Marc Shaver/Veer

38 ❘ MM July/August 2005
When it comes to setting price, economic value
modeling trumps customer
value models.

A Question of

Value
B y G e r a l d E . S m i t h a n d T h o m a s T. N a g l e

In this article, and in a companion article in the May/June issue

of Marketing Management, we contrast two fundamentally different
approaches to using “value” to set price and determine pricing strategy.
In the first, customer value mapping (CVM), value is the perceived quality
customers receive per unit of price. In other words, value is determined in
part by price. In the second, economic value modeling (EVM), value is the
economic savings and gains customers realize by buying the firm’s prod-
uct instead of products from other competitive suppliers. In this case, price
is determined by value. In the previous article, we argued that the implica-
tions of using CVM for pricing lead to consistent and significant biases in
pricing—usually underpricing—that have both tactical and strategic pricing
implications. In this article, we will expand on the strategic pricing implica-
tions of CVM and recommend the better model for pricing—EVM.
The problem with CVM is that it fails to distinguish between the value of
benefits that are priced as commodities and the value of benefits that

MM July/August 2005 ❘ 39
 EXECUTIVE In this second of a two-part series, the authors show how economic value modeling (EVM) is
superior to customer value mapping (CVM) for setting price. EVM properly distinguishes
briefing between the value of highly differentiated product benefits vs. generally commoditized bene-
fits. It calculates the savings and gains that comprise the product’s actual economic value. The result is more robust
and more accurate pricing that recognizes the true differentiation value of the product.
are uniquely differentiated by a brand. “Commodity value” is
the worth of the benefits associated with the features of a
product that resemble those of competitors’ products.
“Differentiation value” is the value associated with the fea-
tures of a product that are unique and different from competi-
tors. The price-per-unit value that buyers would be willing to
pay a supplier for differentiating features is greater than the
price-per-unit value that they would be willing to pay for
commodity features. That’s because refusal to pay a supplier’s
price for differentiating features means that the buyer must
forgo those features. Refusal to pay a supplier’s price for com-
modity features means simply that the customer must buy
them elsewhere.
Take a simple example. Multiple competitors produce com-
peting products. Your competitors’ “commodity” products
create $10,000 in value for customers. Your superior differenti-
ated product creates $15,000. Due to competition, the com-
modity product sells for only $3,000 each (customers get
$7,000 of what economists call “consumer
surplus”). Your product sells for $6,000.
CVM views value in terms of the ratio of
what you get divided by what you pay, and
so leads to an uncomfortable paradox.
The price/benefit ratio of your product,
$6,000/$15,000 (0.40), is higher than the
price/benefit ratio of the competitors’ prod-
ucts, $3,000/$10,000 (0.30). CVM advocates
would say that your product is overpriced
and that you need to reduce your price to no
more than $4,500 to be competitive (.3 times
$15,000). Yet customers are paying more per
unit of benefit for your product than for competitors’ products
because the incremental value of its differentiation, $5,000,
exceeds the incremental cost, $3,000. Exhibit 1 illustrates the
paradox as shown in a customer value map. Your product is
currently located at point A. The relative price ratio vis-à-vis
competitors is $6,000 divided by $3,000, or 2.0. The market-
perceived quality ratio vis-à-vis competitors is $15,000 divided
by $10,000, or 1.5. Thus, your current value position is point
A. The model suggests that your product will lose share
because your position is to the left of the fair value line.
Customers should perceive they are getting less value from
buying your product than from buying competitive products.
The CVM therefore recommends that you reduce price so that
40 ❘ MM July/August 2005
your product moves to the value position corresponding to
point B.
However, buyers who failed to buy your product because
it was to the left of the line would be making poor decisions.
The correct calculation for value comparison among brands is
not “dollar of benefits divided by price,” but is “dollar worth
of benefits minus price.” The customer who buys your prod-
uct receives $9,000 more value than he is paying for ($15,000
minus $6,000). The customer who buys your competitors’
products gets only $7,000 more value than he is paying for
($10,000 minus $3,000). A customer who does not buy your
product is missing out on an opportunity to get $2,000 of
