Pricing An Industrial Technological Innovation

NORTH- H O L L A N D

Pricing an Industrial Technological Innovation: A Case Study What Decision Do You Recommend: Skim?, Penetration?, or Price Parity with an Older Technology?

Arch G. Woodside The manufacturer of a new fencing wire wanted to know if he should price the wire more than, equal to, or less than a larger competitor's product when introducing the new product to customers. Compared to the competitor's product, the new fencing wire was manufactured using a unique technology and component materials. The physical and performance properties of the

new product offered substantial benefits to customers in landbased industries (e.g., sheep stations and cattle range operations). In the case study, three alternative pricing strategies were proposed by three different senior managers. Which pricing decision would you recommend? A discussion of the likely effectiveness of each of the three alternatives is appended. The case study was based on a fieM study of marketing new technologies in New Zealand. The descriptions of the new and

Address correspondence to Arch G. Woodside, A. B. Freeman School of Business, Tulane University, New Orleans, LA 70118.

competing product technologies, and the events presented in the case, are factual.

Industrial MarketingManagement24, 145-150 (1995) © Elsevier Science Inc., 1995 655 Avenue of the Americas, New York, NY 10010

0019-8501/95/$9.50 SSDI 0019-8501(94)000-33-S

Pricing problem is acute for new technology product. INTRODUCTION

Kotler [2, p. 489] emphasized that pricing is a problem when a firm has to set price for the first time. The problem is acute when pricing a product manufactured using a new technology with new component materials unfamiliar to customers, and when these customers are satisfied with their experiences in using the existing product offerings, Three general solutions are possible: (1) pricing the new product noticeably more than the competitors' who dominate in the marketplace (a price skimming strategy), (2) competitive parity pricing, and (3) pricing the new product noticeably less than the dominant competitor's product (a marketing penetration pricing strategy). In the case study described in this article, three different executives were working together on planning and implementing the market launch of a new industrial product; each executive advocated the use of a different pricing strategy. All major details in the case study are factual; some information is included that supports each of the three strategies, A discussion of the merits of each pricing solution is appended. You are asked not to read the appendix until after reading the case study and ticking ( , / ) one of the alternatives at the end of the case. After ticking your recommendation, please consider writing a defense of one or more sentences of your recommended solution in the space provided. Whereas no one solution may be best, the appendix includes my ranking of the likely effectiveness of the three solutions.

FENCING WIRE INDUSTRY IN NEW ZEALAND The fencing wire industry in New Zealand consisted of two major suppliers: the Steel Wire Company and the Kiwi Fencing Company. (Whereas the basic information in this

case is based on real-life events, all names of persons and firms mentioned in this case are fictitious, and several details of the case have been disguised.) The Steel Wire Company supplied traditional, galvanized steel fencing wire; Steel Wire had approximately 95 % of the "traditional" wire market share. Kiwi Fencing supplied "electrified" plastic stranded fencing wire and has approximately 80 % of the electrified wire market share.

Customers and Marketing Channels The largest end users of both wires were enterprises in land-based industries (e.g., the agricultural sector), and the wires were distributed to this sector by the two compariles through merchant resellers and agent middlemen. Most agricultural equipment distributors in local agricultural areas stocked wiring from both Steel Wire and Kiwi Fencing; about half of the agent middlemen representing Kiwi Fencing also represented Steel Wire. The agent middlemen did not take legal title to products; these middlemen represented product lines of noncompeting principals. Principals were manufacturers who preferred to use agent middlemen instead of developing and managing their own sales force (a "direct" sales force). Agent middlemen were paid on a commission-only basis; they were not paid for their marketing expenses by their principals. The sales commissions of"manufacturing reps" must be substantial enough to cover the agent's marketing expenses and produce profits. Competition between the two wiring manufacturing companies was limited because of the different product uses. The traditional galvanized fencing wire was primarily used for permanent boundary fences, subdivision of large paddocks, trellis systems, and other similar types of permanent fence construction. In contrast, the electrified plastic stranded wire was primarily used for temporary internal barriers in break feeding, intensive grazing, or in conjunction with permanent galvanized wire as an inner barrier.

