization model can be as important as the new product itself and the price you charge for it. A highly innovative monetization model can make a new offering take off like a rocket.

A number of innovative—yet proven—monetization models are in use today: subscription, dynamic pricing, and freemium to name just a few. You need to choose one carefully; the right model can make or break your new product, your business, or even an entire industry. How you charge trumps what you charge.

The first thing to realize is that most companies perpetuate the monetization model they’ve always used. They select a model without reflecting on it, thinking strategically about it, or testing it. That’s a missed opportunity and a huge mistake.

With technological advancements such as these, increasingly the monetization model is the innovation.

Monetarily, a bad monetization model can be worse than a bad price.

Subscriptions also open up cross-selling and upselling opportunities. Companies can use the data collected on subscribers to make other offers based on preferences and behaviors.

Last, the relationships between subscribers and brands also prove stronger and stickier than transactional ones. While the company gets to know the consumer, the consumer becomes more intimate with the brand and perhaps even emerges as an unofficial ambassador for the product or service, thereby increasing the brand’s value.

First, dynamic pricing should be considered when demand and price elasticity in your market vary significantly. If they do, you then must ask what factors influence the volatility and whether you could set your price based on these factors. Second, you should consider dynamic pricing if your supply is constrained or fixed.

As such, customers pay when they use or benefit from the product.

A software company that produces lab reports increased revenue by 20 percent just by changing its pricing metric from fixed perpetual license to charging per lab report. It considered this alternate metric model to be much more aligned with the perceived value. The model also minimized customers’ upfront investment commitments.

If your innovation enhances customers’ performance in a way that is superior to the alternatives, the alternative pricing model might be for you. By aligning the metric to your customers’ performance, you achieve full monetization potential. But you must be able to deliver on your promise, as Michelin did with its fleet operator customers.

An alternate pricing model can be very successful when you can align the metric directly to how customers perceive value.

In other words, you are participating in the revenue your customers generate by using your product and services. Ultimately you can showcase your intentions as a win-win situation for you and your customers.

The alternative pricing model makes sense when your innovation creates significant value to end customers but you cannot capture a fair share of that value using traditional monetization models.

With the freemium model, a company offers two or more tiers of pricing for its products and services, one of which is free. The goal of a freemium monetization model is to attract a huge customer base to the free version and later convert a significant percentage to paid subscriptions. This model is also called “land and expand.” You try to land with a freemium offer and expand with paid offers.

Because freemium services lower the cost of customer entry to zero, they spur rapid adoption. The free offering becomes, in effect, a marketing tool for the premium offering. That helps companies reduce their cost of customer acquisition compared with more expensive traditional marketing and sales methods.

The freemium model is definitely not right for everyone. It only works if you have a very low cost of production (preferably no production costs at all) and minimal fixed costs that can and will be offset by the generally smaller percentage of paying customers.

What’s more, companies often struggle to turn the freemium model into long-term monetization. The land-and-expand approach fails for 90 percent of companies. (For an exception to the rule, see the LinkedIn case study in Chapter 13.) In fact, the number of free customers who convert to premium is typically below 10 percent in software companies. In video games, freemium games have an average life span of less than a year, losing 75 percent of free users after just one day and retaining just 2 percent after a month of play.

If you decide to offer a freemium service, you must double down on your efforts to convert customers to the premium version. It is extraordinarily difficult to get consumers to buy something they previously received for free. One need only to look at the scores of Web-based businesses that failed to monetize free online offerings in the last two decades. For example, most newspapers (apart from ones like the New York Times and the Wall Street Journal) have failed to convert free readers en masse to paid online subscribers.

To have a chance at converting free customers to paid customers, you need to test what benefits they will pay for and ensure a functional free experience. You also need to know exactly how many customers will actually be willing to pay. What’s more, you must avoid giving the farm away for free because it will leave your premium offering with very little value.

1. How Likely Are Your Customers to Accept the Model?

2. How Will Future Developments Impact the Model?

3. What Stage Is Your Company In and Does Your Model Choice Fit That?

4. What Are Your Competitors Doing?

5. How Difficult Is the Monetization Model to Implement?

A monetization model is good only to the extent you can make it work. Assess factors like feasibility, difficulty of customer adoption, and scalability. Make sure you can measure the data necessary to enforce the pricing. In addition, you must be able to communicate the model easily to customers and partners. Don’t exclude yourself from a particular monetization model based on existing infrastructure and system limitations, but be sure to factor in the additional investments needed to make the model work. Gauge the total cost of ownership and the ultimate return. Most of all, make sure your model is driving value to customers and your pricing is commensurate with the value you deliver.

