To Innovate or Not to Innovate – That is a Pricing Question

By Rashaqa Rahman

Customers want choice. That is a fact. According to a global Nielsen survey,  63% of customers around the world want manufacturers to offer a new product. Yet, 65% of new products fail, costing US companies alone $260 billion, and that is no pocket change. Oh what a conundrum it is! But it doesn’t have to be. Today markets are dynamic; customers are increasingly more knowledgeable and inertia in bringing new product offerings to the market is just not an option. So how can innovation be made less risky? The answer is value-based pricing.

In the words of pricing guru Madhavan Ramanujam from his book Monetizing Innovation, “Pricing is the most critical factor in determining whether a product makes money… it is an indication of what the customer wants, and how much they want it.”

As per Clayton Christensen’s Theory of Disruptive Innovation, there are two kinds of innovation: sustaining and disruptive. Sustaining innovations either improve products within an existing market or bring completely new products to market, neither of which have a significant impact on existing markets. Then there is disruptive innovation (think Airbnb and Netflix) that taps into a previously unaddressed customer pain points and drives value. Disruptive innovations have significant impact and can potentially completely take over existing markets.

For market incumbents, successful sustaining innovation is key to retaining competitive advantage. Doing nothing is not an option, because existing competitors or new entrants will bring new products to market and shift the market dynamics. The wrong approach to innovation is offering 'me-too' products that add little value for the customer. This approach can potentially rock the boat and push one’s customers into the arms of the competitor.

Market entrant hopefuls can either take the sustaining approach to innovation and try to carve out a share of the pie for themselves in a pre-existing market or bring disruptive innovation to market and create a new value network. More often than not, disruptive innovation comes from new entrants. Even though incumbents may have better access to resources and capital, they are often too limited by pre-existing customer expectations to risk attempting something truly radical. One place where market entrants can innovate is on new pricing metrics. Incumbents find it very difficult to change their pricing models. New pricing metrics that better capture value to the customer can be very disruptive.

For both sustaining and disruptive innovation to be successful, creating value for the customer is fundamental. Secondly, disruptive innovations carry the added risk of needing to cross the chasm (technology adoption lifecycle term coined by Geoffrey Moore) from a handful of adventurous early adopters to gaining acceptance by the masses and growing the customer base to a healthy early majority.

Let’s look at some classic examples of disruptive innovation and their pricing strategies. At its inception, Netflix was competing with brick and mortar video rental establishments. Blockbuster the incumbent market leader at the time had strong brand equity and an imposing number of physical storefronts which acted as a robust barrier to entry against sustaining innovation. Any competitor or new entrant trying to enter the market through the video rental store route would require large upfront capital investments to build enough market presence to compete against Blockbuster.

But, Netflix’s disruptive product innovation did not require huge capital investments in brick and mortar stores. They could add differential value through addressing previously unaddressed customer pain points and providing “….content with an all-you-can-watch, on-demand, low-price, high-quality, highly convenient approach.” Not only was online streaming more convenient than having to pick up and drop off video rentals, Netflix's subscription pricing model captured further customer value by negating the risk of late and re-shelving fees, and the flat monthly fee also had more perceived fairness than a per rental fee. Blockbuster's business model did not allow them to copy Netflix's pricing strategy. Today Netflix’s subscription pricing not only allows them to generate recurring revenue from their client base, but developing original streaming content allows them to charge a further price premium to capture user value.

Another classic example of disruptive innovation is Google Adwords and their disruptive pricing strategy that captured the differentiated value of more effective, targeted leads based on the number of online ad clicks versus the number of  ad impressions. Google AdWords disrupted the market by targeting an initial customer segment who were unable to pay the high upfront costs required by online marketing platforms of the time, and were not being served by the market. Google's innovative price-per-click versus price-per-impression pricing metric not only made them a leader within the online marketing space but changed how we think about online marketing.

In his book, The Strategy and Tactics of Pricing, Tom Nagle showed how an automated voice recognition software that enabled call centres to process more calls within a shorter time frame adapted a value-based pricing strategy. This voice recognition software had the ability to process calls faster than other traditional call software. However, capturing the added user value through the existing price-per-minute metric would have required charging at least a 3X price premium which would surely have met with customer resistance. So this software company shifted the pricing metric from "cost-per-minute" to “cost-per-call.” This allowed them to reframe their price and win a premium. The customers accepted the premium because for them the total cost-per-call was less with the new software. The goal of a call center is to resolve calls within the shortest possible time-frame, so "cost-per-call" is a better value metric. The shift to a 'cost-per-call" metric is a win-win for buyer and seller. It focuses both parties on what is creating value. Creating pricing structures that are in the interest of both buyer and seller is the goal of pricing strategy and one of the key advantages of value-based pricing.

Innovation can be successful if we can truly add value for the customer. And no, we don’t need a crystal ball for that. It requires discipline and a systematic approach to understanding the customer, market segmentation and pricing. Treating pricing as an afterthought to the product design process is a big mistake. Carefully segmenting the market by customer needs, values and willingness-to-pay at the early stages of product design is crucial. While it may seem counter-intuitive to discuss pricing with the customer before one has a product to offer, gauging the customer willingness-to-pay early on during the innovation process means that the right product functions can be prioritized, at the right price, for the right customer. A deep understanding of customer needs creates strong differentiated value for the innovator, which in turn can be captured through a price premium. Innovation done right requires a delicate balancing of creativity with structure.