Monday, April 25, 2011

How to Set Prices: Customer Value Analysis

5th and final post in a series on How to Set Pricing

I first learned about value pricing as a product manager at Metcal.  At that time the company was a startup making high end hand soldering equipment for PCB assembly houses.  To give you an idea of how high end, at that time a Metcal soldering station sold for 5x that of competitive units, and the consumable tips were 10-15x that of the competition in what most would call a commodity market.  Yet, in eight years, the company went from being the #8 to #2 market share player.

Now while there were many reasons for the company's success  - superior technology, ergonomically friendly design, robust product quality, etc. - the killer app in the company's sales arsenal was a customer value analysis created by one of the sales managers.  This simple spreadsheet model translated the product's feature/benefits into a quantified customer value proposition.

When distilled to the basics, B2B customers buy products and services for three ultimate value objectives:
  • Reduce costs
  • Increase revenues
  • Reduce risks
Faster speed, greater convenience, and growth usually translate into one of these three.  In Metcal's case, the product features translated into the following benefits:
  • Superior solder joint quality (reduced defect costs and risk)
  • Faster soldering time (reduced labor cost)
  • Elimination of calibration (reduced labor cost)
  • Faster operator training time (reduced labor cost)
Metcal's value analysis was an Excel spreadsheet that allowed customers to input their time, process, and cost data, compare them against the cost of acquiring new solder stations and more expensive consumables and see the return on investment, payback, and net present value figures associated with the value created.  On top of that, the value analysis often prompted customers to consider factors that they may not have thought of, like training time.  The financial decision makers inside the customer quickly saw that the acquisition cost for Metcal's products was a relatively small percentage of the overall value created (in this case reduced costs), the essence of value pricing.

The main idea behind value pricing is that if your offering creates value, you price such that you and the customer share it.  Normally, this is not 50/50 but weighted in the favor of the customer;  the more value the customer captures, the stronger the value proposition.

Value pricing is widely practiced in B2B markets, especially where relationships are complex and long term.  Examples include logistics outsourcing where the supplier is paid on the basis of procurement costs reduced; SaaS vendors often price their subscription services to capture 10-30% of value created for customers over a three year time horizon vs. using a traditional enterprise software solution.

To create a value analysis requires a deep understanding of how your offering impacts a customer's business economics.  Gaining this insight takes time.  For a startup to gain this insight, it typically must have access to a someone with extensive, specific domain expertise, one who understands the customer's business model well enough to know where the lever points are that have the greatest potential to affect profitability and growth.

Creating a Value Analysis
In order to create a value analysis, you need to know the following well enough to code it into a spreadsheet:
  • What is the main value proposition you are offering to your target customer?  Lower costs, higher revenues, lower risk?  For Metcal it was mainly lowering the per unit cost of production.
  • How does this tie into the customer's value calculation? For Metcal, this had a direct impact on the direct labor line in cost of goods sold on a P&L.
  • What are the factors used by the customer to assess value?  For Metcal, production rate, labor cost, defect rate, calibration and setup time were input factors in assessing value.
  • What factors are not used by the customer to assess value and should be?  For Metcal, many customers neglected to factor in operator training time.
  • What is the feature => benefit => value proposition chain for each of your offering's features?  For example, Metcal's superior technology => x% defect rate reduction => y% less rework => z% lower cost.
  • What is the relevant payback factor used by the customer?  Is it payback time?  IRR?
  • What is the relevant payback time used by the customer? 
Assuming that you can create a value analysis, two value methods can be used to set  pricing.

Method 8:  Share of Value Pricing
In this method, a "typical" customer use case is created using the value analysis.  Pricing is then set at 10-30% of the value, adjusted as needed for competitive market conditions.  This method is practiced by many SaaS companies relative to traditional enterprise software offerings.

Method 9:  Performance Pricing
Alternatively, for a specific customer, using the value analysis, compensation is based on a defined percentage of the value created (i.e. savings or revenue growth).  This method is often practiced by industrial logistics suppliers, auto parts suppliers, electronic contract manufacturers., and cost-control consultants.  Think of it as the corporate equivalent of a commission plan.  Because payment is dependent on performance, using this method requires you to have a good handle not only on the customer's economics, but your own.