ARCH G. WOODSIDE is the Malcolm S. Woldenberg Professor of Marketing at the Freeman School of Business, Tulane

In the mid 1970s when K i w i Fencing started to distribute its fencing on a national basis, Steel Wire informed the

University, New Orleans.

agents representing the Steel Wire products line that Steel Wire viewed Kiwi Fencing as a competitor and that Steel

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Customers prefer to buy locally through distributors. Wire preferred that its representatives did not represent Kiwi Fencing. Most of Steel Wire's representatives agreed to not represent Kiwi Fencing. However, by the early 1980s many of Steel Wire representatives were carrying the Kiwi Fencingproduct line because many oftheir customers (bothdistributors and farmers) asked about the product and were buying Kiwi Fencing products as well as Steel Wire fencing. Although Steel Wire had threatened to drop any agent who started to carry Kiwi Fencing, Steel Wire had not done so. Kiwi Fencing was able to develop a national manufacturing rep marketing channel between 1973 to 1978. The sales manager, Steve Dakin, and assistant sales manager, Bob Hamilton, each invested about 50 % of their time with agents jointly calling on distributors and medium to large farmers and sheep/cattle station managers. (Mr. Hamilton and Mr. Dakin tried to coordinate their schedules so one of them would be at Kiwi Fencing's manufacturing plant to "cover the phone" Ten to 20 reps, distributors, and/or farm/station managers would call per day with questions, problems, and requests for quotations.)

Buying Behavior of Customers Almost all farmers and station managers wanted to buy locally through distributors for repeat purchase items, whenever possible. These customers did not want to tie up their operating funds in equipment inventory. The farmers and station managers expected that "their local distributor" would carry a wide range of equipment and have the equipment available locally when needed. Usually the farmers and station managers would travel in their own trucks to local distributors to buy and transport equipment,

PLASWIRE: A NEW KIWI FENCING PRODUCT By early 1990 Kiwi Fencing wanted to be competing nationally in the traditional galvanized steel fencing market with a new type of permanent fencing wire that Kiwi Fencing intended to manufacture in New Zealand. The product, Plaswire, was a plastic wire made from polyeth-

ylene terephthalate and was designed to be used as replacement for galvanized steel wire in permanent fencing construction.

Features and Benefits of the New Product Plaswire has the following product features: 1. High tensile strength-compatible breaking strength with steel wire 2. Lightweight-approximately 17 % of the weight of steel wire in the same gauge 3. Durability- no significant change in tensile strength from ultraviolet rays, no degradation from agricultural chemicals, tantalized fenced posts, or oxidation from water or salt contact, fire retardation 4. Resistance to temperature extremes- original tension maintained in extreme heat or cold with no brittleness occurring in freezing conditions 5. Handling ease and tight knot performance- special flexibility for handling ease and no movement at the knot point, no special straining equipments or tools required 6. Minimum elongation-large Young's modulus of elasticity for minimum elongation 7. High ultimate yield point-ability to be restrained after permanent wire stretch occurs at lower yield points 8. Choice of colors- high visibility for trellis systems, pathways, and other areas where visibility is required 9. Ability to be "barbed'- no rust or corrosion from surface nicks when barbed 10. Strength against bending-endures 360 ° bending without breaking Kiwi Fencing currently enjoys the prominent position in the "electrified" fencing market with significant brand loyalty from distributors, farmers, and station managers. The introduction of Plaswire into its product line would position Kiwi Fencing in direct competition against Steel Wire. Customer attitudes toward the traditional galvanized steel wire supplied by Steel Wire indicated strong positive product associations arising from the historic use of steel wire on

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President Gurney believes the competitor will not react. New Zealand farms. However, irregular supplies to resellers and agent middlemen, recent product price increases, and shorter product life from corrosive reaction with chemicals suggested changes may occur in customer attitudes toward galvanized steel wire. In order to compete effectively, Kiwi Fencing intends to offer a complete permanent fencing product line, including plain, barbed, and lacing wire, wire netting, and wire chain link netting.

President's Solution: Penetration Pricing The president of Kiwi Fencing, Peter Gurney, has requested Bob Hamilton to implement a pricing strategy for Plaswire that will help achieve national distribution. Mr. Gurney believed that pricing Plaswire substantially lower (30% less) than Steel Wire's prices would help gain distributors' acceptance of the product, because some farmers and livestock station managers may be sensitive to a low price level of the new product. Mr. Gurney felt certain that Steel Wire's management would not respond by lowering its prices in response to a low introductory price on Plaswire, because the cost of galvanized steel raw material for manufacturing Steel Wire products was 300 % higher than plastic raw materials used for manufacturing Plaswire. A low pricing strategy for Plaswire would produce an estimated net profit-to-sales ratio of 25 %; an estimate substantially more than the 20% target objective for the new product,

Assistant Sales Manager's Solution: Competitive Parity Pricing Bob Hamilton was responsible for recommending a final pricing decision. He knew from looking at many pricing lists of industrial distributors of agricultural products that when manufacturers introduced new products at retail prices much lower than competing products, their competitors responded most of the time (three out of four cases) with price reductions that matched or more than matched the new products' prices; the final result was failure or very low market share for new products (failure or very low market share in 92 of the 96 cases Mr. Hamilton was able to

