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Capturing the full value of innovation

Tying pricing to value allowed a network client to boost the price of a new product by nearly 25 percent.

Challenge

A leading maker of network equipment was bringing an innovative new product to market in the midst of a broad industry slump. The downturn had squeezed out many new players in its customer base. Those remaining were reluctant to invest in network upgrades due to high capital costs and falling prices for bandwidth.

Complicating matters was the company’s pricing history. Their customers had grown accustomed to gradual increases for each new product generation. What if, as in this case, a new product represented a big leap forward? How could the manufacturer communicate this breakthrough—and charge for it accordingly? The company called McKinsey to help put in place a “value-based” pricing structure that would better align the price of the product with the benefits it generated for customers.

Discovery

Was the company’s new product really such a breakthrough? We worked with the client to identify all the potential sources of economic benefits to customers from using the new product and compared them to the next-best alternative from competitors. Relative to competing products, we found the new switching solution would have considerably lower capital and operational costs for customers while providing mechanisms for boosting revenues. Furthermore, much of this value was created by the solution's software features, rather than by its hardware.

The cost-plus pricing model initially considered by our client would in fact have been far out of sync with the actual value the product provided to customers—charging them less than 10 percent of the estimated economic value created. In short, the customer would get more than 90 percent of the economic value and the manufacturer less than 10.

What price would provide better proportions? Finding it required a set of precise analyses taking into account: the cost of producing the product and the client’s financial goals (which provided a minimum price) and the economic value created for the customer (which provided the maximum price); and the desired positioning of the client’s product in the market relative to competitor pricing and existing customer perceptions and expectations (which revealed constraints and limitations on pricing levels).

To help customers understand the price relative to the value, we worked with the client to create both executive-level pitch materials and a sales model that would be effective in the field. We then supported the client with the model rollout and materials—including tools designed to reactivate stalled customer negotiations—to the sales force, where it received an enthusiastic reception. Presentations of the new pricing model by company executives were also warmly received by financial analysts, resulting in stronger stock performance.

Impact

Having established the new product's value to customers—and a corresponding range of possible prices—the client realigned its pricing structure to more adequately capture the value created by the product’s software components. The client increased the price of these software features by more than 50 times the initially proposed price by gaining a much deeper appreciation for the full value they offered the customers.

In the end, the client was able to set the true product value, which allowed an increase in the price of the overall new product solution of more than 24 percent.

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