When it comes to setting price, economic value modeling trumps customer value models.
modeling (EVM), value is the economic savings and gains customers realize by buying the firm's product instead of products from other competitive suppliers. In this case, price is determined by value. In the previous article, we argued that the implications of using CVM for pricing lead to consistent and significant biases in pricing--usually underpricing--that have both tactical and strategic pricing implications. In this article, we will expand on the strategic pricing implications of CVM and recommend the better model for pricing--EVM.
The problem with CVM is that it fails to distinguish between the value of benefits that are priced as commodities and the value of benefits that are uniquely differentiated by a brand. "Commodity value" is the worth of the benefits associated with the features of a product that resemble those of competitors' products. "Differentiation value" is the value associated with the features of a product that are unique and different from competitors. The price-per-unit value that buyers would be willing to pay a supplier for differentiating features is greater than the price-per-unit value that they would be willing to pay for commodity features. That's because refusal to pay a supplier's price for differentiating features means that the buyer must forgo those features. Refusal to pay a supplier's price for commodity features means simply that the customer must buy them elsewhere.
Take a simple example. Multiple competitors produce competing products. Your competitors' "commodity products" create $10,000 in value for customers. Your superior differentiated product creates $15,000. Due to competition, the commodity product sells for only $3,000 each ("customers get $7,000 of what economists call "consumer surplus"). Your product sells for $6,000.
CVM views value in terms of the ratio of what you get divided by what you pay, and so leads to an uncomfortable paradox.
The price/benefit ratio of your product, $6,000/$15,000 (0.40), is higher than the price/benefit ratio of the competitors' products, $3,000/$10,000 (0.30). CVM advocates would say that your product is overpriced and that you need to reduce your price to no more than $4,500 to be competitive (.3 times $15,000). Yet customers are paying more per unit of benefit for your product than for competitors' products because the incremental value of its differentiation, $5,000, exceeds the incremental cost, $3,000. Exhibit 1 illustrates the paradox as shown in a customer value map. Your product is currently located at point A. The relative price ratio vis-à-vis competitors is $6,000 divided by $3,000, or 2.0. The market-perceived quality ratio vis-à-vis competitors is $15,000 divided by $10,000, or 1.5. Thus, your current value position is point A.
The model suggests that your product will lose share because your position is to the left of the fair value line. Customers should perceive they are getting less value from buying your product than from buying competitive products. The CVM therefore recommends that you reduce price so that your product moves to the value position corresponding to point B.
However, buyers who failed to buy your product because it was to the left of the line would be making poor decisions. The correct calculation for value comparison among brands is not "dollar of benefits divided by price," but is "dollar worth of benefits minus price." The customer who buys your product receives $9,000 more value than he is paying for ($15,000 minus $6,000). The customer who buys your competitors products gets only $7,000 more value than he is paying for ($10,000 minus $3,000). A customer who does not buy your product is missing out on an opportunity to get $2,000 of additional surplus value from the purchase. Thus, instead of losing share you will gain share because of the additional value you offer in comparison to the price paid.
Why does this happen? Because CVM divides price by a composite sum of the worth of the benefits received, which automatically weights all benefits the same in terms of price paid--creating a composite average of price per unit value. Consequently, it infers that customers will pay no more for highly differentiated benefits than they would for commodity benefits.
Here's a B2B example: A semi-conductor manufacturer sold integrated circuit chips to original equipment manufacturers (OEMs) of telecommunications, who sold various products to the consumer marketplace. A key driver of value for these OEMs was "time to market," that is, the time it took to "design in" the new chip into the new product and get the new consumer product to market. This semi-conductor manufacturer excelled at design-in, which enabled its OEM customers to get their consumer products to market usually two months faster than it would take to design-in chips from alternative semi-conductor suppliers, out of an industry-average 12-month design-to-launch cycle time. Thus, the improvement in time-to-market "productivity" was about 17%% (two months divided by 12 months). But the dollar value created per product sold was considerably higher than 17% vis-à-vis other competitive suppliers due to (a) the incremental share of market the OEM company would realize by being first to market, (b) the price premium it would realize before competition effectively entered the market, and (c) the unit cost savings the OEM would realize by driving volume manufacturing to scale faster than competitors. And this was just one driver of differentiation value.
