Value-Based Pricing of Your Products1
Dave Cranmer, Phase 3 Consulting LLC
How do you price your products and services?In a companion article, I wrote about basic pricing concepts based on knowing all your costs.Cost-plus pricing, done well, will get you a nice profit. But how would you change your pricing if you knew what the real value of your product or service was to the customer?Do you know how much money you're leaving on the table?If you knew the real value, could you use it to counter the constant pressure from buyers to lower your price? If you knew some customers were more willing to pay more for what you produce, would you want to pursue them first?If you know the value of your products and services, your "nice" profit can be even nicer.
What is value?It's the customer's best guess at the product's usefulness and his/her degree of satisfaction in using it. It's the difference between what customers will pay and what it costs you to supply it.
To understand the value of your products and services to the customer, there are six questions to which you need the answers:
There are a number of techniques - based on attitudes, behavior, and inference - and a variety of analysis techniques available to provide the answers to these questions.
To measure attitudes, you can ask your customers.Use focus groups, surveys, and interviews. Find out why the customer values an advantage - saves time, effort, simplifies something, combines advantages of two or more other products, or does something else specific.
For the rest of this article, I want to concentrate one technique - the value-in-use study.Essentially, you look at what your product or service replaces and calculate the direct and indirect costs associated with any alternatives.This gives you a measure of the economic value of your product/service to a given customer, relative to the next best competitor.
I did a value-in-use study recently on a robotic bagging palletizer. This machine takes 50 lb. bags off the end of a production line and stacks them on pallets for shipment. The current process requires 1 person per line per shift. The plant operates two shifts (16 hours/day) 5 days per week. The workers' hourly wage is about $25, and each gets a 30 minute lunch and 2 15-minute breaks. Each worker can move and stack 5 to 10 bags/minute, depending on the worker, the line, and product demand. The robot can work at 22 bags/minute and replace 2 lines for both shifts. At a straight replacement cost of one robot for the 2 lines/2 shifts and working at the prevailing speed of 5-10 bags/minute, the robot's value-in-use is $208,000 annually, or roughly $2,000,000 over 10 years. The base price of the robot is $250,000 and has an expected lifetime of 10-20 years, depending on the number of hours per day it operates.
There are other associated costs. Protective gear is required - face masks with filters at $10 per person per shift. Semi-annual chest x-rays are required and cost $250 per person per exam. There are health-related stoppages that occur as the workers experience back or other injuries. As a result, there are workmen's comp claims resulting in costs to the company of $100,000/year. When on-the-job injuries occur, the line shuts down. Usually a replacement is available, but the minimum shutdown time is an hour. Typically, it happens once a week. Absenteeism is also an issue and occurs at a rate of 10%. There are hiring costs - it requires sorting through 100 people to hire 2. Error rates in palletizing requiring stoppage and restacking are 1% for people, 0.01% for machine. Each error requires 30 minutes to correct.
With these other costs and benefits taken into account, thevalue-in-usefor the robot now rises to somewhere between $3.5 and 7 million per robot over 10 years, depending on the bagging rate. A similar exercise can be carried out on your products and services, but to do so, you need to go see how the customer and customer's customer is using them.
So what's the point?Knowing value to the customer gives you a different way to think about how you price.It lets you be smarter about pricing your products and better prepared for negotiations with customers about what makes a fair price.