Amazon’s New Price Hack

Chris is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

When consultants approach problems regarding how to price a new product, they look to a four-part framework.  Three of the options are traditional ways of pricing a product, and the fourth is innovative.

1. Cost-Based Pricing

In cost-based pricing companies look at their costs per unit then add in their respective profit margins.  Let’s say, for example, that a company paid $75 to produce one unit, the company wants a 20% profit margin, and the retailer wants a 10% margin.  X represents the target price, and the math looks like this:

X - .2X - .1X – 75 = 0 

.7X = 75 

X = $107.15

Based on the company’s goals, the target price is $107.15 per unit.  This pricing method works best for firms that are first to market. 

2. Price-Based Costing

The opposite of the first, price-based costing asks how much consumers are willing to pay for a product.  It essentially asks, “How much value does this product add?”  Firms figure out their desired margins then determine a price.  For example:

  • Value to consumer is $200 per unit (or consumer is willing to pay $200)
  • Company wants 20% margin
  • Retailer wants 10% margin

Price - .2(Price) - .1(Price) = Maximum Cost 

200 – 40 – 20 = 140

In this case, the company is permitted to spend up to $140 to produce each product.

3. Competitor Analysis

In competitor analysis, firms look at the market and see what price gaps they can fill – or see if they can compete at the same or slightly higher price point by adding more benefits and features. 

For example, let’s say that Company’s A, B, and C sell Gala apples for $2.99 per bushel.  Company D enters the market and has a few options.  It can undercut its opponents and charge $2.79 per bushel; it can provide higher-quality apples and charge $3.19 per bushel; or it can advertise that it cleans its apples so consumers don’t have to – and it charges $3.39 per bushel.

4. Company Objective

The firm does not have to make a profit upfront.  Hewlett-Packard falls into this category with its simple printers and ink strategy.  HP sells its printers at a slight loss and makes up the margins by selling ink.  In order to boost its market share, HP makes all types of printers at different price points with many different features – including scanners, copiers, and fax machines – so that it can satisfy nearly every conceivable printing customer.  Then it earns significant margins by selling the ink.

The strategy is also popular with cross-selling, and this is what Amazon (NASDAQ: AMZN) is doing right now with its Kindle Fire.  The purpose is to get market share and to get eyeballs on their Kindles.

Revitalizing an Industry

The pricing framework can often work by starting with #1 and #2 then progressing, meaning that an industry starts with strategy #1 or #2 and takes huge margins.  Then the industry saturates and gradually moves toward strategy #4.

For as long as the tablet market has been alive, companies have made their money on the front-end of the sale, meaning that they profit when they first sell the tablet.  That’s it.  Apple (NASDAQ: AAPL), Google (NASDAQ: GOOG), and Microsoft (NASDAQ: MSFT), the major players, have all thought this way.

Then Amazon comes along.  Amazon turns the business model on its head by trying to profit from the back-end, meaning that it wants to just get its Kindle Fire in people’s hands then turn those users into a recurring revenue stream by cross-selling items like Amazon Prime, advertising, and apps.

Jeff Bezos’ model is certainly industry-shaking – he estimates that the 4G Kindle Fire users will save $400 in just the first year over Apple’s equivalent product.  Here is how the products all compare.

Competitor Analysis

Apple’s lowest-priced tablet starts at $499 and runs up to $829, which has 64 gigabytes of memory.  Customers then select which cellular carrier they use – Apple offers AT&T and Verizon – before ordering.  Remember that the cost does not include a data fee of $180 per year.  More of Apple’s specs are easily found on the firm’s website.

Google has hopped into the market by selling Google Nexus 7, its $199 tablet.  Google is staying within the low-end price point, but its competitive advantage is that it offers a $25 credit to Google Play and a free copy of Transformers: Dark Moon.  Furthermore, its content selection includes more than 600,000 apps compared to Apple’s 250,000.

One last strength of Google is its marketing reach.  Google cleverly featured its new tablet on its homepage, which is viewed by an astronomical number of people each day.

Microsoft is also in the mix.  Its Surface tablet is a colorful creation that runs the new Windows 8.  But Microsoft is far behind.  The company’s website says that the tablet is “coming soon.”  Too bad that most customers will have already purchased a tablet by the time Microsoft gets around to finishing its product.  To learn more about Microsoft’s tablet, the firm’s sleek website has great photos.

Finally, Barnes and Noble’s (NYSE: BKS) Nook is on the market.  The Nook’s $149 price is on the low end of the pricing spectrum, mostly because it lacks any kind of prestige.  The Nook is not a bad product – it has all the essentials of a tablet, and it offers good syncing with Barnes and Noble’s 2.5 million books.  Also, Barnes and Noble sells an e-reader for $99, priced above last year’s Amazon Kindle price of $79.  Sadly, Barnes and Noble’s tablet is not much of a threat.

Amazon Fires Back

In contrast, here are Amazon’s new tablets at their differing price points (source: Wall Street Journal).  From the new release, it is clear that Amazon chief Jeff Bezos wants to compete with Apple, which shipped 68% of all tablets in 2012. 

<img src="/media/images/user_13210/9-10-12-amazons-new-price-hack_large.jpg" />

In conclusion, Amazon is changing the tablet game.  The company has shifted business models from the old-guard approach of front-end profits to the innovative solution of back-end continuous cross-selling where Bezos hopes to turn its users into a recurring revenue stream.

Industries often go from high-margin businesses at the outset to more efficient pricing once competition enters.  Then a company like Amazon enters the space and shakes everyone up.  The outcomes will be exciting to watch.

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ChrisMarasco has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple,, Google, and Microsoft. Motley Fool newsletter services recommend, Apple, and Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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