Marketing, MBA

Value-Based Pricing

I am in the middle of getting a part time MBA. It has been a goal I wrote up a few years ago, so it is exciting to be in the middle of executing it. I was a business major in my undergrad and got a ton out of it. I really enjoyed the classroom environment and was eager to get back into it to re-learn key concepts again.

Over the summer term, I took my favorite course yet, Marketing Management. It brought back a ton of memories from when I had professor @MarkStatonPHD for my undergrad marketing course. Mark was my first marketing professor, became my advisor, and delivered tons of useful information to me when I began showing an interest in marketing.

It is a small world and it turns out the professor I had for MBA marketing taught Mark when he got his MBA at BU in the early 2000s.

Anyway, I am going to share some of the lessons that came from that class here.

First is value-based pricing which is a pricing strategy where you set the price based on estimated value rather than cost. If you can understand the value you are driving, you can get an indifference point which can get you to the willingness to pay (WTP).

Price is not about cost. It is about willingness to pay (WTP). 

The professor gave us an interesting in class case to drive this point home. The case laid out some key scenarios:

  • You are the head of marketing for a mid-size industrial supplies manufacturer and considering launching a new cushion pad to be used with pile driving machines in manufacturing plants. .
  • Current solution is unbranded pads that cost $3 each. The supply houses selling these items sell a variety of other products. The markup is 30% over the cost to buy the product.
  • Rental and labor costs for the manufacturer to run machines are about $150 per hour.
  • Your company is specializing in metal wire twisting technology and you found a new use case for it, these pads.
  • Each pad costs $25 to make and there is no additional equipment investment needed.
  • Company policy is to mark up products by 50% over the variable manufacturing costs.
  • The new pad transferred driving energy more efficiently to the pile. The speed at which piles could be driven went from 100 feet per hour to 150 feet per hour.
  • There was a test job had 15,000 feet of piles to be driven. Five new pads were used and 100 of the old pads would have been used.

How much should we charge for this product? Everyone had a range of answers in the class. I went ahead and priced based off the competition.

  • $3 X 100 olds pads = $300
  • $300 / 5 new pads = $60

That’s it! $60 is perfect. The manufacturer won’t spend any more so it would be an easy sell, and we cover the 50% over variable cost requirement. WRONG! There is operational value created through these pads.

I learned there is more on the table with a little more basic math focusing on the test:

Old Pads: 
  • 15,000 feet of piles
  • 100 feet / hour (speed at which old piles cold be driven)
  • 150 hours
  • $150 per hour

15,000 feet / 100 = 150 hours X $150 per hour = $22,500

$22,500 is the cost associated with machinery and labor to drive the 15,00 feet of piles.

New Pads:
  • 15,000 feet of piles (same amount)
  • 150 feet / hour (speed at which new piles could be drive – little more efficient)
  • 100 hours
  • $150 per hour

15,000 feet / 150 feet / hour = 100 hours X $150 per hour = $15,000

$22,500 – $15,000 = $7,500 + $300 (cost of old pads) = $7,800 
 
We know it is going to take 5 new pads to get this job done so we divide by 5.
 

$7,800 / 5 = $1,560. 

The efficiency of their new product created value to the customer which can in turn drive up willingness to pay. $1,560 for the new pads is the indifference point and means they are spending the exact same dollar amount to get the same job done. It doesn’t mean you definitely price the pad at $1,560 but it gives you a range at which to start and a clear view of the value creation you are providing customers.

This is value-based pricing.

value based pricing