Pricing Tool: The Value Pricing Framework

The Value Pricing Framework provides managers & entrepreneurs with a comprehensive and versatile approach to approach pricing strategy.

The Value Pricing Framework is a broadly applicable, flexible approach to making and evaluating pricing decisions. It is equally suitable for a startup whose founder is starting to think about pricing, as it is for an established corporation with many business units and a complex portfolio of goods and services. The Value Pricing Framework can inform managerial thinking about a variety of pricing issues.

The framework begins with the four pricing decision inputs, the so-called four pillars of pricing (see figure below). Of these, three inputs help to establish the price, and the fourth input regulates the first three. The three inputs include the company’s costs that are relevant to the pricing decision, the customer’s monetary valuation of benefits delivered by the product, and reference prices that customers use to make buying decisions. The fourth input, the business’ chosen value proposition dictates how costs, customer value, and reference prices are weighted in the pricing decision.

At the framework's center are two types of pricing decisions, set a new price and change a current price. A vast majority of pricing decisions involve changing price. The opportunities to set a new price are few and far between; entrepreneurs are more likely to get them than managers in established companies. This means that the company's historical prices and pricing strategy set relatively rigid constraints, at least in the short term, for changing prices.

Furthermore, pricing decisions involve the consideration of two aspects of price: the price level, defined as the average price charged, and the price structure, which is the overall assortment of prices, price-benefit combinations, price variations, and price offers for the product.  Asking prices or listed prices reflecting the price level are more visible but designing a price structure carefully is a far more potent driver of pricing success. (A detailed discussion about price level and price structure is available here).

There is often a significant gap between the quoted or listed prices in catalogs, sales pitches, store shelves, and websites and what customers pay after discounts, markdowns, allowances, and other incentives are considered. The Value Pricing Framework distinguishes the concept of price realization, getting to the actual prices paid by customers from pricing decisions. This allows pricing decision makers to recognize, analyze, and manage the divide between their asking prices and realized prices. The process is labeled price execution in the framework.

To assess the success of pricing decisions, the Value Pricing Framework uses four pricing success measures: sales revenue, profit margin, customer response, and employee buy-in. Instead of maximizing any one measure, an effective pricing strategy tries to balance these measures. The key is to maintain a balance between increasing unit sales and revenue and earning a healthy profit margin, while at the same time having a base of customers that responds favorably to the company's pricing policies and confident and knowledgeable employees who stand ready to execute its pricing strategy. This is the win-win-win-win quadfecta of the Value Pricing Framework. The four pricing success measures, in turn, feed back to the pricing decision inputs, resulting in a cyclical process of price management that reflects the ongoing involvement of customers and employees.

The final part of the framework is the consideration of the pricing context in which the company operates, and pricing decisions are made. The manager must monitor relevant economic, social, political, and technological trends and variables, considering how these will affect the pricing process described in the Value Pricing Framework and the company's pricing structure. The context injects contingencies, opportunities, and increasingly, a greater dynamism that requires frequent price adjustments and a periodic consideration of the price structure.

The Pricing Decision Inputs

Effective pricing decisions rely on careful consideration of the four decision inputs. Every input plays a different role individually, and together, they interact to guide the direction of the company's pricing strategy.

Costs. In every pricing decision, costs are a necessary consideration because, in the long run, costs and prices are inextricably linked. For a business to remain viable, its average prices must be greater than its average costs. Costs, therefore, establish the floor or lower bound on the price. Beyond this simple equation, however, understanding how costs change with sales, and which costs to consider, and which ones to ignore when making pricing decisions are important considerations.

Once relevant costs are adequately understood and a long-term viable pricing structure is put in place designed to cover the average costs, the manager has the flexibility to design creative short-fuse pricing offers to attract new customers or to increase sales to existing customers while adding disproportionately to the company's profits.

Customer Value. Every product feature potentially provides customer benefits. In the Value Pricing Framework, customer value is quantified by mapping the product's features to benefits and benefits to the customer's willingness to pay. For pricing decisions, customer value is an important consideration because it is unrelated to costs. It provides a unique data point about viable prices helping to generate an upper bound on prices customers consider worth paying. An understanding of current customer value also provides guidance about how to increase it.

