"Nowadays people know the price of everything and the value of nothing."
Too often startups take a dangerous route to setting price by just looking at how much a product or service costs to provide and how much competitors are charging, and then setting the price in between. The ambitious may even include a "willingness to pay" survey to justify the numbers (but we now know better than that.) While costs and the competitive alternatives are certainly relevant inputs to pricing decisions, these companies are missing a critical component of pricing that causes them to leak profits.
The reality is, if you're having trouble understanding and estimating your economic value, more than likely you're facing the bigger problem of not understanding how your product positively affects your customers financially. Follow these four steps to quantifying customer value and you'll be on the path to pricing like the pros.
Step One: Identify the Alternative
Better pricing is achieved by understanding how much more or less economic value you drive relative to the other options that are available. Accordingly, the first step to understanding your value is to identify, from the customer's point of view, the competition (the Next Best Competitive Alternative, also known as the NBCA).
Let's say we are in the software business, and one potential customer is currently using IBM's solution which costs $250 per month, while another customer is doing "nothing" (or managing in house, depending on how you look at it). In the first case, we'll need to look for ways we can provide differentiated value above and beyond IBM's $250 solution in order to capture a premium. In the second example, our story needs to illustrate how we are better than doing nothing and illustrate the value we provide above current practices in order to get customers to sign up.
There are two important lessons here. First, the competition is your friend! We will build upon the NBCA's offer and identify ways we deliver more value. It is much easier to find small additional value above the IBM offer than it is to find a ton of value from the ground up, as is the case when the NBCA is "do nothing." This is a major challenge for startups in a new space. Try to overcome it by looking for realistic but favorable NBCAs for your product. For example, instead of "do nothing," are they really managing internally? What does that cost them in salary?
Second, as we see in this example, different customers have different NBCAs, so your value story will change from customer to customer. You may be 5 percent better than IBM but 50 percent better than in-house, which leads to different levels of differentiated value.
Identifying your competition may seem like a no-brainer, but it has big implications for segmentation, offer design, customer targeting, and sales proposition (all topics for another day). So put some thought into this and pick an NBCA that is relevant to a current sale and will be useful down the road.
Step Two: Quantify Your Superiority
This is where it gets fun. We are ready to really dig into how your product is better than what is happening today (the NBCA). Back to the software example: our product helps our customers' systems work 5 percent faster than if they use the IBM solution. But what does faster mean? Why do companies want faster?
In 2008 at eBay, faster systems meant more revenue per listing. The site was loading too slowly and eBay was losing out on buyer bids in the final seconds of an auction. A faster system captured more last second bids in time, creating higher sell prices, happier sellers, and a higher fee for eBay. In a call center, faster systems might lower call time and reduce telecomm and labor costs. The same feature can drive different amounts, and different types, of value for different customers.
Let's dig into the eBay example. How do we put a number to this value? The simpler the math, the better. You will want to show your customers how you came up with the number, so it's best to avoid partial differential equations and other forms of analytical confusion. Start with some reasonably conservative assumptions and basic customer knowledge. Let's say a system that is 5 percent faster than the IBM offer means there is a 1 percent better chance an additional bid is placed on any given auction item (compared to the performance with IBM's solution), and the average bid increment is $1.00. eBay gets a 5 percent commission on sales, and handles 10 million auctions per month. These assumptions let us roughly quantify the performance above and beyond IBM, the NBCA. There is always more than one way to quantify this value, so consider how your customer will think about it, what data you have, and what data you can easily provide potential customers with.
Feature: System runs 5% faster than IBM
Probability of additional bid: 1% (source: performance tests, assumption)
Average incremental bid: $1.00 (source: customer research)
eBay commission (%): 5% (source: customer website)
eBay auctions per month: 10,000,000 (source: customer research)
Value delivered: $5,000 per month (source: calculated)
Based on this math, we believe we add $5,000/month of positive differential value (what is above and beyond what IBM offers for $250/month). This demonstrates that we are impacting such a massively important value driver to eBay that even a slight performance advantage over IBM allows us to justify a significant price premium.
At this point, don't worry too much about perfecting the numbers, just be conservative. Roughly right is better than precisely wrong. As you move forward, customer conversations, annual reports, pilot programs, and field tests will help refine the inputs. The important thing is to understand how we are driving value, and roughly how much it is worth.
Step Three: Acknowledge Your Deficiencies
Your story must be fair and believable to gain any traction with the customer, and a key step is to acknowledge that the NBCA does have some economic advantages. If a customer thinks we didn't look at the entire picture, they may think we're cooking the books in our favor and not providing a real view of the world.
I have never seen a situation where there is no negative differential value, so be careful skipping this step. If the NBCA has superior performance on a different feature, you can replicate math like we used above. Another very common negative differentiator is the switching cost from the current solution, often in the form of installation time or employee training.
Let's look at how we may quantify the installation cost in our example:
Feature: Installation & Training Cost (Negative)
IT Man hours to install and train: 120 (source: assumption)
Fully loaded IT staff cost per hour: $50 (source: market research)
Amortization period (months): 36 (source: assumption)
Negative Differential Value: $166 per month (source: calculated)
Just like in our calculations on positive differential value, we want to use numbers that make a conservative case. The value here is very small compared to the positives, so use numbers your customer will believe.
Step Four: Put it Together and Capture Your Value
In most cases, you'll have multiple positive and negative drivers to consider, but for now we're keeping it simple. We have our NBCA identified as the $250/month IBM solution. We have determined that we provide an additional $5,000/month in positive value, but have a negative differentiation of $166/month. So now what?
Our net differentiated value (positive value minus negative value, in this case $5,000 - $166) is $4,834/month. Since we are more valuable than the IBM offer, their price of $250/month becomes a hard floor for our pricing. Anything below this number can be very dangerous. Our ceiling is that differentiation plus the price of the NBCA, or $5,084 ($5,000 -$166 + $250). Above this price you are asking your customer to make an economically irrational decision.
So here we have created our pricing band - from $250 to $5,084 per month. Decisions on how to share that value creation band with your customers (e.g. where to set your price) depend on your company's strategy, the industry dynamics, and degree of innovation.
In mature and highly competitive markets where innovation happens on the fringes, I typically see companies capture 10 percent of that differential value. In this case, that would mean 10 percent of $4,834 (net differentiation) on top of the NBCA price, or roughly $733/month ($250 + $483). More aggressive companies who focus on profit or operate in younger markets often captured roughly 30 percent of the net differential value. In some cases, such as highly innovative products where psychological drivers are in play or unquantifiable pain points exist, nearly 100 percent of that value can be captured.
With this analysis in hand, your company can make informed commercial strategy decisions. Value-based pricing is not just about coming up with a price. It can help expose the core value of your business and provide a deeper understanding of how you are affecting your customer base, and how that effect varies from customer to customer. It will change the way you think about your competition, marketing and sales and product development. At a minimum, you can maybe prove Oscar Wilde wrong and understand the value of at least one thing - your own product.
This post originally appeared on the MIT Entrepreneurship Review.