Pricing and Value

I’ve talked about pricing before.  Pricing your product or service is extremely tricky. Expect to revisit
your pricing continually throughout the life of whatever it is you are
selling.

This post attempts to provide some useful background that, if nothing else, will help explain why
the process is so tricky. What follows applies to products or services,
but for ease of typing, I’ll just refer to everything as products.

Pricing is the art of finding a dollar amount that your customer is
willing to pay for your product. A customer’s willingness to pay is
dictated by whether or not they see your product as being a “good
price”, a “fair price” or a “bad price”.

In other words, there is the actual dollar amount you charge and an intangible perceived price that reflects what the customer feels that they are paying.

Pricing isn’t simply about dollars (or any other type of currency).
And this is fundamentally what makes pricing a tricky process.

But lets define some terms.

Perceived Price:  Does the customer see your product as cheap, reasonable or expensive?

Willingness to Pay:  Willingness to pay is inversely proportional to the perceived price.  As the perceived price goes down, willingness to pay increases.  As the perceived price goes up, willingness to pay decreases.

Dollar Amount: The amount you are charging for the product.

Perceived Value: The value the customer sees in your product.

The relationship between these three factors is something like this:

Perceived Price ↔   1 / Willingness to Pay

and:

                        Perceived Price  = Dollar Amount / Perceived Value

or if you prefer:

Willingness to Pay = Perceived Value / Dollar Amount

In other words, a customer’s willingness to pay the dollar amount you are asking for has everything to do with the perceived value of your product.

The chart shows increasing dollar amount versus increasing perceived
value. If the Dollar Amount is high and the value low, the product is
seen as too expensive. If the Dollar Amount is low and the Perceived
Value is low, it is a fair price, but probably a commodity product. If
the Dollar Amount is high, but the Perceived Value is also high, your
pricing is still perceived as reasonable, although you are selling a
“premium” product (more on that later). Finally, if your Dollar Amount
is low but your Value is high, you are priced too cheaply.

Lets explore this some more. 

Imagine two products with identical features and identical dollar pricing.  Product A has a high perceived value, while Product B has a low perceived value.  Customers will be more willing to pay for Product A than Product B, even though the dollar amount is identical.   

The higher the value to the customer, the lower the dollar amount will seem, increasing the willingness to pay. In other words, higher value lowers the perceived price.

Here’s an example: coca-cola and coffee. Assuming you drink both,
would you willingly pay $6 for a can of coke? What about $6 for a
Starbucks coffee? In general, both are normally priced at between $1
and $2. But what the customer is willing to pay for Starbucks Coffee is significantly higher than what they would pay for a coke.  And that’s because of the perceived value of a Starbucks coffee.

Don’t confuse value with features. Customers
don’t flock to Starbucks because they provide a unique blend of warm
water, caffeine, milk and sugar in a transportable package and throw in
a free stirring utensil. They choose Starbucks because of the ambiance,
the perceived quality of the products, and the overall “experience”.

For another example, visit the grocery store. Every category is
filled with “premium” items. Haagen-Daz ice-cream is 6 to 8 times more
expensive than Blue Ribbon, but it sells extremely well because the
customer perceives additional value in the product and is therefore
willing to pay the premium dollar amount.

Perceived value can be so high that customers (a) don’t perceive that they are paying a premium and (b) may even place the product in it’s own separate category.
It’s not just coffee, it’s Starbucks. It’s not just a car, it’s a BMW.
It’s not just a play, it’s a Broadway play. It’s not just perfume, it’s
Chanel.

Every product or service category you can think of has premium
products that have higher dollar amount prices than their competition.
The successful ones survive because the value of the product makes the
perceived price acceptable in the mind of the customer. Being a premium
product is a fantastic market position to have, but your product better
be good enough to maintain its premium status.

Would you pay $30,000 for a Kia car? Probably not. But you would pay
$30,000 for a BMW. The difference between the products is a lot more
than a feature list. BMWs have high perceived value based on
desirability, product quality, associated prestige etc. Conversely, if
you were offered a brand new BMW for $11,000 (the price of a base model
Kia), you might buy, but you would be very suspicious about the product
being sold.

