Wednesday, December 15, 2010

What is Value Based Pricing and Value Based Selling ?

What is Value Based Pricing and Value Based Selling ?

Value based pricing takes into account the perceived value of an product or service as seen by a customer. What will be the incremental benefit I will receive from this Seller's product or service. Value based pricing converts that incremental benefit into a marginal price differentiation beyond cost plus or the cost of their competitor which cannot provide those incremental benefits. It reflects a trade off between benefit gained & price paid.

Value pricing is simple. You take the parameters which will be perceived by the customer to limit price and then see if you can build a case to change their perception. It is important to remember that all value lies with the customer. Value is not what you put into your products or services, but what your customer gets out.

Value based selling helps extend the size of the incremental benefit perceived & accepted by the customer. Suppliers will seek to Value Based Sell to potentially increase revenue without increased costs or to gain an advantage by showing customers that the Supplier really understands their business and is delivering value for money.

Suppliers will avoid Value Based Selling to avoid potentially high "cost of sale" due to the need to invest in understanding the customer's business wasted pre-sales effort

1. PROSPECTING (Who/where are the potential customers who need the benefits my product or service will provide ?)

2. QUALIFYING (Can I deliver to meet their expectations. Do I feel that they will be willing to pay the incremental costs to get the benefits I can deliver ?)

3. BIDDING (What is going to unique about my Bid ?) How can I differentiate my bid from the others to give me a competitive advantage.

4. DELIVERING (Now that the customer trusts me, where else can I add value and sell more products and services ?)

5. POST-DELIVERY (What value has customer gained ?) Do I understand the real benefits so I can use them in marketing to other customers using things like customer testimonials.

Companies make certain acquisition decisions infrequently. Most will not have the real expertise to allow them to understand what is needed and what provides true value. Many use questionable information to make decisions. If someone can convince them that they are receiving value and that savings will accrue, in most cases they will be willing to pay a premium price. Customers may be less concerned about the price of an item than the affect that item will have on the cost of their operation. If I can buy an item that will eliminate $100,000 in annual operating expenses and have a pay back period of 18 Months I could easily lose sight of the fact that I may be paying substantially too much for the item - I'm blinded by the bigger value received.

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.

    Value Engineering:

    Value engineering can take many forms:
                Eliminate the part, process  or service !
                Simplify it !
    Alter it to make it more productive (Design for manufacturability, design for serviceability).
                Use standard parts or materials.
                Use lower cost materials.
                Use lower cost processes.
                Use higher cost material which can simplify in other ways.
                Use higher level assemblies.
                Consider alternative methods of production.
    Increase quality at no added cost (process improvement not inspection).
                Seek uniqueness for price differentiation.
                Add features to create uniqueness for price differentiation
                Improve service or warranty offerings
                Improve reliability.
    Provide delivery/flexibility capabilities allowing reduced inventory
                Be predicatable in delivery.
                Seek suggestions from all.
                Insure committed performance is in fact delivered.
    Work performance improvements to 1st, 2nd, and 3rd tier suppliers).

    To ensure that the supplier cooperates in value engineering, they need to have the right incentives to drive the right behavior. For example, if the supplier is paid a fee as a percentage of the work, if they reduce the cost of the work, they reduce their fee. That's a negative incentive. If the change reduces their profit, that's a negative incentive. If the salesperson is commissioned on gross sales, reducing the cost is a negative incentive. To get 100% of their attention and cooperation you need to structure your agreement of business in a way where there is a positive incentive to do value engineering. For example, for the supplier with a fee as a percentage of the work, offer to fix it at a specific level so they aren't penalized in helping you reduce cost. For changes which would reduce their profit, consider offering a sharing of the savings, which will drive their effective profit rate up. For salespeople who are commissioned on gross sales, offer more business to offset the loss, or meet with their management to create a different incentive program where they get compensated for the value enginnering savings.