Economic Value to Customers

In some product categories, value can be expressed as monetized costs and benefits, and calibrated in purely economic terms.  The underlying concept is Economic Value to the Customer or EVC (sometimes called "value in use" or end -benefit value").   In essence, rational buyers add up the anticipated benefits, relate them to the associated costs, and buy the product if it offers enough benefits for justify the price (absolute EVC), and the most favorable economics relative to other spending options (relative EVC).

To illustrate EVC, consider an industrial product like a machine that is required for production and has already satisfied finance-based investment criteria (i.e. absolute EVC is satisfactory).

Assume that the supplier's cost to make the machine is $100,000, that the current fair market price is $125,000, and that the buyer incurs $75,000 of operating cost over the life of the machine (say, 3 years).

Further assume that the supplier redesigns the machine, and that the replacement machine is functionally equivalent (i.e. performs essentially the same tasks as the original machine), can be made at a lower cost ($90,000), that the product life stays the same, and that customers incur $50,000 in operating costs over the life of the redesigned machine.  A $25,000 cost savings.

How should the new machine be priced?

What is the price ceiling, or highest price that the product might command in the market?

A customer is likely to have one or more reference prices in mind, such as their subjective "fair" price for this and similar products, the price they last paid, and, most important, the price of competitive products.

From the customer's perspective, the original product provides a clear point of reference.   It had a total lifetime cost of $200,000 (the $125,000 purchase price plus the $75,000 lifetime operating costs).  Ignoring any time value of money, customers should be indifferent if their total lifetime costs stay the same.  Since the redesigned product's operating costs are $25,000 lower ($75,000 less $50,000), rational customers should be willing to pay $150,000 for the new machine ($150,000 purchase price plus $50,000 operating costs equals the original $200,000 lifetime costs).

Of course, in order to establish the high price, the company (i.e. marketing) must convince the customer that there is a meaningful performance difference and that the operating cost savings will actually materialize.  The company might substantiate the savings with objective data (e.g. from engineering or clinical tests) or have high credibility endorsers (such as technical or industry experts) provide testimonials.

To minimize the customer's risk, the company might offer performance-based guarantees that offer a refund if the savings are not attained.

At this high price ($150,000), the company should be able to maintain its market share (since the customer's lifetime cost remains the same), and would increase its profits by $35,000 (the $10,000 manufacturing cost improvement plus the $25,000 price increase).

In other words, $35,000 of value has been created and the company has captured or retained all of it.  Customers are no better or no worse off.

What is the lowest price that the company might consider?

The original product yielded a profit of $25,000 per machine (the selling price of $125,000 less the manufacturing cost of $100,000), or in percentage terms, 20% (the $25,000 profit divided by the $125,000 selling price).  

The product could be priced at $115,000 and still preserve the dollar profits per machine ($90,000 manufacturing cost plus a $25,000 profit), or it could be priced at $112,500 while preserving the 20% profit margin ($112,500 less 20% equals the new manufacturing cost of $90,000).

So the rough-cut price floor is $112,500 to $115,000.

At low price of $112,500, the company is likely to gain market share, at least in the short-run, until competitors react.   At this lowest price, the company maintains its percentage margins, but dollar profits per machine actually decline $2,500 (from $25,000 to $22,500).  Lifetime costs to the customer decline by $37,500 (a purchase price savings of $12,500 plus the $25,000 in operating cost savings).  Again, $35,000 of value has been created with the new product.  

At $112,500, more than 100% of the created value is ceded to the customer and the company captures none of the added value.  A price of $115,000 would preserve the company's profit per machine and cede precisely 100% of the created value to customers.  

(Note: to be technically precise, a price lower than $112,500 might maximize short-run profits if additional sales volume is generated.  But, longer-run, competitors will typically respond with lowered pricing and/or modified products.  So, the $112,500 price floor is a reasonable long-run planning approximation.)

So why might the company adopt this pricing strategy?  Again, the product should generate share gains.  If competitors are willing and able to respond, the gains may be transitory.  But, if the company has a competitive cost advantage with the new product, competitors may be unable to respond and the gains may be more long lasting.  Or, if the product accrues meaningful first-mover advantages (say, building a large, leverageable installed base), the lower price may be critical to establishing a market position.

Most often, a company will elect to price somewhere between the price floor and the price ceiling.  Doing so captures some of the value created as increased profits, and cedes a portion to customers, improving the product's competitive position.

For example, the current market price ($125,000) is between the floor ($112,500 to $115,000) and the ceiling ($150,000).  

By pricing the product at $125,000, the company would cede $25,000 of created value to customers (the lifetime operating cost savings) and would retain $10,000 of added profits (the lower manufacturing costs).

And, at the prevailing market price, the company has a less challenging sales proposition for customers: the full $25,000 in operating savings does not need to be proven to justify the price.

So, the answer to the 'what price' question is 'it depends'.

If the company is satisfied with its current market share, and is confident that the operating cost savings are real and can be credibly communicated to customers, then a price close to the price ceiling is appropriate.

If the company believes that the manufacturing cost savings provide a sustainable competitive advantage, or that meaningful strategic benefits could accrue from a short-term share gain, then a price closer to the price floor might be appropriate.

Most often though, a company is likely to price between the price floor and the price ceiling, retaining some of the created value and ceding some portion to customers.  In doing so, the company hedges its bets, eases the selling challenge, and provides some 'wiggle room' to cut prices in the future.

When all costs and benefits can be monetized, and buyers are economically rational - as in the preceding illustration - a pricing analysis is conceptually straightforward.

More typically, though, firms make pricing decisions in a context where the economic value of a product's benefits is more implicit than explicit, or where economic value may be enhanced or diminished by non-economic factors.  

That is, buyers make decisions by weighing a multitude of factors that are important to them. Their decision may be a composite of both economic and non-economic factors that can be either objective or subjective.

In this more general case, the starting point for a pricing decision is to calibrate the implied worth of the delivered benefits and match them against the product's price in a competitive space.  An analytical technique for framing the price-benefits relationship is called Value Mapping.