CHAPTER 2

Value Creation - The Source of

Pricing Advantage
 Value Creation
Defining VALUE
Use Value (Utility)
• Monetary gain (or savings) from using a product/service offering
• Psychological benefits (or costs) associated with using a
product/service offering
Economic Value
• Calculated using reference value and differentiation value
Reference Value
Refers to the price of the consumer’s “best” alternative.
Differentiation Value
Refers to the value of whatever differentiates the offering from the
alternative(s). Can be positive or negative.

Total economic value represents the maximum price that a fully-informed

consumer would be willing to pay for a product/service offering.
THE ROLE OF VALUE IN PRICING

The term VALUE commonly refers to the

overall satisfaction that a customer receives
from using a product or service offering.
Economists call this use value — the utility
gained from the product.
VALUE PRICING

Is the practice of setting prices based on

estimates of how valuable a good is to the
customer. This ignores the prices of
competitors and your costs and focuses on
what the customer is willing to pay based
on their needs, preferences and
perceptions.
Potential customers know that except in rare situations,
they don't have to pay a seller all that a product is really
worth to them. They know that competing sellers will
usually offer a better deal at prices closer to what they
expect from past experience

economists refer to the difference between the

use value of a product and its market price
as CONSUMER SURPLUS.
The value at the heart of pricing strategy is not
use value, but is what economists call EXCHANGE
VALUE OR ECONOMIC VALUE. Economic value
depends on the alternatives customers have
available to satisfy the same need.
Economic value accounts for the fact that the
value one can capture for commodity attributes
of an offer is limited to whatever competitors
charge for them. Only the part of economic
value associated with differentiation, which we
call DIFFERENTIATION VALUE, can potentially be
captured in the price.
 VALUE PRICE COST Willingness of
the customer
to pay
100.00 VALUE

CONSUMER
VALUE CREATED

SURPLUS CUSTOMER
VALUE CAPTURED

70.00 PRICE

FIRM’S
PROFIT

50.00 COST
MANAGER/
OWNER
E.g. – The customer is willing to purchase a cloth
worth of 100.00 (The Value – willingness of the
customer to pay). And the price of the cloth is
70.00, the difference between the VALUE and
PRICE is called CONSUMER SURPLUS. For the
MANAGER/OWNER side, the actual cost of the
cloth is 50.00, the difference between the COST
and the PRICE is called FIRM’S PROFIT (The
income that the firms receive after selling the
product) or VALUE CAPTURED. The COST up to the
VALUE (expectation of the customers in price) is
called VALUE CREATED.
DIFFERENTIATION VALUE COMES IN TWO FORMS:
MONETARY AND PSYCHOLOGICAL, both of which may be
instrumental in shaping a customer's choice but require
very different approaches to estimate them.

Monetary value represents the total cost savings or

income enhancements that a customer accrues as a result
of purchasing a product. Monetary value is the most
important element for most business-to-business
purchases.
Psychological value refers to the many ways that
a product creates innate satisfaction for the
customer. A Rolex watch may not create any
tangible monetary benefits for most customers,
but a certain segment of watch wearers derives
deep psychological benefit from the prestige and
beauty associated with ownership to which they
will ascribe some economic worth.
a product's total economic value is calculated as
the price of the customer's best alternative
(the reference value) plus the worth of whatever
differentiates the offering from the alternative
(the differentiation value).

Differentiation value may have both positive and

negative elements as illustrated.
 Economic Value Estimation Framework

Negative Costs unique to doing

Differentiation
Your unique Positive Value business with you
value Differentiation Price to
delivery Value capture a
share of
this value

Price of Total
Customer’s Reference Economic
Next Best Value Value
Alternative
 Economic Value Estimation
Example – Heavy equipment manufacturer
Higher residual Add’l warranty
value = $1200 cost = -$1050
Parts inventory
program savings = Total offering
$1250 economic value
Invoice processing $79,950
consistency savings
= $1500
Differentiation How much of the
Fuel economy Value = $7,450
savings = $2200
Differentiation
Value do you
Increased revenue Capture versus
from higher Share with your
uptime = $2350
Customers
Competitive
Reference price
alternative for
Reference = $72,500
this customer
= $72,500
Economic Value Analysis
Step 1: Identify Reference Value
• Reference value is calculated as the price of the best perceived alternative, not necessarily
the next best competitive alternative, with regard to form, function, effectiveness,
and/or efficacy.

