Tom Nagle, author and strategic pricing expert, answers your pricing questions.
This month, Tom responds to a professor of marketing with examples of companies which were successful in switching to a value-based pricing approach.
Q: Can you provide examples of companies that are using a value-based pricing strategy? Even better, are there any that you have a sense of a pre and post, say they were using cost-plus, then switched to value-based, and have seen the results?
Tom: The classic example of a company that has used value-based pricing for decades is Intel. There are many companies that have made the switch from product-based to value-based pricing more recently. The WSJ article “Seeking Perfect Prices; CEO Tears Up the Rules” (March 27, 2007, page 1) describes how Parker Hannifin was able to increase its average profit margin from 7% to 21% through value-based pricing.
More recently, suppliers of medical products—pharmaceuticals, medical devices, and medical technology—have of necessity become practitioners of value-based pricing. Medical budgets around the world are becoming increasingly strained to pay for new products for aging populations. Clinical value alone is rarely enough to ensure adoption. Consequently, some new clinical innovations have failed (e.g., inhalable insulin) because payers refused to pick up the added cost. But companies that demonstrate that their innovations represent economic, not just clinical, value exceeding the price have still been able to earn great margins.
What all examples of successful value-based pricing illustrate is the absolute necessity to understand how your product or service impacts your customers financially and to communicate that to customers when the impact is not obvious. The mistake that many companies make is to assume that the relative economic value of their product is proportional to its technical performance. Despite the fact that this idea is widely sold by consultants (as “fair value” or “value equivalence”), a little thought or experience exposes its flaw. Think: if you had the choice to pay a $2,000 co-pay for a cancer treatment that was 50% successful, or $5,000 for one that was $70% successful, what would you do? According to the “fair value” idea, you would pay no more than $2800 for the better drug [$2,000 times 70/50]. But the only time that would make sense is if you could get 70% success simply by taking more of the inferior drug. If not, most people would think increasing the cure rate by 20 points would be worth much more than $800.
The same flaw applies in the world of more mundane products where value is less emotional and more objectively quantifiable. Decades ago, DuPont developed a resin called Kalrez®, which could be used as a substitute for neoprene to make O-Rings. The differentiation of Kalrez® was its ability to resist degradation when exposed to corrosive chemicals, many of which are toxic. For any given application, a Kalrez® O-ring would be much less likely to fail over a given period of time, or could be replaced much less often. So what is a value-based price for a Kalrez® O-ring? The answer depends on the application. Take an application, say a refinery, where a Kalrez® O-ring is nine times more durable than its neoprene equivalent. According to the “fair value” myth, which wily purchasing agents try to keep alive, DuPont should not have expected to gain share for its Kalrez® O-rings unless its price was less than nine times the price of the equivalent neoprene O-ring. With a neoprene O-ring selling for around $30 each at the time of the Kalrez® launch, the maximum “fair value” price for an equivalent Kalrez® O-ring would be $270. In fact, DuPont won overwhelming market share in many applications with prices per O-ring exceeding three times that amount—more than $800 each!
The reason for Kalrez®’s success is that relative economic value is not proportionate to relative performance. The financial impact of an O-ring that lasts nine times longer between replacements in NOT just nine times the price of the commodity product. The financial benefit to the customer in replacing O-rings only 1/9th as often is not just the additional neoprene O-rings that one does not need to buy; it is all the labor costs and lost output associated with replacing them and cleaning up possible spills. To understand how much a differentiated product is worth, you have to understand more than your product-performance. You have to understand the impact of that performance on the buyer—which will differ widely across applications. The economic value estimation approach is designed to identify that value in each application—empowering sales reps to destroy the “fair value” myth.
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