Value based pricing- a hot topic in industry today, but what is it and why is everyone talking about it?
Is value based pricing about getting as much price from your customers as possible? Or is it about valuing your longer-term relationship with your customers, or improving your service? In fact, all answers are correct! What is clearly the case, is that cost-plus pricing for services does not always offer the customer or the supplier the best value, however there may be options to combat this with value based pricing.
This short paper is based on research on service pricing and brings together good practices in a solid academic framework. It provides business leaders with a guide on how to create a value based strategy to price B2B services.
Why value based pricing?
During a conference we recently attended, a phrase that kept coming up in conversation was “We should all switch to value based pricing”. An increasingly topical statement in industry today, however, the approach of value based pricing is also one which is not being discussed any further. No one seems to be speaking about HOW to actually achieve this goal.
Pricing is not new- even Oscar Wilde said: “Nowadays people know the price of everything and the value of nothing”. Companies need to focus on customer value in developing pricing strategies as pricing pressure in the industrial B2B market has been increasing as a result of changing customer buying behaviors. In this article we’ll delve deeper into why value based pricing can be challenging and why it has a huge impact on companies’ business.
Is pricing really a strategic capability?
Pricing is an important management tool to help achieve the firm’s objectives and has a huge impact on the financial results. It is a multi-departmental activity influenced by several functions within the firm that may attach different importance to pricing and the value drivers of the business.
Every business manager needs to be aware that pricing has an impact on customer satisfaction and that pricing is not only dependent on price itself. Pricing of services is dependent on situations in which a customer finds themselves in and the jobs in which they need to do at that time. This relation of pricing to customer engagement in this process is shown in figure 1 presenting:
- Cost plus strategy;
- Competition/market base strategy;
- Value based strategy.
Figure 1: Comparison of different pricing strategies according to customer, supplier and market participation
As shown in Figure 1, a range of pricing processes are available and used by firms. The concept of customer, supplier and market participation in different pricing strategies is explained further in the 3 following sections.
Cost plus pricing
The process of cost plus pricing starts with the firm determining the scope of their service. Here, a unit cost is simply calculated and a pre-determined margin is applied to set the price. This margin reflects the desired profitability of the firm. The customers are then told what will be ultimately delivered in exchange for the set price.
Competition/market based pricing
This process begins with pricing based both on the scope and the costs, then additionally on what the competition charges for a similar service. Setting the price here has an influence on the market situation. Large competitors tend to have a scale advantage over the smaller ones since their fixed costs are mostly lower due to a larger customer base. The last step of this process is presenting the customer with the value that is being offered through the service. Remember that data is in your CRM system and in the market – keep track of it.
Value based pricing
The value based pricing approach is based on analyzing each customer’s needs, pains and gains, and their willingness to pay. It depends on the customer interest and acceptance of price for a provided value. Here, the price is set for the offered value, and later the scope of the service itself is determined. Calculating the costs in this strategy is also necessary as they used to make a reality check and afterwards calculate the margin achieved.
Listen to your customers
Using figure 1 again for the comparison of different strategies, the process of pricing in cost and competition based strategies suggests to ask the question “why is the customer situated at the end of the process if all of the companies always state that customers are the most important?”. A juxtaposition to the truth, you will always hear stated that companies involve their customers in the co-creation of service value from the very beginning, but how can this be actually possible with a cost plus and competition based pricing strategy?
Now, how do we turn this approach around and place focus back on the customer? Straight away, let’s forget about pure cost plus strategy. This ‘simpler’ pricing strategy shows that the supplier can have a lack of understanding of the customer value and as a result the customer offering can be weak. In addition to this, the competition/market base strategy, which is endorsed by many companies, indicates that pricing is controlled by the market. As such, this removes focus from the customer and indicates that the supplier does not entirely understand customer value, showing that the resultant value outlined by the firms offering can also be low.
So, how should service companies price in order to bring the customer into the focal point? The answer is quite straightforward; by aligning pricing objectives, strategies and tools according to the holistic strategy of the company.
Note: pricing needs to be strategic… it must not be left solely to Sales, Production or Marketing departments. It needs to be driven by management and agreed by all the departments influenced by pricing
Figure 2: Process alignment towards holistic strategy of the company
Companies should create more customer focused objectives to choose pricing strategies that consider customer value. This means that when pricing services, you as a firm need to firstly understand how your customer creates value and secondly, where you and your equipment fit into this process. You need to know that pricing tools used also need to support the objectives of pricing and the pricing strategies. For example, a pricing tool supporting customer oriented objectives can be bundling as it is a way for firms to present the scope/price negations, thereby providing a different approach to customer value discovery and leading to improved customer experiences.
