Value Creation

The Source of Pricing Advantage

Prepared and presented by:

Jono M Munandar
Department of Management FEM IPB

Source :
THE STRATEGY AND TACTICS OF PRICING
A Guide to Growing More Profitably
Nagle Hogan Zale
Fifth Edition
©Pearson Education Limited 2014
THE ROLE OF VALUE IN PRICING
• The term value refers to the overall
satisfaction that a customer receives
from using a product or service.
• Economists call this as use value —
the utility gained from the product.
• Example : On a hot summer day at
the beach, the use value of a cold
drink is quite high for most people.
• The value at the heart of pricing strategy is
not use value, but is what economists call
exchange value or economic value.
• Economic value depends on the alternatives
customers have available to satisfy the same
need: for example, willing to pay for
convenience.
• Economic value is the fact that the value
one can capture for commodity
attributes of an offer is limited to
whatever competitors charge for them.
• Only the part of economic value
associated with differentiation, which we
call differentiation value, can potentially
be captured in the price.
• Differentiation value comes in two forms:
– Monetary (MV)
DV = MV + PV
– Psychological (PV)
• Monetary value represents the total cost
savings or income enhancements that a
customer accrues (add) as a result of
purchasing a product.
• Monetary value is the most important
element for most business-to-business
purchases.
• Psychological value refers to many ways of the product
creates innate (authentic) satisfaction for the customer.
• Example: Rolex consumer often create more
psychological than monetary value because they focus
on creating satisfaction and pleasure.
• Total economic value (TEV) is calculated as the price of
the customer’s best alternative (the reference
value(RV)) plus the worth of whatever differentiates the
offering from the alternative (the differentiation value
(DV)).

TEV = RV + DV  TEV = RV + MV + PV
Total economic value is the maximum price that a “smart shopper,” fully
informed about the market and seeking the best value, would pay.
• Differentiation value is the net benefits that
your product or service delivers to customers
over and above those provided by the
competitive reference product.
• The degree to which a supplier differentiates
its offer (in terms of those needs) will have the
greatest impact on the price the marketer can
successfully charge above the reference value.
HOW TO ESTIMATE ECONOMIC VALUE

To develop quantified estimate economic of

customer value:
• Analyze competitive reference prices.
• Two approaches:
– Quantifying monetary value
– Quantifying psychological value
Competitive Reference Prices
• Identifying the next best alternative product
and gathering reference prices
• Some products may not have a single
competing product that customers would
consider a suitable alternative.
• Customers might construct a set of different
products and services as a viable alternative.
Another challenge :
• It is gathering accurate price data and ensuring that it is
comparable to the pricing for the product.
• Competitive prices are measured in terms of the segment
(for example, price per pound, price per hour) and are stated
in the same units as product.
• Marketers must be creative in finding secondary
information by using polling the sales organization or
interviewing customers.
• Secondary price data will be less reliable than primary data
obtained directly at that point of sale.
it is possible to take imperfect competitive price data and treat it becomes useful
to a value estimation exercise.

