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!

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