The same thing happens in many B2C contexts. Volvo positions its cars as the safest that one can drive. Customers pay a significant price premium for Volvo's safe image. Yet, even though Volvo advertising makes substantiated claims about Volvo's safety record (X% more steel than other cars or X% fewer injuries), people pay more for the psychic value of knowing that they or their loved ones are more likely to survive an accident. This differentiation value is far greater than a percentage improvement in performance that Volvo may document and promote to the marketplace.
It is important to define what "value" is. One of the reasons for the weaknesses of CVM is that it fails to distinguish between different types or definitions of value. We define four concepts of value, which are usually confused in the discussion of value and CVM. (See Exhibit 2.)
Value in use. This is the monetary worth of a product's set of benefits actually received by the customer as a result of using the product or service. Economists call this use value, or the utility gained from the product. In their 2002 book The Strategy and Tactics of Pricing (p. 74), Tom Nagle and Reed Holden explain:
"On a hot summer day at the beach, the 'use value' of something cold to drink is extremely high for most people--perhaps as high as $10 for 12 ounces of cold cola … [but] few potential customers would be willing to pay such a price. Why not? Because potential customers know that, except in rare situations, they don't have to pay a seller all that a product is really worth to them. They know that competing sellers will give them a better deal, leaving them with "consumer surplus." … [Perhaps] a half mile up the beach is a snack shop where beverages cost just $1."
Richard Thaler's seminal 1985 Marketing Science article "Mental Accounting and Consumer Choice" describes this definition of value-in-use in terms of "acquisition utility" and its value equivalent (i.e., the amount of money that would leave the individual indifferent between receiving the product or its monetary equivalent as a gift). Value in use is realized over the life of the product or service and includes all associated savings and benefits, such as installation or maintenance savings or personal or product performance benefits.
A product's objective monetary worth to a customer adjusted for the availability of competitive substitute products is known as economic value, or value in exchange. Even though a product's value in use may be substantial, competitive market forces barter away some of that value through competitive pricing. This value is not lost but simply transferred from sellers to buyers in the form of consumer surplus. Consequently, buyers may be willing to pay sellers in one market less than they pay for similar benefits in another market because the first market offers more competitive alternatives. To calculate economic value, one must first determine the reference price of competitive substitutes in the marketplace and then determine the incremental use value that the product delivers over and above that of competitive substitutes. (See Nagle and Holden, 2002. Also see James C. Anderson, Dipak C. Jain, and Pradeep K. Chintagunta's 1993 Journal of Business-to-Business Marketing article, "Customer Value Assessment in Business Markets: A State of Practice Study," which explores the many definitions of value studied by scholars and researchers and settles on this relative conceptualization of value.)
Market value. Market value is the value buyers perceive the product to be worth. Nagle and Holden (2002) comment: "A product's market value is determined not only by the product's economic value (i.e., value-in-use or value in exchange), but also by the accuracy with which buyers perceive that value … (p. 110). This means that it is critical to understand not only perceived value (market value) but to understand it separately from actual value so that marketers can compare, diagnose, understand, and recommend strategies to manage the gap between perceived value and real value.
Willingness to pay. This refers to the price buyers are willing to pay to obtain the value buyers perceive the product to be worth. Despite buyers' perceptions of value, they may be either unable or unwilling to pay this due to price sensitivity. For instance, heavy volume purchasers may perceive significant product value, but are sensitive to unit price because the total product expenditure is large relative to total income or budget. Thaler's 1985 description of "transaction utility" and its value equivalent (i.e., the difference between the price an individual pays and some reference price) reflects willingness to pay.
CVM assumes that value is value. However, as these different conceptualizations show, understanding which value you are measuring has important implications for how to market the product or service, and particularly how it should be priced. For example, for many products in competitive markets, much of the actual value customers realize is use value. But much of that value is commoditized because other competitors offer essentially the same features, benefits, and therefore value. The relevant definition of value for these products is therefore exchange value, which explicitly accounts for the commoditization of competitively available features and benefits and explicitly identifies and quantifies the worth of truly differentiating the features and benefits.
CVM virtually ignores this distinction between use value and exchange value. It begins the analysis by asking customers for their subjective ratings of benefits, an indirect way of measuring perceived value--indirect because it measures the value of benefits as a subjective "score" rather than in monetary terms. By measuring only perceived value, CVM also fails to make the distinction between actual value and perceived value. The consequences of this omission for pricing and marketing are significant, since if a product is selling poorly, trying to raise perceived value may be a better alternative than lowering the price, if the price is justified by its exchange value.