Summary of Pricing Methods
To summarize the nine different pricing methods discussed, they are:
  1. Cost Plus Pricing
  2. Direct Market Competitive Pricing
  3. Competitive Substitute Pricing
  4. Target Customer Survey
  5. Price Bracketing
  6. Price/Feature Stripping
  7. Customer Set Pricing
  8. Share of Value Pricing
  9. Performance Pricing
Happy pricing!

Sunday, April 10, 2011

How to Set Prices: Value Pricing Methods

4th in a series on How to Set Pricing

Last post we discussed tangible pricing methods.  We now turn to value pricing methods.  Simply put, value pricing methods seek to establish a price based on some percentage of the value perceived by the customer.  While this seems straight forward in theory, this can be difficult to establish in practice for the following reasons:
  • One must understand what the customer perceives as value in your offering
  • One must understand the customer's time frame over which value is calculated
  • The full value may be in intangible areas that the customer may not be aware of
Customer Perception of Value
In order to determine what percentage of value you can capture in your pricing, you must first understand what your offering's value is to the customer. This means you must first understand who your customers are.  Again, while this seems like a no brainer, I've found that for most startups, while they have strong beliefs about who their customers are and what value they are offering to them, they actually have NO CLUE.  Beliefs unsupported by data means NO CLUE!

Does that sound harsh?  See if you can answer the following question about your customer value:
  • What is the demographic profile of your target customer?  What hard evidence do you have to support this?  Can you put this on paper?
  • What are their acute pains in ranked order and what is your supporting data?
  • How does your offering's features address each acute pain and what customer evidence do you have to prove this? (Not what hypothetical, logical reasoning you have that it should address this?)
  • What competitive substitutes are your target customers using today to address their acute pain and how do you know this?
  • What does your customer's life look like before they start using your offering?  How is it different afterwards?  What facts do you have to support this?
  • Can you construct a mathematical model for value analysis that shows how different levels of acute pain reduction translate into customer value?  (This will be the subject of the last post in this series.)
If you can't answer these questions, I would argue that you don't truly understand the value of what you are offering your customers.  For help on this, see my previous post "Developing a Customer Profile".  A large part of the value of Steve Blank's customer development methodology is to convert these customer beliefs into customer facts.

There are a couple of methods that can be used to collect value data.  But unlike the four tangible pricing methods discussed previously, value pricing methods require (1) talking directly with individual target customers (2) an attempt to close a sale and (3) involve the risk of alienating a target customer to get the data.
The reason for this is that the only form of validated value data is a sale or other binding purchase commitment.  What people tell you they will pay in conversation is very different than when you ask them to sign a purchase order.

Each of the methods described below requires that you:
  1. Know and have access to customers who fit your target profile
  2. Have a hypothesis about your offering value that you can quickly communicate to customers (see my post on "Focused Selling")
  3. Have hypotheses about how different features of your offering address target customer acute pain
Method 5:  Price Bracketing
Start discussion with an initial set of target customers.  Once you think you have a good understanding of the reasons the customer might buy and they have a good understanding of what you have to offer, to get an initial feel for value, ask two questions:
  • Below what price would this be a "no-brainer" purchase that you could commit to today?
  • Above what price would there be no chance of them ever buying and why?
Once you've determined this, tell the customer your pricing is coming in at a figure that is 75% of the range (i.e. if the "no brainer" price is $100 and the "no way" price is $1100, the 75% figure is $850).  Try to close the sale.  Most likely when (not if) they balk, find out what's stopping them from making a commitment today and pay attention.  Assuming you still can't close the deal, thank them for the valuable information and let them know that you obviously have some work to do on your costs and find out if they would be willing to talk again in the future.  Most likely, if you do this with 3-5 target customers, you'll quickly be able to determine what parts of your value proposition are holding up and which need adjustment.  Adjust accordingly.

Method 6:  Price/Feature Stripping
Armed with a new offering presentation from Method 5, ideally meet with a different set of target customers.  (If you are in a small B2B market with a restricted set of target customers, you may need to go back to the first set).  This time, once you think you have a good understanding of the reason the customer might buy and they have a good understanding of what you have to offer, try to close a sale at the 75% price number from Method 5.  Depending on which reaction you get do the following:
  • Customer Accepts:  Congratulations, you've gotten a sale...but you haven't learned much.  Raise the price by 20% before you talk to the next target customer.
  • Customer Rejects:  Understand why.  Then get a counter-offer.  Once you have it, talk about which features you can strip to get to the counter-offered price.  As you have the feature stripping discussion, you should get a feel for the relative value of each feature.
Again, 3-5 target customers should give you a good feel for how your value proposition should be adjusted.  It should also give you a feel for your minimum viable product.