additional surplus value from the purchase. Thus, instead of
losing share you will gain share because of the additional
value you offer in comparison to the price paid.
Why does this happen? Because CVM divides price by a
composite sum of the worth of the benefits received, which
automatically weights all benefits the same in terms of price
One of the reasons for the weaknesses
of CVM is that it fails to distinguish
between different types or
definitions of value.
paid—creating a composite average of price per unit value.
Consequently, it infers that customers will pay no more for
highly differentiated benefits than they would for commodity
benefits.
Here’s a B2B example: A semi-conductor manufacturer sold
integrated circuit chips to original equipment manufacturers
(OEMs) of telecommunications, who sold various products to
the consumer marketplace. A key driver of value for these
OEMs was “time to market,” that is, the time it took to
“design in” the new chip into the new product and get the
new consumer product to market. This semi-conductor manu-
facturer excelled at design-in, which enabled its OEM cus-
tomers to get their consumer products to market usually two
■ Exhibit 1
The value ratio paradox
A something cold to drink is extremely high for most people—
Higher 2.0 Current
price
value
position
B
1.5
Relative CVM recommended
price value position
ratio 1.0
Lower 0.5
price
Fair value line
0 “Mental Accounting and Consumer Choice” describes this def-
0 0.5 1.0 1.5 2.0
Market-perceived qualtiy ratio
Adapted from Managing Customer Value (The Free Press, 1994) by Bradley T. Gale
months faster than it would take to design-in chips from alter-
native semi-conductor suppliers, out of an industry-average
12-month design-to-launch cycle time. Thus, the improvement
in time-to-market “productivity” was about 17% (two months
divided by 12 months). But the dollar value created per prod-
uct sold was considerably higher than 17% vis-à-vis other
competitive suppliers due to (a) the incremental share of mar-
ket the OEM company would realize by being first to market,
(b) the price premium it would realize before competition
effectively entered the market, and (c) the unit cost savings the
OEM would realize by driving volume manufacturing to scale
faster than competitors. And this was just one driver of differ-
entiation value.
The same thing happens in many B2C contexts. Volvo posi-
tions its cars as the safest that one can drive. Customers pay a
significant price premium for Volvo’s safe image. Yet, even
though Volvo advertising makes substantiated claims about
Volvo’s safety record (X% more steel than other cars or X%
fewer injuries), people pay more for the psychic value of
knowing that they or their loved ones are more likely to sur-
vive an accident. This differentiation value is far greater than a
percentage improvement in performance that Volvo may doc-
ument and promote to the marketplace.
CVM Value
It is important to define what “value” is. One of the rea-
sons for the weaknesses of CVM is that it fails to distinguish
between different types or definitions of value. We define four
concepts of value, which are usually confused in the discus-
sion of value and CVM. (See Exhibit 2.)
Value in use. This is the monetary worth of a product’s set
of benefits actually received by the customer as a result of
using the product or service. Economists call this use value, or
the utility gained from the product. In their 2002 book The
Strategy and Tactics of Pricing (p. 74), Tom Nagle and Reed
Holden explain:
“On a hot summer day at the beach, the ‘use value’ of
perhaps as high as $10 for 12 ounces of cold cola . . . [but] few
potential customers would be willing to pay such a price.
Why not? Because potential customers know that, except in
rare situations, they don’t have to pay a seller all that a prod-
uct is really worth to them. They know that competing sellers
will give them a better deal, leaving them with “consumer
surplus.” . . . [Perhaps] a half mile up the beach is a snack
shop where beverages cost just $1.”
Richard Thaler’s seminal 1985 Marketing Science article
2.5 inition of value-in-use in terms of “acquisition utility” and its
value equivalent (i.e., the amount of money that would leave
the individual indifferent between receiving the product or its
monetary equivalent as a gift). Value in use is realized over
the life of the product or service and includes all associated
savings and benefits, such as installation or maintenance
savings or personal or product performance benefits.
Economic Value
A product’s objective monetary worth to a customer adjust-
ed for the availability of competitive substitute products is
known as economic value, or value in exchange. Even though a
product’s value in use may be substantial, competitive market
forces barter away some of that value through competitive
