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The Next-Best Alternative

July 2014 Pricing, Product

Needs are primitive; what changes with time are the options available to address them. Successful firms are always on the lookout to create more options for the customers. Undoubtedly all products are designed and launched with the noble intention of making life better in some way or another. However not all of them survive in the market place for long. This article aims to provide a primer on what it takes to make a new product survive in, if not rule, the market.

To begin with, let’s understand that an innovation is marketable only when it addresses a particular customer need.  The need was always there, but was previously addressed differently.  So at launch, even the most innovative products are in competition with multiple available alternatives.  Sometimes the alternatives are easily identifiable; sometimes they are less obvious. To be successful in such a landscape, it is important for a firm to be able to foresee where their new product would fit in vis-à-vis the existing alternatives.  I will share here a framework for better understanding the alternatives, and in the process understanding the target customer base more realistically.  Understanding the correct customer base is highly critical, as it can realistically predict the revenue and profit that the new product would generate.  This knowledge, in turn, would make a firm cognizant of the return on investment of the product and hence help make a go no-go decision with ease.

There are two dimensions to consider while deciding whether to invest on developing a new product:

  1. Value of the product with respect to the existing alternatives.
  2. Ease of switching from an existing alternative product to the new product.

So let’s study the dimensions in a bit more detail…

Value of the product

The value of a good or service is relative to its next-best alternative.  Empirically, value can be defined by the following equation:

Value = Differential Benefits – Differential Cost

Please note when I say differential, I mean differential with respect to the next-best alternative. Thus a new product will be deemed valuable if either it is has better features and performance than existing alternatives (even at a higher price), or if it is a lower-cost solution to sufficiently address a particular need (with performance/features less than existing alternatives).

There are in fact two steps to position a product as more valuable –

  1. Calculate the value of the product with respect to the alternatives – This is done by making use of exchange value model.  The price of the next-best alternative is taken as a reference, and the value of the new product is calculated by adding dollar values to the additional features or deducting dollar values for features which are removed.  The total economic value can be higher or lower than the next-best alternative.  Yes, it is okay to have lower economic value than existing alternatives.  The next-best alternative may be just too good and thus too pricy for addressing the need.  Imagine a world with only private jets for travel and five-star resorts in which to stay.
  2. Price it right – The price of the new product has to be less than the economic value of the product or else why would the customer switch at all?  If the price is less than the economic value, then by default the customer would see the new product as more valuable (going by the above equation).

It is important to foresee the correct price while planning a new product. Understanding the value well is the key to pricing it right.  Foreseeing the right price is important for understanding whether an offering is worth launching at all.

While launching the iPod to the market for the first time, Steve Jobs positioned it against the CD player, flash player, MP3 CD, and hard-drive jukebox player, and explained the limitations of each of them.  He used the unusual but convincing metric of cost/song to explain why the iPod was the best-value option.  He then went on to highlight the iPod’s ultra-portability and its other value-adds, and finally stated the price.  By the end of the presentation, the audience was convinced about the product and price.  The fact that 125,000 units were sold in the first month itself demonstrates the success of the iPod.

You can check the full video here.

Ease of switching

Unfortunately the due diligence doesn’t end with merely understanding the value and how it relates to price.  What if the new product is valuable but fails because the customers are not willing to switch due to switching barriers?

In September 2013, an article published in Forbes titled The Problems with Reinventing CAD Softwaretalked about the difficulties faced by the new design softwares in capturing the CAD market because most designers are reluctant to switch from existing softwares like AutoCAD.

From my understanding I have identified the following roadblocks to switching:

  1. Financial – If a large investment has been made on the current solution, switching can make that investment seem like a waste.
  2. Cognitive – If the customer is fully accustomed to doing something in a particular way, they may not be impressed by a new solution (though it may better or cheaper).
  3. Behavioral – I would call this block “inertia”.  Switching may be a challenge due to lengthy associated processes. A solution may not be compliant with existing protocols, making it difficult for customers to accept the full time and energy costs of switching.

It is important to be aware of the switching barriers, not only to craft strategies to overcome them, but also to be able to predict the correct target market size.  For example, the new CAD companies are facing a cognitive switching barrier.  A good way to overcome them could be to team up with engineering institutes so that new engineers graduating from universities are knowledgeable about the new softwares.  Some of these engineers will be future decision makers for firms.

Finally, the framework:

While the value analysis is a predictor for price, understanding the ease of switching would be useful predicting the volumes.  Thus, together, these two analyses can help correctly forecast the revenue:

[Note: NBA = next-best alternative]

Sengupta 1 July 2014

[Note: different areas and fields use differing terminology for “economy customers” and “savvy customers”, the most common of which probably being “price-sensitive” and “value-sensitive”.]

The reason I have indicated new “economy” customers as green, while placing new value-sensitive customers in the yellow category is because new price-sensitive customers are easy to locate.  For example, with the introduction of low-cost airbuses in many countries, the biggest change is the increase in travelers choosing a plane-based solution.  Even when existing air-travel customers are reluctant to switch to a new solution, an economic solution can definitely find acceptance amongst customers who were unable to use existing alternatives due to the price barrier.  The same may not always be true for the segment relying totally on “new savvy customers”.  We observed that previously when we studied the difficulties of the new CAD softwares.

From a pricing standpoint, the following pricing strategies are recommended for each situation–

Sengupta 2 July 2014

 



About the author

Anirban is a core-team member at Lifkart (an Early stage Indian Construction Start-up). Prior to the current gig he worked for about 5 years as a pricing manager at Cypress Semiconductor. He holds a BE in Electrical Engineering from National Institute of Technology , India and an MBA in Marketing from Symbiosis Centre for Management and Human Resource Development (SCMHRD), Pune, India.

Anirban Sengupta
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