For example, customers may place tremendous significance on a feature that costs the company very little money to offer. When buying season ticket packages, for example, sports fans may be happy to pay a hefty premium to receive playoff ticket purchase priority, a feature that costs a professional sports team virtually nothing to offer.

On the flip side, customers may be willing to pay little or nothing extra for features that are very expensive to deliver. In early versions of Amazon's Kindle reading device, for instance, the text-to-speech feature was added at a significant cost. However, few customers used this feature, leading Amazon to drop it in later versions to avoid dealing with objections from the publishing industry. Now, with improvements in technology and greater customer appreciation, the feature is back. Knowing how features translate to benefits and benefits translate to dollars and cents valuations by customers allows the company to design and then make value-aligned pricing offers.

Reference Prices. Customers rarely judge prices individually. When assessing whether a price is a "good" price or not, customers usually compare the price to other prices and then decide. In the words of Hans Rosling, "A lonely number also makes me suspicious that I will misinterpret it. A number that I have compared… can instead, fill me with hope." The prices customers use for comparison are called reference prices in the Value Pricing Framework.

Reference prices can be anything. They can be prices that the customer is familiar with, like the product's previous price, or they can be prices encountered during the purchase process like competitors' prices, or even prices of totally unrelated products.

Reference prices play the dual roles of establishing a frame of reference and helping the customer to form a range of prices deemed as reasonable. For pricing decisions, staying within the range of reasonable prices is an important consideration because customers tend to focus less on price and more on non-price attributes when prices are maintained within the range.

The second role of reference prices is persuasion. Prices serve as persuasive cues. By strategically supplying reference prices through means such as prices ending in 5, 9, or a round number, explicit comparisons, or any number of other methods, the manager can influence how customers judge the price at every stage in their decision journey.

The Value Proposition. The fourth pricing decision input is the company's value proposition, which articulates its core differentiators. From a strategy standpoint, it is the most significant of the four inputs. Without a compelling and clearly articulated value proposition, it is virtually impossible to have an effective pricing strategy. A differentiated value proposition that is compelling to targeted customers wins half the pricing battle.

The value proposition verbalizes the marketing strategy and core values endorsed by the firm. It provides a broad set of guidelines to make specific pricing decisions. Its primary function in the Value Pricing Framework is to establish the relative weights managers give to the other three decision inputs.

For example, a company that has built its brand and value proposition around a Value For Money positioning strategy, like the discount grocer Aldi, weights its costs and its prices relative to competitors heavily. It will price its products always to be significantly lower than its peers. In contrast, the fast-casual restaurant chain Panera Bread, whose value proposition centers around "creating a guest-centered, personalized experience using freshly prepared, responsibly raised and high quality ingredients," places greater emphasis on customer value and less on costs or reference prices. The upshot is that it will be willing to charge higher prices than competitors, as long as they remain within the reasonable range.

Pricing Decisions & Price Execution

The Value Pricing Framework distinguishes between setting the prices and price structure and executing the price strategy. This is because there is a gap between the prices companies ask for and what they get. It is one thing to quote a price, another entirely to be paid in full. In business markets, customers may get a quantity discount, an allowance to run an advertising campaign, free freight, or an additional discount for paying promptly. In consumer markets, buyers may use a coupon, purchase during an exclusive flash sale, receive a promotional giveaway, or receive incentives as members of a rewards program. These are just some examples of ways in which the gap between the asked-for price and the realized price expands.

For many companies, the price realization gap can be significant and undermine pricing effectiveness. When the 2017 Toyota Prius was launched, for example, its listed base price was $30,960. But this price meant little to customers. They only paid an average of $28,352, a gap of 8.4%. Even worse, a fifth of Prius owners paid less than $27,513, resulting in a price realization gap of 11%. In business markets, a cement manufacturer listed one of its products at $11.97 in its price lists. When all incentives given to customers were taken into account, however, it was only earning $6.53 per bag sold. Put differently, its price realization gap was 45.4%1.

To understand the extent of harm created by this gap, consider a mountaineer who decides to climb Mount Everest and spends two years preparing and planning for the climb. During the climb, however, they only end up reaching the first base camp before turning back. The mountaineer's decision-making process was perfect, but their execution missed the mark. Think of the asked-for price as Mount Everest, the process by which it is set as analogous to the mountaineer's preparation, and price execution as the mountaineer's actual climb.

