Value-Based Pricing and Assessing Customer Value
Innovation & New Business Planning - TUHH Institute of Innovation Marketing & Institute of Entrepreneurship, Hamburg · part of my Technology Management MBA · study notes for revision.
Pricing has three possible anchors, and the session calls them the three C’s: your own company, the competition, and the customer. The basics chapter works through the first two. This chapter takes the third one apart, because it is the only anchor that asks the question which actually decides whether money changes hands: what is this worth to the person on the other side of the table?
The deck is blunt about why that matters. One of the pricing myths it lists is the belief that costs are the basis for pricing, and the correction is that pricing has to be based on customer value. It quotes Nike saying that the change they made was to focus on the consumer when setting prices, because pricing is about the value equation being created with that consumer.
So this chapter builds the model the session uses, reference value plus differentiation value equals total economic customer value, splits differentiation value into the monetary kind that dominates business markets and the psychological kind that dominates consumer markets, shows how to put the monetary kind into a business customer’s own currency, lists the six methods for reading willingness to pay, and ends with the two families of pricing model - usage-based and outcome-based - that turn a value argument into a contract.
1 · Where this picks up from the basics chapter
Section titled “1 · Where this picks up from the basics chapter”The three C’s are cost, competition and customer value. Two of the three are comfortable and both are wrong as a starting point: costing up from your own expenses tells you what you need rather than what anybody will pay, and copying the competitor tells you what somebody else guessed. Only the customer anchor starts outside your own head, which is why it gets a chapter of its own.
Everything below rests on one formula, so it is worth stating once and then leaving alone.
Total economic customer value = Reference value + Differentiation valueReference value the price of the next best competitive alternative, the NBCA, that the customer would buy instead of you
Differentiation value the net money value of everything your offer does better, less everything it does worse, compared with that alternative
Autonomy condition
Differentiation value > 0 is what gives you any freedom over price at all
The price corridor the price has to sit between the cost floor and that total economic customer value ceiling, and every point in between is profitable
Two consequences follow, and both are easy to lose in an exam. The ceiling is not the price: at the total economic customer value the customer is exactly indifferent between you and the alternative, so a share of the created value has to stay with them as their reason to move. And for an innovation the reference value is a framing choice rather than a fact, because which alternative you position yourself against sets the base of the whole calculation before you have argued a single benefit.
The profit-leverage arithmetic, the corridor, and the cost and competition anchors are worked through in Pricing: The Basics, including the case of hunting for a reference value when the product is brand new.
2 · Two kinds of differentiation value: monetary and psychological
Section titled “2 · Two kinds of differentiation value: monetary and psychological”The deck splits differentiation value into two forms, and attaches each to a market type.
- Cost savings for your customer, the example given being a shorter assembly time
- Income enhancement for your customer, the example given being a higher quality end product that they can sell for more
- Both land in the customer’s own profit and loss account, which means they can be counted, argued and audited
- Demonstration value, what owning it says about you, with Rolex and the Apple MacBook Air as the examples
- Use value, meaning well-being, a clear conscience, higher convenience, less stress, higher personal performance and more fun
- Real and often larger than the monetary kind, but it has to be measured by asking rather than by calculating
The word dominating matters in both lines. It does not say business buyers have no feelings, and it certainly does not say consumers cannot do arithmetic. A purchasing manager still worries about how the decision looks internally, and a consumer buying a heat pump does run the numbers. What it says is where the bulk of the differentiation sits, and therefore which kind of evidence your value argument should lead with.
3 · Quantifying the monetary differentiation value for a business customer
Section titled “3 · Quantifying the monetary differentiation value for a business customer”For a business customer the value argument should end in a number in their currency. The deck names two headline categories, cost savings and income enhancement, and its two teaching examples show what those look like in practice. It is worth noticing that risk shows up inside both categories rather than as a third one: a reduced probability of an expensive failure is a cost saving that you have to express as an expected value.
- The deck’s own example of a cost saving is a shorter assembly time at the customer
- Priced as hours saved multiplied by the fully loaded hourly cost of the person doing the work
- The exoskeleton case sits here: assisting operators with lifting heavy weights and tools and reducing fatigue during manual labour
- Less scrap, less rework, fewer consumables, less energy, less inventory tied up
- Priced from the customer’s own unit costs, which is why the calculation has to be done with the customer rather than for them
- The hologram case names lower costs for hospitals as one of its benefits
- Fewer accidents, less downtime, fewer claims. The hologram case names less malpractice explicitly
- Priced as the probability of the bad event multiplied by what it costs when it happens
- The softest of the numbers and usually the one the customer’s finance team attacks first
- The deck’s example is a higher quality of end product, which the customer can charge more for or sell more of
- The hologram case adds better patient outcomes, which is value to the hospital, the patient and the insurer alike
- Priced as extra units multiplied by the customer’s own contribution margin, never by their revenue
The exoskeleton exercise. The company has developed a robotic exoskeleton that helps operators and construction workers perform physically demanding tasks, including lifting heavy weights and tools and reducing fatigue during manual labour. The assumed lifetime of a device is 10 years. Groups one and two are asked for the price of one device for shipyards.