Sometimes the best innovation is the innovation in the monetization model itself!

We described in earlier sections how to choose one of the five monetization models. A price structure builds on such monetization models to account for different levels of usage. This is especially applicable when the monetization model is pay per unit, alternate metric, or subscription.

Monetization models can confer significant competitive advantage on a new product or service. How you charge trumps how much you charge. As the Michelin case showed, when done right, the best monetization models are a win-win for you and your customers. Companies have countless monetization choices, but these five work well for most new product monetization: subscription, alternate metric, dynamic pricing, auction, and freemium. You can also combine pieces of these five models for a mix-and-match model. Furthermore, by instituting two price structures (volume-based and matrix), you have the flexibility to adjust for different levels of usage.

CEO Questions What monetization model do we envision for our new product? Why is it the right one, and how did we choose it? Which models did we not pick, and why? What are the most important trends in our industry? How do they affect our choice of a monetization model? How do we plan to monetize our product if customer usage varies significantly? Which price structures have we considered and why? Do we have the right capabilities and infrastructure to execute the chosen monetization model and price structure?

Finally, the word “because” is the most important word in this or any pricing strategy. It forces you to think through your pricing strategy thoroughly and also ensures that you are able to articulate this to your team to gain their buy-in.

Without a clear goal, you won’t have an effective pricing strategy. It’s that simple. A clear, overriding goal is a prerequisite because different goals can lead to contradictory strategies and actions. For example, if you want to maximize market share, you must choose strategies and price levels that will be different from the goal of maximizing total profit. So which goals are most important for your new products? Revenue? Market share? Total profit? Profit margin? Customer lifetime value? Average revenue per unit? Something else? Whichever goals you choose, you cannot maximize all of them at the same time. In setting goals, you must make trade-offs.

Forcing trade-offs in goals is crucial. A workshop task we call Goal Allocation Exercise helps companies do that. Every workshop participant is ideally from a company’s C-suite. We ask them to allocate 100 points to a series of goals. That puts each executive in a trade-off mindset. “Should I allocate 20 points to this goal, or should I allocate 60?” The more points an executive allocates to a given goal, the more important that goal is relative to the other goals.

Maximization: This strategy maximizes your goal (such as profit or revenue) in the short term. Most companies choose this strategy for new offerings. You determine the optimal price—the point on the price elasticity curve at which the profit or revenue curve reaches its maximum.

By quantifying each price option’s revenue, volume, and profit implications, you can be sure not to veer off the pricing strategy.

Penetration: With this pricing strategy, you intentionally price your product lower than in a maximization strategy to rapidly gain market share. This is also known as a land-and-expand strategy. When should you choose it? In some markets you must gain share quickly, especially in those dominated by network effects or where customers are highly loyal to the first brand they choose. If you gain customers early in such markets, you are better positioned to maximize customers’ lifetime value from future sales and upsells. With a penetration pricing strategy, you make a grab for market share and then expand.

A penetration strategy might be right if you also plan to hike prices in the future.

A penetration strategy might also be the right strategy for you if you are in a position to rapidly gain share, bring down unit costs, and purposefully price low to create barriers to entry. In such a case, even if you operate at a laser-thin margin, you might still make up for it because of your very high volume of sales.

But a word of caution: A penetration strategy is the riskiest from a profit and revenue standpoint. You must focus as much on expanding revenue from customers as you do on landing them in the first place. Or you need to gain huge market share rapidly. And you’d better be able to follow through on those future price increases if you had planned them while deciding on this strategy.

Skimming: Here you first cater to customers with a higher WTP—the early adopters. Then, you systematically decrease price in order to reach other customer segments with lower willingness to pay. Your initial price needs to be higher than the price you would have charged had you chosen a maximization strategy. A skimming strategy is especially appropriate if you have a significant number of customers who are willing to pay a higher price than others for your product. Put another way, your customers’ WTP varies greatly between early adopters and late followers.

Two other scenarios make skimming the right choice. One is when the product represents a breakthrough—an offering that delivers far superior value. The other scenario is when you have production capacity constraints in the initial launch periods but must mass produce in the future.