Notice that in this analogy, the reason why the mountaineer couldn’t make it to the top could be due to any number of reasons, physical fitness, the support team's competence, bad weather. The same is true for price realization. Controllable factors and the uncontrollable pricing context can both affect price execution. The fact remains that a thoughtfully established price is only meaningful when it is earned by the company. Otherwise, it is like a mountaineer charting an elaborate plan to climb Mount Everest but only getting to its foothills.

Why does the price realization gap occur?

There are many reasons, of course, and we can only scratch the surface in this piece. One factor has to do with the company simply not having a good understanding of what the gap is and how many and what amounts of incentives customers are getting, individually or collectively. And this is far more common than you might think, even in 2021’s data- and analytics-obssessed corporate culture. A second reason concerns who within the company, if anyone, has responsibility for price execution, and how they are compensated for managing the price execution gap. Oftentimes, no one is in charge, and no one is getting any rewards, monetary or otherwise. Not surprisingly, no one cares.

Third, price execution may fall outside the domain of managers who make pricing decisions, and the company's pricing guidelines for price execution are simply not communicated properly to frontline employees. These managers may carefully go through a process in which they consider the decision inputs carefully before setting prices. However, someone entirely different within the company, say the sales organization, then takes over the negotiation process. What concessions are given during the negotiation will dictate the size of the price realization gap.

A significant amount of recent academic research has sought to understand how to measure, analyze, and close the price realization gap, which I will consider another time in another post. Here, the main point is that price execution is just as important as making good pricing decisions for pricing strategy success. Doing all the work to figure out the best price to charge customers is of little value if they only pay a fraction of it.

Pricing Success Measures

The last part of the Value Pricing Framework measures the success of pricing decisions and price execution. Intuitively but incorrectly, many managers think of effective pricing strategy narrowly in terms of either sales maximization or profit margin maximization goals. While both metrics are obviously significant, it rarely makes sense to charge prices that will bring in the most customers or sell the most units, or even generate the highest revenue. The company could simply lower prices far beyond reasonable levels to achieve such goals. Nor is it advisable to pursue the maximum profit margin. This would mean setting prices in the highest possible range, close to the ceiling, sell few units, and earn a huge profit margin.

The fact is that the goals of revenue and profit margin conflict with one another. One can only be achieved at the other's expense. Companies can "buy" unit sales by sacrificing profit margin, or they can exercise restraint, giving up low-priced sales and increasing earned margin. Complicating things even more, pricing not only affects the company's financial performance as measured by its sales and profits, but it also has meaningful effects on customers and employees.

Customers like to buy from companies whose pricing strategies reflect their own values and whose prices are fair, transparent, stable, and aligned with the product's economic value. Just witness how consumers still flock to stores or websites every time a new Apple iPhone or Supreme collection drops. These items are not cheap, but customers find their prices to be congenial. On the other hand, consider online retailers that are constantly changing prices of products on sale or the surge pricing used by ridesharing services. Customers hate this price volatility because it complicates their buying decision and makes it hard to form or use reference prices. This type of pricing leads to a negative response. Along similar lines, there is a trade-off between financial performance and customer response. Giving customers more and more benefits will satisfy them, but without commensurate price increases, profit will erode. Happy customers, unhappy CFO, and irate shareholders!

For employees, a well-strategized and well-executed pricing strategy can be a source of organizational pride. When prices and price increases are explained, align with common sense, and come across as fair, they are easy to communicate to customers and defend during sales negotations. Such pricing contributes to creating an aura of competence around the company. It provides confidence to employees and boosts their morale. In contrast, when a company adopts an "aggressive growth at any price" mentality and embarks on the path of offering discounts in an ad hoc way, employees lose their confidence in their products and become confused and embarrassed executors of the pricing plan. Employee buy-in is critical for pricing success.

The soft, people-based measures are often overlooked by managers, even though they are crucial for pricing success. With the Value Pricing Framework, the manager tries to balance the four success measures. They not only pay attention to changes in financial measures of pricing performance, but they are also sensitive to the reactions of customers and employees to the company's pricing decisions and price execution.

1

The Price Advantage has an excellent chapter on the discrepancy between list price and realized price. In it, the authors call the realized price as the “pocket price” and provide readers with a graphical tool called the “Pocket Price Waterfall” to understand different incentives and deductions that lead to the price realization gap for a particular product or customer segment.