The hologram exercise. Today doctors read standard imaging, which gives no spatial information and no volumetric structures, makes abnormalities hard to see, and cannot be used hands-free. The proposed solution processes the data with artificial intelligence and shows it as a three-dimensional hologram, giving better visualisation, better surgery planning and sterile interaction. The benefits listed are better patient outcomes, less malpractice and lower costs for hospitals. Groups three and four are asked for the price of one licence for one surgery room.
The instruction attached to both is the important part. Assume for now that neither costs nor competition play any role, provide arguments, assumptions and calculations for how you arrived at the price, and consider the different benefits and their monetary value for the customer and possibly for other stakeholders too. That last clause is the subtle one: in the hospital case the party that saves the money on malpractice may be an insurer rather than the buyer, and value that lands with a third party is real but much harder to charge for.
4 · Methods for assessing customer value and willingness to pay
Section titled “4 · Methods for assessing customer value and willingness to pay”The deck gives one slide of approaches for evaluating customer willingness to pay. They differ mainly in whether you ask people, watch people, or make people put something at stake.
| Approach | What it is | What it is good at, and where it breaks |
|---|---|---|
| Asking directly | Put the price question to the customer and record the answer | Cheap and fast, and the only sensible move when you have five prospects rather than five thousand. People overstate what they would pay when nothing is at stake, so treat the number as an upper bound |
| Asking indirectly, for example conjoint analysis | Present whole offers with different feature and price combinations and let respondents choose between them, then infer from the choices what each attribute is worth | You never ask about price directly, so the answers are far less strategic, and it prices individual features rather than the product as a lump. It needs a real sample and careful design, so it is heavy for an early-stage venture |
| Auctions and lotteries, for example a Vickrey auction or a Becker, DeGroot and Marschak lottery | Mechanisms designed so that the participant’s best strategy is to state their true valuation, because they may actually have to buy at that price | The most honest numbers of all, because money is genuinely at risk. Artificial settings and small groups limit how far the result generalises |
| Sales and price data of analogous markets | Look at what similar products or services already sell for and read your price band from theirs | The fastest route to a reference value, and it needs no respondents. It only works if the analogy holds, and choosing the analogy is the same framing decision as choosing which reference class you position against |
| Deep interviews and observations of pilot customers, ending in a value calculation | Sit with a small number of real or pilot users, watch the work, and build the economic value calculation from their own cost figures | The method that produces a defensible business case rather than an opinion, and it doubles as a sales tool because the customer helped build it. Very slow, and one customer’s numbers are not the market’s |
| Market tests, for example A and B tests, customer panels, or regional and local test markets | Offer the real thing at different prices to different groups and watch what actually gets bought | Behaviour rather than statements, which is the strongest evidence available. It requires a live product, it is visible to competitors, and it can annoy customers who discover the price differences |
5 · Turning value into a pricing model: usage-based and outcome-based
Section titled “5 · Turning value into a pricing model: usage-based and outcome-based”Estimating customer value gives you a number. The last part of the section is about the contract shape that lets you collect it, and the deck sorts the practical applications of value-based pricing into two families.
| Usage-based model | How it works |
|---|---|
| Software as a service | Cloud computing with no local installation and online access, sold on subscription contracts, with the price depending on the intensity of use |
| Infrastructure as a service | The customer buys data storage, databases and other services on an as-needed basis while the supplier manages and maintains the infrastructure |
| Power by the hour | The manufacturer keeps ownership of the aircraft engines, the airline pays per hour of use, and the manufacturer performs the maintenance and repair |
| Outcome-based model | How it works |
|---|---|
| Build, own, operate, transfer | Clients pay for the output they want rather than for the creation of the capacity to produce it. The facility is built and then run by the party that constructed it, and in output pricing the construction cost is treated as overhead |
| Commissions and brokerage | Estate agents earn commission as a share of total sales volume, and banks receive commissions from third parties when they sell certain products to their customers |
| Payments based on key performance indicators | In logistics services the payment depends on punctuality, order fill rate and the number of complaints from recipients. In blasting, a blast specification service shares responsibility for the outcome of the blast by taking on risk against agreed indicators |
The common thread is that the supplier takes over part of the customer’s risk. Power by the hour means the engine maker, not the airline, loses money if the engine needs unplanned work. A blasting service paid on indicators is betting its own margin on the quality of its advice. That is a genuine value proposition on its own, and it links straight back to the adoption chapter: converting a large irreversible purchase into a payment that only happens when the value appears removes several of the perceived risks that stop customers buying at all.
