Value-Based Strategy Resources: A Collection

The Authors — Wed, 28 Jul 2010 16:43:58 +0000

Our partners at LeveragePoint have made available a number of articles that we have written with our colleagues over the years. These cover many aspects of value-based product development, pricing, marketing and sales. We will add new articles and white papers as they are written, and will expand this to cover emerging best-practices.

Value-Based Strategy Resources

Book Signing at PPS Spring Conference

The Authors — Thu, 27 May 2010 19:15:59 +0000

There was an excellent turnout for Tom Nagle’s book signing at the recent Professional Pricing Society Spring Conference in Chicago. About a hundred conference attendees stood in line to purchase the book and chat briefly with Dr. Nagle after he delivered the conference’s opening keynote presentation, “Advantage Based Marketing for Profit, Not Just Sales”.

If You Know Your Value, What Determines the Price?

tnagle — Mon, 24 May 2010 15:28:44 +0000

Value-based pricing does not assume that one can price fully to value. How much differentiation value one can actually capture, even once it is quantified and communicated to buyers, depends on other factors. Before one can set a viable market price, one must firm understand and manage those factors.

For example, how certain is the buyer that the savings will actually be realized? This is always a big one for new pharmaceuticals, since drugs perform better in controlled trials than when real world patients take them less consistently and real world doctors prescribe them for less than ideal candidates. When the pharma company is willing to price a new product much below its potential value at the time of launch but the payer is unwilling to take the risk, pharma companies are increasing offering guarantees. In return for paying a higher price that more closely reflects the value, the payer gets a refund—or even more in the case of a recent osteoporosis drug—if the treatment fails.

There are also purely psychological factors that determine the amount of differentiation value that can be captured. One of those is the importance of the end-benefit associated with the purchase. You might happily pull out your coupon to offset part of the cost of a regular dinner with your husband or wife. But would you use a coupon for a discount if the differ were to celebrate your first wedding anniversary? Would you send a gift to a client, say an excellent bottle of wine, from a discount wine merchant or from one with a name that everyone knows charges full price? For some reason, paying fully for the differentiation value seems right when then end-benefit (use value) of something is very high.

Exhibit 6-4 on pages 132-33 of the Strategy and Tactics of Pricing, 5^th edition describes eight such factors that influence the amount of differentiation value that is can be captured in the price.

Size of expenditure: Buyers are more (or less) price sensitive when expenditures are relatively large (or small).
Shared costs: Buyers are less price sensitive when some or all the purchase price is paid by others.
Switching costs: Buyers are less sensitive to the price of a product the greater the added cost (both monetary and non-monetary) of switching from their current supplier (if any)?
Perceived risk: Buyers are less price sensitive when it is difficult to compare suppliers and the cost of not getting the expected benefits of a purchase are high.
Importance of end-benefit: Buyers are less price sensitive when the product is a small part of the cost of a benefit with high economic or psychological importance.
Price-quality perceptions: Buyers are less sensitive to a product’s price to the extent that price is a proxy for the likely quality of the purchase.
Perceived fairness: Buyers are more sensitive to a product’s price when it is outside the range that they perceive as “fair or reasonable”.
Price framing: Buyers are more sensitive when they perceive the price as a “loss” rather than as a forgone “gain”. They are more price sensitive when the price is paid separately than when it is part of a bundle.

Those factors that suppress a buyer’s wiliness to pay must either be reflected in the share of differentiation value that you attempt to charge for, or must be managed through communication that changes buyers’ perception of them.

LeveragePoint uses these pricing sensitivity factors in its new Price Setting Tool. The value model (based on Economic Value Estimation™) that establishes the reference price of the next best competitive alternative and the differentiated value is imported into a pricing tool that walks the price setter through the pricing sensitivity analysis and factors in cost considerations.

“Pricing the Differential” & “A Question of Value” available on-line

tnagle — Tue, 18 May 2010 02:44:23 +0000

LeveragePoint has recently made available two key articles by Gerald E. Smith and Tom Nagle on the Resources page of their website.

“Pricing the Differential” first published in Marketing Management, May/June 2005, published by the American Marketing Association.

Summary: Customer value mapping (CVM) and economic value modeling (EVM – often referred to as Economic Value Estimation or EVE) are held up as alternative means to setting price. But their use leads to very different pricing outcomes. In this first of a two-part series, the authors show that CVM results in a series of consistent pricing biases that lead firms to get paid less for the differential value they create, especially with the market introduction of new, highly differentiated products, features, or services.