Step 2: Estimate Differentiation Value

• Determine the value drivers – those attributes that impact customer perceptions and
purchase choice
Are they monetary gains or cost savings?
Are they psychological benefits or costs?
Comment regarding differentiation value . . . .

In most cases, the components making up differentiation

value can be quantified to some extent. Some consumers,
however, will pay more for a product simply because of the
brand name – despite the fact that the tangible value
of the product may be substantially lower than alternatives
available to them. Therefore, the brand name can often be
a component of the differentiation value (brand equity).

What type of differentiation value does a brand name provide?

Economic Value Analysis
Step 1: Identify Reference Value
• Reference value is calculated as the price of the best perceived alternative, not necessarily
the next best competitive alternative, with regard to form, function, effectiveness,
and/or efficacy.

Step 2: Estimate Differentiation Value

• Determine the value drivers – those attributes that impact customer perceptions and
purchase choice
Are they monetary gains or cost savings?
Are they psychological benefits or costs?
• Identify attributes that differentiate between your product and the competitive
reference product. What benefits or costs are associated with your product? How
can you quantify each benefit and cost?
– Gather data that can be used to assign the monetary amount to each value
driver (e.g., in-depth customer interviews, surveys, focus groups)
– Focus on the underlying customer business model (what drives the business
model will typically drive the value perceptions of the customer)
– Value drivers can vary across customers & across time
• Determine the value derived from a bundle of features
One of the most critical factors driving customer
choice and willingness-to-pay is the set of
alternative products under consideration for
purchase. From the marketer's perspective, these
products represent the “next best competitive
alternatives” or NBCA. Given the centrality of
competitors' pricing in the purchase decision,
economic value estimation begins by determining
the price the competitor charges (not necessarily
the NBCA's use value), which becomes
the reference value in our model.
COMPETITIVE REFERENCES PRICES

Identifying the next best competitive alternative to your

product and gathering accurate reference prices, while
conceptually simple, offers a number of challenges that
often trip up pricing strategists. Some products, for
example, may not have a single competing product that
customers would consider a suitable alternative. Instead,
customers might construct a basket of different products
and services as a viable alternative. The “triple play”
offered by communications companies such as Comcast,
Time Warner, and Verizon gives price allowances to
consumers who choose one vendor for phone, Internet
connection and cable television service.
Untreated Reference Price Data
Adjusted Reference Prices
Nonindustrial markets

such as academic institutions and government

laboratories estimate economic value in a similar
fashion.
VALUE-BASED MARKET SEGMENTATION

Market segmentation is one of the most important tasks in

marketing. Identifying and describing market subgroups in a
way that guides marketing and sales decision-making makes the
marketing and pricing process much more efficient and
effective. For example, customers who are relatively price
insensitive, costly to serve, and poorly served by competitors
can be charged more than customers who are price sensitive,
less costly to serve, and are served well by competitors. At
many companies, however, segmentation strategy focuses on
customer attributes that are not useful for pricing decisions,
creating customer groupings that do not adequately describe
differences in purchase motivations among customers and
prospects, or classify them in a way that's meaningful for
making pricing decisions.
Consultants and market researchers abound who
peddle various segmentation-modeling schemes.
Often those plans emphasize the obvious, such as
statistical differences in personal demographics or
company firmographics (customer size, standard
industrial classification, and so forth). While the
results seem clear and sometimes coincidentally
differentiate buying motivations, those
segmentations seldom assist pricing decisions,
especially for setting different prices that maximize
profit from different segments.