For example, if a product's perceived value (perhaps as measured by a CVM benefit score) were lower than the seller expected, the problem may well be that buyers are uninformed, poorly informed by their own lack of product knowledge or ability, or misinformed by competitors selling tactics. Rather than lower price to a level that reflects buyers' poor perceptions of value, the firm would be much better off properly educating customers about the product's true potential value and raising perceived value. It might also reassure risk-averse customers that they will truly realize this actual value by offering stronger warranties or perhaps communicate to late-adopter customers that other "opinion-leader" buyers have purchased the product because they know the true value it delivers, and so on.
Finally, the value of the benefits does not tell the full story of why customers may not buy (i.e., why the product is a share loser rather than a share gainer). Willingness to pay merits just as much strategic and analytical rigor as value. Even if customers perceive significant value in the product or service, they may be unable or unwilling to pay because of low budgets or income, because the price represents a large share of the buyer's total available budget, and so on. In such cases, the answer simply may be to restructure the transaction to facilitate purchase--by offering financing so that buyers can spread payments over time or offering lower prices only for buyers that purchase in large quantities.
True Measure of Value
The process for estimating value has been reasonably established by pricing and marketing scholars. Nagle and Holden (2002) summarize this process. James Anderson and James Narus show a practical application in their 1998 Harvard Business Review article "Business Marketing: Understand What Customers Value." John Forbis and Nitin Mehta provide a foundational conceptualization and excellent application in their 1982 Business Horizons article "Value-Based Strategies for Industrial Products."
Economic value is the price of the customer's best alternative (the reference value) plus the value of what differentiates the offering from the alternative (differentiation value). Differentiation value identifies all factors that differentiate the firm's product from the competitive reference product; these are sources or drivers of differentiation value. The worth of each of these drivers of differentiation value is estimated by quantifying the savings and gains that customers would realize by using the firm's product rather than the competitor reference product.
Total economic value is the sum of reference value and differentiation value. (See Exhibit 3.) What is the value of knowing total economic value? First, it is the logical reference point for setting price since it is the monetary worth of the benefits the customer receives in exchange for the price paid. Second, it becomes the anchor of a value-based pricing strategy that guides the setting of price points that encourages buyers to pay for the value they receive, rather than other flawed pricing methods such as setting price based on what the customer is willing to pay or based merely on competitive prices. Third, economic value is useful in persuading potential customers of the superiority of the firm's product offering because it calculates the true economic impact from buying your product rather than a competitor's. (See Forbis and Mehta 1982.)
To be sure, although rational customers will often pay much more than the price that the value equivalence model would predict, they're rarely willing to pay as much as the EVM would say a product is worth. Factors such as uncertainty about the promised benefits, switching costs, and perceptions of fairness will all reduce willingness to pay to a level below economic value. Economic value is, however, a useful starting point for communicating value to customers and for building a marketing program that supports capturing a large portion of it in price. "Value equivalence" is, in contrast, a declaration that innovation and marketing are not true value since, despite building product differentiation and the means to communicate it, all pricing is basically commodity pricing that is pegged to industry prices. We believe that the success of many premium-priced brands refutes that contention.
For pricing and marketing, the truest and most accurate way to determine value is the old fashioned way--to estimate it based on knowledge of how customers actually use the product and realize value from its use. CVM is handy and simple to do and easy to understand. It is an appealing analytical framework for high-level executive decision makers who are not close to a product, its customers, and how customers receive utility (and value) from product use. But it consistently leads marketers to simple analytical heuristics that sidestep a true and robust estimate of customer value.
In this second of a two-part series, the authors show how economic value modeling (EVM) is superior to customer value mapping (CVM) for setting price. EVM properly distinguishes between the value of highly differentiated product benefits vs. generally commoditized benefits. It calculates the savings and gains that comprise the product's actual economic value. The result is more robust and more accurate pricing that recognizes the true differentiation value of the product.
GRAPH: Exhibit 1; The value ratio paradox
DIAGRAM: Exhibit 2; Distinguishing between types of value
DIAGRAM: Exhibit 3; Economic value model (EVM)
By Gerald E. Smith and Thomas T. Nagle