Why does a firm exist? Who are the key stakeholders it serves?

These may seem to be odd questions for a book about pricing, but the answers to these questions underpin the approach firms take to pricing. The answers to these questions have also evolved over time, across geographies, and within societies and the firms themselves. As the defining purpose of the firm evolved, so did the definition of good pricing. So starting with the fundamental purpose of a firm will lead to an understanding of the culture and philosophy around pricing practiced at the world’s leading firms.

The Purpose of Firms: Serve Customer Needs Profitably

The key stakeholder group served by firms has waxed and waned over decades between shareholders, employees, customers, and the greater society at large. Each of these key stakeholder groups has had its moment of glory. Shifts in stakeholder dominance have had dramatic effects on how pricing is done, how it is managed, and even on the culture of profitable pricing.

In the latter part of the twentieth century, firms elevated the shareholder to the key stakeholder role. Some went so far as to think that firms existed solely to enrich shareholders and that all decisions should be made in the context of maximizing shareholder return. After all, the pundits rightfully pointed out, shareholders own the firms.

This shareholder focus impacted the culture of pricing in a relatively logical and straightforward manner. In order to ensure shareholder return, firms had a strong incentive to take a cost-plus approach to pricing. Under a cost-plus approach, executives calculated their cost to serve then marked it up to identify prices that ensured profitable customer transactions. For cost-plus pricing, better pricing meant better, or more accurate, costing information. Thus, calculating the true cost to serve or using activity-based costing became a normal part of the best-practice process for making pricing decisions.

On the positive side, the focus on shareholder returns drove firms to reduce costs as a means to grow profits and market size. On the negative side, it prevented the separation of the issues in pricing from those in costing, for pricing is not costing.

This dominance of the shareholder rose to its peak while Jack Welch was the CEO of General Electric, and Welch served his shareholders well. During his 20-year reign as CEO, GE’s valuation grew 40-fold.

Shareholder returns and accurate costing are both good things, but shareholders are not the only stakeholders, and costs alone provide woefully inadequate guidance for pricing. The stock market valuations and society backlash demonstrated in varying forms and in different industries that an adjustment was needed.

Within months of his retirement, Welch himself condemned the dominance of shareholder value as an organizing principal for determining what a firm should do, stating “shareholder value is a result, not a strategy” in and of itself (Guerrera 2009).

Welch was not alone in noticing the shortcomings of placing shareholders as the primary stakeholders in formulating corporate strategy, nor pricing strategy for that matter. The software, entertainment, and medical industries had been growing in importance across the globe. Their near-zero variable cost structures made nonsense of cost-plus pricing.

With the waning of the primacy of shareholder value has come the waxing of the importance of customers. And, as with other cultural shifts, the importance of customer focus has had many predecessors over many decades.

We can trace the corporate focus on customers from Peter Drucker through the work of Theodore Levitt and to modern thinkers today. Peter Drucker (1909–2005), the father of management by objectives and perhaps the first management guru, highlighted the importance of customers in stating: “The only profit center is a customer whose cheque hasn’t bounced” (Drucker 2002). Similarly, the late Theodore Levitt (1925–2006), from the Harvard Business School, was known to help students rethink the role of a business by noting: “People don’t want to buy a quarter-inch drill, they want a quarter-inch hole.” And today, many consultants urge firms to ask themselves, “How do you make a difference that customers care about and are willing to pay for?” (D. Dalka 2012).

To drive home this shift, Bill George, former Medtronic CEO and current Harvard Business School professor, stated:

I don’t subscribe to the notion that companies exist to create value strictly for their shareholders. I think they are there to create value for their customers, and that gets to the mission of the company. And ultimately, doing that, they create value for society.

If they forget about that, they have no legitimacy, they have no right to exist, no matter how much short-term shareholder value they create. And the shareholder value is misunderstood. It comes as a result of great value for your customers that leads to growth, and that comes from engaged employees that are innovative and provide superior customer service.

(McKinsey & Company 2013)

Each of these leaders has been urging firms to rethink their strategy from the view of the customer. What customers will they serve? What problems will they solve for those customers? And how do customers value the solutions the firm offers to solve their problems?