A classic way to implement skimming is by combining product and pricing actions. Here’s how this works: You launch the higher-end product first, skim the market, and then launch lower-end products. A great example of this is when Porsche launched its four-door car, the Panamera. It first debuted the eight-cylinder model to skim the market, then released the lower-priced six-cylinder model a year later.

Figure 8.3 is an example of what your price-setting principles might look like in practice. Figure 8.3 Examples of Price-Setting Principles

Competitive Reactions These principles help you think through countermoves against your rivals. Before you react, you must anticipate competitors’ moves, understand the reasons behind their moves, and prepare for possible counterreactions to your moves. To do so, you should conduct war-gaming sessions prior to launch. These sessions should include questions such as: How might the competitors react, and why? Are competitors likely to react only once? If we match a competitor’s price, what will be the impact on our revenue and profit? What counterreactions do we expect to our reactions?

Price Optimization and Price Elasticity The most important input for optimizing your price is the price elasticity curve (also known as the demand curve and price–demand relationship). It shows how much the sales volume of your product decreases and increases if you move your price up or down: Price Elasticity = Change in Sales (%)/Change in Price (%) To calculate the price elasticity and profit curve for your new product, you need two sources of data: your analysis of what customers are willing to pay (discussed in Chapter 4) and your costs (both variable and fixed). Everything else is simple math.

The smaller the margin per unit, the bigger the impact of suboptimal pricing.

Sometimes companies prefer to illustrate these relationships in a graph (see Figure 8.6) rather than a table. In either case, the most important input for calculating your optimal price is the shape of the price-elasticity curve—its steepness and level. The steeper the curve, the more sales volume you lose when you raise prices.

A pricing strategy is your short- and long-term monetization plan. The best companies document their pricing strategies and make it a living and breathing document. Documenting your pricing strategy will help get the executives in your company on the same page; more important, it will help keep you accountable. The price strategy document should have four building blocks. First, set clear goals and prioritize among conflicting goals (for instance, price to maximize revenue but ensure a 10 percent profit increase). Second, pick one of the three types of pricing strategies: maximization, skimming, or penetration. Third, set price-setting principles that define the rules of your monetization models, price differentiation, price endings, price floors, and price increases. Finally, define your promotional and competitive reaction principles to avoid knee-jerk price reactions. Companies that have well-defined pricing strategies are 40 percent more likely to realize their monetizing potential than firms that don’t have them.

Your very first version of the business case should be created right after you determine the high-level WTP for your product. You need to keep evolving it as you define your customer segments (discussed in Chapter 5), determine product configurations and bundles (Chapter 6), select a monetization model (Chapter 7), and set your pricing strategy (Chapter 8

the recommendation tied the four critical elements together—price (WTP), value (to customers), volume (the expected demand at those price points), and costs in delivering the service (including the risks based on probability of car failure within the warranty period).

Your business case must model the linkages among the four elements of price, value, volume, and cost. When you do that, your monetary forecast will be far more precise.

A business case should be a living document that keeps you grounded on the true monetization potential of your innovation.

Products are almost never launched without some sort of business case. But 95 percent of the business cases we’ve seen are built from the inside out, not the outside in. Consequently, they fail to account for critical market information, particularly customer WTP and price elasticity. If you don’t know what your customers will pay for your new product and how demand changes when you change the price, you simply don’t have a business case. Without this information, your business case will only tell you what you want to hear. Moreover, most business cases are static documents, employed to gain budget approval. Once the money has been allocated, they are quickly forgotten. That’s a very limited use of a powerful tool. A business case that’s a living, breathing document will help you figure out how to react effectively once your product hits the market and theory becomes practice. To create this kind of business plan, you need to gather data on the four pillars: value, price, cost, and volume. Then you must integrate them because they all affect one another. This starts with including the WTP data discussed in Chapter 4.

As management guru Peter Drucker once said: “Customers don’t buy products. They buy the benefits that these products and their suppliers offer to them.”

It sounds easy, but consider this: You have thought about your innovation for months or even years. You know the product inside and out. However, a salesperson may only have 10 minutes with the customer. Your customer might stay on your website only for five minutes. An advertisement may only run for 15 seconds. That marketing message, that sales pitch, and that ad must clearly articulate the value to customers in a very short period of time. If they don’t, the would-be customer tunes out.