“A Question of Value” Marketing Management, July/August 2005, published by the American Marketing Association

Summary: In this second of a two-part series, the authors show how economic value modeling (EVM – often referred to as Economic Value Estimation or EVE) is superior to customer value mapping (CVM) for setting price. EVM properly distinguishes between the value of highly differentiated product benefits vs. generally commoditized benefits. It calculates the savings and gains that comprise the product’s actual economic value. The result is more robust and more accurate pricing that recognizes the true differentiation value of the product.

These articles are referenced in Chapter 2 – Value Creation of The Strategy and Tactics of Pricing Fifth Edition. We hope that over time other classic pricing articles can be made available.

Stop Reacting to Buyer’s Price Expectations; Manage Them

The Authors — Sat, 01 May 2010 18:14:16 +0000

Expectations drive behavior and nowhere more so than when setting prices. A customer’s decision to buy something at the offered price, or not, depends upon more than the tradeoff between benefits and price. It also depends on customers’ expectations, and their experience answering this question: how might our behavior influence the prices we have to pay? For example, a retail consumer may believe that a new fall fashion is well worth the price asked for it in September, but still not buy it if she expects that the store following its past behavior will have a 20 percent off sale within the next month. A policy of regular, predictable discounting has trained many retail consumers to wait for the sale price. As a result, sales at regular prices are less than they would otherwise be, increasing the amount of inventory that ultimately will be sold at the lower sale price. The same dynamic plays out –only more so—when businesses sell products and services to other businesses. Professional buyers have learned to hold their purchases until the last couple weeks of each quarter when sales managers are often willing to discount more deeply to achieve their quarterly goals. Sellers in these situations see the increasing portion of their sales made when prices are discounted as a sign that customers are becoming more price sensitive in their brand choice. In fact, they are only responding to incentives for how to get a better deal on what they were otherwise willing to buy at a higher price. Read more on Monitor Perspectives …

Tom Nagle “Why Apple Should Win the E-book Price War” on HBR

The Authors — Sat, 03 Apr 2010 14:52:27 +0000

Dr. Tom Nagle recently put up a post on the Harvard Business Review’s blog.

“A clash of the titans will erupt on Saturday when Apple releases its iPad: it will be Amazon, with most e-books costing $9.99, versus Apple, whose prices on some titles, rumor has it, will exceed Amazon’s standard e-book pricing. Let’s hope Apple wins the fight.

Why would I champion higher prices — particularly when it essentially costs nothing to ship an e-book?”

Read more at Harvard Business Review. “Why Apple Should Win the eBook Price War“

Linking Value to Price Realization

The Authors — Sun, 28 Mar 2010 22:31:31 +0000

It is one thing to understand the value that one’s products and services deliver to a customer, but quite another to realize that value in the price. The gap between the value and willingness to pay has long led marketing researchers (as well as scientists outside the field of marketing) to argue that the value of something is simply what someone will pay for it. Consequently, they prescribe making “optimal” pricing decisions based upon measurement of the price-feature tradeoffs that people are willing to make, as revealed by conjoint (tradeoff) surveys. This approach has been touted as “scientific”, while attempts to understand and manage the psychology behind those choices has been seen as highly suspect.

Despite my training in economics, I have long suspected that managing the psychology of the transaction was as central to profitable pricing as was managing the price level. Even the first edition of The Strategy and Tactics of Pricing (1987), written while I was still a professor of economics and marketing, listed nine psychological factors that can affect the relationship between value and willingness-to-pay. An example: If the emotion you feel about the end-benefit that you seek from a purchase is positive, the more you are inclined to spend even when there are cheaper alternatives. Thus the success of the slogan “Michelin: Because so much is riding on your tires” campaign in raising the willingness to pay for its brand of tires.

I recently read a book that vindicated the belief that pricing strategy needs to involve both the analytical and the emotional. That book, How We Decide by Jonah Lehrer is beautifully written, non-technical, and engaging book. In it, he describes the emerging consensus among neuroscientists that analytical and emotional aspects of a decision are not, as economists and scientists have long believed, integrated to make a decision. People make decisions either by relying on their emotions, or by relying on their analytical capabilities, or by breaking the decision into sequential parts. This has profound implications for value-based marketing and pricing.

At Monitor, where I work, we do a lot of work with pharma and life science companies. One of our clients developed a product that, while it had little impact on clinical outcomes (leaving the hospital alive and healthy), had a huge impact on the pain and suffering that the patient would endure to get to that outcome. Compounding the benefit, the patient was often a child who, along with his or her parents, was particularly traumatized by the existing procedure. Now the problem, US hospitals are paid in most cases a fixed amount to treat a patient for each condition, regardless of how much or little they spend to do so.

