Pricing the Product — Pricing Principles
A beginners guide to Pricing Strategy — The role Pricing Principles play in maximising returns, the concept of Exchange Value to Consumer, theoretical application, and why Product Team should drive product pricing.
Pricing is something that only seldom gets its due importance. Many businesses, esp. startups, possibly go to the n’th depth of the product design, however, will mostly think of the price when the product is either about to be launched in the market, or after it starts getting beaten in the market post launch. Even then, only rarely they think of pricing strategically. Many a times, given limited resource, it’s just Cost-Plus. Sometimes, competition pricing clouts the decision. Rarely, the value generated by the product becomes the foundation for the pricing.
Result? Prices either end-up being set too low, or too high, or being offered with a completely wrong pricing structure. Hence, businesses fail to find enough customers who pass down the funnel, and product adoption fails to take-off. Pricing is about market perception. Pricing is about product adoption. Pricing is about success or failure of the business. Hence, businesses should take strategic approach pricing.
There are three components to the overall pricing strategy:
- Choice of a Pricing Principle: Cost-Plus, Competitive, Value-Based
- Choice of a Price Positioning: Market Skimming, Neutral, Penetration
- Choice of a Pricing Structure: Unit Pricing, Tiered Pricing, Bundled Pricing, Subscriptions etc.
In this article, we will focus on the Pricing Principles, what and why of Value-based-Pricing, and why Product Manager’s must understand as well as be skilful in the art and science of pricing.
So, what are the Pricing Principles?
As inferred from the report (Kurz & Toebbens, 2012), there are three fundamental Pricing Principles:
- In Cost-Plus Pricing approach, the list prices are mostly driven by company’s own cost structures which could possibly also be heavy on unwarranted overheads.
- In Competitive Pricing, the list prices are mostly driven by competitor’s prices followed by own cost structures. Customer’s ability and willingness to pay only seldom plays a role.
- In Value-Based Pricing, the list prices are mostly driven by the balanced consideration of all three variable, namely, (a) Customer’s ability and willingness to pay, (b) Competitor’s price levels, and © Company’s own cost structure and current price levels.
A lot has been said on these principles, and esp. in favour of Value-Based Pricing:
“When relying on Cost-plus or Competitive Pricing principles, pricing strategy and management are based on a too narrow array of decision making criteria.” — Kurz and Toebbens (2012)
“in face of competitive realities, old dependence on cost-driven pricing strategies and techniques must give way to profitable customer-driven pricing procedures.” — Forbis & Mehta (1981)
With specificity of B2B or industrial markets:
“To meet the demands of industrial customers seeking value, the seller must understand value from the buyer’s point of view and use that information in determining price.” — Shapiro & Jackson (1978)
Clearly, of the three pricing principles used in B2B markets — Cost Based, Competition Based and Value Based — Value-Based approach is considered superior. However, Cost-Based and Competitor-Based approaches continue to play a dominant role in practice. — Liozu & Hinterhuber (2012).
What is this Value-Based Pricing?
“Value-based pricing seeks to identify the value an offering delivers from the customer’s perspective and then charge accordingly.” (Smith, 2016)
Value-based pricing requires collecting data that can be transformed into consumable information and formulate customer’s perspective to answer:
- What do my customers need?
- How do my product impact those needs?
- What’s the perceived value of that?
The crux of the value-based pricing decision is then answering ‘How do I quantify this value?’, and ‘which of the values is pertinent for pricing?’
From the customer’s perspective, the value he derives is the quantified benefits he gets less the price he paid to get those benefits. Mathematically, this can be written as:
- Value (V) = Benefits (B) - Price (P) …(i)
However, in a competitive market, there is no absolute Value-Based Pricing, but rather a combination of Competitive and Value-Based. In this case, value for customer is not absolute, but rather relative w.r.t. the alternative choices or offers he may have. Differential Value can thus be described as:
- Differential Value (dV) = Differential Benefits (dB) - Differential Price (dP) …(ii)
If a: the firm, and b: closest competing alternative
- dB = Benefits’a - Benefits’b
- dP = Price’a - Price’b
Note that the customer will purchase only if the perceived differential value delivered is positive, i.e., criteria for purchase decision:
- Differential Value (dV) >= 0 …(iii)
From the customer’s perspective, differential benefits generally cover both tangible and intangible benefits that the customer derives, incl. any associated opportunity cost that he may save.
For example, the benefit of increased accuracy in e-commerce fulfilment can be quantified into reduced return shipping due to wrong fulfilment. The intangible benefit on this aspect could be that the customer is able to deliver better experience to his customer, which can be mapped into customer loyalty.
Concept of Exchange Value to Customer (EVC)
Exchange or Economic Value to Customer (EVC) of an offer is the maximum achievable price for the customer to find the offer attractive. (Smith, 2016)
For purchase decision, as per equation (iii): dV >= 0. Rearranging equation (ii) while applying criteria for purchase decision from equation (iii):
- EVC = Price’a <= Price’b + Differential Benefit (dB) …(iv)
Hence, from equation (iv) above, the maximum price a firm can demand is price of its closest competitor plus the value advantage its product has for the customer relative to that of its competitor’s product (Tucker, Spring 2010).
Note that EVC denotes the maximum price a firm may charge. However, basis fairness effect (Sanfey, et al., 2003), the firm may decide to forego some part of their differentiation value (Anderson, et al., Winter 2010).
Note: One of the most basic statistical tool to analyse EVC between two products, whether your own or competitors is ‘Cojoint Analysis’.
A Simplified and Theoretical Application
Above theory though valid, is only applicable from the customer’s perspective. In the real practical application, esp. in B2B scenarios, it’s not just difficult to get competitive prices in order to be able to evaluate differential pricing, it’s nearly impossible.
So, in order to make a definitive case for pricing decision, one must resort to capital budgeting concepts of Net Present Value (NPV), Internal Rate of Return (IRR) and Payback Period or Return on Investment (ROI). Each of the NPV, IRR and Payback Period can be derived from above eq. (i) described earlier as: Value (V) = Benefits (B) - Price (P)
Using DCF methods and putting dollar number to this Value, the criteria for pricing and purchasing decision could then be formulated as (Kapil, 2015):
- Net Present Value (NPV) > 0 …(v)
- Internal Rate of Return (IRR) >= Cost of Capital (CoC%) …(vi)
- Payback or Return on Investments (ROI) <= N years …(vii)
The final decision could be basis any of the above or a combination or all of the above.
So, why should Product Team set and own Pricing?
“Your price is the exchange rate on the value that you’ve created.” — Patrick Campbell, CEO of Price Intelligently
Value-Based Pricing is the Profit-Maximizing strategy among all pricing strategies and principles. To use Value-Based Pricing, the person pricing the product or service offered must understand the value that the customer and the customer segment derives from using the product or service. The person must also know and understand the competitive landscape: competitors, their prices, and the differentiating factors and value of those. Lastly, to ensure profitability, the person must also know the dollar being spent to build the product.
If there is anyone who can understand all these values, and should be able to put a dollar value on each of these values is no one but the person who defined the product, i.e., the Product Manager and the Product Team, and thus should be responsible for setting prices.
Therefore, if you are a product manager, or aspire to be one, of the many-many skills that you are expected to master, Pricing Strategy is definitely one of them.
For the aspiring PMs, next time and every time you see/use/purchase a product, do question the value that it is or it might deliver to you, put a dollar number on that value and validate if the return on investment (ROI) meets your expectations. Do the same with a competing product. See if you can do a mental math around how much would it have cost to make the product. Figure which one is priced right, and why?
This article has also been published on LinkedIn.