At this point, go back to the first set of target customers and let them know that you've found some ways to work the cost issue both internally and by removal of certain features to get closer to the the previously discussed "no brainer" price.  See if you can close the sale again, this time at the average counter-offer price from the second set of target customers.  You will then get one of two reactions;
  • Customer Accepts:  Congratulations, you've gotten a sale and validated the feature/value hypotheses.
  • Customer Rejects:  Understand why.  In many cases, the new objections won't be price based, but will be sales process based.  Congratulations, you can now move forward to address the non-price related set of impediments to gaining market traction.
Method 7:  Customer Set Pricing
One alternate method for determining value is to let customers set their own price.  Examples of this include self-published e-books where the author request that people pay what they think the item is worth and museums, which request visitor set donations in lieu of an admission fee.  The most obvious risk of letting customers set prices is not being able to set prices adequate to cover costs, but depending on the nature of your offering this method may work for you.  To be viable it helps to have:
  • Large potential customer base where the volume of payers is likely to be large enough to offset the inevitable free riders.
  • Target customer base has some social or peer pressure element to pay something - This works for many charitable organization and the museum example cited earlier.
  • Low or no incremental cost to delivering additional offering vs. probability having more paying users - In the case of the museum whether they have 500 or 5000 visitors a day does not change their operating cost but greatly increases the likelihood of donations.  For the e-book author, once the book is written, delivering additional copies across the web is pretty cheap.
There is one final method for setting value based pricing.  This involves the creation and development of a mathematical customer value analysis.  Pricing is then based on some percentage of this calculated value.  This will be the subject of the final post in this series.

Next post:  Customer Value Analysis

Sunday, April 3, 2011

How to Set Prices: Tangible Pricing Methods

3rd in a series on How to Set Pricing

In order to set pricing, certain decisions need to be made with respect to:
  1. Pricing Strategy
  2. Business Revenue Model
  3. Pricing Mechanisms
As discussed in the prior two posts, these three elements can be combined in many different ways; arriving at the proper combination is part planning, part art, and part trial and error.  But assuming you've gotten this far, it still leaves the question of what price to charge? 

First, let me state that I've been pricing goods and services for many years and for those of you who like precision and certainty, the pricing process is messy and imperfect.  Nevertheless, there are several methods that can be used to establish initial pricing.  These tend to fall into two group:  tangible pricing and value pricingTangible price methods stem from obtainable data.  Value price methods require more exploratory efforts.  This post will deal with tangible price methods.

Method 1: Cost Plus Pricing
The most basic and simplest to understand is cost plus pricing.  This is where you add up your costs, tack on your target margin to set a price.  Remember that one of the key objectives in pricing is to charge enough to cover your costs and make a profit.  At least on the surface, this would seem to address the issue.  However, cost plus pricing often results in a price that is not competitive in the market place (i.e. think $500 screwdrivers for the government).  So what to do?

First, you cannot ignore cost but there are two kinds of cost:  direct and indirect.  Direct costs, typically classed as Cost of Goods Sold (COGS), are the immediate costs tied to delivering a unit of product or service.  For example, if you're selling a widget, the cost of the parts in the widget plus the amount of labor time to build the widget plus the cost to ship it are direct costs.
 Your pricing must be greater than the direct cost.  Otherwise you are shipping dollar bills out with each unit.
On the other hand indirect costs are not directly tied to the cost of delivering a specific unit, though they may be needed for producing the product or service.  Often times they are relatively fixed costs like engineering wages, rent, or electricity.  They are real costs needed to support operations but not directly assignable to a specific unit of product or service.

These costs are often allocated across the total units produced. For example, if you have $500/month in rent and build 5000 units/month, you might allocate $0.10 of this cost to each unit built.  But if you only build 500 units/month, you would allocate $1.00 of this cost to each unit.  And this is what complicates cost plus pricing.  To cover this, do you charge $0.10 or $1.00?
Not only must you charge more than the direct cost, in order to make a profit, you must charge enough more to cover the indirect costs at a particular volume level.
To further complicate the picture, the line between a direct cost and indirect cost is often murky.

