Friday, October 13, 2017

Value based pricing framework

Price is one of the most important components in a 4P analysis and in general, it has a big influence on customer and company behavior. Price contains an information about the market and it is a guide for people and organizations to make important decisions about their future movement and strategy. But the question is how prices are set, who is the one to decide the price of a certain good? To answer this question we need to go back in a time.
The price can be defined as a mean or a term of a contract between the buyer and seller. In the past, there was just a barter exchange that is to say people were changing some good with another. But it became harder and harder to implement, because when the network is increasing and needs differ it is hard to make a transaction on this framework. For example, person A has an apple and needs spade which is owned by the person B. But the B does not want an apple but wants C’s leather. Now imagine the huge network in the same logic which can exist in the world of divers goods and needs. This was the base of creation of a money, which becomes a measure for a product value. So, the other good description of a price is a quantity of money which customer wants, has the willingness to pay.
After the industrial revolution, products started to be more standardized. There was an exciting need, demand in the market and there was no diversification of products as now. Till 1940th there was a widespread opinion that the only reason of every company to exist is to maximize its shareholder's wealth. So, that time there was no market or customer orientation as they were weaker than now. The pricing had a cost base framework. Companies were producing a product, calculating costs in terms of materials, salaries, transportation and so on, then putting a margin on that cost setting a price in a best possible manner to increase shareholders wealth.
Companies were not driven from the market they had a sought that they can promote what they produce and it was possible because of low competition in any market.

But then after companies started to think also about other stakeholders, mainly because they became stronger and also culture started to change. Nowadays all successful companies are market driven, they are customer oriented even Bezos the founder of Amazon told that he is not interested in competitors behavior but mostly he is concentrated on customer’s needs. These changes made companies have a different attitude to prices than the cost-based method is. The new method is called value-based pricing. And the framework is the vice versa of a cost method.  How it works?
Companies search some needs in a market, they find a price which customers are willing to pay to satisfy that need than designing a good. After they set a cost below the price and try to reach that goal.
The other question is what is a value and how it is connected with the willingness to pay?
The value of a good for a customer is a combination of costs and benefits that the product provides, actually the difference between the benefits and costs. The major cost is a price and that is why it should be less than the benefits of a good. The formula is used to describe this above-mentioned statement:

V = B-P

However, there can be a fair question: The benefit from a water is much higher than the benefit from a gold why the price of gold is higher. To answer this question we need to bring another concept, which is called differential value. That is an additional value that product or a company provides after its competitors. There are a lot of water supply compared with gold and suppliers do not offer much differential attributes to each other that is why water has lower price.  The formula for differential value is:

       V=      B-     P

Where is a differential part of any abovementioned factors.
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