“Too good to be true” can be as big a barrier to sales as too high a
price. And both are driven by the perceived value in the mind of your
customer.

Going back to the relationship between Perceived Price, Willingness to Pay, Dollar Amount and Perceived Value, it is a pretty obvious conclusion that if the dollar amount increases and the value stays the same, the willingness to pay goes down (the perceived price has gone up). 

That’s why an established dollar amount puts an upper limit on what
customers are willing to pay. Once you charge $299 for something, it is
pretty hard to then convince your customers to pay $499.

What you can do is add more value
to the product and then charge more. You can also reduce the dollar
amount while proportionally reducing the value, hence all those “Lite”
versions of products.

Under certain circumstances you can temporarily lower the dollar
amount, for example during a sale, or with a coupon. But the longer you
maintain the discounted dollar price, the more established it will
become in the mind of your customer. If you continually run sales and
special offers, your customers will just wait for the next good deal to
make their purchase.

Okay, so why not just slash the advertised price? In principal that
drives the perceived price down and the customer’s willingness to buy
goes up. Sounds like a good plan, right?

Nope.  Generally speaking, it is always a bad idea to compete on price.  There are three fundamental  problems with slashing dollar amounts:

1. It’s hard to raise a price again once it has been lowered (see the previous paragraph)
2. There is always someone somewhere that will undercut you
3. There is a limit to how low you can go while maintaining a viable business

No matter what the lowest price is that you can afford to sell
something at, someone else can sell it cheaper. Or at least they think
they can. You can compete with them all the way down to zero and
beyond, but you will most likely destroy your business in the process.
Companies with deep pockets, alternative business models or excess
stupidity can and will undercut you on price. But remember, if your
perceived value is high, your customers will still be more willing to
pay even if the dollar amount is actually higher.

You can offer products for free if you still have some kind of revenue
source. What you can’t do is offer products for free if your business
is built on the expectation of revenues from that product. But that’s a
whole different topic…

And lastly, just because you decide to offer something for free
doesn’t mean you can’t be undercut on price. There are always companies
that are willing, even if only for a short time, to pay customers to
use their products. In other words, the price becomes less than zero.  Think of free trials, mail in rebates and “buy X get Y free” coupons.

So remember, it is almost always a bad idea to compete on price. The only way to win the game is to have high perceived value.

There is only one occasion on which you should compete on price, and that is when your product fundamentally changes the game.  What does that mean? If an existing market charges $100 for a product and you have an innovative way to profitably
sell it for $20 or less, you may be on to something. But usually an 80%
(or greater) drop in price means that your product takes advantage of a
fundamental change in thinking.

For an example, let’s roll back the clock and look at Autodesk,
makers of AutoCAD. Prior to the arrival of AutoCAD, Computer Aided
Design software cost anywhere from $100,000 to well over $1M per copy!
AutoCAD arrived and was priced at less than $3000. They offered 90% of
the functionality of the other systems for less than 10% of the price.
How did they do it? They created CAD software for the PC. Every other
system used proprietary hardware, or expensive mini-computers. At the
time, the PC was just beginning to be accepted for business use. John
Walker, the founder of Autodesk, made the perceptive leap that a PC
could be used for CAD and that the software could therefore be
dramatically cheaper than anything else currently available. Of course,
since then various other companies have created CAD products that have
90% of the functionality for 10% of the price, resulting in AutoCAD now
being the expensive end of the market and good CAD tools being
available for less than $100.

Okay. So they competed on price.  Or did they?  Not exactly.  Price was a factor, but they also offered mind-blowing perceived value.  So willingness to buy skyrocketed the company to success.

Don’t believe me?  Would you spend $3000 on something that didn’t have much value to you?  No, of course not.

So if you are fundamentally changing the game you can offer a
dramatically lower price, but at the end of the day, always remember: a customer’s willingness to buy will always be driven by perceived value