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?

Moving to Customer Driven Product Development and Pricing

Does this sound familiar?

  1. Long list of features that are thought to be cool and must-haves. Most of them compiled by looking at other products in the market and  by generalizing from an individual’s personal pain-points and wish list.
  2. All these esoteric features hastily force-fitted into benefits – because marketing is about benefits and not features.
  3. Search for customers – and if the first set of customers don’t like it, try another and another

If this is the product development flow then it inherently drives a marketer to commit the mistake of cost based pricing.  Since product development starts with features, pricing starts with cost — cost of components, cost of R&D etc. Then a marketer tacks on an artificial margin that is treated as sacrosanct and determines the price.  Then they search for customers with needs and  are willing to pay that magical price. Economic value add to the customer does not picture in this process. As the marketers find fewer customers willing to pay that price they resort to price cutting and eventually to complaining that customers decide on price not on “features”.

(Sidebar: The extreme case of this is what is happening with all things digital for which the marginal cost (cost to produce, store and distribute one additional unit ) is $0.)

Which funnel is yours?

Now consider this, take a look at the funnel on the right:

  1. Identify the needs and wants of different customer segments, select those that offer the greatest opportunities and you have unique competitive advantage in serving.
  2. Create a credible value proposition. Determine the product positioning to credibly answer the question, “what jobs are your customers hiring your products for?” and what benefits are key to get those jobs?
  3. Design the minimal product that delivers  those benefits at the lowest possible cost.

Starting with the customer segments and their needs leads a marketer to the correct way of pricing – value based pricing. Asking what jobs customers are trying to solve enables the marketer to create a credible value proposition. Calculating economic value add to customers reveals what the customers must be willing to pay for the product. Then it is applying innovation to design the product with the minimal feature set  that can be produced at a profitable cost.

When you start with customers and value the marginal cost becomes not the prime determinant of pricing but just a gating factor below which the products cannot be sold.

Which funnel is yours?

How is This For Cost Based Pricing?

[tweetmeme source=”pricingright”] Cost based pricing is tacking on a % margin to the cost of the unit instead of pricing your product/service based on the value it adds to your customers. Costs does not matter to your customers and nor should it matter to pricing your product. Costs matter only to the extent that it makes no economic sense to sell a product below its marginal cost. I am dismayed to see the extent to which people go to compute costs, allocating a share of every cost incurred to every unit sold.

Let me try to explain how ridiculous cost based pricing is by taking it to the extreme.

Suppose you ran a coffee shop that sold just one SKU (as I said I am taking this to the extreme to prove the point). As your customers buy their cup of coffee they see a row of jars in front of them. Each neatly labeled with

  1. a short definition of what it is for
  2. a dollar value

There is a jar for

  • mortgage
  • insurance
  • delivery
  • coffee beans
  • milk
  • utilities
  • bathroom cleaners
  • interest
  • depreciation on coffee machine
  • salary for employee 1 &2
  • childcare (for your child while you work)
  • profit

Each jar is also marked with a respective dollar amount.

You ask your customers to drop exact amount marked on every one of those jars.

Every time the price of coffee beans, milk etc goes up you re-lable your jars.

What do you think your customers will do?

Ask your self what your customer is paying for? Did they walk into your store to get their daily caffeine fix, experience the great ambiance you provide or to help you offset your costs?

Do you practice effective price management?

Value – Pricing Gap

How do you convince your customers to pay for additional products and services that are required to fix problems with the original product/service they bought from you? That is a challenge and a tough act. No marketer can charge for something that does not add net new value. While the marketer would like to position the new product in its own standing, customers view it as part of the whole. So the values and prices are treated additive. Unless the new product/service adds net new value it leaves no consumer surplus for the customers.

One such product is femtocells, which boost wireless signals indoors. The market projection for femotocells show a 200 times growth from their 2008 numbers by 2012. But the challenge is asking customers to pay for it so they can use their cellphones indoors. For one, customers may not be using their cellphones as much inside their homes and for the amount of time use they may not see value in paying $100 for a device.