This is a tectonic conceptual shift in the existential purpose of a firm. It is a shift from stating that a firm exists primarily to serve its shareholders to stating that the firm exists to serve its customers profitably. This shift is not complete, but it is definitely underway.

It isn’t that shareholders, employees, or the society at large do not matter. Shareholders are motivated to invest by the expectation of returns. Employees are motivated to work by the expectations of growth and wages, both today and in the future. And society at large is motivated to ensure that firms act in a morally virtuous manner with minimal negative economic externalities. All of these stakeholders and their concerns are important to manage, but they do not define the purpose of the firm.

In stating that the existential purpose of a firm is to serve a customer profitably, we can even leave the word “profitably” out of this claim and still be accurate. Customers that are not profitable are not customers. They are leeches sucking the lifeblood, that is, cash flow, out of the firm. No firm can serve leeches for long. Leeches should be eschewed rather than pursued. Hence, we could simply state that the purpose of a firm is to serve customers. Period.

Along with this shift toward a customer focus has been a shift in identifying the key activities of the firm. The first requirement in serving customer needs is to identify the stated and unstated goals of the customers. Once those needs are identified, the second key requirement is to understand how much value customers would associate with meeting those needs. The third key requirement is to determine how customer needs can be met at a cost below the price they are willing to pay.

Hence, the activities of the firm shift from the sequence of engineering an offer, costing the offer, marking up the price of the offer, and then pitching the offer to gain customers, to detecting the needs of customers, understanding the value of meeting those customer needs, defining the target price according to the value customers place on the offer, then defining a target cost below that target price to ensure profitability, and finally engineering that offer to meet those needs profitably.

This is the exact opposite of “if we build it, they will come.” It is “what will make them come is what we will build.”

The world’s most successful firms are detecting customer needs and converting their understanding of those needs into products and services that deliver outcomes in line with customer goals. And, to discriminate between profitable customers and leeches (those that take the firm’s output but fail to pay enough to keep the firm moving forward), they are choosing to deliver only those products and services whose pricing is aligned with their customers’ willingness to pay and whose costs are profitably below that willingness to pay. In doing so, these successful firms are delivering solutions for a chosen set of customer needs—and doing so profitably.

This clarity in the purpose of the firm has driven a change in the culture of pricing, one that is radically different from the pricing practices of the past. This culture is known as value engineering and it results in value-based pricing.

Value Engineering

Value engineering frames strategic offering decisions such as “how can we deliver products and services that customers care about and are willing to pay for at a price higher than we expend in costs?”

Value-engineered firms focus every aspect of their deliverables to customers on what adds value in excess of the costs to produce and then execute against that mandate.

That is, in value engineering, the firm works backward from the customer’s needs and value to define the firm’s actions. Value- engineered firms strive to understand their customers’ willingness to pay for different benefits in defining the target price of the offering. From this target price, a target cost is identified that ensures profitable customer interactions. Using the target cost and the target need to be addressed, all attributes of the offering are redefined to ensure market goals are met.

In drilling down on the issue of value engineering, we confront a simple fact of competitive free markets: customers have alternative choices. Customers can buy from the firm, its competitors, or do nothing at all. Hence, it isn’t enough to deliver value to customers; value-engineered firms focus on delivering value in excess of their competitors for their select customer segment.

That implies value engineering requires redefining the offering to deliver to the firm’s chosen set of customer goals profitably and removing attributes and features that, though they may be common, are not necessary for meeting the selected customers’ goals. Parts of the standard offering may be removed because they don’t deliver value in excess of their cost. Other parts may be added or enhanced, even though they don’t normally appear in that product or service category if they add value for a particular customer segment in excess of their costs to deliver.

In setting prices, rather than focusing on costs and markups, value-engineered firms work from an understanding of their customers’ willingness to pay. This is called value-based pricing. In value-based pricing, a firm identifies those prices that most closely match customers’ willingness to pay without leaving money on the table nor entering into unprofitable or unhealthy transactions.

Value-based pricing is not cost-plus pricing. It does not always start from the costs to produce and add a markup. This is a good thing. Too often, cost-plus pricing either (1) sets prices far below a customer’s willingness to pay and therefore leaves money on the table or (2) sets prices so high that few, if any, customers will purchase at that price.

