Before we move to a discussion of value based pricing it is useful to look at couple of commonly held beliefs which often inhibit managers from increasing prices:
The first is that high prices are incompatible with high(er) levels of sales or market share. In fact, however, in many industries market leaders tend to charge higher prices. This has been confirmed by studies across the board (this does not refer to so called Veblen or exclusive / positional goods or goods with strong premium branding usually found in B2C industries). The higher price is a reflection of the differentiation, both explicit and implied, of the offering.
The second is the notion that customers are highly price sensitive. The reality though is that managers frequently have an exaggerated sense of price sensitivity of customers. According to studies there is an inverse relationship in perceived importance of price between sales managers and corresponding purchasing managers. In surveys sales people tend to rank price significantly higher in importance than buyers, who rank product and service attributes higher. Surveys, of course, do not always obtain truthful answers: For sales people a reduction in price to win a deal is an easy way out (particularly as they also want to uphold relationships built over what is usually a long time), while buyers can be constrained by corporate policies that may be strongly price driven. Nevertheless research in price awareness of buyers also suggests that it is frequently overestimated and that therefore managers as price setters have often more leeway than they seem to think.
In the previous article in this pricing series we saw that competitive pricing is based on competitive products in the market. However given that no products are identical (apart from commodities, however even there, while the core product may be a commodity the total offering may not be, as it might include differentiating attributes such as delivery or other services) this requires a comparison in terms of how products perform relative to each other in satisfying customer needs (providing benefits) and this in turn requires some proxy of customer value, while retaining the competitive product as a reference. For example if product A includes more valuable features than product B it makes sense that product A is priced higher than B. Nevertheless this is an area where many companies go wrong by misunderstanding what customers actually want (and are prepared to pay for) and it is often the case that companies misprice products either underestimating or overestimating their value relative to the competition (one should not forget that in the case of after sales services, business process outsourcing or outsourced maintenance etc. the competition might well be a customer internal process or department).
Value based pricing goes a step further in the sense that it advocates setting prices according to value created and perceived by the customer. In effect this implies a pricing range between the supplier’s cost (assuming that suppliers will not sell below cost, not counting the special case of loss leaders) and customer perceived value, where value is defined as benefits minus cost (including what is paid to the supplier and any costs incurred beyond that). The price that ends up being paid therefore effectively determines how value created is shared between the customer and the supplier.
Two issues need to be dealt with here:
First, benefits (and value) usually are quite subjective and are therefore customer specific. In addition they may be driven not only by economics, but also by strategic, organizational, social or other factors. Therefore not only quantification is difficult but even understanding the context of value creation from the point of view of the customer is a challenge for any supplier and requires significant resource investment.
Second, to make the notion of value an “operational” concept, useful for a supplier’s price determination –and avoid a circular logic situation in which value is defined in terms of the supplier’s price and vice versa- it is necessary to de-link its definition from that price. Useful, for example, could be a definition where value is defined as the price of a customer’s best alternative, a so called reference value (assuming it is known or can be estimated) plus the value (which can also be negative) of whatever differentiates the supplier’s offering from that alternative. This definition is also not perfect because it is still necessary to price the incremental value, but is better because it narrows the range and therefore limits mistakes and allows a comparison with a reference value which for the particular supplier can be deemed “objective” (if the customer is willing to pay the price of the reference product or service).
If therefore one were to adhere to this definition, pricing could be determined on the basis of the following steps:
- Identify the cost (price) of the competitive product(s) / service(s) that a customer views as best alternative(s). This doesn’t have to be a physically similar product or service process, but anything that performs the required function and achieves the result the customer requires. It is important to understand that this must be done from the point of view of the customer not the supplier.
- Segment the market / Understand the customer: Significant differences in perceived value arise from the way customers use (and therefore derive value from) the product or service and the respective reference products. These differences result from distinctive customer characteristics and other (external or internal) factors which drive customer behavior. For example a company with a broad product line, limited available physical space for inventory and rapid response times will assign a higher value to just in time delivery than a company with only one product line and ample space for inventory. In similar fashion a company building a greenfield plant which has difficulty recruiting a sufficiently skilled workforce to operate and maintain it will assign a higher value to outsourced maintenance than a company successfully operating an existing plant, which has invested significant resources over time to train and sustain its workforce and maintenance management systems. A company whose downtime is very expensive (e.g. process industries) will assign a higher value to a rapid repair response service, fast spare parts delivery or, in fact, services designed to prevent failures from happening at all than a company whose downtime is less expensive (e.g. due to inventory buffers between process steps). These preferences though might change over the economic cycle and will also depend on a company’s relative situation in the market or even its proximity to sources of know-how and skills: The same company might behave quite differently in terms of its preferences and choices in an emerging market than an industrialized market.
- Identify, make tangible and quantify all attributes and features, including “soft” non-technical features such as perceived reliability of vendor or ease of doing business, that differentiate the product /service from the reference product / service. It is necessary to emphasize that this again must be done from the point of view of the customer: One of the greatest risks lies in trusting internal perceptions of which attributes drive customer choice under which circumstances -and a host of empirical / analytical tools is available to help in this exercise.
- Assign a monetary value to all relevant differentiating factors. For some of these factors this might be fairly straightforward, for others more difficult. For example experts can fairly easily define and quantify in monetary terms the benefits of technical features / attributes of industrial machinery, an excellent spare parts service or an O&M service designed to improve reliability and performance of plant. It is much more difficult however to value a vendor’s response capability, capacity in resolving problems, responding to non-standard challenges or sustaining performance over a long period of time. Needless to say that valuation issues are overall more pertinent in services simply because services are produced and consumed concurrently and the customer has no means of knowing the “quality” (in a very broad sense) of a service before it is actually produced and consumed. This makes the notion of “social proof” (the reputational capacity) of a vendor much more important (which can be provided through track record and references, testimonials, certifications, various forms of communication and other means). Nevertheless, in the end, some form of performance guarantee might be more important in services than in products.
- Sum the reference value and the differentiation value to obtain the total (economic) value. It should be understood here that these values may vary significantly across customer segments or categories, therefore the result will not be one monetary value, but a range or pool reflecting the fact that different categories of customers will assign a different value to the various differentiating factors and so to the product or service
- Use the value pool to determine different price points. For standard products or services or when a vendor wants to offer a standard price to all customers, any price point sales would include a significant share of all customer segments which value the product higher than the specific price examined. Alternatively for one-off products (projects) or special types of services (e.g. large specialized service contracts) a vendor may offer specifically tailored prices.
In summary: Value based pricing attempts to use price as a way for suppliers and customers to share the (incremental relative to the next best alternative) value created and perceived by the customer through an offering. This value, which can also be non-economic, must be quantified and made “operational”. This requires suppliers to expend significant resources to identify and deeply understand both competitive alternatives as well as the real requirements and thinking of customers in the context of their circumstances. It assumes therefore a significant degree of marketing sophistication and an astute sales force.
The next articles in this series will deal with specific aspects of value based pricing in services, the issue of price getting (rather than price setting) and obstacles in using value based pricing