“Price is what you pay. Value is what you get”. – Warren Buffett.
Takeaway: To price a product right, figure out how much value it provides to your customers, not how much it costs you to offer it.
One core element of your Marketing Mix (which we have discussed in an earlier post) is your pricing strategy. Finding the right price for a new product can be tough since there are many factors that play into the pricing decision such as cost, competition, brand value, positioning etc.
The most basic way to price a product is using the cost-plus approach. Here, simply spoken, you take the total cost of your product or service and add some margin that allows your company to make a profit. For example, if you run an online store and find that a profit margin of 50% would be appropriate, you would charge your customers twice the amount it costs you to purchase an item you sell. A t-shirt that costs you $10 (i.e. cost for material, labor, overhead) would be priced at $20 at your online shop, giving you a nice 50% margin or $10 in profits per sale.
While this is an easy and straight-forward way to price your products, it ignores how your competitors price their products and what your customers are willing to pay. A better approach to pricing is the Economic Value to Customer (EVC). The basic idea behind the EVC is that your customer’s maximum willingness to pay is the sum of the price of the closest substitute to your product (reference value) and the additional value your product provides relative to the best alternative (differentiation value). If you express this relationship in a formula, it looks like this:
EVC = reference value + differentiation value
Let’s look at an example: Say, you are in the market to buy a smartphone and you have certain needs such as a good camera, a high amount of storage, a big display etc. After some research, you find an Android phone by a leading brand that seems to fulfill all your needs for $300. This is your reference value.
Now you are debating whether you should get an iPhone instead that would also tick all the boxes on your feature wish list. But the iPhone, in this example, is priced at $600. So, under what circumstances would you (or anyone else) buy the iPhone? This depends on whether the iPhone provides equal to or more than $300 in differentiation value ($600 – $300 in reference value).
What are sources for this differentiation value? The Apple branding, the design, the quality of the materials used, additional features, fast availability, network benefits (maybe all your friends have iPhones or your other devices are Apple products), support and so on. Do these factors provide you as a customer with an additional $300 in value? It depends on what you value. And this is where pricing becomes even trickier because not all customers are created equal. For some people, the design and the branding alone might be worth $300, for others all the factors listed don’t provide any additional value.
What implications does this have on your pricing decisions?
- First, figure out what benefits your product provides to your customers. What sources of value do you have? A feature alone is worth $0 if your customers don’t value it.
- Second, identify what the closest substitute to your product and its price point is. Realize that the more identical and cheaper the substitute is, the lower the EVC of your product will be.
- Third, calculate what sources of differentiation value are and how much $-value these create for your customers. Here, it’s important to keep in mind that different customer segments will assign different values to certain benefits. This should inform how you tailor your product to different customer segments (all smartphone brands offer more than one model to do exactly this) and how you communicate the differentiation value to them.
- Finally, find the right price by looking at reference and differentiation value. Note, that you shouldn’t necessarily price your product at the EVC but rather use it as the maximum price at which customers receive the value they perceive.