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The Radicalness of Value Based Pricing

November 2014 Pricing 4 Comments

Value-based pricing aims to price offerings according to the value customers’ associate with the offering in comparison to its alternatives. This is a pretty well accepted definition of the concept.  Pretty well, but not completely, for this definition leaves out a word most people want to associate with every pricing concept: cost.  To not explicitly include costing information in approach pricing challenges is a radical idea.  Is it possible?  Is this a good idea?  What does this imply for business, economics and public policy?

In no less than a few hours after posting a definition of value-based pricing devoid of the word “cost,” David Nyy, Director of International Sales & Marketing at Celanese won the award for answering the brainteaser of “what word was deliberately not used in conjunction with the definition of value-based pricing.”  Not that he disagreed with the omission — just that he noticed it wasn’t mentioned (I actually believed he was amused).

Since that moment, some individuals commented that the omission of costs in defining an approach to pricing was a serious lapse of thought, other individuals thought it was appropriate, and some others found it to be it was a very broad definition which they could customize for their specific needs, audience, or address their concerns.  Who was right?  What does this do for us?  What does it imply?

Can Value-Based Pricing Really Be Defined without Mentioning Costs?

From a definitional stance, omitting cost information in defining the concept of value-based pricing is absolutely possible and highly appropriate.

Not that techniques that drive a firm towards value-based pricing should never include costing information, for many of the best value-based pricing methodologies are deeply rooted in costing information.  Many, but not all.

Nor should firms always sell offerings at the price identified by value-based pricing.  They may choose not to sell the offering at all because the price customers are willing to pay is below the costs to deliver.  They may choose to sell the offering at a lower price than that identified through value-based pricing in the strategic belief that, long-term, the firm will gain a competitive advantage, perhaps in a different market, by penetrating the current target market or maintaining current market share.  They may even choose to price it higher than that identified through value-based pricing for legal, psychological, industry development stage or other reasons.

But value-based pricing is not cost-based.  These two concepts are different.

Yet while value-based and cost-based pricing are conceptually different, they do share some techniques and structures.  Some of the specific formulas, software, methodologies and processes used in cost-based pricing can also be used for value-based pricing.  Some, but not all.

(To use a metaphor, a hammer can be used to shingle a roof or hang a picture.  The aims of “hanging a picture” and “shingle a roof” are different, even though both aims share the common tool of “hammer.”  Moreover, “hanging a picture” may require a level while “shingling a roof” may require knee-pads.  Hence some tools will be shared though the aims are different, others will not.)

Hence, yes it is obviously possible to define value-based pricing without explicitly mentioning costs.  It has been done.  (See What Is Value-Based Pricing?)

Why Is It Good to Separate Value-Based Pricing from Costing?

Value-based pricing allows executives to separate the questions of “what price can we get for this offering?” from the question “what will it cost to produce?”  And yes, this is a good thing.

From a process and decision making viewpoint, pricing is not the same as costing.

Pricing, under a value-based approach, is an exercise of asking and answering — “What will this customer pay? What will other customers like that one pay?  What will different market segments pay?  Can prices be structured or managed to vary between customers in proportion to what they will pay?  Which product-market segment parings generate interesting revenue streams?”  These are hard questions.  They are fundamentally questions about the world external to the company, the world of its customers.

Note these questions are very different from costing questions. “What is the variable cost? What is the marginal cost of one more unit?  What is the expected incremental cost of adding a new line?  How would costs be effected if more capital expenditures were undertaken to improve productivity?  What does the firm’s actions look like from an activity-based costing viewpoint?”  These too are hard questions, but they aren’t the same as value-based pricing questions.  They are fundamentally questions about the world internal to the company, the world of its employees, facilities and suppliers.

The pricing community has documented methodologies and approaches for addressing these pricing questions from a value-based viewpoint, but these techniques don’t always need costing information.  And many times, the costing information needed for doing a good value-based pricing exercise is only minimal or rough approximations of the true costs.  Sometimes, accurate costing is required, but not always.

(In fact, many highly profitable firms in fields fueled by intellectual property don’t even consider costs when it comes to pricing.)

By separating the challenges of costing from pricing, executives are positioned to make better decisions about both.  They can kick-off a pricing exercise without conducting a costing exercise, or vice versa, thus isolate and optimize the process for each issue without undertaking a massive information gathering effort.  This is clearly a good thing from a “management decision-making effectiveness and efficiency” viewpoint.

Moreover, executives may lower costs without a commensurate price decrease or raise prices without a commensurate cost increase.  When they do, they are turning a suspected competitive advantage into a tangible economic outcomes.  This too is a good thing.  If prices and costs are completely correlated, competitive strategy would be reduced to a trite exercise and all economic profits would be impossible.  The creative-destruction engine of capitalism which enables growth of human potential would be destroyed, and firms may have little incentive to do better.

What Does Separating Pricing from Costing Imply?