Starting with an understanding of what customers value—from their perspective, not the firm’s—results in a culture of value-based pricing.

As for competitors and competitive pricing, value engineering positions competitive offerings as an alternative choice for the target customer. It doesn’t ignore competitive prices. Instead, it accounts for their role in engineering the value proposition itself. It suggests that if firms want to outdo their competitors, they have to out-serve their customers—profitably.

Value-Based Pricing

Value-based pricing results from value engineering. As a construct, it works from the premise that in order for the firm to serve customer needs profitably, it needs to understand what those customers need and what they will pay to have their needs met. That is, value-based pricing seeks to identify the value an offering delivers from the customer’s perspective and then charge accordingly.

Value-based pricing requires approaching pricing challenges through the lens of detecting and understanding value from the customer’s perspective. It requires gathering facts that can be constructed into meaningful information about what needs customers have, how an offer will impact those needs, and how valuable that impact is, all from the customer’s perspective.

Value-based pricing isn’t a specific technique or process, but rather a paradigm for managing exchanges between the firm and its customers. As a paradigm, it flows across the firm’s decision-making process. It defines the context through which all pricing and strategic competitive positioning decisions are made.

If value-based pricing relies on understanding value from the customer’s perspective, then what is that value? That is, what value is relevant for pricing decisions?

The total value a customer receives from a product is the difference between the total benefits the product or service delivers and the total price the customer must pay to receive that bundle of benefits. We can write this as:

Value is the benefits a customer receives, less the price the firm extracts.

where V denotes value, B denotes benefits, and P denotes price.

This definition of value is also the economist’s definition of consumer surplus.

It has long been known, however, that the total value delivered to customers is not relevant for pricing. To demonstrate, conduct a simple and common thought experiment comparing water to diamonds. Both deliver value to customers, and it is obviously true that potable water is far more valuable to human life than diamonds, but customers routinely pay far more for a single diamond than they do for a bucket of water.

Hence, the relevant value for pricing decisions is not the total value delivered. The total value delivered is too broad of a metric for pricing decisions. Something more specific is needed.

Recall earlier we stated that customers make choices among alternative offers. These alternative offers reframe the perception of value for customers from “What’s the total value delivered by the offer?” to “How much better off am I by choosing one firm’s offer over all the alternatives?” That is, the relevant meaning of value for customers is not an absolute, total value construct but a relative, differential value construct.

Differential value is the difference in value delivered to customers by choosing one firm’s offer compared to that delivered by choosing an alternative offer. Using the above definition of value, we can write this as:

Differential value is the differential benefits less price differential.

where Δ (the Greek letter Delta) denotes change, or difference, in value, benefits, and price between offers.

The concept of differential value, ΔV, covers both hard, calculable issues and softer, perceptual issues. It includes both the differential benefits and the differential price.

Differential benefits, ΔB, highlights the importance of points of differentiation and places the points of parity as necessary elements to keep the differential value positive. From the customer’s perspective, benefits include both the tangible and intangible benefits delivered. This implies collectively that the impact of financial, accounting, or economically identifiable differences and the impact of psychological, behavioral, or perceptual differences in benefits between offers will all define the relevant differential benefits in customer decision-making.

Similarly, the differential price, ΔP from the customer’s perspective, includes both the actual and the perceived difference in price extracted from a customer. That is, the relevant differential price is not simply the numeric price difference between offers, but also the method by which those prices are achieved, how that price is presented and communicated, and where that price lies with respect to the expected price for the offer.

By including all rational, behavioral, and psychological aspects of customer decision-making, we have a definition of differential value that can be used for anticipating customer choices and, therefore, guiding pricing decisions.

Customers will choose the offer that they perceive, at the moment of purchase, has a positive differential value in comparison to all alternatives in their consideration set. That is, they seek a positive ΔV.

Customers will purchase if the differential value is positive.

The concept of differential value is useful because it provides the construct for making pricing decisions. It drives executives beyond simply asking, “What price should we put on this offer?” toward the better question of “How much more value will customers get from choosing an offer from our firm than from all of their alternatives—even ones most would not consider to be a direct competitor?” and, “How much of that value should we share with our customers?”

