Over the course of the past couple of months I spent a lot of time thinking and talking about the dynamic between value and price. With expert input from Frank Gong, you can read some thoughts in this post.
The premise of the discussion flows from the definition of a business strategy. In the post titled What Is (Good) Business (Strategy) we proposed that any good business strategy involves focusing on those attributes for which the customer is willing to pay some money. In other words, the value created by the business should convince the customer to purchase the good or service for the listed price.
We will discuss the concepts and consequences using the image below.
We can define value as the resulting sum of the benefits of ownership and the costs of ownership.
Benefits and costs of ownership
Benefits of ownership include all tangible and intangible elements or attributes the good or service offered allows the customer to achieve when it operates over the lifetime of the offer.
- Tangible: increased productivity, better production quality
- Intangible: status, security
Costs of ownership includes all tangible and intangible elements or attributes, excluding the price, the customer needs to spend to enable the offer to operate over the lifetime of the offer.
- Acquisition costs: delivery, installation, procurement, …
- Ownership costs: licensing, servicing, training, insurance, …
- Operation costs: energy, labor, testing, ordering, …
- Disposal costs: decommissioning, migration, …
The value of an offer increases if there are more benefits, and the value of an offer decreases if there are more costs.
The value gap defines the difference between the value offered by the firm and the perceived value by the customer. In an ideal world the value gap is zero but in the real world the value gap will always exist.
There are a couple of reasons for the value gap to exist.
Firstly, a firm typically creates an offer that covers several use case scenarios and segments of the market. On the contrary, a customer’s use-case is usually very well defined. The value gap captures the difference between the customer need and the firm’s offer.
For example, a mobile carrier may offer a range of plans that includes data, voice and text. The value offered is the total of all minutes, gigabytes and message included in the plan. If I’m a customer who is only interested in a plan with data, the value perceived is determined by the number of gigabytes included in the plan. The value gap consists of the minutes and messages included in the plan but of no interest to me.
Secondly, firms may not understand the customer’s needs very well. In that case it may focus on attributes that the customer simply does not care about.
For example, smartphone makers emphasize and charge a premium for marginally thinner devices. Many customers are not willing to pay much extra for a mm less thickness. In this case the firm believes it has created a lot of value for the customer, but the customer does not perceive it as value. That difference is capture in the value gap
Customer Incentive to Purchase
Central in the dynamic between value and price is a customer’s incentive to purchase (CIP). Sometimes we refer to the CIP as a customer’s willingness to pay (WTP) for a good or service.
A customer’s incentive to purchase is the difference between the value perceived by the customer and the purchase price.
Note that the customer incentive to purchase is function of the customer only! Neither the value offered by the firm nor the firm’s cost of offer have an impact on the incentive. CIP represents the reason why the customer believes the offer is worth it.
Therefore, no offer is too expensive by itself. It may be expensive given a certain set of attributes or a given situation.
Example: consider you are by yourself on a deserted island. You have a lot of scrap wood but nothing to set it on fire to create a source of heat. A single match is worth a lot of money and you will be very willing to pay a lot of money for the match. However, when returning to your daily life in an apartment with central heating that same match will be worth almost nothing.
In the real world you can expect that a customer will seek to maximize the CIP by comparing the value and price of similar offers.
Surplus Created by Firm
Surplus is the difference between the perceived value and the cost of the offer. It is the sum of the CIP and the margin of the offer.
A key challenge for the firm is to decide how to allocate the surplus created. Increasing the margin will increase the profit for the firm but reduce the customer incentive to purchase, and vice versa. As obligated to its shareholders, the firm should aim to maximize the margin.
Therefore, there is a continuous dynamic between a customer’s aim to maximize CIP and a firm’s aim to maximize margin.
The firm has additional challenge from competitors in the market whose products may offer a better CIP or have better margin. Generally, the firm should aim to offer a larger CIP than the one of the competitor’s best
The dynamic of value and price is function of the customer’s perception and their ability to capture as much value for as little price as possible. A firm should focus on reducing the value gap, increasing customer incentive to purchase, and increasing the surplus created.
In next posts will talk about how to overcome challenges related to the customer incentive to purchase and value gap.