How can you maximize your acquisition success? You need to start by articulating benefits—not features—and focus on the most important ones. You need to speak the customer’s language, not your language. Finally, you need to get your marketing and sales teams involved early in the product development process.

We’ll explore the most frequent root cause of the problem: People in functions charged with communication are typically detached from the innovation process and thus come in too late.

Nonetheless, the MacAskills had to solve their value communication and sales problems.

The average customer could now quickly understand what they would get with each product offering. If you wanted only photo storage, you would choose basic. Want personalization? Choose power. Did you want to sell online? Choose portfolio. How about marketing what you sell online? Then you would choose business.

Most companies do not pay enough attention to this gap, believing the handoff from R&D to sales and marketing is a standard business process. But in practice, it’s not. It requires special effort. Great new products, even when they are priced right, don’t sell themselves. Marketing needs to promote them, and sales needs to sell them.

A company that excels at value communications articulates its products’ benefits in meaningful terms to customers. This is not about describing product features. A feature belongs to the product; a benefit belongs to the customer. Value is a measure of the benefit to the customer. Communicate benefits, not features. Take each feature and ask yourself this: What does the customer achieve because of this feature? If you are still unsure about how to phrase your product’s benefits, probe your customers about their pain points and how your product would solve them. Ideally, you should understand how customers measure their performance—and how your offering would affect those measures. Once you know that, you can tailor your messages to the customers’ priorities. You should also quantify the relative value of your product: the value it would deliver compared to the value your customer gets today from other offerings.

To be more specific, when you create a value message, you should determine the customer purchasing criteria and how your product or service might perform on those criteria compared to existing alternatives. Such information can be captured in a 2 × 2 matrix that we call the matrix of competitive advantages, or MOCA for short.

When communicating the benefit statements, it’s easy to fall into the trap of thinking your features are the same thing as the benefits to your customers. They aren’t.

Customers are hardly interested in how you created your innovation or how much you spent on it. What’s fascinating for you is not necessarily fascinating to your customers.

Step 2: Make Your Benefit Statements Segment-Specific As described in Chapter 5, homogeneity is one of the biggest wrong assumptions you can make in your new product design. Your customers are different. The same value messages are not likely to work for all of your customer segments. You should tailor your value messages to the needs of each segment.

Mastering the art of value communications is just as important as mastering the process of designing products that customers will pay for. If you can’t clearly communicate that value, how can you expect customers to understand why they need your new offering and why they should pay for it? While it sounds simple in theory, we routinely see companies struggle with crafting their value communication when it comes to new products. The most frequent root cause of the problem: People in functions charged with value communication are typically detached from the innovation process and thus come in too late. To fix this, integrate marketing and sales into the innovation team. Follow the three steps mentioned in this chapter to create compelling messages—those that communicate benefits (not features), are segment-specific, and are monitored and continually improved.

CEO Questions What benefits do our customers derive from our new products? Have we quantified these benefits? How did we go about it? Are the marketing and sales teams involved with the innovation team from the get-go, or are they plugged in toward the end of product development to create the value messages? If the latter, how do we fix the situation? To what extent are our value communications in tune with the benefits customers perceive? Have we tested our messages? If so, how? If not, why not? How do the messages change by customer segment? Did the entire innovation team (R&D, product, marketing, sales) check and approve the value communication materials we developed? How closely? Did anyone object? If so, why? What processes do we have to measure the effectiveness of our value messages? Have we used the matrix of competitive advantages as a framework to create our value messaging? How regularly are we planning to measure the effectiveness of our value messages?

Their willingness to pay (WTP) for your product is not solely based on the value they get from it. Psychological factors also can play a big role. We refer to the pricing tactics that play to this irrational side of customers as behavioral pricing.

Behavioral pricing is a separate matter. It calls for refining your product offers and the messages you create about them to make it easier for customers to compare, decide, and purchase. And making it easier doesn’t necessarily mean providing information for logical, rational analysis. Sometimes, that data only makes deciding harder. Behavioral pricing is the magic that happens when value pricing meets irrational customer psychology.

Such offers, promoted to make another product look better, are called anchors. The small soda makes the more expensive option look like a bargain, and who can resist a bargain? That’s the only reason for a $4.99 small soda at all.

Pricing that doesn’t consider the irrational aspects of customers is likely to be suboptimal.

If you work at a multibillion-dollar company, you aren’t likely to get a 14 percent revenue increase using behavioral pricing; a 1 percent to 3 percent sales boost is more likely.

