The previous blog on Pricing Strategy for your Product, explored the factors that influence the right pricing strategy for your startup. The factors included industry dynamics, competition, initial capital expenditure, and the growth-profitability tradeoff. Here, we explore an example of a capital-intensive company in the automation machinery industry. The pricing strategy for hardware companies is a little more complicated!
We realised that immediate profitability that recovers initial R&D isn’t feasible due to high upfront investments. Instead, a cost-plus pricing strategy emerged as the most viable approach. This strategy allows the company to cover all costs, including significant initial expenditures, while recovering over time!
You would remember how Tony Stark moved from Mark I to Mark LXXXV suit to do the final snap. So, for us to reach the Endgame, the next challenge on our roadmap is to set a price that covers our expenses and margins, while positioning us favourably in the market. This is the intersection where analytics converge with strategy, and gut feelings align with data.
Start with the Production Cost!
- The production cost would include the hardware and infrastructure costs, which remains fairly constant over the years.
- Other major costs that we will consider here would be software and R&D costs. Software costs are assumed as a part of the R&D expenditure. The marginal cost is assumed zero here. This allows us to crank up our software margins and compensate for the fixed hardware and infrastructure costs. For this reason, software cost would be the anchor from where we would be deriving our margins and additional costs. (REMEMBER THIS AS AN AXIOM!!)
- We will take the R&D costs as the initial investment to develop the smart equipment.
For simplicity, we take the following numbers: These definitions are explained in the previous blog
Next comes Growth & Profitability!
Remember the discussion on growth and profitability. As you may have inferred till now, initially the driver would be growth to achieve profitability in the long run. So here we will consider the long term profitability of 30% over a time period of 7 years over the sale of the targeted number of vehicles.
The above figure presents the assumptions about the growth of yearly production of the equipment.
- We assume the number of units produced will double every year due to our focus on growth and expansion.
- As time passes, there are economies of scale in the production that lowers down the cost of production per unit. Then there is the impact of inflation that inflates the cost of production.
- For simplicity, we will assume that the effect of inflation and economies of scale are nullified. Therefore, the cost of production and hence price of each vehicle remains the same over the period of time.
We have accounted for the above assumptions and are now ready with the levers to set up the pricing. We will set the pricing to recover our production and R&D costs, along with 30% profit margins, over a period of 7 years.
Getting into the Numbers!
The aim is to come up with an anchor number that would represent the price of the equipment. Now, get ready because we are going to walk through a simple sheet full of calculations based on the assumptions laid down earlier.
Column B represents the number of vehicles produced in the year. It doubles every year as discussed earlier in the assumptions. Now, move your eyes to column C which shows the total number of vehicles running in that particular year. This includes all vehicles produced till the current year.
We can observe from Column E that the future prices are discounted to their present value using the discount rate method. This method is similar to the discounting method employed in DCF valuations. With a discount rate equal to the inflation rate (i.e., 6%), a revenue of Rs 100 in year 7 is worth Rs 20 in year 0 (refer to column E).
The Revenue Multiplier!
The intuition behind calculating the aggregate revenue multiplier (in cell E10) is the idea that 5000 units produced over the tenure 7 years is equivalent to the production of 1530 units in the base year. Recall the earlier axiom: Marginal software cost is zero. The pricing for the software allows us to compensate for the fixed hardware and infrastructure costs. Hence, the money to be recovered from software comprises of the R&D cost and the 30% margins over total (Hardware + Infrastructure) costs:
The Total HW + Infra Cost comes off as Rs 75000*(1530.33) = Rs 114,774,912.63
We get the total hardware and infrastructure cost by multiplying the total effective number of vehicles (cell F10) by the cost per vehicle.
Effective Hardware Units are 1530?
We multiply the effective number of vehicles (1530) by the cost per vehicle, rather than using the total number of vehicles (5000). We do this, because of the fact that vehicles are produced over a period of 7 years. They are produced in different years. But here we want to calculate the price for the base year (year 0/ current year). Thereby we take the effective number of vehicles and not the total vehicle count.
Get Back!
Accordingly, we determine that we need to recover around Rs 40,932,473.79 from the prices that we will set for the software. We then divided by the effective number of vehicles (1530) to get the software price of a single unit, derived from the method of cost plus pricing (see cell G2).
The final price of the equipment turns out to be: HW + Infra + Software costs = 50K + 25K + 26.74K = 104k or Rs 1.04 Lakh
Over the years, we consistently recover the software cost per unit. Cell G3 and subsequent cells in column G represent the discounted value of the fixed price (26.74K) to the present year, using the inflation rate as the discount rate. Check again: Rs 26.74K at the end of year 1, is worth Rs 25.2K today.
Next Steps
Hence, after all this computation we have reached our anchor number for the price of the equipment. The pre-assumed rates for inflation, production growth can vary from time-to-time and industry-to-industry. Hence these are changeable.
But is this the end? The answer is no. We will build with this price further to set up different sale strategies and purchase options for the customer. We will have a look at the strategy to make our pricing more effective.
The approach assumes a fixed margin over our costs, here. We are making a margin of 30% today on my costs! We can play around with these numbers as well as the growth trajectory. The numbers as the as growth changes and so does the pricing!