Monetizing Innovation: How Smart Companies Design the Product Around Price

1. 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. Porsche understood all this when it set about creating the Cayenne. Porsche's top executives knew they had a bold, perhaps even revolutionary, concept. They also knew the car would be a tremendous risk. They instructed their product team to rigorously determine what the customer wanted in a Porsche SUV and, importantly, how much they were willing to pay. The message was clear: If the customer was not willing to pay a price that would ensure success, Porsche would walk away from the Cayenne. Porsche's masterstroke was thinking about monetization long before product development for the SUV was in full speed, then designing a car with the value and features customers wanted the most, around a price that made sense. The result was total corporate alignment: Porsche knew it had a winner, and had the confidence to invest accordingly.
2. 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. It is so much of an afterthought that companies frequently call us and say, “We built a product—oops, now we need your help in pricing it.” To boil it down, these companies conduct product development this way: They design, then build, then market, then price. What we will teach you in this book is to flip that process on its head: Market and price, then design, then build. In other words, design the product around the price.
3. We've found recurring patterns in new product monetization failure. 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:
   1. 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.
   2. Minivation: an innovation that, despite being the right product for the right market, is priced too low to achieve its full revenue potential.
   3. Hidden gem: a potential blockbuster product that is never properly brought to market, generally because it falls outside of the core business.
   4. 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.
      1. 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. Had these firms asked customers what they'd be willing to pay for their inventions before drafting the engineering plans, and had they identified the market size by segment and who would be willing to pay the most (and least) for it, they would have reformulated their products to meet an acceptable price. Or, finding there is no acceptable price, or that the market size is too small, they would have scrapped the product altogether before they incurred too much financial damage.
4. In this book, we have boiled these secrets down into the following nine new rules for innovation success. The rules are contrary to what most executives have learned about product development:
   1. Have the “willingness to pay” talk with customers early in the product development process. If you don't do it early, you won't be able to prioritize the product features you develop, and you won't know whether you're building something customers will pay for until it's in the marketplace.
      1. 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?”
      2. 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.
      3. Ask questions like “Do you value these products/features?” and then ask why. Then switch gears to ask questions like “What would you consider an acceptable price?” Switching from value to price is an easier transition to make in determining customer WTP.
      4. Avoid the “average trap: ”When you analyze the answers to your WTP questions, look at the distribution, not just the average response. The average response can be misleading. For instance, for two groups of customers, one willing to pay $20 and another willing to pay $100, if you calculated the average price they would pay, it would be $60. But that would leave money on the high side (the group that would pay $100) and make your product unaffordable to the low side (they'll only pay $20). You might be better off building the product to a $100 price point or—even better—making two versions, one at $20 (with different features or materials) and the other at $100. Either way, you must look at the distribution to arrive at the right insight, not just the averages.
   2. 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.
      1. Most businesses do segmentation, but many are ineffective because of these three pitfalls: Segmenting too late.
      2. Segmenting only by observable characteristics.
      3. Having too many segmentation schemes.
      4. If you have more than three, you are headed for organizational confusion.
      5. Smart companies start with a few segments—three to four—and then expand gradually until they reach the optimal number.
      6. 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.
   3. Product configuration and bundling is more science than art. You need to build them carefully and match them with your most meaningful segments.
      1. Our definition of product configuration refers to the decision of which features and functionalities will be included in a product. In some industries, like software and tech, product configuration is also referred to by the term packaging. By bundling, we mean combining a product or service with other products and services. Successful innovators get the product configuration and bundling decisions right from the start.
      2. 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.
      3. Bundling helps you determine whether your products and/or services should be sold together or separately. When done right, it can increase total profit because customers end up buying more than they would have if you hadn't bundled. Take an example many are familiar with: McDonald's and its Value Meals.
      4. 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.
      5. 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.
      6. 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.
   4. Choose the right pricing and revenue models, because how you charge is often more important than how much you charge.
      1. 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.
         1. The Subscription Model
         2. Dynamic Pricing
         3. Market-Based Pricing: Auctions
         4. Alternative Metric Pricing/Pay As You Go
         5. Freemium Pricing
            1. 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.