One, reducing the functionality of the entry-level Basic offering made the offering immediately above it much more attractive to buyers who previously would have been misclassified as price-sensitive. Two, the Premium offering came with a premium price: $299. That made the Standard and Advanced products look more attractive. The Premium offering was the anchor, the Internet start-up company’s version of the movie theater’s small soda. The offering’s sole purpose was to make the other products look like bargains. It drove a higher percentage of customers who wanted a high-quality solution—but still loved getting a deal—to choose the Standard and Advanced product. Three, a few customers were willing to pay the premium price for the premium offering with the most functionality. We have seen this time and again: Certain customers will always go for the most expensive product in a lineup, the one they perceive to have the highest quality. They believe you get what you pay for and that they deserve the best. As pricing experts, we have come to accept this as a fact of life.

You can’t base your price-setting strategy only on behavioral techniques. Rational tactics, those that discern what customers value and what they are willing to pay, are prerequisites. Combining rational and behavioral pricing approaches is the most effective strategy.

Compromise effect: Make decisions easier for people who can’t choose.

Recommendation: If you are launching a new product, plan on having a compromise option.

Anchoring tactics: Set the context for value.

Anchors make the other options look attractive.

Anchoring is a crucial behavioral pricing tactic in B2B sales negotiations. If you start with a high price, inevitably you will end up at a higher net price when the negotiation concludes. Anchoring lets you establish a reference point that will influence subsequent offers and shift the range in your favor.

“This new proprietary part is priced at a 40 percent premium over standard versions because of significant development costs and superior technical advantages. But since you have been a great customer, we can bake in some price concessions.”

Make sure you have an anchor product in your new product offering portfolio, and start every B2B sales negotiation for new products with a high anchor price.

Using price to signal quality: If it costs more, it reinforces the customer’s perception of quality.

A product’s price sends a powerful signal about its quality. Low price equals low quality; high price equals high quality.

Recommendation: Pricing your product too low is worse than pricing it too high. If you start high you can still go down; if you start low you can hardly go up. Therefore, when launching your new product, beware of a too-low price. It can ruin the perception of product quality in the mind of the buyer.

Customers are influenced by costs that are immediately in front of them. Even if they calculate their total cost of ownership of a product over time, they will be swayed by the initial costs.

Why? The customer’s upfront cost has a much bigger psychological impact than the total cost of ownership. Your pricing strategy should be to land a customer by showcasing the lower upfront costs and then expanding on a higher variable amount.

Recommendation: Use this tactic only if you are 100 percent sure you can sell your downstream products to customers—your razor blades, printer ink, and so on.

Aside from fundamentally changing your business model to be like Amazon’s, are there easier ways to use pennies-a-day pricing? Absolutely. And the simplest is breaking up time.

Companies often look to establishing annual contracts to ensure predictable revenue. But yearlong contract prices can look prohibitively expensive. Breaking that cost down into monthly installments makes the cost appear more reasonable. Instead of charging an annual price of $120,paymentsof$9.99 per month can have a very different effect on customer signups. Recommendation: Put the proper thought into framing your price to make it look attractive—not just in coming up with the price.

Recommendation: Identify the price thresholds for your products and stay on the cliff.

Focus groups provide customer feedback on potential behavioral tactics. They serve as small, controlled tests for understanding the thought processes driving product selection. You can watch how customers react as price anchors, deals, and other factors change.

For online offers, controlled A/B tests let you assess click-through and conversion rates on different behavioral pricing tactics. They give you statistically significant data on the options with the best outcomes. But you must set up these tests correctly, which includes clearly defining your control and test cases. You must also divide the sample in each group so the customer populations are similar.

Both rational and irrational factors drive customer purchases, and this applies to business customers and consumers alike. Behavioral factors influence whether customers purchase your product and which configuration they choose. These six behavioral pricing tactics are among the most powerful for new product launches: the compromise effect, anchoring, price to signal quality, razor/razor blades, pennies-a-day pricing, and psychological price thresholds. Before putting behavioral pricing tactics into play, you should try them out first through focus groups, controlled A/B tests, and large-scale experiments.

What happens is that you will feel intense pressure from every corner of your organization to cut the price. That’s almost always a bad idea.

