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

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