      2. The reason to ask this question is not to mimic your rivals' monetization approaches but to set yourself apart. Wherever possible, use your monetization model to create a competitive difference, as Netflix did to the point of transforming the video rental business and displacing video store competitors like Blockbuster. The question becomes especially relevant when competitors are not equipped to react to any model changes you can bring.
      3. 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.
      4. At the highest level, a sound pricing strategy must have clear intent, quantifiable goals, and a time frame for execution.
      5. Like a recipe for a great meal, a solid pricing strategy document must have the right ingredients. It must also have a process for adding those ingredients in the right sequence. Let's review the ingredients, or building blocks.
         1. Building Block #1: Set Clear Goals
            1. 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. Here's an example: Assume you could sell your product at either $10 or $15. Further assume when you sell your product at $10, you get 100 customers, and when you sell it at $15, you get 80 customers. So how should you price your product? Will you take 20 percent fewer customers in return for a 20 percent increase in revenue?
         2. Building Block #2: Pick the Right Type of Pricing Strategy
            1. The good news is only three types of pricing strategies matter: maximization, penetration, and skimming. Let's look at each.
               1. Maximization: This strategy maximizes your goal (such as profit or revenue) in the short term.
               2. 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.
                  1. Facebook has become immensely profitable as well, generating $7 billion in profits in aggregate from 2009 to the first half of 2015. A penetration strategy might be right if you also plan to hike prices in the future.
               3. 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. Some prime examples are buyers of movies, music, online games, high-definition TVs, gaming consoles (such as Microsoft's Xbox video game console), smartphones (Apple iPhone, for example), and some automobiles. These customers won't wait for a product to become mainstream. It gives them bragging rights; they want to show it off to their peers. 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.
         3. Building Block #3: Develop Price-Setting Principles
         4. Building Block #4: Develop Principles for Reaction
            1. Price reaction principles come in two varieties: those based on how customers behave (such as promotional reactions due to lower-than-expected demand) and those based on how competitors behave with their prices. Planning your reactions is much like playing chess and thinking a few moves ahead. Companies that don't think ahead react spontaneously and make unintentional yet avoidable mistakes.
            2. Or you could skimp on promotions because you've chosen a premium strategy (like Apple). Or you might do something in between. The most important aspect of promotional reactions is to decide early which principles you will base them on.
   5. Develop your pricing strategy. Create a plan that looks a few steps ahead, allowing you to maximize gains in the short and long term.
      1. 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. Here's
      2. Rule of thumb: The smaller the margin per unit, the bigger the impact of suboptimal pricing.
      3. In other words, 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). 
      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.”
      5. 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.
   6. Draft your business case using customer willingness-to-pay data, and establish links between price, value, volume, and cost. Without this, your business case will tell you only what you want to hear, which may be far afield from market realities.
      1. Many of the firms the company thought of as peers priced on a per-user basis (for instance, $50 per month per user). But the SaaS company knew this would be suboptimal (that is, a minivation!). It wanted to position its product, and its price, on the value it delivered. So the firm started by creating a spreadsheet salespeople could use with customers to quantify the payback on the product after asking a few basic questions about their operations. (See Figure 10.1.) The salesperson could enter such data as the number of hours the customer spent having warehouse workers manually pick orders from shelves (a task the software automated), the amount of inventory carried (the software would reduce costs of carrying excess inventory due to better forecasting), the number of shipping errors that occurred (the software would eliminate those), and the savings from eliminating paper documentation (by ending the paper shuffling, real-time coordination in the warehouse would greatly increase efficiency). The spreadsheet then calculated the customer's total return on its software investment.
   7. Communicate the value of your offering clearly and compellingly; otherwise you will not get customers to pay full measure.
      1. Features, not benefits
      2. The benefit statements, such as “beautiful design” and “unlimited storage,” were music to many ears. 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.