6 · Why the value argument has to be communicated, and the handover to sales
Section titled “6 · Why the value argument has to be communicated, and the handover to sales”The section closes with group work: discuss whether a value-based pricing model, or at least a value-based element or metric, is promising and feasible in your project, and if so which model or metric you would use.
The honest note for revision is that the value-based pricing section itself contains no communication module, so nothing inside it tells you how to sell the value story. That thread is picked up on the very first slides of the sales part, and it starts from exactly this problem. A price above the reference value is a claim about a benefit the customer has not yet counted, so the price only survives if the customer can be brought to count it.
Customers need information that challenges what they already believe. The sales slides argue that customers need new information that challenges their current beliefs and understandings, and they draw a progression of three buyers who need very different things from a seller.
| What the customer already thinks | What they therefore need from you |
|---|---|
| I have a problem and I want to be told how to solve it | An explanation, because the need is recognised and the buyer is open |
| I know roughly which type of solution I need | A comparison, because the category is settled but the choice is not |
| I already have solutions to most of my problems | Something new and surprising, because nothing else will get their attention |
Against that third buyer, selling means telling people what they do not know yet. That is the same job as defending a value price. If the customer has already counted your benefit, there is nothing left to argue about, and the entire premium lives in the part of the value calculation they have not yet made for themselves.
The drop-outs come late. The other bridging point is that selling an innovation carries high uncertainty, and buyers of innovations drop out late rather than early. The buying process runs from inquiry through needs recognition, evaluation, decision and after sales, and the deck splits it into an early enthusiastic phase and a later uncertainty phase, by which point the sales force has already invested a great deal of time and effort that may still not convert.
That is the practical reason to build the value case at all. Enthusiasm carries the early meetings on its own. It is exactly when the enthusiasm cools, in the second phase, that the conversation needs something harder to stand on, and the only thing available then is a number in the customer’s own currency, built from their own cost figures.
Worked example
Section titled “Worked example”A full economic-value-to-the-customer calculation, built on the exoskeleton case the deck sets up. This example is my own construction with invented figures, used to show the mechanics; the deck supplies the product, the shipyard customer and the ten-year lifetime, and leaves the numbers to the class.
The situation. We sell a robotic exoskeleton to a shipyard, for a welder doing overhead and awkward-posture work. Device lifetime is 10 years. The shipyard’s next best alternative is a mobile mechanical lifting rig that costs 6,000 euros and lasts the same ten years. All figures below are per device over the full ten years, and I ignore discounting to keep the arithmetic readable, which is a simplification a real business case would not make.
Reference value = price of the NBCA = 6,000 EURStep 2, quantify each differentiator in the customer’s own money.
| Differentiator | Category | The calculation | Value over 10 years |
|---|---|---|---|
| Faster work in awkward postures | Labour saving | 12 minutes saved per shift, 220 shifts per year, is 44 hours per year, at a fully loaded labour cost of 40 EUR per hour, giving 1,760 EUR per year | +17,600 EUR |
| Fewer spoiled welds needing rework | Materials saving | Rework consumables and wire worth 600 EUR per year avoided | +6,000 EUR |
| Fewer back-strain absences | Risk and downtime | 1.5 fewer lost days per year, at 320 EUR per lost day of production | +4,800 EUR |
| Charging, cleaning, annual service and battery replacement | Negative differentiator | 400 EUR per year of upkeep that the mechanical rig does not need | -4,000 EUR |
| Net differentiation value | +24,400 EUR |
EVC = 6,000 + 24,400 = 30,400 EURDifferentiation value = +24,400 EUR, which is greater than zero, so we have price autonomyStep 5, choose the price. Charging the full 30,400 euros is the mistake the model is designed to expose. At that price the shipyard is exactly as well off as it would have been with the lifting rig, and it has to justify a new technology, train the welders, negotiate with the works council and carry the risk that our start-up is not around in year four. Nobody accepts a break-even deal plus risk. So the created value has to be shared, and I set the price at 18,000 euros.
Seller captures 18,000 - 6,000 = 12,000 EUR (49 percent)30,400 - 18,000 = 12,400 EUR (51 percent)(18,000 - 6,000) extra spend / 2,440 EUR net annual benefit is about 4.9 yearsWhy that split. Slightly more than half of the created value stays with the buyer, which gives a purchasing manager a clean sentence to take to their board: we pay 12,000 euros more than the rig and get 24,400 euros back. Note also that the split is not a rule from the deck, it is a negotiating position, and it should move with how confident the customer is in my numbers. If the risk-and-downtime line is the one they doubt, strip it out and the differentiation value falls to 19,600 euros, the ceiling falls to 25,600 euros and the same logic supports a price nearer 15,000. Finally, the price corridor still applies underneath all of this: if our total cost per device is above 18,000 euros then the value argument is fine and the business is not.
