Pricing Strategy Is My Business

The SECONDS Framework

NOTE: This framework was first developed by me (Adam Juda) in February of 2020.

Introduction

When business owners want to increase their profits, they often introduce new product lines.

Unfortunately, these titans of industry tend to use an ad hoc approach to deciding which offerings should be produced. Such methods are far too reliant upon luck and, inevitably, result in unpredictable outcomes.

The SECONDS framework is an attempt to formalize the process of evaluating potential product lines and minimize the role of luck in the equation.

Although originally intended for the software field, the SECONDS method can be applied to other disciplines as well. Please keep in mind, however, that this model is a work in progress. If you have any comments or suggestions, please let me know.

Scalability

Producers with economies of scale have a leg up on the competition: their per unit cost of production drops as the number of units produced increases. All things being equal, products that enjoy economies of scale are more profitable than those that do not, once a minimum threshold of production has been met.

There are a variety of methods that can be employed to increase a firm's economies of scale, but two of the most powerful are standardization of offerings and mechanization of production.

It should be noted that just because something is scalable, it need not be scaled immediately. It is often a good idea to confirm market fit before investing heavily in the fixed costs that generate economies of scale. Many software vendors, for instance, will utilize manual processes behind the scenes to keep expenditures low in the short term. Avoidance of scaling in early states will also allow for an earlier introduction of a product and provide the potential for a greater first-mover advantage.

Expensiveness

The greater the price of a finished product, the higher the indication that the offering is both highly valued, and, commonly, faces minimal competition that would otherwise drive its price down.

While there are many companies that earn their profits from low-margin, high-quantity sales, this approach is far from ideal. Attracting and servicing a large pool of customers can be expensive. Not only do the masses possess a wide variety of preferences, but they also respond differently to signaling, and they can be quite difficult to reach.

It's often simpler, and more efficient, to market to small groups of buyers who are willing to spend large sums of money. Even if a firm intends to pursue a mass-adoption strategy, it may still make sense to start small and utilize price skimming to maximize profitability, prestige, and cash flow.

Many firms prove far too shortsighted when evaluating the expensiveness of a given offering. While the initial outlay of cash by buyers should be taken into account, some offerings, due to their recurring nature, the cash flow of the targeted customer segment, or availability of credit may prove more valuable than those that possess higher initial prices. The razor and blades model is but one technique that can yield significant long-term profits despite significant short-term losses.

It should be noted that expensiveness is not just a measure of what buyers will pay on an absolute scale. It is also a relative measure that refers to the magnitude of difference between the final price paid by the customer and the cost of production paid by the vendor. The greater the spread between these two prices, the more desirable the product line will prove to its potential vendor.

Cannibalism

Most companies already possess existing portfolios of offerings, and these portfolios should be taken into account when evaluating a potential addition.

In general, a product line that cannibalizes, or steals, income from an existing offering is likely an inferior option that creates entirely new streams of income.

Astute readers will note that I used the word likely. While it's always a good idea to be wary of cannibalization, this fear should occasionally be ignored.

Do you know which company developed the first digital camera? It was Kodak, a firm that was so afraid of damaging its profitable film offerings that it chose not to release its innovative digital camera until it was too late to matter.

Long story short, it's often a good idea to avoid cannibalization unless a long-term strategic reason to do so can be identified.

Opportunity Costs

As demonstrated by the production possibilities frontier, businesses can't build everything at once. There are limits to the resources that they can obtain and invest at any given time.

Some resources can be converted to others quite easily. A large furniture company can convert dollars into bolts of fabric almost as easily as a restaurant can convert a waiter into a busboy. Other types of resources are much harder to replicate. A research lab may find itself unable to locate a scientist with a rare specialty at any price in the short term.

In most cases, the product line that utilizes the least valuable and most easily acquired resources should be prioritized over others. Such prioritization will allow the most worthy resources to be used for other purposes.

Network Effects

Some products become more valuable to their users as they become more popular. This augmentation in value is known as the network effect. The characteristics that create network effects are many, but often involve the inclusion of interoperability. Telephones, for instance, famously increased in value as more and more people began to use them. This is because each time a phone was installed, every other phone user gained an additional party that he could call.

Some products that do not possess network effects can still benefit from them. Offerings that are complementary goods to products exhibiting network effects can still prove worthy of attention. For instance, headphones are not considered to be products with network effects. If I were to purchase a pair of headphones, the value received by any other headphone owner would remain unchanged. That said, each time a cell phone is sold, Apple has the potential to earn quite a bit from the sales of its AirPod headphones.

Defensibility

It's one thing to come up with a great idea for an offering, but if a firm's position in the marketplace cannot be defended, its profit margins will be short-lived.

No company can produce a perfect defense. All firms can do is attempt to dissuade potential competitors by making the prospect of competition appear as expensive, difficult, and unenticing as possible.

There are many types of defenses that can be employed. Here are a few:

It should be noted that without constant vigilance, even strong defensive positions tend to weaken over time.

Scope

One of the biggest mistakes that businesses make is not recognizing the importance of economies of scope that provide firms with a cost advantage when producing similar types of output.

Creating economies of scope is fairly straightforward. It involves sharing the same resources and means of production across product lines. The fact that shared resources lead to lower costs should be obvious; as resources are obtained in greater and greater quantities, they can typically be acquired at lower per unit costs.

There is a less frequently discussed advantage as well. Firms with strong economies of scope can often reallocate resources between product lines as market forces change. This provides a strong benefit of resilience that may not be obvious in financial statements.

Conclusion

The creation of a new offering is often fraught with risk. A manager can accept that risk by going with his gut, but a more advantageous approach is to use a formal framework to evaluate his options and select the most favorable. SECONDS can be used for just that purpose.

Why aren't you using SECONDS?