Friday, August 31, 2012

Value-Based Pricing

£ coins by Images_of_Money 
The prospect of identifying a vacant market-niche and its associated price-point gap prior to sourcing and design (as in Ikea) is compelling: Ikea first identifies a market niche (customers with small kitchens) then the need for a product range (cabinets that fit) and next a vacant price point. Only then do they turn their attention to design and manufacture of a product to fill the need.[1] Indeed, design is the last step in their process rather than the first, considered only after materials and manufacturing environments are agreed upon.

My initial reaction to Ikea’s product development strategy was “how novel,” however further exploration reveals that my response reflects how little I know about current pricing theory.

While casting about for references to help me get a better handle on How Pricing Is Done, I stumbled on the Value Pricing Group, a consulting firm in St. Louis specializing in “value-based pricing”. Their CEO, Jerry Bernstein has written a number of articles on the subject that are well worth a look. His landmark article "Engineering New Product Success"[2] was published in 2002, around the same time as Margonelli’s article about Ikea.

Engineering New Product Success” describes an alternative to the classical model of establishing price on the basis of cost of production and distribution. Bernstein describes a multi-step process developed during his tenure at Emerson Process Management, a manufacturer of equipment for industrial process-control.

The steps, in order, are laid out here:
  1. Qualitative research to ascertain that the product and feature set in question is being evaluated in the proper set of prices ranges by the right customer population.
  2. Quantitative research to provide formal analysis of the information gleaned in step one, e.g. how much value do potential customers attach to specific features, and how should those values be reflected in pricing? In other words, how much are intangibles such as  “name brand” worth to customers, or what value do customers attach to incremental changes in device performance, e.g. +/- 1% accuracy in measurement versus +/- 5%?
  3. Creation of a “numbers story” to compare likely outcomes from introducing the product at one price versus another. This step takes into account questions such as how introduction of the new product might impact sales and revenue from existing products: it is one thing to maximize revenue from any given product, but quite another to price a product in such a way that profit is optimized across the entire product line to maximize benefit for the producer.

Bernstein takes care to point out that successful implementation of this process requires significant commitment, training and dedication of resources. That is, the overhead to value-based pricing is non-trivial. He also emphasizes the importance of hearing the customer to ensure that the product offered is one that will fit their needs.

Bernstein also takes pains to emphasize the importance of integrating questions regarding pricing and perception of value into the design process earlier rather than later.

The outcome of Emerson’s pre-production market research for the item in question was the realization that they would be better setting a price of $3150 than the $2650 that their marketing department had initially specified. The higher price permitted them to maximize profit while minimizing cannibalism of revenue from existing products. Emerson’s analysis permitted them to charge significantly more per item while nevertheless satisfying their customers that they were receiving good value for their money. They also ensured that they were producing an item for which there was sufficient demand to make the endeavor worthwhile.

In short: Emerson did not finalize design or even think about nailing down production details until well after empirically establishing market demand and price point.

Compelling though the concept of value-based pricing might be, there are some obvious potential pitfalls, e.g. the expense of the commitment, training and dedication of resources mentioned above. Careful selection of product environment is clearly a critical initial step when considering implementation of this technique.

How might value-based pricing be applied to service industries such as banking or healthcare?

Under what circumstances might pursuit of value-based pricing be good use of resources? Contrariwise, when would it be wasteful or yield a low return?

[1] Lisa Margonelli, "How Ikea Designs Its Sexy Price Tags", Business 2.0 (October 2002),1643,43529,00.htm
The URL is dead, alas. The current Business 2.0 archive only dates back to 2004. I have been unable to find a live mirror for the article.

[2] Jerry Bernstein “Engineering New-Product Success: The New Product Pricing Process at Emerson accessed 2012.08.30. Article Copyright 2001 Elsevier Science Inc. Industrial Marketing Management 31, 51 – 64 (2002)

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