Source of pricing power
Here, a B2B example is given, showing that the source or pricing power comes from customer need states. Let me take you through the example of a simple bolt used in industrial equipment. Bolts are widely present in everyday life and more specifically, they are present in almost every technologically advanced machine or construction, from compressor valves and turbines, to the foundations of wind mills. So, what is the price of tightening a single bolt? The price of a single bolt varies from market-to-market, from machine-to-machine and from company to company. The most significant result of bolting, however, is the residual load that a customer requires from the bolting supplier. Now, to show where the pricing power of services come from, let’s imagine a situation where you exchange a single bolt worth a couple of dollars, in a compressor valve which is worth hundreds of thousands or install one in an offshore wind turbine, worth even more. How much should the tightening of one bolt be worth to keep the compressor running or the turbine safe on its foundation? In this case, bolting provides safety and savings on a huge scale however, the value of the service to each customer varies depending on the scope of the project. Here, not all customers are the same, so they should also not be treated with the same approach – figure 3
Figure 3: Customer value connection based on colors
Customer value connection shows that companies need to do what their particular customer values. If the value proposition you offer creates no customer value, it is then only a purely basic cost to your customer. It is time to use the “knowledge” about your customers to move to customer value propositions and find ways to deliver what is really valued. Hence, what they are really ready to pay for?
Firms need to consider what is core and what is standardized. It is important to be aware that pricing can be different for different modules. This means that the customer can pay a different price based on the “menu” or “á la carte”, and shows that there are multiple pricing points for services but what is really interesting, is that its components don’t change. So what is changing? It is the location and more importantly the type of service provision together with the customer need state. In the first mentioned case, the compressor valve is available in a workshop where the bolt can be tightened with use of onshore equipment, in a quite friendly environment. However, the tightening of wind turbine requires going offshore to harsh conditions with special trainings and guaranteeing the customer that a bolt tightened worth a percentile of the whole wind mill will provide safety from failing the whole project. This clearly shows that the customer gets usage, location and utility from the supplier. And if a firm is able to segment customer needs states and purposes for buying. It is also able to find the right pricing points for it. This helps to identify margin and revenue opportunities available to a company. This shows that that customer value identification process work for product based firms too.
Pricing waterfall for value based pricing
A prototype of pricing waterfall diagram displayed in figure 4 below provides guidance towards value based service pricing. It considers the most important aspects of pricing, starting from benchmarking competitors to considering the customers’ willingness to pay. As such, it helps you to triangulate on the value based price that your customer is willing to pay.
Figure 4: Pricing waterfall- a guide to value based pricing
The pricing waterfall diagram presents that single, inflexible offerings can limit companies to sharing limited value. Whereas, flexible offerings respond to customers’ changing needs. Also, flexible pricing based on all important factors helps to increase customer value. Offering flexible service dimensions that support customer choices, together with flexible pricing strategies can provide the supplier with additional pricing dimensions that can have a positive margin increase impact. The pricing waterfall in figure 4 highlights the importance of triangulation of pricing based on market analysis, internal value creation and customer value.
This article presents that pricing is a strategic capability and needs to be kept in line with the company’s overall strategy. There is a great need to focus on customer value creation during service pricing, and aligning strategies and tools to support the objectives set by the company. Understanding customer value rather than simply relying on cost-plus or market-based approach, is a key to pricing industrial services. Another very important step in the process of pricing, is margin calculation based on the identified costs and value price offered. It is essential to calculate the margins in order to assess the correctness and validity of the price.
To summarise, consistency in pricing is of great importance and needs to be maintained across all pricing objectives, strategies and tools used to determine the final price of a service offering.
So after reading this article, ask yourself again, “Should I switch to value based pricing?”. The answer is not always, but one can learn to determine situations, locations, needs and pains to price according to value.
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Value based pricing in the capital equipment aftermarket
Creating and measuring value: Alternative operations and maintenance business models
Shaun West PhD, is a Lecturer in Product-Service Systems at Luzern University of Applied Sciences. He has worked for over 18 years in the aftermarket for GE Energy Services (Italy), Sulzer Rotating Equipment Services (Switzerland) and RWE (UK) before moving to into his academic role. In each of the roles pricing has always been an important aspect, from estimating value creation, to M&A transactions and service contracts. Today in his academic role he is bringing together his industrial experience with academic rigor to investigate and disseminate key issues associated with product-services systems primarily in an industrial setting.
Dominik Kujawski has recently graduated with a Master’s in Engineering from University of Applied Science in Luzern where he gained experience by cooperating with Alstom, ABB and SKAN AG. Currently, he is concentrating on developing a start-up firm, Arvick, in the Netherlands. In each of the companies he worked with, service pricing played a very important role, from analysis of current pricing objectives, strategies and tools, to improvement of pricing through a customer-centric approach, customer value and Design Thinking methods.
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