Wednesday, December 15, 2010

Value Equivalence

In an article in the McKinsey quarterly by Ralf Lszinski and Michael V. Marn on setting pricing, the authors describe a concept that they referred to as the value equivalence line which companies should use to price their product. The value equivalence line runs at  the midpoint between the two axis of price and the axis of value. If you think about this there is simple common sense to what they propose. If a product’s price and value is plotted above the line, you are charging more for the product than is warranted by the value and your sales ill be impacted. If the product’s price is below the line, you are charging less for the product than is warranted by the value which should result in higher sales, but at a lower price and profit margin than what would be warranted for the value.

They also note that frequently there will be different price/value clusters along the Value Equivalence line, with each cluster targeted at different market made up of different requirements. You see this in most markets where there may be one market focused on economy buyers, another for middle market and one for high end. A company could have three similar but different value products that are focused on different clusters such as Walmart version targeted toward lower end Customers, A Macy’s version targeted mid-range customer’s or Neiman Marcus version targeted at the high end customer who wants and will pay for value . As clusters can be driven by a number of factors such as allowable budget, approval levels, etc. they further argue that it can be important to have the Price of the Product to fall within one of those clusters. That’s seems like common sense too as product falling between clusters may be at a price and value that individuals in the next lower cluster simply will not migrate up to and the next higher cluster may not be interested in buying it because it offers lower value than what they are looking for.   

What does all this have to do with negotiations? In negotiating the cost of a product with a Supplier, value equivalence is another cost negotiation approach that’s similar to what procurement would refer to as benchmarking. For example, if all the Supplier’s provide the same functionality, you could plot all their prices, along with the price of the Supplier you want to negotiate with, on the value equivalence line. If they provide no additional value, the key message in the negotiation is that if they want to take business away from the competition they need to offer a better value equivalence position. This means that they need to either give you more, or they need to sell it to you for less.

If there is a difference in functionality, you would still plot that on the chart versus similar products that should fall on the Value Equivalence line. This allows you to highlight the incremental difference in price for that difference in functionality and value.
Then there are two approaches:
  • You don’t need the added value and functionality so they need to be competitive price wise with the lower cluster.
  • You can see the value, but the incremental cost of that value isn’t worth the incremental price they want to charge. Use the cluster price as the benchmark and negotiate the incremental cost for the additional value. You are willing to pay for additional value, but that incremental amount needs to be justified based on incremental value.

Let me show you how this would look. Create an the axis with price as your vertical line and value as your horizontal line. Now draw a diagonal like that separates the axis. That diagonal line is the value equivalence line.

If a Supplier is above the value equivalence line to the other suppliers, you might give them the message that they aren’t competitive on a value equivalence perspective and to win the business, if they can’t give more value they need to lower their price.
If a Supplier is providing the right value for there price but there are Suppliers that offer a better price value equivalence, you might give the message that they aren’t competitive on a value equivalence perspective and to win the business, if they can’t give more value they need to lower their price. 
If you are dealing with the supplier that offers the best price/value equivalence, you might give them the message that you don't need all the value that they provide, and they need to be competitive with those that offer less value.  For example if they have more features than the other Suppliers, you could tell them you don't need all those features. The key is creating uncertainty which can provide the supplier the incentive to either provide more value or reduce their price to win the business.

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