The economic case for the new procedure involves some positive, quantifiable benefits: quicker processing of the patient through the hospital; more goodwill with patients and relatives likely to return to a hospital where people seem more “caring”, better morale among nurses who seriously disliked having to hurt people. So did the emotional case: it’s not right to hurt people (especially children) when you don’t have to. But some hospitals bought the new procedure and others did not. Traditional research on willingness to pay for features and benefits (tradeoff analysis) could not predict the differences in choice.

What did predict the difference was how the buying process was structured. If the pharmacist brought the decision to the P&T committee (a group that decides whether to fund a new therapy in a hospital), the decision was framed in terms of whether the potential financial benefits from adopting the new therapy were large enough to justify paying the price. In that case, there was much counter-arguing on the committee about how much reducing the discomfort of the procedure really would improve consumer preference for that hospital and how much improved job satisfaction by nurses would really reduce the cost of nurse turnover. The tenor of the discussion was one of distrust of the numbers and anger that the price revealed a lack of appreciation on the seller’s part of the tenuous financial conditions under which most hospitals operate. Expenditure on the new procedure was often rejected when the decision was defined as an analytical choice, and people subsequently connected their feelings to that choice.

However, in hospitals where nurses and doctors had tried the new therapy during a trial period, the P&T committee review began with impassioned arguments about why adopting the new procedure was the right thing to do for patients and the clinical staff. Nurses would cry when describing how they felt about hurting children who did not understand that the nurses were trying to help them. After that, the committee set out to create a viable economic case for doing what everyone emotionally wanted to do. Rather than arguing why the economic benefits might not materialize, they argued about what they could do to make them materialize. Rather than seeing the company’s economic value story as full or tenuous sources of revenue, they saw it as full of useful ideas for how they might be able to afford the therapy.

This case was a particularly dramatic demonstration of the importance of understanding the decision process and what you can do to influence it. Even given the same perceptions of the analytical numbers and the uncertainties surrounding them, the decision changed when the process changed. That is why at Monitor we never create a marketing or pricing strategy without first attempting to understand the decision process and how best to influence it.

In B-to-B markets, a key to influencing the buying process is often to identify the drivers of value to the customer, since that forces a change in the process on the part of purchasing. Instead of the decision being framed in terms of how important the buyer is to the seller and what concessions that justifies, economic value reframes the discussion in terms of the value that the seller will lose if he/she does not buy your product. That enables you to identify who in the buying organization may benefit personally (and thus be motivated emotionally) from purchase of your product or service. You can then think about how to influence the buying process in a way that engages them early in framing the decision and in advocating for and committing to the realization of the value.

Partner, Monitor Group

What the Heck is a Pricing Model?

The Authors — Wed, 24 Mar 2010 20:55:03 +0000

In my last post, I raised a question about when a company should consider changing its pricing model. In response to that post, a reader asked an even more fundamental question: what, precisely, is a pricing model? It strikes me that the term pricing model is one those buzzwords that is frequently used and seldom understood. If we asked 30 executives for a definition, no doubt we would get 30 different answers. Since we did not include a formal definition of pricing model in the Strategy and Tactics of Pricing, I thought I would share some thoughts here.

Simply stated, a pricing model is a mechanism to capture the value created for customers. The simplest and most common pricing model is that used by most retailers: put a price on each unit of product. This is model used by Amazon when it launched the Kindle in November 2007 priced at $359. Not long after the initial launch, Amazon’s one-price-fits-all model came under duress because customers placed widely differing values on the innovative book reader.

Some customers valued the reader highly and all but stopped buying traditional books. Not surprisingly, these customers were fine with the $359 price tag. Others found the Kindle to be fine for occasional use such as when they are traveling. These customers tended to find the price to be a bit steep. In response, Amazon evolved their product strategy by introducing two versions of the Kindle. At the time of this posting, the basic Kindle is priced at $259 while a higher end model, the Kindle DX, is priced at $459. This two-tiered price point allows Amazon to capture higher margins from high-value customers while driving volume to lower value customers.

The ability to use price to drive volume for the Kindle is essential to Amazon’s pricing strategy because of the other way in which it captures value – through the sale of e-books. The introduction of the Kindle platform enabled Amazon to create what is affectionately described in strategy circles as a “two-sided market” with publishers on one side and customers on the other. The creation of a two-sided market created a virtuous cycle for Amazon. As more people purchased the Kindle, the more publishers were selling e-books. As Amazon sold more e-books through its Kindle device, the more leverage it has to negotiate bigger discounts with publishers. The bigger discounts allowed Amazon to sell the books at still lower prices making the Kindle an even more attractive value proposition to end customers. The brilliance of this strategy is that Amazon is sitting in the middle of this market making money on every book sold.