Apply it to your project
Section titled “Apply it to your project”-
Name one specific customer in one specific situation, because economic value is never a property of the product. The same exoskeleton is worth a different amount to a shipyard and to a warehouse.
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Decide what they would do instead of buying from you and price it. That is your reference value, and it may be a competitor, an older technology, an in-house workaround or doing nothing at all. If several framings are available, write down all of them and notice how far apart the resulting price bands sit.
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Choose your framing deliberately. Which reference class you position against is a pricing decision taken before any selling begins.
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List every way you are different from that alternative, better and worse, and be ruthless about including the worse ones. A value case with no negative line in it will not be believed.
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Put a money figure on each difference using the customer’s numbers, not yours. Sort them into labour and time saved, materials and throughput, risk and failure avoided, and revenue the customer earns. Multiply hours by their loaded labour rate, extra units by their contribution margin, and bad events by their probability and their cost.
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Ask whether the value is monetary or psychological. If you sell to businesses it is mostly monetary and belongs in a spreadsheet the customer can audit. If you sell to consumers it is mostly demonstration and use value, and it belongs in a message and a test rather than a business case.
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Sum to total economic customer value, then confirm that the differentiation value is positive. If it is not, you have no pricing autonomy and the honest conclusion is that the product, not the price, needs work.
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Pick your price inside the corridor between your total cost and that ceiling, and state explicitly how much of the created value you are leaving with the customer and why that is enough to make them move.
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Choose a method to test the number. Ask directly if you have a handful of prospects, run a conjoint study if you have a market and a budget, build a value calculation with two or three pilot customers if you sell complex business goods, or run an A and B test if the product is live.
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Decide whether a usage-based or outcome-based model fits better than a one-off price. A metric that tracks the customer’s value, hours of use, units produced, or a performance indicator you are willing to be paid on, both raises what you can capture and removes the customer’s risk of paying for a benefit that never arrives.
Key terms
Section titled “Key terms”| Term | What it means in plain words |
|---|---|
| Value-based pricing | Setting the price from what the offer is worth to the customer, rather than from your costs or a competitor’s list price |
| The three C’s | The three anchors of a price decision: company, competition and customer |
| Next best competitive alternative (NBCA) | What the customer would buy or do if you did not exist |
| Reference value | The price of that next best alternative, which is the base your price is built on top of |
| Differentiation value | The net money value of everything you do better than the alternative, less everything you do worse |
| Total economic customer value | Reference value plus differentiation value, meaning the highest price at which the customer is still no worse off than with the alternative |
| Price autonomy | The freedom to set your own price, which you only have if your differentiation value is positive |
| Monetary differentiation value | Cost savings and income enhancement for the customer, the dominant form in business markets |
| Psychological differentiation value | Demonstration value and use value such as convenience, well-being, less stress or more fun, the dominant form in consumer markets |
| Price corridor | The range between the cost floor and the customer-value ceiling; every price inside it is profitable, and the basics chapter takes it apart |
| Willingness to pay | The most a given customer would actually hand over for the offer, which is what the six assessment methods try to measure |
| Conjoint analysis | An indirect method that infers what each feature and the price are worth by watching which whole offers people choose |
| Value calculation with pilot customers | Building the economic value case from a real customer’s own cost figures during deep interviews and observation |
| Usage-based pricing | The customer pays in proportion to how much they use, as in software as a service, infrastructure as a service, or power by the hour |
| Outcome-based pricing | The customer pays for the result rather than the equipment, as in build-own-operate-transfer, commissions, or payments tied to performance indicators |
Test yourself
Section titled “Test yourself”- Name the three C’s of pricing and explain in one sentence why only one of them can tell you what a customer will actually pay.
- State the customer value formula, define both of its inputs, and give the condition under which a company has price autonomy.
- What is the difference between total economic customer value and the price you should charge, and what happens if you set the price equal to the total economic customer value?
- Give the two forms of differentiation value with two examples of each, and say which one dominates in business markets and which in consumer markets.
- A machine costs 20,000 euros and lasts five years. Your replacement saves the customer 9,000 euros of labour, 3,000 euros of scrap and 2,000 euros of downtime over those five years, but needs 2,000 euros more servicing. Calculate the differentiation value and the total economic customer value, and propose a price that leaves the customer roughly half the value created.
- List the six approaches for evaluating willingness to pay, and say which one you would choose for a complex business-to-business product with only four realistic prospects.
Revision summary
Section titled “Revision summary”Next: Sales and Channel Management → - getting the offer in front of the buyer.