If firms adopt value-based pricing as they have observably been doing, we may find the correlation between prices and costs becomes broken, at least in some industries.  This has some radical and serious implications, many of which are currently unresolved.

For instance, what does accounting and finance look like if prices and costs become unrelated?  How should firms project future revenues when prices vary between customers dramatically?  How can investments be made when the underlying revenue of firms are generated through prices which are predictable only with large uncertainties?  Even moving from the metric of “price” to “average selling price” helps, but it doesn’t address all the issues of potential price variance or potentially high fluctuations in revenue generation.  Will real-options analysis be adopted by firms doing value-based pricing when considering new business development and product launches?  How will that be managed?

Or, from a sales and marketing viewpoint, can firms do value-based pricing without undertaking value-based selling?  Is this just another hoopla about gouging customers, or does it work towards better supplier-customer relationships?  What role do sales-persuasion techniques have in a value-based pricing world?

And, what does economics look like if prices and costs become unrelated?  Does this change the expectations of supply curves in microeconomics?  Does the paradigm that contrasts perfect competition with monopolistic competition, oligopolies and monopolies really make sense in a value-based pricing (can we at least change the name of one of these entities to let it cover the concept better)?  What happens to the “law of one price” in a value-based pricing world?  Are we creating the new field of nanoeconomics:  the pricing of offerings at the firm level which leads to the pricing of offerings at the microeconomic industry level?

Or, how should the adoption of value-based pricing affect public policy?  Who defines the difference between exorbitant prices and appropriate prices?  Should regulators really allow firms to practice value-based pricing in the expectation that competitive dynamics will, in time, unseat the current leader and change price expectations?  Will the people accept such a turbulent and creative world, or will the calls for manageable predictability and security destroy the acceptance of the process and its outcomes?

These are not easy questions.

Are We on This Path?

Insight to value-based pricing working is proven by its increasing adoption by firms.  And yes, value-based pricing can be meaningfully defined without mentioning costs.  These are good things, yet their implications have not fully been resolved nor uncovered.

There is more work to be done.  We may be able to define the concept, but we clearly haven’t understood all of its nuances and implications yet.  What an exciting field to be in.

Counter Note:

Despite what Wikipedia might say, value-based pricing isn’t just for niche markets, it is a broadly applicable approach across durable and consumable, business and consumer, tangible and intangible markets.  And the word is “Economic Value Model” not Estimation, for the idea of modeling the value delivered to customers.  Do you really expect a source that doesn’t use the pricing mechanism to sustain its existence nor pay for its inputs to be a good source of information on how pricing works, especially when pricing is a dynamic and growing niche field? Ok, I love Wikipedia too, but it isn’t always the best source for all specialized knowledge. And they shouldn’t be using a trademarked name for a general idea.  If you care to, update their page for them.  I won’t.  They don’t pay me.

 

 

 



  • Tim, you can edit Wikipedia you know. I may go in and do this on the weekend if someone does not beat me to it. Brilliant article. I will reference it.

  • Thanks Tim for sharing the article and Steve (Steven Forth) for sharing this on linkedin. Glad that I caught attention to this before it moved down in the list of network updates.

    I am curious to understand how dynamics play in a relatively newer market where there is plenty of competition but NONE of the existing players or new entrants is applying Cost based pricing or value based pricing. Everybody is in for long-haul – trying to break-even in 5-8 years through multiple revenue stream. It is like creating barriers of entry for players who don’t have deep enough pockets. There are market defined price bands for the services/products being offered. If a new entrant or an existing entrant even tries to apply these principles, chances are pretty high that they would have to raise their prices which they won’t because competition is offering services at the lower prices. Thoughts?

  • Armin Kakas

    Tim – great article. But how viable is an implementation of VBP in the world of retail where products can number in the 10s of thousands, competition is intense between physical and online platforms, and price transparency powerful and active for consumers, especially for items like electronics?
    I would think all these factors essentially commoditize the products, thereby making VBP great in concept, but much harder in reality to implement. Would love to hear your thoughts on this.

  • Dave_Ormesher

    “Or, how should the adoption of value-based pricing affect public
    policy? Who defines the difference between exorbitant prices and
    appropriate prices? Should regulators really allow firms to practice
    value-based pricing in the expectation that competitive dynamics will,
    in time, unseat the current leader and change price expectations?”

    Very relevant questions in light of Gilead’s Sovaldi, the drug that cures Hepatitis C but costs $1,000/pill… I would argue that this is VBP, and that the premium price not only attracts competitors which will bring down the price over time, but that it is the engine to fund future innovation.

About the author

Tim J. Smith, PhD is the Managing Principal of Wiglaf Pricing, and an Adjunct Professor at DePaul University of Marketing and Economics. His most recent book is Pricing Strategy: Setting Price Levels, Managing Price Discounts, & Establishing Price Structures.

Tim J. Smith, PhD
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