pricing. This value is not lost but simply transferred from sell-
ers to buyers in the form of consumer surplus. Consequently,
buyers may be willing to pay sellers in one market less than
they pay for similar benefits in another market because the
■ Exhibit 2
Distinguishing between types of value
Value
in use
Value
in exchange
(economic
value) Perceived
value
(market
value)
Differentiation
value Willingness
to pay
Commodity
value
MM July/August 2005 ❘ 41
first market offers more competitive alternatives. To calculate ■ Exhibit 3
economic value, one must first determine the reference price Economic value model (EVM)
of competitive substitutes in the marketplace and then deter-
mine the incremental use value that the product delivers over
and above that of competitive substitutes. (See Nagle and Negative
Holden, 2002. Also see James C. Anderson, Dipak C. Jain, and differentiation
Pradeep K. Chintagunta’s 1993 Journal of Business-to-Business value
Marketing article, “Customer Value Assessment in Business
Markets: A State of Practice Study,” which explores the many
Positive
definitions of value studied by scholars and researchers and differentiation
settles on this relative conceptualization of value.) value
Market value. Market value is the value buyers perceive Total
the product to be worth. Nagle and Holden (2002) comment: economic
“A product’s market value is determined not only by the prod- value
uct’s economic value (i.e., value-in-use or value in exchange),
Reference
but also by the accuracy with which buyers perceive that value value
. . .” (p. 110). This means that it is critical to understand not
only perceived value (market value) but to understand it sepa-
rately from actual value so that marketers can compare, diag-
nose, understand, and recommend strategies to manage the
gap between perceived value and real value. monetary terms. By measuring only perceived value, CVM
Willingness to pay. This refers to the price buyers are will- also fails to make the distinction between actual value and
ing to pay to obtain the value buyers perceive the product to be perceived value. The consequences of this omission for pricing
worth. Despite buyers’ perceptions of value, they may be either and marketing are significant, since if a product is selling
unable or unwilling to pay this due to price sensitivity. For poorly, trying to raise perceived value may be a better alterna-
instance, heavy volume purchasers may perceive significant tive than lowering the price, if the price is justified by its
product value, but are sensitive to unit price because the total exchange value.
product expenditure is large relative to total income or budget. For example, if a product’s perceived value (perhaps as
Thaler’s 1985 description of “transaction utility” and its value measured by a CVM benefit score) were lower than the seller
equivalent (i.e., the difference between the
price an individual pays and some reference
price) reflects willingness to pay.
CVM assumes that value is value.
However, as these different conceptualiza- Although rational customers will often pay
tions show, understanding which value you
are measuring has important implications
much more than the price that the value
for how to market the product or service, equivalence model would predict, they’re
and particularly how it should be priced.
For example, for many products in compet- rarely willing to pay as much as the
itive markets, much of the actual value cus-
tomers realize is use value. But much of EVM would say a product is worth.
that value is commoditized because other
competitors offer essentially the same fea-
tures, benefits, and therefore value. The rel-
evant definition of value for these products is therefore expected, the problem may well be that buyers are unin-
exchange value, which explicitly accounts for the commoditi- formed, poorly informed by their own lack of product knowl-
zation of competitively available features and benefits and edge or ability, or misinformed by competitors’ selling tactics.
explicitly identifies and quantifies the worth of truly differen- Rather than lower price to a level that reflects buyers’ poor
tiating the features and benefits. perceptions of value, the firm would be much better off prop-
CVM virtually ignores this distinction between use value erly educating customers about the product’s true potential
and exchange value. It begins the analysis by asking cus- value and raising perceived value. It might also reassure risk-
tomers for their subjective ratings of benefits, an indirect way averse customers that they will truly realize this actual value
of measuring perceived value—indirect because it measures by offering stronger warranties or perhaps communicate to
the value of benefits as a subjective “score” rather than in late-adopter customers that other “opinion-leader” buyers

