The Value Equation

For your customer the net value from using your product is total value created less the price they pay. The total value can come in the form of:

  1. Incremental revenue
  2. Decrease in costs
  3. Relationship value

As long as the total value created is more than what they have to pay for it, i.e., net value created is positive, customers are happy to pay. (Let us set aside Reference Price effect here).

For a marketer the value created from making and selling a product is  revenue (function of price)  less costs. As long as this is profit it makes sense to serve the customers at the price.

But let us put these two together.

The total  value of the customer and marketer  is = Customer Value + Marketer Value. This is the size of the pie.

Customer Value =  Value Created   – Price

Marketer Value =  Price    – Cost

Which means Total Value =  Value Created  –   Cost

Surprising to see price not being part of the total value equation? This does not mean price is irrelevant, it is the line that determines marketer’s share of the value created. While price is important in customer’s decision making and marketer’s profitability, it is irrelevant to total value maximization. To maximize total value you either increase total value created or aggressively drive down costs.

A moment’s reflection will convince you that both these levers are under the control of the marketer. Bigger the pie, bigger is the share of marketer even at current proportional division. This leads us to define the role of innovation. A marketer’s efforts are better spent not on pricing innovations but on innovations that drive up value for their customers and innovations that drive out costs from their operations.

What is your value equation?

How do you define your innovation?

Free Radical

[tweetmeme source=”pricingright”] As a follow-up to Mr. Chris Anderson’s talk at Haas Alumni Luncheon and his description of continuously decreasing marginal cost I talked about opportunity costs and when it replaced the cost to produce/store/serve one additional unit.

Let us set aside the cost discussion and focus on price. Mr. Anderson’s new book’s sub-title is “The Future of a Radical Price”. Free service with Ad supported business model is not new and Mr. Anderson says that as well. What he says about free model is the emergence of a “freemium” model. What is “freemium”? Mr. Anderson explains this in a letter he wrote to The Economist,

The big shift since the crisis has been the rise of “freemium” (free+premium) models, where products and services are offered in free basic and paid premium versions. Think Flickr and Flicker Pro (more storage), virtually all online games and even your own site (some free and some paid content).

So many users pay nothing and get limited service and some pay to get a different class of service. I am not certain why this is radical or new. Let us consider following scenarios

  1. Taxation on Paying Customers: The free users are irrelevant to provide service to the paid customers. In this case the business is simply throwing away money by serving the free customers. There is nothing new here. Paying customers subsidize the free customers – so paying a higher price to support the marketer’s higher cost structure. What is in it for these customers to support the freeloaders? If the business one day decides to jettison all free users, it is simply eliminating a cost function that has no associated revenue and giving value back to paying customers.
  2. Up-sell: The business depends on converting a part of the free users to paid users over a period but otherwise it does not need the presence of free users to serve paid users. In this case it is no different from a business spending on marketing to bring in paid customers. Any one free user  by herself is not important but as a collection she is. This is similar to a mail campaign that has 1% conversion rate. Each mail you send out by itself is not important, but it is as part of the whole bunch you send out. So suddenly eliminating free customers is the equivalent of completely cutting off marketing spend. As long as the business can hold on to current paid customers and  has other ways to acquire new customers it can cut-off free users. In this case too the model is no different from what exists  in non digital businesses. Incidentally, whether or not there is a  cost to serve one single free user is irrelevant because the relevant cost to consider is the total cost to serve all free customers.
  3. Value Distribution: The business needs the presence of free users to serve its paid users, in other words presence of the free customers adds value that is shared between the marketer, paying customers and the free customers. This is the classic two sided market, like eBay, in which one side creates value and hence is not charged and the other side consumed value and is charged for that. One again this is not radical. The presence of free customers is essential for the service and the paying customers who are not subsidizing free customers but compensating them for the value add.

Price is about capturing value created for customers, if the business chooses not to charge for that value-add then they do not have a working business model. Free is not a price, definitely not radical,  it is either failure to capture value, customer acquisition activity or  simply matching price with value added.

Pricing When Cost To Serve Is $0

What do amusement parks, airlines, hotels, baseball games, and  theaters  all have in common? Two things, first their capacity cannot be stored for future use and second the cost to serve one additional customer (marginal cost) is $0.  Once a plane takes off, all the empty seats in the plane expire, generating no revenue for the airline. How should a business price its service that falls in this category? Just because the marginal cost is $0 and the lost revenue opportunity should the excess capacity be sold at the lowest possible price?

There is a renewed focus (in the echo chamber of blogosphere), almost an obsession, with marginal costs and the fact that it is “spiraling to $0” for digital goods. Wired magazine editor, Mr.Chris Anderson, has been talking and writing about this and has a book coming in July. Before we go further I would  like to reiterate that what it costs to produce a product/service does not matter in how it is priced and higher capacity utilization is not a valid reason for lowering prices.

The answer to the pricing question lie in:

  1. Opportunity Costs: The cost to consider is not the marginal cost but the opportunity cost of admitting one additional customer – that is what is the lost revenue opportunity from selling one airline seat now at a lower price. Only airlines excel in implementing this pricing strategy that is based on yield management.
  2. Value: That said, the business should look at the value created for the customer using the service. It is common sense that a business makes profit not just by creating value but by capturing some of it.  Note that the value created is different for different segments (technically it is different for each consumer but it is hard to quantify).
  3. Reference Price: Businesses must consider the impact of low (or zero) price now on future profits due to the reference price effects. Once an airline sets a very low price or allows a customer to travel free because the cost is $0, then it risks setting a very low reference price in the minds of customers.  In the future, such customers will despise paying regular prices and may even be up in arms. The effect of reference price cannot be understated, despite the value added to consumers the reference price prevents the business from capturing a fair share of the value added.

Do you know your opportunity costs, value created and the reference price? Please use trackbacks to comment on this.