10/19/2013. Value-Based Pricing. Common Pricing Approaches. Target-return pricing Customer-driven pricing Competitive-based pricing Cost-plus pricing

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1 Value-Based Pricing Common Pricing Approaches Target-return pricing Customer-driven pricing Competitive-based pricing Cost-plus pricing 2 1

2 Customer-Driven Pricing Prices are set to reflect market conditions Short-term focus undercuts perceived value and depresses profits Buyers are professionally-trained to negotiate lower prices Buyers are rewarded for getting a lower price, not more value We should not accept whatever price customers are willing to pay We should raise the customers willingness-to-pay to a level that reflects our product s true value 3 Customer-Driven Pricing Undermines Value Creation Focus on what the offer is worth, not willingness-to-pay Sophisticated buyers will drive prices down Salespeople will want price exceptions in face of competition Never ask, What price are you willing to pay? Focus on buyers who will recognize true value of offering Price to profitably capture more value, not just make more sales 4 2

3 Cost-Plus Pricing Fully-burdened + markup = Price Ignores relationship between prices, demand, and costs Low-price items are typically over-costed Pricing death spiral 1. Increase price to cover costs 2. Higher price reduces demand 3. Lower demand increases average unit costs 4. Go to #1 and repeat 5 Value-Based Pricing Objective is profitability Translates differentiated benefits into customer perceptions of a fair price premium Discourage behavior that drives excessive service costs How is value captured? How is value communicated? What creates value? Who does it create value for? How is value measured? 6 3

4 Successful Pricing Strategy Principles Value-based Pricing reflects changes or differences in value to customers Proactive Anticipate disruptive events and develop strategies in advance to manage Profit-driven Evaluate price management success by what its earns relative to alternative investments rather than by revenues relative to competitors 7 Value Creation 8 4

5 Determining How Value is Created Features PRODUCT What do your customers want? Reliable Supply Benefits APPLICATION Why should the customer care? Minimize Excess Inventory Value $$$ CUSTOMER What is it worth? Lower Warehousing and Finance Cost 9 Total Economic Value Negative Differentiation Value Positive Differentiation Value Total Economic Value Reference Value (Next Best Alternative) 10 5

6 Total Economic Value Example Reference Value Competitive Product $1, Total Economic Value Example Maintenance Savings $50 Differentiation Value Increased Speed $300 Energy Efficiency $500 Reference Value Competitive Product $1,

7 Total Economic Value Example Differentiation Value Maintenance Savings $50 Increased Speed $300 Energy Efficiency $500 $1,850 Total Economic Value Intangible values, such as safety, application expertise, and troubleshooting support, are noted. The stated price is less than the total economic value. Reference Value Competitive Product $1, Total Economic Value Example Differentiation Value Maintenance Savings $50 Increased Speed $300 Energy Efficiency $500 $1,850 Total Economic Value Intangible values, such as safety, application expertise, and troubleshooting support, are noted. The stated price is less than the total economic value. Reference Value Competitive Product $1,000 $1,250 price charged (32% discount off of the economic value) 14 7

8 Why is Economic Value Important? Positive Differentiation Value Negative Differentiation Value Total Economic Value Induces purchasers to engage in a value discussion Reframes price premium as a discount off the unique value Competitive Reference (Next Best Alternative) Empowers purchasers to justify higher-priced choices 15 Pricing Policy 16 8

9 General Criteria for Pricing Decisions Operating Rate Price Focus Criterion Capacity < 80% Capacity < 100% Capacity > 100% Generate volume to cover all costs and also earn a profit Generate volume to create highest contribution dollars Use target gross margin to maximize profitability Maximize contribution per sales dollar generated Maximize contribution dollar per scarce resource Maximize contribution dollars consistent with target gross margin 17 Guidelines for Managing Price Competition Don t fight for every sale. Select your confrontations for maximum advantage. Do we have a cost advantage or product line synergy (pull-through revenue) to justify proactively competing on price? Can we design a cost-effective strategy for reacting to price competition? 18 9

10 Guidelines for Managing Price Competition Don t wait for competition to happen. Plan for it. Do you have realistic goals that reflect the reality of the competition? Do you have a plan that focuses your resources where you can win profitably rather than where the volume is or where traditional markets have been? 22 Guidelines for Managing Price Competition Don t wait for information to reveal itself. Use information strategically to avoid unnecessary confrontations. Regularly compile information on the competitor s pricing Make your price intentions, and their rationale, transparent To support a general price increase To defend your existing customer base To win at price competition 23 10

11 Pricing Psychology 24 Prospect Theory: Value Function People respond more to perceived changes than absolute levels. Value function is defined over perceived gains and losses relative some natural reference point rather than wealth. A difference between $10 and $20 seems greater than the difference between $110 and $120. The loss function is steeper than the gain function. Buyers are more risk averse than gain seeking

12 Compounding Rules Mr. Johnson was given two lottery tickets and won $50 in one lottery and $25 in the other. Mr. Dunkin was given one lottery ticket. He won $75. Who was happier? Johnson Dunkin 26 Compounding Rules Mr. Johnson received a letter from the national government saying that he made a small mistake on this tax calculation and owed $100. He received a similar from the local government saying he owed $50. Mr. Dunkin received a letter from the national government saying that he made a small mistake on this tax calculation and owed $150. Who was more upset? Johnson Dunkin 27 12

13 Compounding Rules Mr. Johnson bought a lottery ticket and won $100. Also, the same day he damaged the carpet in his apartment and had to pay his landlord $80. Mr. Dunkin bought a lottery ticket and won $20. Who was happier? Johnson Dunkin 28 Implications of Compounding Rules Segregate gains for products with more than one dimension Present benefits (gains) separately Consolidate costs (losses) into a single number and integrate with larger gains Do not give a rebate as a discount off of the invoice segregate gains by providing rebate as a separate check 30 13

14 The Logic of Profitable Pricing 34 Contribution Margin The difference between total sales revenue and total variable costs On a per-unit basis, it is the difference between the unit selling price and the unit variable cost Is used to analyze the relationship between costs, prices, volume, and profit Closely tracks material margin (1 (material cost / price)) 35 14

15 Contribution Margin Formula Unit Selling Price Unit Variable Costs Contribution Margin = Unit Selling Price 36 Contribution Margin Example Price = $5 Variable Costs = $2 Contribution $ per Unit = $5 - $2 = $3 Contribution Margin = (5 2)/5 = 0.60 = 60% 37 15

16 The Logic of Profitable Pricing Price Variable Cost 38 The Logic of Profitable Pricing Price Total Contribution Dollars Variable Cost 39 16

17 The Logic of Profitable Pricing Price Total Contribution Dollars Variable Cost Fixed Costs 40 The Logic of Profitable Pricing Price Profits Total Contribution Dollars Variable Cost Fixed Costs 41 17

18 The Logic of Profitable Pricing Price Profits Total Contribution Dollars Variable Cost Fixed Costs 42 Thinking Broadly About Creating and Capturing Value Value Management Price Management Value Creation Gap Value Communication Gap Price Structure Gap Price Policy Gap Price Execution Gap Potential Value Actual Value Perceived Value Willingness to Pay Target Price Actual Price 43 18