How should the mobile phone service providers market femtocells? The first step is to augment the product, like Sprint did with additional data services that by themselves add net value to customers at the price point attractive to customers. The second step is realizing that the 20 million units market projections are just that and do not translate into revenues or profits. All these customers may have a true coverage problem at their homes but that does translate into willingness to pay for the device. Instead of looking at this as a product for the entire market, they should look at those segments that have a need for the product and willing to pay for it. For example, shopping malls and department stores that want to provide better coverage to their customers as a value added service. Looking at the market segment by segment reduces the market size as measured by number of units but drastically increases the size in dollars.

Back to Basics

For any marketer, the goal should be to maximize profits and take actions (legal and ethical)necessary to achieve that.  The key to profit maximization is knowing your customers and serving them better than your competitors do. About six months back I published on  Slideshare a simple tutorial on Conjoint analysis. Despite the esoteric name and the statistical analysis involved behind this, the premise is very basic – Segmentation and Targeting. I want to go back to my previous quote from Mr. A.G. Lafley’s book Game Changer,

As you work to better understand the WHO, you’ll discover that people use your product for different reasons. They may have different occasions for when and how to use it; differences about what they think is a good value, and what they are willing to pay. One size does not fit all.

Marketing is about finding those reasons, occasions, usage scenarios and hence what the customer is willing to pay for. If there is no congruence between what the customers value vs. what a marketer charges for and how much do the customers value the offering vs. the price a marketer charges,  they end up missing out on profits. The loss comes from:

  1. Foregone profit from lost sales – because the marketer is charging for the wrong factors or simply pricing it wrongly
  2. Forgone profit despite large sales because the marketer is not charging for things that customers value

There is nothing more fundamental and relevant than segmentation and targeting. But this message is getting lost in the noise created by fads like   “Free”, “freeconomics”, “economics of abundance vs scarcity”. It does not matter what market you operate in, what services you provide and what your marginal costs are, the basics of marketing remain the same.

Lose sight of your “WHO” and their reasons you lose.

Enough With The Marginal Cost Argument

Economists love to talk about, “marginal this, marginal that”.  Two relevant terms to producing and pricing widgets are, Marginal Cost (cost to produce and sell one additional widget) and Marginal Revenue (additional revenue by selling one more widget). The commonsense rule is no one should sell widgets at a price lower than its marginal cost, otherwise you are losing money on each marginal unit you sell.

Now there is wider uptake of the marginality concept among the some of the well known names of the digital media world. The first is Mr.Chris Anderson who makes a case for his “FREE” based on the argument that marginal cost of digital goods is $0. Recently, Mr. Seth Godin, author of several marketing books made  this same marginal cost argument about education. He  is making a valid point, except from cost and producer perspective and not from the consumer value perspective. He writes,

MIT and Stanford are starting to make classes available for free online. The marginal cost of this is pretty close to zero, so it’s easy for them to share. Abundant education is easy to access and offers motivated individuals a chance to learn.

Scarcity comes from things like accreditation, admissions policies or small classrooms.

The marginal cost is $0 only for units 2 through N, the first unit has a very high marginal cost (the cost to set up the operations and run it).    But that is still not relevant to the value argument.

Being admitted to the school, accreditation, the many learning opportunities from the classmates, the network and the complete immersion all are considerable value to the the customers (the students). The value-add  increases when schools restrict their class sizes and implement stringent admission criteria – in other words by creating scarcity.

Even for the digital course one could argue that with proper segmentation there exists a segment that is willing to pay for it or some aspects of convenience. Again it is the value-add to customers argument not the cost argument that is relevant to pricing.

For any marketer the key is to know what their customer segments are, what they value , what they don’t and make a credible value proposition. It is not about the marginal cost!