      3. The Three Steps to Create Great Value Communications
         1. Step 1: Develop Crystal-Clear Benefit Statements—Not Feature Descriptions
            1. 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
            2. Matrix of Competitive Advantages (MOCA) To create this matrix, you list the relative importance of your innovation's benefits to customers on the y-axis. On the x-axis, you rate your innovation's performance against the competition—not as you see it, but as your customers see it. The benefits your product delivers that are most important to customers and that competitors can't match (top right quadrant) are the ones to emphasize in your sales and marketing messages. But those aren't the only benefits to communicate. For the ones in the lower right quadrant—benefits you are better at delivering than competitors but which are less important to customers—you are trying to convince customers these benefits are more important than they might realize. However, if you can't prove it, don't emphasize them in your value communication. The factors in the top left quadrant represent your competitive disadvantages, and you should prepare arguments to defend them. Using this matrix, creating value communications will become more structured. It will also become easier to get all the innovation team members (R&D,
         2. Step 2: Make Your Benefit Statements Segment-Specific
         3. Step 3: Measure the Impact and Refine Your Value Messages
   8. Understand your customers' irrational sides, because whether you sell to other businesses or to consumers, your customers are people. You should take into account their full psyches, including their emotions, in making purchase decisions.
      1. 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.
      2. Behavioral pricing is the magic that happens when value pricing meets irrational customer psychology.
      3. These tactics can markedly increase the success of a new product launch. Based on behavioral economic theories we've tested in many different customer settings, these six tactics become more powerful when you combine them. Here they are, along with examples that illustrate them:
         1. Compromise effect: Make decisions easier for people who can't choose.
            1. When given a set of choices, people will avoid extremes.
         2. Anchoring tactics: Set the context for value. We illustrated two examples of anchoring—the movie theater concessions and the Internet start-up company. Anchors make the other options look attractive.
            1. 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.
         3. Using price to signal quality: If it costs more, it reinforces the customer's perception of quality.
         4. Razor/razor blades: Get a foot in the door. 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.
            1. 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.
         5. Pennies-a-day pricing: Reduce sticker shock and build loyalty.
            1. Instead of displaying prices in the hundreds or thousands of dollars per server, EC2 shows prices in dollars or even fractions of a penny for hourly prices. 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.
         6. Psychological price thresholds: Avoid falling off the price cliffs. You might wonder why you rarely see prices like $101 in retail; you almost always see $99 or $99.99. The reason is that customers typically have price thresholds in mind.
            1. Recommendation: Identify the price thresholds for your products and stay on the cliff.
         7. 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.
   9. 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.
      1. 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.
      2. A telecommunications firm in Latin America instituted the rule of forcing managers to come up with three nonprice actions before making price cuts. A board member of the company stated afterward: “This simple rule had the highest impact we have ever seen and instilled the right discipline we were seeking. It was simple and everybody understood it.”
      3. If your product delivered more value than you thought customers were expecting, raise your price. But do it carefully, and in several steps. We've seen this happen many times. In the 1970s, Mercedes introduced a new SL car. The model sold out in a few months, and would-be customers were put on a waiting list of two years! Mercedes learned its mistake quickly: Its price for the new SL automobile was about 20 percent too low. However, it could raise the price only 3 to 5 percent a year. So the automaker had to wait a few years until it reached the optimal price level. In doing so, Mercedes left hundreds of millions of dollars in revenue on the table. The Mercedes example shows the importance of getting the right price at the beginning. 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.
      4. 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.
5. Myth: Until the business knows precisely what it's building, it cannot possibly assess what it is worth.
6. Paid pilots: Instead of giving the product to beta-testers for free, LinkedIn typically goes to market and sells the beta version of the product. Why? It provides another layer of validation for the monetizing potential of the new service based on the value delivered. In the words of Josh Gold, “Our beta users have skin in the game by actually paying for the pilot tests.” And there is a clear impact of having skin in the game: It generates better concept-testing feedback from the testers. It also allows LinkedIn to fine-tune the price levels prior to a full go-to-market launch.
7. “By doing such voice-of-the-customer research, you can ‘test-sell’ your product even though you haven't even started the product development process yet,” Drews says. “Then, when the customer asks when he can have it, you know you created a very powerful product idea.”
8. They found, for example, that a button reading “learn more”—rather than “sign up” or “join us now”—was more likely to get a visitor to give his e-mail address.
9. 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.

What I got out of it

1. Extremely practical book with some excellent insights on positioning and why starting with price rather than product is an ideal way to go - moving from hoping to knowing a product will succeed