Differential Benefits

As mentioned, differential benefits covers all differences in benefits that customers perceive between offers. This includes any form of benefits that a customer can derive from the offer: tangible and intangible, current and future, real and perceived.

One way to think about benefits is that they are outcomes that are enabled by the product or service’s features. Those features may be technical in nature, such as the operating system within an iPad or the blade engineering within a turbine. They may be design oriented such as the Nike swoosh or Emerson shield. They can include distributional issues such as shelf placement for Tide or outlet selection for McDonald’s and Caterpillar. They may be timing features such as FASTPASS tickets at Disneyland or similar accelerated services from Vulcan Materials Company.

Southwest Airlines offered a unique set of features at launch. Some features were not commonly offered by competing airlines. Some features that competing airlines offered were missing. In each of these feature areas, Southwest Airlines made trade-offs to value engineer its offer for its target customer. A short list of the unique feature set the airline offered or declined to offer included:

• Frequent takeoffs/landings between Dallas, Houston, and San Antonio
• Courteous and fun flight attendants
• Less congested, and perhaps more remote, airports
• No reservation system
• Pricing simplicity—no complex pricing
• Peanuts and Dr. Pepper but no meals
• No assigned seats
• No connecting flights
• No first-class service
• No travel agents—all reservations made directly with Southwest

This list of Southwest Airlines’ features and benefits highlights the importance of considering what features to include in an offer. Features design should be guided by benefit design. That is, in selecting which features to use, executives should ask what benefits they seek to deliver.

On their own, features are basically commodities. They don’t add real value until they deliver benefits a customer cares about.

Benefits are designed to enable a customer to accomplish a goal—to do something. As such, firms should consider what goals customers seek to accomplish and how specific benefits contribute to customer goals. In making the full connection executives may ask: What can those features enable customers to do? Why are those features necessary for the goals the customer would “hire” the product to achieve?

To make it concrete, let us first consider benefits that are economic in nature.

Offers may have direct economic impact such as the cost savings delivered through a labor-saving machine or an energy conservation program. They may have indirect economic impact such as enabling a customer to reach a goal faster (college education and career objectives) or enabling a customer to manage risk better (health insurance and accidents).

Opportunity cost reduction can also deliver observable economic benefits. For instance, consider the time-savings associated with convenience stores over discount retailers and the ability to price relatively similar products at the two different outlets at very different price points. This price differential is derived directly from the benefit differential, a benefit differential embedded within the concept of opportunity costs.

In business markets, economic benefits are often a primary driver to purchase decisions. They drive the choice to participate in the market, impact the evaluation and selection of offers within the category, and frame the experience of a product or service long after it has been consumed. This fact has long given rise to sales process steps that include the calculation of total cost of ownership in guiding executive customers to select an offer that may have a higher up-front cost but results in a lower lifetime cost.

In identifying economic benefits, executives need to ask: How does the offer impact the economic well-being of the customer?

Beyond economic benefits, there are behavioral, emotional, hedonistic, and psychological benefits as well. Though calculating the impact of these benefits may be difficult, their impact on customer choices often outweighs purely economic arguments alone.

Behavioral benefits, such as anchoring, strongly impact customer perceptions of value. Customers gain information sequentially. Generally, once information is learned, it is difficult to unlearn or adjust to new information. This can make customers overvalue a set of benefits identified early in their selection process, which may actually be immaterial to the offer being made, or undervalue new benefits, which are highly material to the offer. When that occurs in a purchasing engagement, the technical description would be that the customer has “anchored” a set of beliefs and exhibits “under adjustment” to the new information.

Anchoring is just one of many behavioral impacts on the perception of benefits. Others include risk aversion, risk seeking, endowment effects, framing effects, and many dozens more.

Emotional and psychological effects impact the perception of benefits as well. In consumer markets, customers are often influenced by their beliefs regarding peer-cohort perceptions and the desire to appear in vogue. In this case, branding is a feature that delivers a type of social benefit that connects customers to others. Even in business markets, customer decision makers will often consider how their purchase decisions will impact the perceptions of their peers, especially if things go wrong. And in all markets, customers will seek self-constructive benefits, that is, benefits that enable them to express themselves and achieve their self-actualization goals.

