Previous posts in our series on value pricing have examined its risks, rewards, and mechanics, all with the goal of maximizing earnings for your company. Let’s expand on this foundation with practical tips and methods for considering the impact and likely market response to your pricing decisions.
There are several factors that need to be evaluated in your pricing decisions:
- Competitor response
- Sustainable pricing
- Cost structure
- Market size and share
To help you benefit from your pricing decisions, let’s look at some of the most important factors that need to be evaluated.
The Competition
How is the competition likely to respond to your pricing? Are they likely to follow your lead or undercut your price?
If a competitor has a significantly lower cost structure, their likely response will be to lower prices. They know they can make margin at lower prices than you can, and will use it to their advantage. When you set your price, take into account how much you believe they can lower their price and still be comfortable.
If a competing product is either a significant part of their business or a loss-leader to sell other products, be ready for their response and price accordingly. If, however, you deliver considerably more value, and that value is far more than the amount that they can lower their price, you can be less concerned about their price reaction.
Alternatively, if you are considered the premium supplier, and thus the price leader, you can set a price point to capture a significant amount of the value, and your competitors are likely to follow. This is especially true with new offerings. It is easier to capture a sizable amount of the value delivered with a new offering because prices “almost” always go down over time. I say “almost” because absolutes are dangerous but if you look out over a long enough time period, it’s hard to find something that doesn’t become cheaper in relative currency.
Sustainable Pricing
Sustainability is an especially tricky part of pricing. If you set your price too high, you could encourage potential buyers to consider next-best alternatives. Setting a high price shines a big light on other options available in the market. This could drive customers to attempt to develop in-house alternatives, or competitors to develop cheaper ways to solve all or part of the problem you solve.
The bottom line is that you need to understand how sustainable and defensible your differentiation is over time. There are great consumer product examples on this.
On one hand, you have a pharmaceutical company developing a new drug to treat or cure disease. (This is not a philosophical or ethical debate about how much the company should charge for the drug, but a discussion of economic reality.) Besides potentially spending billions of dollars on research and development, the company has a limited amount of time before a generic version of the drug can be made by competitors. Thus, during the patent life of the drug, the price they charge is based on the next best alternative at the time.
Let’s assume the alternative is surgery or a medical procedure that costs $20,000, and the patent protects the drug for eight years. The patient could be willing to pay close to $200 per month for the drug to avoid the procedure. Once the patent expires, the next best alternative is a generic drug that may cost only 15 to 20 percent of the original price. This means the price of the original drug would need to drop to roughly $40 to be competitive. The pharmaceutical company had an 8-year run at five times their final price. In this case, the profit-optimizing price was very close to the maximum price.
At the other end of the spectrum, you have an offering that can easily be copied within six months. You have two choices: charge a price that captures significant value if you believe you’ll make more money in the time it takes for your competitors to copy your offering, or charge a lower price over a longer period of time.
We’re all familiar with consumer examples where some fad took off for six months and the company made a lot of money, but you can’t count on that in B2B. In B2B, the best approach to sustainable value pricing is often giving a significant share of the value to your customer. This helps you lock in the customer without incentivizing competitors to create a next best alternative or modify pricing.
Cost Structure
Your customer’s cost structure is another consideration in establishing value pricing. If the cost of your offering is a small percentage of their overall cost, you can likely price to capture more of the value created. However, if your offering is a major portion of their expenditures, they will be more sensitive to your price. You’ll need to share much more of the value created to get the customer to move.
An extreme example of this is if your offering allows your customer to charge a $1,000 premium for their product. Since your price impacts their margin, it’s highly unlikely they would pay more than a fractional percentage of that value, possibly 10 to 20 percent. But if your offering helps them cut that same $1,000 from their manufacturing process for every unit produced, it will be easier to capture more of that value, possibly upwards of fifty percent.
Next, let’s consider the impact of your offering and cost structure. Sometimes being able to deliver and capture more value requires significant changes to your offering. This is the one and only place where your cost becomes part of the pricing decision. If the cost of delivering your offering (Cost of Goods Sold / CoGS) rises faster than the value created, you should evaluate less expensive alternatives that deliver value to your customers and more net margin to you.
Market Size and Share
Market size, market share, and the impact on current customers are important considerations when determining value pricing. Ask yourself these questions to better understand your environment and the ramifications of your decisions.
- Is there a large part of the market that could be addressed at a lower price?
- Are there segments of the potential market where the cost of solving the problem is too great to be affordable, even if it creates significant value?
- Could you penetrate untapped market segments with a scaled down version of your offering at a lower price?
- Would you generate greater net profit by addressing these untapped markets or by addressing the current identified market?
Then ask yourself if within the current identified market, are there segments of customers that are more or less price sensitive? If so, those sensitivities may be due to perceived value, their sophistication and ability to realize and measure value, or their availability of investment dollars. What’s the size of each of those segments? Can you price differentiate between them? Will a higher price with a lower market share deliver more earnings than a lower price with a higher market share?
Finally, you need to consider the impact your pricing will have on customers that are already buying products or services from you. Even if you deliver high value, a high price that captures a significant portion of that value could cause those customers to stop buying other things from you. If that’s likely the case, be sure to factor in the negative earnings impact from the loss of those other sales.
Here is a table that helps to evaluate each of these variables:
| Price to Share More Value | Price to Keep More Value | |
| Next best alternative ability to lower price | High | Low |
| Ability of competitors to duplicate offering | High | Low |
| Time for competitors to duplicate offering | Short | Long |
| Percentage of customer’s cost structure | High | Low |
| Total market elasticity | High | Low |
| Current margin from other offerings sold to same customers | High | Low |
Conclusion
The goal of these exercises and analyses is to be honest about where the market is today and how these factors might change over time. Then build your best pricing estimates based on how various decisions will impact your customers, your competitors, and your business.
Unless you have a crystal ball, you will never have perfect information about the future. However, using all the information and insights you have today, you can make an informed value based pricing decision that will maximize your long-term returns.
Our next blog post in the series will share potential pitfalls in value pricing and how to avoid them.
