Value Base Pricing
Pricing Above the Competition and Still Winning the Market
If a pricing manager claims that a product could be sold for twice the price of your competitor’s or nearest substitute, most executives would respond with a mixture of joy, greed, and skepticism. Between the responses of “Great, let’s raise our prices tomorrow” and “You must be daft”, the pricing manager often finds him/herself defending a new idea against an entrenched belief system.
Yet, some leading edge companies are doing exactly that. Not only are they charging much more than the price of the nearest competing solution, but they are also able to win dominant market share within the mass market. How do they do that? Their solution delivers more value than the next-nearest competing solution and they set their prices according to the value delivered.
Example 1: Drug-Eluting Stents
Coronary stents are useful devices. When plaque builds-up on the interior walls of an artery within the heart, a cardiologist will insert a metal stent within the artery. Once released, the stent expands, enlarging the artery and allowing for more blood to reach the heart. The invention of the stent and the improvement of methods to insert stents have replaced many dangerous bypass surgeries, saving lives and money.
Prior to 2003, most coronary stents were sold for approximately $1000. In mid 2003, Johnson & Johnson released a new drug-eluting stent. This stent is similar to pre-existing stents with the added feature of a pharmaceutical coating. The pharmaceutical formulary is designed to enable the body to accept the metal stent rather than attack it as an invading object.
When J&J released their new stent, did they charge 10% more than competing stents to cover the cost of the pharmaceuticals with the hopes of market acceptance? No, they sold the drug-eluting stent for approximately $3500, a 250% increase over the next-nearest competing product. Did the market balk at the higher price? No, the market shifted to accept the new value proposition making drug-eluting stents the standard within 6 months. Why was J&J able to both dramatically increase the price of stents and take the mass market? When examined from the whole-solution viewpoint, J&J’s drug-eluting stent has dramatically greater value than standard steel stents.
A typical stent implantation operation costs over $30,000, stent included. With standard steel stents, patients suffer from rejection or complication at a rate of approximately 20%. When the stent is rejected, a second stent operation is often undertaken. Combined, the average cost of the whole-solution is $30 K plus the expected cost of managing rejections, or 20% of another $30 K, bringing the total average cost to $36,000. With drug-eluting stents however, the patient reject rate declines to approximately 5%. This lowers the average combined cost to $31.5 K for each patient. In other words, the drug-eluting stent saves insurers, hospitals, and patients an average of $4500. Viewed from the whole-solution perspective, the $3500 drug-eluting stent is a good value over a $1000 standard stent.
J&J increased prices dramatically over the next-nearest competitor and took market share because they engineered a product that delivers greater value from the whole-solution perspective.
Example 2: Complex Utility Billing
Electric service account management for large Commercial & Industrial (C&I) customers is a highly complex process. Each C&I customer may have multiple meters, multiple plant locations, and time varying service rates. Each C&I customer may also have special discounts and contracts for unique services. Because C&I account management is highly variable and complex compared to residential account management, and because there are fewer C&I customers, many electric utilities manage C&I accounts and billing separately with the aide of Excel spreadsheets.
Lodestar produces a software product tailored specifically for the management of C&I accounts. A salesperson reported to me that their next-nearest competitor to the Lodestar C&I account management solution is Excel. Excel is perceived as a free solution for most businesses, being a standard part of the Microsoft Office Suite.
When Lodestar sells their C&I account management solution, do they price it near that of Excel? Not even close. Lodestar sells an enterprise license for their C&I account management solution for approximately $300,000. (The actual price of the Lodestar C&I account management solution is dependent upon a number of factors and is a proprietary secret of Lodestar. The price used in this article is only a ball-park figure based upon the beliefs of this author given for the sake of the article’s main argument. It should not be construed as the exact price.) Do customers purchase at this price? Yes, the Lodestar solution is being adapted throughout the utilities industry. Why is Lodestar able to charge dramatically more than their next-nearest competitor and attract customers? Because the Lodestar C&I account management solution provides dramatically more value than Excel when viewed from the whole-solution vantage point.
Using Excel, C&I account managers must hand prepare customers’ bills. They must also provide a copy of the bill to accounting for the general ledger, coordinate with operations to gather data with respect to actual consumption, and perform hundreds of calculations without error. While Excel works, the business process of hand producing customer bills is labor intensive. Automating the complex billing challenge with a flexible solution can cut the workload of the account management team by 20% or more. With improved productivity delivered by the Lodestar C&I solution, the account management team can spend more time understanding existing customer’s needs, attracting new customers, or deliver the same results with a smaller team. Using the team size requirement as a means to calculate the value of the Lodestar solution, savings created by decreasing the account management team from 15 to 12 (20%) more than covers the cost of the $300 K solution when using the fully loaded cost of an account manager to compare values. By improving team productivity, the Lodestar C&I account management solution can easily pay for itself inside of a year despite the fact that it is priced much higher than its next-nearest competitor.
Lodestar prices their solution dramatically higher than their next-nearest competitor and is winning the market because their product delivers greater value to the whole-solution.
Getting value based pricing right isn’t simply a matter of looking at the next-nearest competing solution and saying “Well, ours is better. So, let’s add 10%.” In both of the above examples, the companies were able to price much higher than their next-nearest competitor. On an item-by-item basis, their prices may seem ludicrous. But, they didn’t price their product based on competitive items. Rather, they examined the challenges customers face in delivering a solution and produced a product that positively impacts the entire solution.
With an understanding of the effect of the product on the entire challenge faced by customers, companies are able to quantify the value provided with their approach to the challenge. When this value far exceeds that of the next-nearest competitor, the company is able to dramatically increase prices and still win market share. In the examples provided, the prices reflect a fair brokerage of value between the customer and the producer. Customers accept higher prices when a solution delivers greater value.
The challenge of true value based pricing lies in understanding the value from the customer’s perspective. When companies understand their value and price accordingly, they can win the market even with dramatically higher prices.