Returning to the story of Southwest Airlines, we see a number of benefits that cross many forms. There was the convenience and simplicity of Southwest’s no-hassle approach to selecting, purchasing, boarding, and arriving. There was the fun and frivolity demonstrated by its flight attendants. And for a Texan, a Dr. Pepper and peanuts hit home like barbecue brisket at a summer picnic. The lack of an assigned seat or first-class seating had little to no impact considering that the flight might only last a few minutes. Rather, the ability to get to work efficiently, hold the face-to-face meeting, and return home to be with the family far outweighed any interest in many of the features that competitors could tout as benefits at the time.

A useful way to think about benefits is the customer benefit hierarchy pyramid (see Figure 2.1). At the base of the pyramid, the offering is designed with many features. Each feature should be chosen according to its ability to deliver a benefit, one that a customer in the target market would care about. Not every possible benefit needs to be delivered, just those benefits that the target market would care about.

Moving up the benefit hierarchy, benefits can be aggregated into economic benefits or behavioral, emotional, and psychological benefits. We place the latter category above the economic benefits precisely because, as numerous researchers have shown, these behavioral, emotional, and psychological benefits outweigh rational economic arguments in most human beings.

This hierarchy works in business markets just as well as it works in consumer markets. The economic argument may be required to drive the business relationship, but it will often be insufficient to drive the purchase decision alone. Even in business markets, purchase decisions are made by human beings not businesses. To drive customers to purchase, the psychological aspects need to be aligned as well. In fact, when they are not aligned, customers will often feel some level of cognitive dissonance. If that cognitive dissonance cannot be resolved, it is highly likely that the customer will delay the purchase decision, or worse, make no purchase decision at all.

As an offer moves up the benefit hierarchy it gains value, perhaps even inimitable value. It is more difficult to copy a firm’s brand position than it is to copy its economic value offering. It is also more meaningful to simultaneously satisfy both the customer’s psychological and budgetary needs.

Combined, this leads to pricing power reflected in the ability to absorb small fluctuations in competitors’ prices because customers will not perceive those differences as substantial enough to encourage a brand betrayal. It may also lead to a tighter definition of the target market. Not everyone will perceive the chosen group of benefits to be better than the alternative, but the target market must.

At times, firms will determine that they are offering benefits that customers fail to acknowledge. These can be identified as points of contention (Anderson, Kumar, and Narus 2007). Points of contention include underappreciated benefits: benefits that the firm is delivering in excess of its competitors that the customer fails to fully appreciate. Points of contention also include unacknowledged benefits: benefits that the customer perceives the competitors offer but do not perceive the firm as offering.

To address these points of contention, firms must present evidence to customers that will correct their misperceptions. That evidence may come in the form of financial calculations, but more often through case studies or offer clarification and repositioning. The point of addressing these points of contention is to help customers understand the benefits the firm is delivering, thus enabling them to make a positive purchase decision.

In the case of Southwest Airlines, not everyone was enamored with the airline’s offering. Some customers did, and still do, hate the fact that Southwest Airlines does not have assigned seating. Others have been turned off by the absence of meal service and first-class seating. And for those seeking to make connecting flights with a different airline, Southwest Airlines makes no accommodations. The offering from Southwest Airlines was clearly not for every business traveler. But for those who don’t mind flying a “bus on wings,” these missing benefits were outweighed by the efficiency, flexibility, reliability, and downright fun time with the flight attendants’ banter.

This type of thinking, the value engineering and selective inclusion and exclusion of benefits, has made Southwest Airlines one of the most loved and profitable airlines in commercial aviation history. Cheap imitators like Ryanair or EasyJet have risen, but few of their customers would describe them with love. Southwest customers do.

And we see value engineering in the words of Herb Kelleher in shunning the goal of trying to be all things to all customers and pursuing the goal of deeply satisfying Southwest Airlines’ target customer:

Market share has nothing to do with profitability. Market share says we just want to be big: we don’t care if we make money doing it. That’s what misled much of the airline industry for fifteen years after deregulation. In order to get an additional 5% of the market, some companies increased their cost 25%. That’s really incongruous if profitability is your purpose.

(Freiberg and Jackie 1996)

Differential Price

The other half of differential value deals with price differential. While in some cases the offering’s price alone will remove it from the selection criteria, in the relevant cases for pricing decisions, it is the offering price relative to its competitors that matters.

