How the 4Cs of pricing interact (Customer Value, Customer WTP, Competitors, Costs)

In his book Getting Price Right, Gerald Smith has made a compelling case that effective pricing strategy and execution requires the application of four different pricing orientations. These are ...

• Customer Value - the value delivered to a customer or segment
• Customer Willingness to Pay (WTP) - how much a customer is willing to pay for that value
• Competition - the frame for the solution space that sets the value of competitive alternatives (it is better to think of these as alternatives than competitors, but then we would lose the mnemonic of the four Cs)
• Costs - set a floor on prices and frame operating volume requirements

Smith also sets out the models and tools that can be used in each of these pricing orientations.

Models for each Pricing Orientation

Customer Value

• Value Modelling - mathematical models of how and how much economic value is provided to specific customer and how value delivered changes over time (Ibbaka Valio includes a value modelling platform)
• Value Metrics - a value metric is the unit of consumption by which a user gets value, most solutions have several value metrics
• Price Metrics - a price metric is the unit of consumption for which the buyer pays, the price metrics should track the value metrics
• Value Communication - value models recast as value stories
• Value Documentation - value models documented with actual data from a specific customer, remembering that value changes over time

Customer WTP

• Customer Pricing Analytics - how much are customers actually paying, what determines how much they are willing to pay, WTP modelling (often using predictive analytics and machine learning)
• Conjoint Analysis - how much does each attribute of a solution contribute to willingness to pay
• Price Elasticity of Demand - how does overall demand for a product or service change with price
• Cross Price Elasticity - how does the probability of switching suppliers change with price

(The interaction of price elasticity of demand and cross price elasticity determines market dynamics.)

Competition

• Algorithmic Pricing refers to price setting through algorithms, this enables dynamic pricing and trading and increasingly these algorithms are developed and tuned using machine learning
• Game Theory provides tools for analyzing situations in which parties make decisions that are interdependent, this interdependence causes each player to consider the other player's possible decisions, or strategies, in formulating their own strategy, all of which helps understand how a series of pricing decisions will play out in a competitive environment
• Value Maps have price on the Y axis and Value on the X axis and then place solutions based on their price and value, the assumption is that solutions will fall along a value equivalence line as buyers trade off price and value, they can be useful in designing product portfolios and understanding competitive strategies (Smith does not include value maps and has shown that they over estimate the value of commoditized offers and underestimate the value of differentiated offers)
• Value Chain Analysis breaks down a solution into all of the steps used to create value and looks at how much value is created at each step and how that value is captured into price; there is often competition within a value chain for profit capture

Costs

• Activity Based Costing allocates costs to specific activities and avoids pooling costs into general, and generally meaningless, categories like 'overheads'
• Price Waterfall is an analytical tool that begins with value or the list price and then looks at the various ways that profit leaks away through costs and discounts (formal or otherwise) until one is left with the 'pocket price' or the amount of money you get to put into your pocket
• Pricing Breakeven Analysis asks for any price change, how volume needs to change to keep another variable constant (this could be revenue or profit); when considering a pricing change this is one of the first questions to ask

There are also integrative models like customer segmentation, price dispersion graphs and market evolution models that draw on models from more than one pricing orientation.

Pricing Models in Conversation

There is no one model that can fully determine price strategy and design decisions. We have to take a many model approach. This is what Scot Page advocates in his book The Model Thinker.

To successfully navigate a complex series of decisions one needs to use more than one model. The models need to be in conversations with each other. This is the case with pricing. One begins by establishing a foundation using a value-based market segmentation. This segmentation is informed by the value and the buying process. An actionable segment is a group of potential customers who buy in the same way and who get value in the same way. The two models that lead this conversation are a formal value model and the customer buying process.

Value Model: A value model is built up from quantified value drivers. You can learn more about value models here. An example value model, built in Ibbaka Valio, is shown below. The key insight is that not every value driver matters to every customer and that the impact of any value driver can be customer specific.

Buying Process: This is the series of steps a buyer goes through from awareness of pain and awareness of solution leading to consideration, evaluation and trial, decision, commitment, adoption and growth.

Putting the two together gives a value-based market segmentation. The foundation for effective pricing, but just the beginning of the journey. Conversations between other models are needed to devise and execute on a pricing strategy.

Customer Value and Customer Willingness to Pay

One of the key interactions is between Customer Value and Customer Willingness to Pay WTP). Some people confuse these two pricing orientations and think they are the same thing or that WTP is a proxy for customer value. It is not. The two orientations use different models and lead to different insights. But value and WTP are usefully considered together.

Value shapes WTP and informs customers buying decisions. Willingness to Pay constrains value and sets an upper limit on a value or usage based price. It can also be useful to add WTP into a customer segmentation.

Customer Value and Competition

The most common approach to building a Value Model is Economic Value Estimation or EVE, a model introduced by Tom Nagle in The Strategy and Tactics of Pricing. The starting point for an EVE is the next best competitive alternative, in other words, the competition. In pricing, the value provided by the commoditized parts of an offer is set by the market (the commodity component of the price) while the differentiation value (the unique value of a solution) contributes the value-based component of the price.

Competition also plays an important framing effect and defines the category the solution competes in. One can change price framing by changing the perceived alternatives. This can lead to order of magnitude change in price.

Customer Value and Cost

Cost plus pricing is a sub optimal pricing approach in most situations, but that does not mean that cost is irrelevant to customer value. The basic rule is that you have to be able to create (and capture in price) more value for a customer than it costs to deliver that value. If you cannot do that you do not have a business.

And of course cost reduction is one of the main categories of value driver. So understanding your own costs and the impact of your solution on the costs of your customers is central to pricing work.

Competition and Cost

As noted above, competition both frames the market category and sets the price for the commoditized part of value. One plays the pricing game with ones competitors and customers, the goal being to find ways to convert zero sum games to positive sum games and to avoid negative sum games.

Zero Sum Game: A game in which the rewards are fixed and if you win more I win less by the same amount. Pricing negotiations are often framed as zero sum games. This is a losing strategy. Good negotiation finds ways to convert zero sum games into positive sum games.

Positive Sum Game: In a positive sum game there are moves that increase the overall pool of rewards. Value models and value based pricing help to shift pricing negotiations to positive sum games. See How to Negotiate Price (Getting to Positive Sum Pricing)

Negative Sum Game: A game in which the reward pool can get smaller depending on the actions of the players. Prisoner's Dilemma (discussed in Pricing Done Right) is a classic example. In this game one has to decide whether to collaborate, defect or punish at each turn of the game. A narrow framing of one's short term interest results in a sub optimal outcome for both. This maps directly to the conditions that lead to price wars, which can destroy long term value in whole product categories.

Customer Willingness to Pay and Cost

There is also an interesting relationship between customer willingness to pay and costs that one can see today. In many cases buyers are willing to accept a cost increase at the supplier as a reason to increase prices. Inflation can lead to higher overall willingness to pay. This is a double edged sword though, as it creates a positive feedback loop that can drive prices higher and higher eventually crushing the economy until it is tamed with higher interest rates and fiscal constraints. See Pricing and Inflation: How to Respond.

Value and Pricing Models in Ibbaka Valio

Today Ibbaka Valio supports the conversation between a value model and a pricing model and gathers the data needed to inform pricing decisions. It is the place where value communications are crafted and value delivered is documented. In future releases we will be integrating more of the models used in pricing work, so that the people leading strategic pricing and pricing execution will have a place to facilitate and organize their own conversations.