The Kindle value delivery model developed provides multiple options to Amazon in its pricing model. It can price the readers low to spur book sales or use discounted books to increase the value (and price) of its reader. The Kindle illustrates the increasingly sophisticated ways in which value is created for customers and the need for increasingly sophisticated pricing models. Which brings me back to my first blog: is it time to rethink your pricing model?

Is it Time to Rethink Your Pricing Model?

The Authors — Fri, 19 Mar 2010 13:55:17 +0000

A recent article in the New York Times describes how Amazon is flexing its market power to force changes in the pricing models for all of the major publishers. The conflict is centered on the price of e-books – Amazon wants the publishers to agree to major discounts for e-books to support its Kindle-driven business model. And they are playing hardball. When MacMillan, one of the leading publishers, refused to comply with Amazon’s discount demands the bookseller removed the “buy” buttons from thousands of MacMillan books.

Most of us are not facing such dramatic challenges to our pricing model as that posed by Amazon. But the recession has fundamentally shifted customer’s willingness and ability to pay in many markets. Coupled with rapid changes to the technological and competitive landscape, its no surprise that many firms are experiencing dramatically increased price pressure from customers.

It’s a critical mistake is to assume that changing prices alone can address the pricing challenges caused by structural shifts in your market. Astute managers are realizing they must step back and rethink their pricing model to ensure that it is capturing the value of their offers. Given all of the market turbulence of late, its not surprising that the business press is filled with examples of companies implementing new pricing models:

Technicolor® is implementing a pay-for-use model for small theaters that want to upgrade to its new 3D projection technology
ITunes is implementing a tiered pricing model in which music will be priced at $0.69, $0.99, and $1.29 depending on format and popularity
Dow Corning has shifted all of its silicone business to a two-tier pricing model in which purchases from its online marketplace can be made at substantial discounts
AT&T has announced intent to move toward a usage-based model for its 4G phones, effectively ending the era of unlimited use

The challenge for us as managers is to understand how to respond to structural change in our markets. When should we just change the price and when should we rethink our pricing model? I’ll begin to answer these questions in subsequent blogs.

John Hogan

What’s New in the Fifth Edition

The Authors — Tue, 09 Mar 2010 21:14:07 +0000

One purpose of this blog, and of our book, is to change the common misperception that pricing is simply about calculating the “right” price for a product or transaction. In the years since the first edition was published in 1987, we have learned that pricing, if it is to be effective, cannot be so reactive and simplistic. Profitable pricing requires looking beneath the demand curve to understand and manage the monetary and psychological value that is a primary determinant of the purchase decision. Mastering the value proposition enables a firm (1) to segment prices to reflect differences in value and cost, (2) to communicate the value of offers to customers unfamiliar with the market, and (3) to create pricing policies for managing pricing issues fairly and consistently. In short, this book shows managers how to move from tactically “optimizing” prices in markets where they seemingly exercise little control to managing their markets strategically. When that happens, pricing becomes an integral part of a profitable growth strategy, rather than a blunt instrument to drive sales and market share. The principles of strategic pricing, which were foreign to most business practitioners more than two decades ago, are now more widely accepted in principle. But most companies still struggle with the application. The changes in this fifth edition of our book reflect our attempts to address this need:

A completely new chapter on “Pricing Strategy Implementation” identifies the challenges involved in embedding strategic pricing principles within an organization and describes how managers can lead a structured change process to build a commercial organization more consistently focused on value creation, for the firm and its customers.
The revised chapter on “Pricing Policy” provides a theoretically grounded framework to describe specific policies for managing price changes for a variety of situations including raw material cost increases, demand recessions, and new product launches.
The chapter on “Value Creation” for the first time addresses explicitly how to deal with value differently when it is driven by subjective psychological drivers (such as doing the right thing for the environment) rather than by tangible monetary drivers (for example, saves money on fuel).
The chapter on “Value and Price Communication” has been substantially revised to describe how to communicate value in a wide variety of product and customer contexts. It demonstrates how to target communications to affect specific behaviors throughout the customer’s buying process.
The chapter on “Price Setting” has been expanded to provide a robust process for setting prices that can be widely applied both to consumer and business markets.
Throughout the book, we have updated examples with more topical illustrations of current pricing challenges (such as iPhone pricing, new models for pricing music, and services pricing).

To complement this edition, we also introduce software from LeveragePoint Innovations Inc. for creating and communicating economic value estimations systematically. The trial software can be accessed at http://home.leveragepoint.com/signup. While versions of the software that enable sharing require corporate contracts for access, versions for individual student and practitioner use are available without charge for three months. This software puts theory into practice and allows the reader to explore real-world scenarios.

Tom Nagle, Ph.D.
Monitor Group
John Hogan Ph.D.
Value Management Advisors
Joe Zale
Monitor Group