Exhibits 2 and 3 provide an illustration of how secondary price data

can be treated for use in a value estimation
Exhibit 3 revealed much more consistent pricing behaviors that could be
used as an input to the value estimation.
• Note for exhibit 2 and 3:
– The data was collected by a technology
manufacturer in North America as part of a
competitive strategy assessment.
– Data in Exhibit 2 was seemed there was little
coherence to how competitors were setting
prices.
– Based on the untreated data, the product
managers noted that:
• the competitors were completely irrational in their
pricing
• much of the variation was due to differences in volume
and service levels.
 Monetary Vs Psychological Value
• The distinct characteristics of monetary and
psychological value drivers require different
approaches to quantify.
• In contrast, the intangible nature of
psychological value drivers (such as
satisfaction and security) are not inherently
quantifiable. Therefore, marketers often rely
on sophisticated quantitative techniques
(such as conjoint analysis).
Estimating Monetary Value
• After determining the competitive
reference prices, the next step is to:
– understand customer value drivers
– translate that understanding into
quantified estimates to support pricing
decisions.
• Monetary value drivers are related to the
customer’s financial outcomes (tangible cost
reductions or revenue increases).
• Monetary value drives are already
quantitative, therefore it can be estimated
using qualitative research techniques (rich
understanding of the customer’s business
model or personal finances).
• The first step in quantifying monetary value drivers is to
understand how the product category affects the
customer’s costs and revenues.
• In consumer markets, this is a relatively straight-
forward (easy) exercise because end consumers usually
have few monetary value drivers for a given product
category.
• Quantifying monetary value drivers in business markets
is more challenging because of the complexity of most
business operations and the need to understand fully
how a product affects a customer’s profitability.
• This complexity is started with a detailed
assessment of the customer’s business model
to understand how our product contributes to
the business customer’s ability to create value
for its own customers and to reduce its
operating costs.
• Once the mechanisms for value creation are
understood, the next step is to collect specific
data to develop quantified estimates.
• In-depth customer interviews are the best
source of information. It probes the
underlying economics of the customer and
the product’s prospective.
• The goal is to develop value driver
algorithms, the formulas and calculations to
estimate the differentiated monetary worth of
each unit of product performance (Exhibit 4).
Once the differential value algorithms have been determined, the final step is to sum the
reference value and the differentiation value to determine the total monetary value.
Several guidelines for estimating monetary value:
• First, consider only the value of the difference between
your product and the next best competitive alternative
(NBCA) product.
• Second, measure the differentiation value either as costs
saved to achieve a particular level of benefit or as identical
cost to achieved extra benefits. Don’t add both; that’s
double counting.
• Finally, do not assume that the percentage increase in
value is simply proportional to the percentage increase in
the effectiveness of your product.
Monetary Value Estimation: An Illustration
 Value Driver 1 - Yield Opportunity Cost
No Items Amount Unit
1 Annual Revenue from succesful commercial drugs range 250-1000 M$/yr
2 Conservative estimate of revenue 400 M$/yr
3 75% of revenue = contribution margin (CM) (75%x400) 300 M$/yr
4 The cost of developing typical drugs (CD) 590 M$/yr
5 NPV (Based on CM and CD) 41 M$/yr
6 The Value of Target Test (41 M/500 target test) 82000 $/yr
The Value of Target Test/hr (82000/2100 hr works per
7 years) 39 $/hr-yr
The Value that saves if using Dyna Test (39x40* hours
8 additional time) 1560 $/yr
* 40 hr saved time as amount one week per year (8 hr x
5 days)
 Value Driver 2 - Yield Labor Savings
No Items Amount Unit
Labor savings from using Dyna Test (16 hours savings x 24$/ hr
1 384 $
wages of labor)

Value Driver 3 - Quality Control Savings

Customer cost saving cause of high quality test (2 hours x 24$/ hr
1 48 $
wages of laboratorian)

Value Driver 4—Sample Size Opportunity Costs

1 Estimated Opportunity cost (3 x 1560$) per project 4680 $
Opportunity cost averages (10% x 4680 $ Estimated Opportunity
cost) 468 $

Value Driver 5 - Sample Size Labor Savings

1
Value of using Dyna Taste (24$ wages of labor x 16 hr research
labor x 10%) 38.4 $
Estimating Psychological Value
• Psychological value (satisfaction and
security), by virtue of their subjective nature,
do not let themselves to estimate via
qualitative research techniques like in-depth
interviewing.
• But must rely on a variety of quantitative
techniques to estimate the worth of a
product’s differentiated features.
• The most widely used of these techniques is
conjoint analysis—a technique to discern
the hidden values that customers place on
product features. Another technique is
regression.
• The basic approach is to decompose a
product into groups of features and then
provide customers with a series of choices
among various feature sets to understand
which they prefer.
• In recent years, marketing researchers have
extended the basic conjoint techniques so
that virtually any type of consumer choice
can be tested including choices involving
different brands, budget constraints, and
even purchasing environments.
• Using conjoint analysis makes it possible to
estimate the value of different feature sets in
driving willingness-to-pay and, ultimately the
purchase decision.
 Physiological Segmentation Example at Sport’s Co.
• Innovators: Frequent golfers highly focused on performance. They tend to have
higher incomes and purchase clubs through their local pro shop after extensive
consultation with the club pro and friends.
• Value Seekers: Casual players who play from 5-10 times during the season. They
have moderate income and purchase from major retailers such as the Sports
Depot or Golf Warehouse. Value seekers are thrifty (saving), but they will pay a
premium for added performance.
• Lost Players: This is a large segment of occasional players who have largely
drifted away (avoid) from the game. They do not purchase significant amounts of
golf equipment, but they can be drawn back to playing if a new innovation
creates enough buzz to capture their attention.
• Budget Shoppers: These players range widely in ability and frequency of play,
but they have budget constraints that limit the amount they can spend on
equipment. They typically buy new equipment through discount stores such as
Wal-Mart and online outlets.
Psychological Value Estimation: An Illustration
The High Cost of Shortcuts
• When setting prices, there are no shortcuts for
understanding the economic value received by the
customer.
• Many companies, nonetheless, shortchange
themselves by assuming that if their differentiated
product is “x” percent more effective than the
competition, then the product will be worth only
“x” percent more in price.
• The total economic value of a
differentiated product is proportional
to its technical efficiency only when a
buyer can receive the benefits
associated with a superior product
simply by buying more of the
reference product.
• At the center of this misconception is the popular
concept of customer value modeling (CVM),
which emerged from the total quality
management movement when companies tried
to measure and deliver superior quality at a
competitive price.
• CVM relies on customers’ subjective judgments
about price and product attribute performances.
• It assumes that customers seek to purchase the
products that give them the greatest perceived
benefit—which might be quantified in monetary
terms, but need not be—per unit price.
The simple example in Exhibit 10 illustrates the difference between
economic value estimation and customer value modeling (CVM).
VALUE-BASED MARKET SEGMENTATION
• Identifying and describing market subgroups
in a way that guides marketing and sales
decision-making makes the marketing and
pricing process much more efficient and
effective.
• Significant differences between value-based
segmentation and other methods are
especially critical for pricing.
• First, most segmentation criteria correlate
poorly with different buyers’ motivations to
pay higher or lower prices.
– Both plumbers and personal-injury lawyers
consider online advertising to be very important,
for example. They advertise to attract customers
who have an immediate, unexpected, and high-
value need.
• Second, even needs-based segmentations give
priority only to those differences that are
important to the customer.
• Finally, the customer in-depth interviews
required for value-based segmentations also
uncover why customers find certain product
benefits appealing—or would find them
appealing were they sufficiently informed.
Six Step Process to conduct a value-based segmentation :

