Do you have a long-term pricing strategy?

Actively pricing products across their life cycle is increasingly important, particularly in innovation-intensive industries. Failing to do so may forego potential profits or even destroy value.

In the late 1990s, the world's three major independent producers of hard-disk drives invested about $6.5bn in research and development in the course of just four years. During the next decade, the bytes that can be stored per unit of a drive’s surface area increased a thousandfold - while the price per unit of that surface area dropped 70 per cent. The three companies created enormous value for customers. Yet their failure to price products correctly throughout this period of significant innovation contributed to net losses totaling almost $800m.

Entire industries can suffer when companies fail to grasp the importance of pricing products or services across the life cycle, particularly in innovation-intensive sectors such as consumer electronics and consumer durables, IT hardware and software, medical devices, and pharmaceuticals. That's especially true today. Companies introduce products more regularly, with life cycles often measured in months, not years. There's external pressure for low prices from customers expecting more for less and internal pressure from the belief that pricing is a make-or-break factor when products launch. And a company may have a number of related products in the marketplace simultaneously, which complicates their life cycle pricing.

Two points are essential to price effectively throughout the life of a product or service. First, companies should actively manage the trade-off between price and volume (or profit and market share) to maximise returns. Most businesses fail to test customer value perceptions and price sensitivity after products launch and have no idea how the critical trade-off between price and volume shifts over time. Second, companies must make pricing decisions in the context of their broader product portfolios because when they have multiple generations of a product in a market, a price move for one can have important implications for others.

With these two principles in mind, companies should consider how they respond to pricing challenges during the three major phases in the life cycle of a product or service: launch, midlife, and late life.

The launch phase
Correctly setting the launch price for a product or service can reset market price expectations and boost the profit trajectory across the remainder of that offering's life cycle. In the launch phase, it’s critical to concentrate on three imperatives: setting a launch price that maximises the long-term capture of value, avoiding "anchor effects" from older products, and working the product portfolio to a company's advantage.

One prerequisite for setting a launch price that maximises long-term value is conducting scenario-based analyses that incorporate different pricing models, potential responses by customers and competitors, and the implications for earnings. This approach can help companies avoid common mistakes, such as setting the launch price too low or reducing a product’s price soon after launch. The careful adjustment of prices for existing products also can minimize the degree to which they drag down prices for new ones. More broadly, businesses should assess new-product pricing in the context of their existing product portfolios.

Consider the case of a medical-device manufacturer that launched new versions of all major products every 6 to 18 months. Each version - whether it was a significant innovation or a minor improvement - was priced only a few percentage points above the existing one, in an effort to encourage migration and mitigate potential customer backlash. The company would then drop the price of older products precipitously (by 20 to 40 percent) while continuing to sell them for an extended period because of ongoing demand from some customers and the company's desire to provide a lower-cost alternative to the new products.

This approach dragged down the prices of new products because their incremental value versus the old ones remained more or less constant. As happens at many companies, the average price for each product line declined every year despite annual R&D investments in the hundreds of millions of dollars.

In other words, the company was rapidly innovating itself from a market leader into an average performer. Once the company recognised what was happening, it eliminated "fire sales" on older products, changed the incentives of the sales force to support the new life cycle - pricing strategy, and carefully launched subsequent products at greater premiums.

To read the full version of this article on McKinsey Quarterly, click here.