The bottom line is that you should not use cost as the sole means of establishing price, but you cannot ignore it either.  And if you find that you can't price high enough to cover all of your costs or reduce your costs sufficiently, you may have a more fundamental business model problem.

Method 2: Direct Market Competitive Pricing
If you have direct competition for your product or service, one way to establish a reference price point is by surveying the competition.  Where prices are posted (e.g. for retail goods) this is easy to do.  For services, where prices are often not posted, there are a couple of ways to get prices:
  • Ask people who use the services what they are paying
  • Attempt to contract for the service to get a quote
  • Get a friend with a business to attempt to contract for the service to get a quote
5-10 quotes should enable you to get a feel for the average and range of competitive market pricing.  Keep in mind that this just establishes a reference point.  Depending on your pricing strategy, you may choose to price higher or lower than market.

Method 3:  Competitive Substitute Pricing
In some cases, there may not be a directly competitive product or service to your offering.  In this case, you should look at pricing for competitive substitutesCompetitive substitutes are products or services that in combination with other things allow the buyer to gain the same functionality or achieve the same goal as your product or service would directly.  As an example, if I need to add up a bunch of numbers, I can use a calculator, my computer, my cell phone, my digital watch, a pen & paper, an abacus, or just do it in my head.  All are competitive substitutes to each other with different costs associated with purchasing the different items.

Depending on the strength of the competitive substitute in achieving the buyer's purchase objective vs. your product or service, the price being charged may limit the premium you can charge.

For example, lets assume that high speed rail service between San Jose, CA and Los Angeles actually becomes a reality in my lifetime.  If I have to price the service, three competitive substitutes are plane, car, or bus.  Transit time by high speed rail is 3 hours, plane is 1.5 hours, car is 6 hours, and bus 7 hours.

Assuming I own a car, this is the cheapest in dollars, involving maybe $50 in gas.  The bus is about $55 and I don't have to drive;  I can spend the time reading or on my laptop courtesy of mobile Wi-Fi.  The plane is ostensibly the fastest but when you add all the security and boarding issues associated with air travel, total time is probably closer to 3-3.5 hours for a ticket price of $120.

So what should the price of a train ticket be?  You can definitely charge more than the car or bus because of the speed advantage.  The plane is the nearest serious competitor so a floor reference price would be $120 per ticket.  Could it be more?  Absolutely.  It depends on how well the train positions its value to its target ridership;  this moves into the realm of value pricing.

Tangible price methods make it relatively easy to determine a current market reference point.  But if your product is meant to be a superior solution to the market, it does not help you determine what premium over market you might be able to charge.  (This is less of an issue if your product is meant to be a cheaper solution to the market.)

Method 4:  Target Customer Survey
While method's 2 & 3 look at competitive pricing, another way to determine pricing is to survey potential buyers.  This first involves understanding who are your target customers.

Customer surveys work best for familiar product categories with fewer options.  Most people find it difficult to establish an anchor price point for innovative or unfamiliar product categories and will therefore skew answers low.  Products with many features can be confusing, although conjoint analysis can help establish  feature/price tradeoffs.  It also helps to have product samples or some kind of demo; people give better feedback with things they can see or touch versus abstract concepts and ideas.

But one potential strength of this method is that it may tell you something about the nature of the price-demand curve.  Why is this important?  Let's look at two price-demand curves.  The one on the left is a stereotypical commodity demand curve where demand falls with increasing unit price.  The one on the right is typical of many branded goods where too low or too high a price can cause demand to fall (e.g. the Mercedes C-Class example mentioned in the first post in the series).
As you can see, depending on what the nature of the curve might be, and where you are on the curve a decrease in price may or may not improve demand.

The other pro of this method might be to identify the existence of an optimum price point different from the current competitive market price.  For example, when LCD TVs first came out, a 42" model was ~$4500.  But the LCD TV makers knew this was not the optimum point; it was a price constrained by their costs.  By conducting customer surveys, they determined that $1000 was the magic inflection point at which demand would skyrocket.  They worked diligently to drive costs down so as to be able to price to this point.  Sure enough, 42" LCD TVs hit the $1000 retail point in 2008 and took off, in spite of the fact that a global recession was underway.

Next post:  Value Pricing Methods