But reducing your price so soon sends an unintended message: that your new offering has less value than you initially communicated. In effect, you’re telling potential buyers your company has made a mistake, in quality or otherwise. But even if you have a quality problem, a price cut won’t fix it. In fact, it could make matters worse for you.

We call that losing price integrity. Products lose integrity when a company’s knee-jerk response to a lukewarm early market reaction is to reduce their product’s price in the first few months. You don’t want to do that.

You don’t want to lose price integrity because it creates two large hazards: eroding profits and eroding customer lifetime value. If you developed a price elasticity curve in your new-product plan, you did lots of hard work to arrive at your price. Don’t be hasty and abandon all that work at the first sign of weak sales. You’ll instantly give up the profit margin you targeted in your plan, and that profit will be gone forever.

Showing patience about pricing is more important than fretting over sales numbers in the first months after a product launch. Think price last.

Be patient addressing post-launch problems. They typically come in only four varieties, and you can prepare for them: (1) the market doesn’t understand your product’s value or you didn’t explain it well; (2) your competition undercuts on price; (3) the competition launches a competing product; and (4) regardless of what the competition does, sales are below plan.

Alternatively, your poor sales could be due to a feature problem, a distribution channel problem, a market awareness problem, or a quality problem.

2. Go beyond financial KPIs and track monthly outcomes. To measure the progress of new product launches, most companies track only financial key performance indicators (KPIs)—typically volume, revenue, and profit. These measures are grossly inadequate. You must also track sales, customer metrics, and operational metrics to keep a pulse on your new product after launch. Sales KPIs such as win-loss ratio, percent deviation of final price from target price, average sales quoting time, and price as a reason for win/loss will give you crucial insights on sales team performance.

As a rule of thumb, at most 20 to 30 percent of your deals (depending on industry) should be escalated.

3. Do deal “deconstructions” regularly. You need to dissect the reasons why you’re winning and losing deals. You should bring together a cross-functional team (including sales, marketing, pricing, finance, and product) that was involved in the deal. The objective is to fully deconstruct the deal to understand whether product strategy, price strategy, and value communications were applied correctly.

Nonprice actions can include increasing advertising or adding to the value of the product. You could give customers a higher-end product at the same price. That will help you preserve your price. Even if you lower your price, you should ask customers for something in return. That something could be a longer-term commitment, greater volume, introductions to departments you have not sold to, endorsements and references, or joint press releases. Or it could be something else—as long as you’re getting value for giving value.

When you don’t—when you severely and needlessly underprice your new product—you should accompany price increases with small product improvements that justify the price hike.

Alternatively you could accelerate the development of the next generation of products and offset prices in the future releases.

Price wars are about seeing who can lower prices the most. You don’t want to start one, and you don’t want to be the first one to move. Ultimately, a price war has only one winner: the supplier with the lowest cost. Most likely, that’s not you.

To maintain price integrity, you need to take a cross-functional approach to diagnosing the problem. It may turn out you don’t have a pricing problem at all. It may be the inability to communicate the substantial value of your product, a quality problem, a sales-force training problem, or another problem. Don’t assume first that you put the wrong price on your product.

At Porsche, the burden of proof is always on why a feature should be included. Porsche puts every feature on trial.

A key step in this process is deciding which features will be standard equipment and which will be options. What matters most is customers’ value and WTP for each and every feature. If nearly all customers have a relatively high WTP for a certain feature, Porsche makes it standard in the vehicle. If only some customers will pay, Porsche makes it an option.

At LinkedIn we typically use a multi-step, iterative process to test new concepts with customers. As our confidence in the product’s potential increases, we invest more time and energy into optimizing our go-to-market monetization strategy.

“You really want to understand how people are dealing with your equipment,” he says.

You may be thinking, how can you ask customers about a new product that you haven’t yet developed? How can customers react to something they can’t see? Dräger Safety creates simple presentations that show key product benefits—exactly what customers get if they purchase the device. These presentations vary by customer role. For example, the purchasing function gets a presentation on the benefits it cares about. The safety engineers get a presentation on what matters to them, and so on.

These mindset, cultural, and strategic changes can only be driven from the top of an organization.

You want supply to always be full, and you use price to basically either bring more supply on or get more supply off, or get more demand in the system or get some demand out. It’s classic Econ 101. —Travis Kalanick, CEO and co-founder of Uber

There are two levers to Uber’s pricing strategy—the dynamic piece and penetration pricing.

