From my experience, value-based pricing is one of the most often used, yet least understood concepts in product management. While deceptively simple on the surface, most product managers have trouble turning it into something concrete. Sure it makes sense that a good product should provide value to the customer, but trying to get a handle on this is like trying to catch smoke with your bare hands. Luckily, this task is a bit easier for those of us in the B2B space since we don’t typically have to be overly concerned with the fuzzy intangibles so important in B2C like how our brand will help the consumer achieve their personal goals, laddering up to get closer to the consumer’s core values, and all that noise. But even still, understanding how your product can help a customer improve their business does not automatically translate into a price point.

Economic Value to the Customer (EVC), a concept I mentioned in a previous post, can be of great help in this situation – especially when you’re working on pricing a new product and you don’t have the luxury of existing sales data to calculate a demand curve (not that this is exactly easy either). Once you’ve completed the EVC framework for your product you’ll be able to use it to help diagnose why sales are slow, assist sales force personnel in negotiations and even determine which enhancements will result in the largest gains in customer willingness to pay.

The basic premise behind EVC is that consumers buy not just on price, but on the basis of the economic value that the price represents. This means that customers attempt to discern the Net Value of your product. For those that are mathematically inclined, you can think about it like this:

After customers gather information about all the options in the marketplace, they will (quite logically) select your product only if it proves to yield the highest Net Value relative to competing offerings. Reordering variables shows us that the price you charge for the product, therefore, must be less than or equal to the sum of the Differentiation Value (∆V) and the Reference Value (R). The Reference Value is the price of what customers view as best substitute and the Differentiation Value is the value to the customer (both positive and negative) of any differences between your offering and the reference product.

Said another way, a product’s total economic value is the price of the customer’s best alternative (the Reference Value) plus the economic value of whatever differentiates the offering from the alternative (the Differentiation Value).

Of the times that I’ve used EVC, one case illustrates the process extremely well. I was launching a bundle of web services that allow third-party service providers to automate receiving work assignments from their customers. Prior to this solution, the only alternative was a manual process, so in other words, the Reference Value was the cost associated with employing staff to manage the work conducted between the two companies. Through a number of conversations with managers at these firms I was able to uncover the fully loaded cost per employee as well as the ratio of employees relative to work volume on the average. These details unlocked the cost of the manual process and hence, the Reference Value.

The Differentiation Value consisted of a number of components. First, the new system would require an up-front investment in information technology to implement the web service interface. So relative to the manual approach, this was a negative – remember that your product will probably have pros and cons when compared to the competition. Benefits over the manual approach included reduced headcount, improved performance (increased throughput) and improved quality.

Once you have these details, calculating the Willingness To Pay (WTP) is fairly straight forward. Simply sum the dollar value of the cost savings generated from the labor reduction and the value of the productivity and quality gains. This exercise yields the maximum WTP. Note! This isn’t the price, but rather the amount at which the customer would be indifferent between the manual process and the web services. You’ll want to set the price below the maximum in order to share some of the value created with your customer and entice them to make the purchase. Economists know this as Consumer Surplus.

As you can see, the process of measuring your Differentiation and Reference Values isn’t exactly a plug-n-chug operation. Applying EVC necessitates effort and creativity, which requires you to think broadly about the sources of value for your product. Usually, in the B2B space economic value can be expressed as revenues gained or costs avoided by purchasing the product. This means you need to truly understand your customer’s business and how your product will impact it. Only then will you be able to determine if your pricing is doing a good job of getting a piece of the value your product is delivering to the customer.

It’s usually true that most members of an organization appreciate how pricing has the potential to be used as a strategic tool. Unfortunately, it is also fairly universal that many are at a loss as how to best incorporate pricing into their new product development process for strategic advantage.

At many software companies new products begin with a general awareness of a market opportunity and as the idea grows in shape and potential, managers may assign a team to work together to design a product that they believe will sufficiently meet the needs of the customer.  Once the product is more-or-less market ready, management assesses the current and future costs associated with developing and supporting it. In an attempt to be fiscally responsible, the price is set high enough to ensure that the costs are covered and a profit is generated.

Can you see the flaws in this method?

First, you can’t calculate sales volume and hence, unit-cost, without first taking into account the price. I apologize in advance, but we’ll need to briefly dust off the downward sloping demand curve to illustrate this point.  The greater utility a consumer receives from a product, the greater the demand; conversely, as prices increase (utility falls) and demand decreases. Thus, setting the price impacts the units sold and therefore the unit cost. Simply put, managers cannot assume that they can adjust price without changing the unit cost, which leads to an exercise in circular logic!

Another problem with the cost-based approach is that the investments are made up-front without considering the value that the new product will provide to the customer. In other words, at launch-time, marketing is put to the test of convincing prospects that the new product creates enough value to justify the price needed to cover costs. In the case of products that have overspent on low-value features, this may prove to be challenging indeed.

Value-based pricing solves these problems, but as a product manager, you need to start early! Rather than leaving pricing until the end of the process, pricing strategy should be determined before development is ever started. In this way, you can ensure that a product can be sold profitably at a target price. Think about it this way, once you have identified a market opportunity; determine what potential customers will be willing to pay based on the value that your anticipated product will provide. Determining whether to invest in the product or not then becomes a function of product development’s ability to develop the product at a cost low enough to make the price profitable.

With a firm understanding of the value baked into the product creation process, value-based pricing also makes it a great deal easier for marketing to create sales tools that effectively communicate your product’s value to prospects. Likewise, the sales team will have less motivation to reward the strongest negotiators by giving into pricing discounts.

Sounds great, yes? Well sure, but how do you know how much your target customer is willing to pay? How do measure the value your new product will provide? These are great questions and luckily a concept called Economic Value to the Customer (EVC) is a big help… but that’s a topic for another post (see Unlock Your Product’s Value with Pricing).