Strategic Pricing Using Value Equivalence Lines

The number one variable that can impact your profitability is pricing.  Yet it is amazing how little many marketing and product managers really understand about pricing strategies, and therefore use poor decision-making processes to set price plans.  McKinsey consultants Michael Marn, Eric Roegner, and Craig Zawada have produced an excellent work on pricing approaches called The Price Advantage in which they discuss pricing at three levels:

• Industry – set by supply and demand conditions, input prices, and overall competition,
• Strategic – product / market level pricing set by comparing and positioning solutions within a given segment of the market, and
• Transactional – executing pricing on a day-to-day basis, establishing “on-invoice” and “off-invoice” mechanisms and channel- and customer-specific agreements.

The product or marketing manager generally owns strategic pricing for their product or market.  Unfortunately, it is all too easy to rely on simple pricing methods such as “cost-plus” models to establish pricing guidelines.  There are three major issues with “cost-plus” pricing.  The first two are the cost competitiveness of your offering and your margin expectations compared to competition.  These are generally sorted out over time – you either improve your cost to get more competitive or adjust (most typically lower) your margin expectations.

The third issue is more significant and gets at the heart of poor pricing strategies.  This is the fact that your cost typically has very little to do with the value that your solution brings to customers.  It is conceivable, for example, that something that costs you $10 may bring $500 of benefit to a customer.  Your cost-plus approach might price it at $15 when in reality you could command far more.  Since you do need to “share” the benefit of your solution with your customer to encourage them to purchase, you wouldn’t be able to charge the full $500, but perhaps $100, or a 90% gross margin vs. the 33% or so you might realize under a cost plus strategy.

One tool to analyze and set pricing strategies described in The Price Advantage is the value equivalence line, or VEL.  The VEL identifies the perceived benefits vs. perceived price tradeoff that various customers are willing to accept within a given market, as shown below. In this graph, offerings that are to the right and / or below the VEL are perceived to be of greater value / benefit for a given price. While obviously a simplification (and in particular, this approach does not work well in categories subject to frequent disruptions due to innovation, new entrants, etc.), there are several powerful insights you can be gain from the process and result of creating a VEL for your solution space.  Most specifically, you can identify how your offering is positioned against competitive solutions and how adjusting your value proposition or pricing may impact your sales and margins.

The graph shows the positioning of several offerings (the ellipses labeled A, B, C, and D) in the same “market”.  Note that these solutions can be different in nature, not just different versions of the same concept; you could compare materials like steel, plastic, and aluminum in their ability to fit the need for a certain component, for example. It also shows the pockets of demand (the bars along the line) based on various customer segments (and in a prior post I discuss a market segmentation approach).  When positioning your offering, it is important to note that demand is not spread evenly along the VEL, and there may be no demand for a certain price/benefit combination.  The graph also represents that fact that understanding of the price and benefit tradeoff may be a little vague (represented by the dotted lines on either side of the VEL) and perceptions of a given solution may vary from customer to customer (thus the ellipse to represent the offering instead of a dot).  It is not critical to get the exact size of these bands or ellipses correct, but it is in general helpful to consider how broadly perceptions might vary, as narrowing these differences may be an effective strategy for better positioning you r solution.

As a theoretical example of using the VEL to inform pricing decisions, consider offering A, for which the provider desires to increase their market penetration.  There are three ways to do so, as shown in the accompanying picture:

1. Change customer preferences: this is the hardest but has the least impact on the industry pricing structure; you can seek to move demand from one point on the curve to another through education, marketing, or other selling tools. Some customers may not be aware of the benefits that your solution offers that justify its price, so this approach can help for such a situation.
2. Move your benefit-price ratio along the VEL to tap unmet demand.  It may be that there is latent demand that is unsatisfied by existing solutions and that by repositioning your solution, you can capture some of that demand (which is currently being filled by suboptimal solutions, if at all). This may be difficult as well depending on the work required to change your value proposition, but again it has minimal risk to the industry price structure.
3. Move a new or existing offering off the VEL.  This could be accomplished through a new or upgraded offering at the same price, thus moving to the right, which would serve demand from E (who will be happy to find a cheaper solution that meets their needs) and A’s current customer base (who will be happy to get more benefit for the same price).  This could also be accomplished by cutting your price, moving down on the graph, and thus serving existing customers more cheaply plus potentially capturing demand from D by providing more benefit for the price.

Note that each of these approaches may (and probably will) provoke eventual competitive reaction.  The risk is greatest in scenario 3, as in fact the new offering from A will have shifted the VEL, and competitors are very likely to develop their own new higher-benefit solutions, reduce their prices, or both to re-establish their position on the VEL.  Some uncertainly is also added to the demand patterns, as some customers will choose to pay less for their existing level of benefits, and some will take the additional benefits at the same price, thus splitting existing demand pocket.

While clearly a simplified approach, with some challenges involved in collecting the data needed (or, in many cases, making meaningful assumptions and estimates), the VEL tool is a powerful approach to analyzing pricing situations and feeding decisions.  Like most good tools, much of the value is in developing and debating the data.  Should you wish to learn more about VELs (as it is impossible to give them sufficient treatment in a single blog post), I’d encourage you to read The Price Advantage.

Another good book recently published regarding the use of VELs (price-benefit lines) in assessing pricing situations, mostly from a crisis mode, is Beating the Commodity Trap by Richard D’Aveni, which I review in a subsequent post.

You may also find these interesting:

• Successfully Selling Through a Price Increase
• Innovation in Aftermarket Offerings for Industrial Marketers
• Book Review – Beating the Commodity Trap
• Mitigating Strategic, Operational, and Organizational Business Risk
• Market Segmentation for Electric Vehicles