There are many flawed practices when understanding the value to the customer, such as taking into account development/products times or cost, "coolness factor", size of the customer's business, number of customer units etc.
The reality is that the maximum amount a customer is willing to pay (the Economic Value to the Customer or EVC) can be calculated with a simple formula:
EVC = Reference Value + Differentiation Value
The Reference Value is the price of the closest perceived substitute. This is extremely important - understand what alternatives and substitutes the customer sees in the market.
The Differentiation Value is the value of your product's attributes that exceed the reference value. These attributes includes features and functionality, time to market, size, cost, licensing, support etc. You also need to ensure that the customer is fully informed of all of the differentiation you provide.
As an example, when I moved to California two years ago I needed to buy a new car for commuting in the bay area. Initially, I was thinking about a BMW M3 convertible (my requirements list has convertible as mandatory), and went to talk to the BMW dealer, took a test drive etc. From memory the M3 was about $70K.
After driving the M3 I decided to check out the Mini Cooper S convertible, and found that it met my needs and had a total price of approx $35K. So the Mini Cooper S became my Reference Value. Although the BMW M3 was clearly a better car than the Mini, I couldn't determine $35K of differentiation value. The Mini had the same three year service plan included, had a cabin size roughly the same as the BMW, had an automatic roof, had more than enough power. So purchased the Mini and I have been very happy with my decision.
Remember in the technology space that any company can copy and build any other product, unless it is protected by patents. And in the days of open source, there is often a reference value of zero, which has significantly disrupted pricing dynamics. The take away here is that you must get inside your customer's head and understand what they see as the reference value.
Hass Business School Strategic Pricing Course, Professor Teck-Hua Ho listed three "Magic Bullets" for affecting price sensitivity:
- Substitutes Awareness Effect - Buyers are more price sensitive the higher the price difference between this product and the percieved substitute.
- Difficult comparison effect - Buyers are less price sensitive the more difficult it is to compare competing offers.
- Switching Cost Effect - Buyers are less price sensitive the greater the sunk investment they have made in anticipation of it's continued use.
Each of these points can be converted to a takeway:
- If your strategy is to price high above the reference value then you must focus intensely on informing your customer of your differentiation, and be prepared for a longer sales cycle as the customer grapples with the difference between Reference Value and EVC.
- Get out of crowded markets and into a market where you have a unique solution and the customer finds it difficult to come up with the EVC.
- "Sticky" products are best - look at how difficult it is to be displaced after you make a sale.
So the next time you are sitting in a room discussing pricing, try raising your hand, and asking what is the Economic Value to the Customer (EVC) of your solution. See how many blank looks you get, and then go back to basics and calculate EVC.