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find where a new product was introduced with a lower price than competing products and the competitors reacted by lowering their prices). However, Mr. Hamilton also knew Mr. Gurney often had predicted correctly whether or not Steel Wire would decrease its prices when Kiwi Fencing offered a lower price; Mr. Gurney had been correct in his predictions in two of three recent cases. Mr. Hamilton favored pricing Plaswire to match the price of competing Steel Wire products. This pricing strategy would guarantee a very substantial return on the financial investment in developing and marketing Plaswire, and Kiwi Fencing would be likely to gain a "meaningful" share of the market for permanent boundary fences, assuming that Steel Wire did not lower its prices.

Sales Manager's Solution: A Skimming Pricing Strategy Mr. Dakin recommended pricing Plaswire 10 % higher than the price of competing Steel Wire prices. He felt that few agricultural customers would buy the new permanent boundary wire because of a low price, and Steel WLrewould lower its prices to match or beat the price of Plaswire. He noted that in most cases since 1985 (cases in industrial distributors' records) of new product introductions with prices higher than competitors' prices on existing products, only one in ten competitors reacted by lowering the price on an existing competing product. The new products were still available for most of the other nine products introduced at prices higher than existing competitors' prices.

YOUR PRICING SOLUTION FOR MARKET INTRODUCTION OF THE NEW FENCING WIRE, PLASWlRI: Given the following options, what pricing decision would you select? Please tick ( , / ) one solution in one of the three spaces provided. 1. ( ) Mr. Gurney's penetration pricing solution should be followed: price Plaswire 30% lower than the prices of competing Steel Wire products.

F o c u s o n g a i n i n g a n a d e q u a t e return on investment. 2. ( ) Mr. Hamilton's competitive, parity pricing solution should be followed: price Plaswire to equal the prices of competing Steel Wire prices, 3. ( ) Mr. Dakin's price skimming solution should be followed: price Plaswire 10% higher than the prices of competing Steel Wire products.

of a competitor reacting by lowering price in response to new competitor's product, P(R), based on some new or additional knowledge. Bayes' Theorem applied to this case study:

Please offer a brief defense of your choice (and why the other two should be selected):

where P(R) is the baseline likelihood of a reaction, .75

P(R)P(SNR/R)

P(R/SNR) =

P(SNR)

P(SNR/R) is the likelihood of predicting a reaction will not occur, "stating not a reaction," given a reaction does occur, that is, Mr. Gurney predicts a reaction will not occur and he is wrong; his recent accuracy is two of three cases, thus P(SNR/R) = .33 P(SNR) is equal to: P(R) P(SNR/R) + P(NR) P(SNR/NR)

APPENDIX

(.75) (.33) + (.25) (.67) = .415

to the K i w i F e n c i n g ( P l a s w i r e ) Case Study

thus: P(R/SNR) -

Solution

1. Follow Mr. Gurney's penetration, pricing solution. This choice is the NOVICE-MARKETER Solution. The baseline evidence (three of four cases, or 75 %) of competitors reacted by lowering prices when a new competing product was introduced at a lower price should be a prime factor in making a pricing decision. Even if this estimate was adjusted to account for Mr. Gurney's prediction that Steel Wire would not react, the likelihood is still more than 50 % that Steel Wire would lower its prices. Such a reaction by Steel Wire is likely to result in market failure for Plaswire. The major error in predictive judgment is to treat each case as unique. Although every future event is, by definition, u n i q u e - t h a t is, it has never occurred b e f o r e - m o s t events can be considered to belong to a "reference class" [1], about which much is known. Singular data (e.g., Mr. Gurney's prediction) should be modified by baseline data. In this situation, Bayes' Theorem (or rule) would be used to estimate the likelihood of Steel Wh-e responding by lowering the price on products competing against Plaswire. Bayes' Theorem [see 3, pp. 153-160] is an equation that revises the probability of an event, for example, the probability