Step 1: Determine Basic Segmentation Criteria

• The goal of any market segmentation is dividing
a market into subgroups whose members have
common criteria that differentiate their buying
behaviors.
• Choosing appropriate segmentation criteria
starts with a descriptive profile of the total
market to identify obvious segments and
differences among them.
Step 2: Identify Discriminating Value Drivers
• Having preliminary segmentations in hand,
you identify those value drivers— the
purchase motivators—that vary the most
among segments but which have more or less
homogenous levels within segments.
• Never assume for pricing purposes that preliminary
segmentations based on obvious criteria will
coincidentally yield effective discrimination on value
criteria.
– Commercial and nonindustrial medical laboratories probably
have similar needs, for instance, and derive similar value
from an undifferentiated product such as laboratory
glassware.
• In-depth interviews probing how and why buyers
choose among competitive suppliers provide the
additional input required.
Step 3: Determine Your Operational Constraints
and Advantages
• In this step, you examine where you have
operational advantages.
– Which value drivers can you deliver more
efficiently and at lower cost than others? Also,
– which drivers are constrained by your resources
and operations?
• Experience, capital spending plans, personnel
capabilities, and overall company strategy are
among the inputs to this step.
• Examine competitive strengths and weaknesses
on key drivers as closely as you can.
• With these data, you can cross-reference and
compare lists of customer needs served and
unserved, the seller’s advantages and resource
limitations, and competitors’ abilities.
Step 4: Create Primary and Secondary Segments
• This step combines what you’ve learned so far about
how customer values differ and about your costs
and constraints in serving different customers.
• Your secondary segmentation divides primary
segments into distinct subgroups according to your
second most important criterion.
• Your tertiary segmentation divides second segments
based on the third most important criterion, and so
on.
• Your primary segmentation should account
for your company’s and constraints as well as
customer needs.
• Your secondary segmentation, therefore, will
use the value driver that varies the most
among the sub-segments within each primary
segment
Step 5: Create Detailed Segment Descriptions
• Value-based segmentation variables can look
fine to the price strategist, but segments
should be described in everyday business
terms so that sales people and marketing
communications planners know.
Step 6: Develop Segment Metrics and Fences
• it’s important to recognize that segmentation
isn’t truly useful until you develop the metrics
of value delivery to market segments and
devise fences that encourage customers to
accept price policies for their segments.
• Metrics are the basis for tracking the value
customers receive and how they pay for it.
– For example, car rental companies once used a
distance-based value metric and charged
customers for the mileage traveled, in addition to
the time used.
• Fences are those policies, rules, programs, and
structures that customers must follow to
qualify for price discounts or rewards.
• Choose metrics and fences that establish and
enforce premium prices for high value segments,
and allow feature repackaging and unbundling to
appeal to low-value and low-cost-to-serve segments.
• Identifying value-based segments, the metrics of
pricing offerings, and the fences that maintain a
price structure allow a marketer to expand its profit
margins by aligning its prices, service bundles, and
capacity utilization with the different value levels
demanded by different customers.
THANK YOU 