Price credibility floors and price caps define the cases when the price alone removes the offering from the selection. Price credibility floors arise when customers do not perceive that an offer so inexpensive can possibly deliver the benefits they desire. Price caps arise when budget constraints limit the ability of a customer to participate in the market. Between these two extremes lie transactable prices.

Within the zone of credible prices, customers will consider price differentials, and these are the relevant price points for value-based pricing.

Firms can adjust their prices to deliver a positive differential value and ensure they win the customer, but that isn’t the only way to win customers. Firms can also adjust their benefit differentials, and sometimes they only need to adjust the perception of their differential benefits in order to win that customer. At other times they can adjust the perception of that price without actually changing the price. And, as we will explore in a later chapter, lowering the price to win one customer at one point in time may have other, more detrimental effects on transactions with other customers and perhaps even with that same customer.

Moreover, it isn’t just the perception of the price associated with the offer, but also the way that price is derived. For instance, a $400 item marked down by 5 percent is perceived differently than a $400 item with a $20-off coupon even though the price is the same. This is but one example that demonstrates that the way in which the offer is presented affects the perception of the price associated with the offer.

Exchange Value to Customer

Putting the concepts of value, differential benefits, and differential price together, we construct a useful theorem of value-based pricing: The maximum price achievable to attract a customer is the exchange value to customers (EVC) of that offer.

The logic is rather straightforward. We can state it in words or in equations:

1. Value, from the customer’s perspective, is the difference between the perceived benefits delivered and the perceived price extracted.

   

2. Customers will purchase if the differential value, that is, the value of the firm’s offer compared to the value of the competing offer, is positive.

   

   If we denote the firm’s offer with the subscript F and the nearest competing alternative within the customer’s mind with the subscript A, and require positive differential value:

   

3. We then conclude that for a customer to purchase, the maximum price the firm can extract is the price of the nearest competing alternative adjusted for the points of differentiation.

   

   Notice what just happened.

Building from the definition of value as the difference between what is received and what is extracted, and the position that customers choose offers that deliver them the greatest perceived value relative to their alternatives, we derive the conclusion that the maximum price the firm can achieve with an offer is that of its nearest competitive alternative adjusted for the difference in benefits.

Therefore, if the firm’s offer has more benefits that the customer cares about than its competitors, then the firm can charge a higher price. If you’re better, you can charge more.

Alternatively, if the firm’s offer has fewer benefits that the customer cares about than its competitors, that firm must charge a lower price if it is to attract that customer. If you’re worse, you must charge less or exit.

Value-based pricing doesn’t ignore a competitor’s price, it simply states that the competitor’s price is not sufficient for determining the price a firm can extract. Competitive pricing, where a firm simply seeks to match a competitor’s price, doesn’t go far enough. It isn’t precise enough for making good pricing decisions. Competitive pricing is an input into value-based pricing but not the result. Rather, value-based pricing requires executives to identify the competitor’s price and adjust that price to account for points of differentiation.

What is commonly called the exchange value to customers is that which has been identified in the theorem discussed previously defining the maximum achievable price. That is, the exchange value to customers is the price of the nearest alternative plus the sum of the additional benefits an offer provides less its missing benefits, which are found in the alternative solution, all taken from the customer’s perception of reality.

The exchange value to customers is often visualized as shown in Figure 2.2. It starts by identifying the price of the nearest comparable alternative. Then, one adds up all the positive points of differentiation (Benefits B₁ through B₃ in the diagram) and subtracts the negative points of differentiation (Benefit B₄ in the diagram). The result is the exchange value to customers.

Because the exchange value to customer relies on the perceptions of customers, we can make some useful lemmas regarding the willingness to pay of customers:

Any price above the exchange value to customers would leave customers better off buying the nearest comparable alternative, thus customers would not be willing to pay that price.

Any price below the exchange value to customers would leave customers better off buying the firm’s offer, thus customers should be willing to pay that price.

Thus, the exchange value to customers identifies the maximum willingness to pay of customers.