Rapidly advancing technologies make all kinds of newfangled products and services possible, but innovators face a great monetization challenge: determining whether a brand new product can sell, and at what price, before investors pony up their money.

The MUVs pricing model also simplified Optimizely’s sales process, since customers only needed to know their monthly site traffic (not how many users might use the software)—a measure they invariably knew. (If they didn’t, it was doubtful Optimizely could help them. After all, it was software, not a magic wand.) The MUVs pricing model is exactly analogous to the Michelin monetization model described in Chapter 7: charging by the miles truckers drove the tires, not per tire.

To further complicate matters, there was no clear consensus among the prospects on whether a prospect should buy Testing before Personalization or vice versa. A small segment clearly needed both products, but not so many to warrant bundling the two. Everything pointed to keeping Personalization a stand-alone product, but under the same optimization experience platform that Optimizely was building. When customers used the products together, they needed to be seamlessly integrated, but one should be able to work without the other. Optimizely chose this route: Customers who wanted both products could choose from the good/better/best options of Personalization and Testing (that is, mix and match between the products). This also allowed advanced users of the Testing product to purchase a basic package of Personalization to get started. As the customer advanced on the learning curve, retrieving increasing benefits (from advanced packages) would be possible.

The moral of the Optimizely story is that there is no one right answer for monetizing a suite of products. Had Optimizely kept its monetization model the same for the two products, it might have created a suboptimal outcome. By designing each product separately around the value and the price, Optimizely and its products have been a huge market success.

Concentrating more dollars in fewer products is actually less of a commercial risk than spreading the risk across a large number of products or compounds. Why is this the case? Having a much more incisive understanding of the market and a drug’s commercial prospects reduces risk significantly.

Having a deeper understanding of a few high-potential products is far better than a superficial understanding of many products.

The broader lesson is that in innovation, less is more. Having a deeper and more specific knowledge about fewer products is superior to knowing only general information about a multitude of new offerings.

But the change starts with you. You must lead by example. You need to start showing up at new-product meetings and asking tough questions.

Of course, this is a culture in which a “yes” to every new product idea (or feature) no longer rules. You could say it’s a culture in which the old approval process shifts from “yes/maybe/no” to “no/maybe/yes.” It’s a mindset in which every product has to earn its way into the market before it is launched.

Cultures built on yes/maybe/no may seem more exciting. But if every idea starts with a yes and you go all the way, by the time you can say no, it is far too late and the train has left the station—and so has your product.

Too many managers set low goals for new products—lower revenue targets, lower-than-necessary prices—with the hope that more customers will buy them. But by lowballing, managers are returning profits that belong in your company’s coffers to customers in the form of ill-conceived discounts.

In the early stages of designing your product around a price, when you are having the WTP conversations, remember you’re only trying to get to a ballpark idea of an acceptable price. As you keep designing the product, you must keep refining this estimate. Trying to optimize your price before you start designing produces a false sense of precision. You may get an A on your process but an F on your innovation. Applying the philosophy and principles you find in this book is far more important than applying its math.

Be prepared: The information you collect won’t be perfect. In this life, nothing is. Some of it will be confusing. Don’t let that throw you off. Step back and draw pragmatic conclusions from the data you have, and don’t follow the arrival of data that fails to align with it with a witch hunt. If you accept that you will encounter messy information, you will be better prepared to take a step back and see the majesty and magnitude of the forest instead of all those twisty, confusing trees.

When C-level leadership is not committed in body and soul, if monetizing innovation is not one of your top two organizational priorities, and if that is not reflected in C-level involvement, we would advise you not to embark on the journey.

In the 1999 science fiction movie The Matrix, the hero, Neo, is presented with a blue pill and a red pill and asked to choose. Taking the blue pill will allow him to continue to exist within the comfortable but fabricated reality of the Matrix. The red pill will push him into the real world to confront the difficult truth of his existence. If your company’s innovation process is built on hope—a gut instinct before you bring your products to market that they will pay off—your organization has chosen the blue pill. If some (or even most) of your innovations have paid off, you still have been building them on a tenuous foundation, one that could give way at any moment.

This book has attempted to show you the red pill. It may have made you uncomfortable; reality is often hard to face. It is always easier to take the blue pill and keep building products and slapping on a price that you hope will deliver a profit. But, if you want to transition from hoping to knowing, you must take the red pill. That is the one that will set you on a fast trajectory to fully monetize your innovation.