.2475

-

.596

.4150

The likelihood is .596 that Steel Wire will react by lowering its price if Plaswire is introduced at a price lower than Steel Wh'e's current prices, based on both the base-line (reference class) data and the singular data of Mr. Gurney's accuracy and prediction of the future. 2. Mr. Hamilton's solution of pricing Plaswire's price to equal competing Steel Wire prices. An alternative more likely to be effective than the penetration pricing solution, because a price reduction by Steel Wire to a perceived threat would most likely cause failure for Plaswire, Kiwi Fencing should adopt the less dangerous action. 3. Mr. Dakin's price skimming solution. The MASTERMARKETERs solution. Mr. Dakin's recommendation is most likely to be successful in not provoking a price reduction of competing Steel Wire products. Agricultural customers are likely to be sensitive to substantial price reductions offered for products these customers are using currently, but not to new products. The new plastic boundary wire is a new product for which agricultural customers have not personal (singular data, again) evidence that the new product will perform as claimed. 149

The strategy for introducing Plaswire boundary fencing should focus on gaining an adequate return on the development and marketing investment and n o t gaining a specific market share objective nor national distribution. Kiwi Fencing needs to identify a few (three to five) of their current manufacturing reps who would be enthusiastic about marketing Plaswire; most likely reps not currently representing Steel Wire. "Field trials" need to be accomplished with cooperating farmer and station managers to offer evidence that the new boundary wire actually performs well. In such field trials the cooperating agricultural customer agrees to use the product without paying for the product until the end of an agreed upon test period. Such "innovator" agricultural customers usually are younger, well-educated, economically successful, and l e s s active than other agriculrural customers in trade associations.

New Product Pricing Decision Checklist Whereas intuition based on experience and insight is helpful, it is not sufficient for pricing products developed from new technologies competing against a large installed-based product based on an older technology. The new product, pricing strategist in such situations may benefit from seeking answers from multiple sources to the following brief checklist of questions: CUSTOMER PRICE SENSITIVITY? How do different customers, and different segments of customers, respond to different price points (assigned to the new product) in terms of the share of their available business they will award to the new product versus the existing products they are buying? For the new product, are customers more or less sensitive to different price points compared to changes in levels/configurations of other features and benefits? Using research methods that include asking a few customers to hypothetically make such concrete choices is useful in answering these questions; for example, hybrid conjoint analysis provides useful estimates of how customers will respond to different price points for new versus existing products [see 4]. COMPETITORS' RESPONSIVENESS TO DIFFERENT

PRICE

Moore and Pessemier [5, p. 201] note that "the magnitude of the [competitors'] response is likely to be proportional to both the degree of injury or the extent of the opportunity an action provides and competitors' capacity to respond" Determining competitors costs is helpful but not good enough in answering POINTS FOR THE N E W PRODUCTS?

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this question; the new product pricing strategist should search for information on how specific competitors have responded to such threats in recent years. The competitors may be willing to sustain losses for several months or years if such a strategy will work to prevent successful market entry of the new product. DOESTHE RECOMMENDEDPRICE COVER FULL COSTS AND "NORMAtYPROFITS? Products created using new (often electronic-based) manufacturing technologies often result in the counterintuitive combination of higher performance and conformance quality and lower operating costs for both the new product marketer and customer. Consequently, a wide latitude may occur of acceptable price points relative to the prices of existing products based on the older technology. Thus, pricing the new product at 50%, 70 %, or 90 % of the competitors' prices may each result in acceptable projections of new profit. However, the new product strategist needs to prepare proforma, financial spreadsheet analysis of different estimated demands and for different levels of competitors' responsiveness, for example see Clarke [6]. PRIMARYPRICINGOBJECtiVE? Does the new product marketer want to avoid or start a price war? Is achieving a posirive cash flow in year one a priority? Is a 30 % market share by year 3 the top objective? Answers to such questions need explicit consideration in pricing new products created from new technologies. Such questions and answers should be reviewed for different scenarios of customers' and competitors' sensitivities to new product pricing and different costs and net profit estimates. Using such sophisticated "what if" analysis leads to wisdom and sound pricing decisions.

REFERENCES 1. Kahneman, D., and Tversky, A., IntuitivePrediction:Biasesand Corrective Procedures, in TIMS Studies in Management Science, S. Makridakis and S. C. Wheelwright, eds., 12, 313-327 (1979).

2. Kotler, Philip, Marketing Management. Prentice-Hall, Englewood Cliffs, New Jersey, 1994. 3, Oltman, Debra Olson, and Lackritz, James R., Statistics for Business and Economics. Brooks/Cove, Pacific Grove, California, 1991. 4. Woodside, Arch G., and Pearce, William G., Testing Market Segment Acceptance of NewDesignsofIndustrialServices,Journal of Product Innovation Management 6 185-201, 1989. 5. Moore, William L., and Pessemier, Edgar A., Product Planning andManage-

ment. McGraw-Hill,New York, 1993. 6. Clarke, Darral G., Marketing Analysis and Decision Making. The Scientific Press, RedwoodCity, California, 1992.