Embedded in the exchange value to customers is the fact that customers have choices. Customers don’t have to purchase the firm’s offer. The firm usually faces competition and always faces the option of the customer doing nothing. But since customers make trade-offs between competing products and services, and seek to maximize the value they receive, or at least their perception of value, the ability of the firm to attract customers is something the firm can manage.

Furthermore, the exchange value to customers is dependent on the context of the offer. If the alternatives are changed, then the value of the offer changes. This fact reinforces the usefulness of dynamic pricing in many industries where competitor prices and the availability of competitive offers change frequently, and it also supports the importance of managing prices over the course of a business cycle as competitors change prices or enter and exit the industry.

The inclusion of perceptions and context within the exchange value to customers explains why two very different offers can profitably coexist in the same market. For instance, consider offers with a low up-front price but a short lifetime or high cost to maintain, such as IKEA furniture or Doosan earth moving machinery, competing against offers with a higher up-front price but a lower overall total cost of ownership, such as Ethan Allen furniture or Caterpillar earth moving machines, respectively. Budget-constrained buyers may perceive the high up-front price offer to be ill-fitting with their overall needs. Meanwhile, strategic buyers facing fewer budget constraints may perceive the offer with the lower overall total cost of ownership as a bargain even though the up-front price is high.

The exchange value to customers demands that executives determine if the benefits they offer, as perceived by customers, are better, worse, or the same. Successful firms have made offers in all three positions: better, worse, or the same. For pricing, the firm must know which position its offer assumes. Firms don’t always have to deliver more benefits; many firms have competed quite successfully with benefit-deprived offers. And firms don’t always have to offer the cheapest item with the fewest benefits; many firms compete very profitably with high-benefit offers. But firms do have to know what they are worth to customers.

Design Costs against Price to Profit

The description of value-based pricing virtually ignored the cost to produce. Given the long history and common experience most managers have had with cost plus pricing, it is only right and proper to discuss the role of costs in pricing. But where do costs appear in pricing decisions?

We identified the purpose of the firm as being to serve customers profitably. In value-based pricing, we identified the maximum price the firm can extract from customers as the price of the nearest comparable alternative adjusted for the points of differentiation. For the firm to profit, that price must cover the cost to produce.

Thus, a direct answer to the relation between costs and price is as follows: If customers are willing to pay more than the cost to produce, then the firm should produce. If customers are not willing to pay more than the cost to produce, then the firm should not produce.

Notice that this direct answer doesn’t imply that costs should determine price. Rather, it simply states that costs are a lower limit on prices. That is, costs act as a hard price floor for profitable pricing.

Importantly, value-based pricing doesn’t state that prices should be raised to cover costs. Rather, it states that if you can’t cover costs in the long run at the price customers are willing to pay, you shouldn’t produce.

To use the colloquialism: “You can’t cover a strategic mistake by making another strategic error.” For pricing, this implies that just because a firm is a high-cost producer, it doesn’t follow that it must also be a high-priced supplier. Prices are determined by the customer’s viewpoint of value, not the firm’s viewpoint of costs.

Now that is rather harsh advice for many. Though it does address many of the misguided recommendations issued on pricing and production, a more nuanced prescription is leveraged by the leading firms—one that returns to the issue of value engineering.

In value engineering the offering, firms will add specific features according to the customers’ willingness to pay for the benefits of those features as long as the price they are willing to pay is above the cost to add those features. Value-engineered offers will also subtract other specific features if the price their target customer’s willingness to pay for the benefits of those features is below the cost to include those features.

That is, in value engineering the offer, target customers and their needed target benefits define target prices, which, in turn define target features and costs. Notice the sequence: Customers and their needs are first and they define the price potential. Price is second and it defines the cost ceiling. Costs and operations are third and are designed to hit the price and value goals. This is the opposite of letting costs define price. It is letting price define costs.

Our research has found that leading firms price according to the customer’s willingness to pay, not the firm’s costs to produce. They treat costs as a constraint with regards to pricing and a lower boundary on prices that the firm will accept. When it comes to pricing, they treat value as the goal. That is, they seek to deliver value to customers—profitably.

Serving customer needs profitably is in keeping with the value-based philosophy of profitable pricing. It puts the customer as the key stakeholder in the firm. As for shareholder returns, employment security, or social responsibility, they are the result of a good strategy but not the strategy in and of itself.

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