42 ❘ MM July/August 2005
have purchased the product because they know the true value
it delivers, and so on.
Finally, the value of the benefits does not tell the full story
of why customers may not buy (i.e., why the product is a
share loser rather than a share gainer). Willingness to pay
merits just as much strategic and analytical rigor as value.
Even if customers perceive significant value in the product or
service, they may be unable or unwilling to pay because of
low budgets or income, because the price represents a large
share of the buyer’s total available budget, and so on. In such
cases, the answer simply may be to restructure the transaction
to facilitate purchase—by offering financing so that buyers can
spread payments over time or offering lower prices only for
buyers that purchase in large quantities.
True Measure of Value
The process for estimating value has been reasonably
established by pricing and marketing scholars. Nagle and
Holden (2002) summarize this process. James Anderson and
James Narus show a practical application in their 1998 Harvard
Business Review article “Business Marketing: Understand What
Customers Value.” John Forbis and Nitin Mehta provide a
foundational conceptualization and excellent application in
their 1982 Business Horizons article “Value-Based Strategies for
Industrial Products.”
Economic value is the price of the customer’s best alterna-
tive (the reference value) plus the value of what differentiates
the offering from the alternative (differentiation value).
Differentiation value identifies all factors that differentiate the
firm’s product from the competitive reference product; these
are sources or drivers of differentiation value. The worth of
each of these drivers of differentiation value is estimated by
quantifying the savings and gains that customers would real-
ize by using the firm’s product rather than the competitor ref-
erence product.
Total economic value is the sum of reference value and dif-
ferentiation value. (See Exhibit 3.) What is the value of know-
ing total economic value? First, it is the logical reference point
for setting price since it is the monetary worth of the benefits
the customer receives in exchange for the price paid. Second,
it becomes the anchor of a value-based pricing strategy that
guides the setting of price points that encourages buyers to
pay for the value they receive, rather than other flawed pric-
ing methods such as setting price based on what the customer
is willing to pay or based merely on competitive prices. Third,
economic value is useful in persuading potential customers of
the superiority of the firm’s product offering because it calcu-
lates the true economic impact from buying your product
rather than a competitor’s. (See Forbis and Mehta 1982.)
To be sure, although rational customers will often pay much
more than the price that the value equivalence model would
predict, they’re rarely willing to pay as much as the EVM
would say a product is worth. Factors such as uncertainty
about the promised benefits, switching costs, and perceptions
of fairness will all reduce willingness to pay to a level below
economic value. Economic value is, however, a useful starting
point for communicating value to customers and for building a
marketing program that supports capturing a large portion of
it in price. “Value equivalence” is, in contrast, a declaration
that innovation and marketing are not true value since, despite
building product differentiation and the means to communi-
cate it, all pricing is basically commodity pricing that is pegged
to industry prices. We believe that the success of many premi-
um-priced brands refutes that contention.
For pricing and marketing, the truest and most accurate
way to determine value is the old fashioned way—to estimate
it based on knowledge of how customers actually use the
product and realize value from its use. CVM is handy and sim-
ple to do and easy to understand. It is an appealing analytical
framework for high-level executive decision makers who are
not close to a product, its customers, and how customers
receive utility (and value) from product use. But it consistently
leads marketers to simple analytical heuristics that sidestep a
true and robust estimate of customer value. ■
About the Authors
Gerald E. Smith is chair of the marketing faculty at the
Carroll School of Management, Boston College. He may be
reached at gerald.smith@bc.edu. Thomas T. Nagle is chairman
and CEO, Strategic Pricing Group Inc., Waltham, Mass. He
may be reached at tnagle@strategicpricinggroup.com.
WHAT’S NEXT September/October
in Marketing Management?
nderstanding how branding works and what it takes to
U make marketing efforts successful in that arena will
be the focus of our September/October issue. Notable
experts in the field also will address topics of concern for
marketers when it comes to brand management. Another
feature to look forward to will be a follow-up article to our
thought-provoking cover story by Ken Demma, Julie Phillips
Baker, and Niall Budds.
And for additional information on branding, you can always
turn to our regularly featured branding column. Our other
always interesting columns and departments will include
the latest thoughts on marketing that works, customer
bonding, and leadership.
MM July/August 2005 ❘ 43