Chapter 4. Pricing Method
Cost-based: Asset, Market, or Income (DCF/NPV) | Value-Based: WTP | Markup v. Margin | Surveys: Van Westendorp, Gabor-Granger, Conjoint Analysis
Pricing is arbitrary.
The Pricing Uncertainty Principle tells us that. I mean, it’s anyone’s guess what a single person might be WTP, so why try?
But here’s the deal.
Since value equals WTP, then valuation methods ought to tell us something quantifiable about broad-scale WTP.
And understanding the demand of a crowd — how entire markets value your product — is very useful.
The four valuation methods are:
- The Asset Approach, a.k.a Replacement Cost
- The Market Comparison Approach
- The Income Approach, a.k.a. Discounted Cash Flows or Net Present Value
- The Value-Comparison Approach
The first three methods are “cost-based” approaches (the fourth, as you’ll see, deserves special treatment).
4a. Cost-Based Approaches
The Asset/Replacement Cost Approach
This method holds that a thing is worth whatever it costs to replace it.
Makes sense, right?
A historic building, for instance, could be valued based on how much it would cost to rebuild it if it burned down.
Likewise, a company might be valued as the sum of its assets — equipment, real estate, inventory, and IP.
Replacement cost is rational, logical, and works… sometimes.
But then sometimes it doesn’t.
For example, according to John Rowan, if you had to assemble an entire automobile, buying each component one at a time, you’d end up paying as much as ten times more for that vehicle than buying one already assembled off the lot.
Why?
Car manufacturers gain efficiencies or economies of scale by building vehicles in large runs, not one at a time. As a result, it doesn’t make sense for cars to be priced using Replacement Cost.
Also, in the last chapter I discussed the intrinsic nature of value. Human beings can be irrational, especially when it comes to deciding what they value.
One example of this is the endowment effect. People tend to value something they possess more than something they don’t — a way of saying, A bird in the hand is worth two in the bush. (More about pricing psychology in Chapter 7.)
Because something cannot always be valued as the sum of its parts, we need other methods besides Replacement Cost.
Market Comparison Approach
This is the “look around” method.
The price of similar items is a signal for the market’s WTP.
So, how similar do items need to be?
When there isn’t much differentiation, those products are called commodities and the price is similar across the whole category.
In the public markets, the trading prices of commodities like gold or wheat move together. On a given day, the price of gold will be the same in Georgia or Seattle. The Market Approach tells us precisely what gold is worth.
Likewise consumer packaged goods (CPG) often exist in established and competitive markets. There might be some opportunity for differentiation based on quality, features, or brand strength — for example I might pay a little more for premium toothpaste or laundry detergent than the bargain option — but the prices aren’t likely to be wildly different. As a rule, lots of competition puts downward pressure on margins and commoditizes prices.
What about products that are very dissimilar? How does the Market Approach work with something that’s unique like a home, a business, or a software product?
Comparison is such a powerful signal that the Market Approach still works for differentiated products.
A home appraisal, for example, will include a list of comparables. None of the comparable homes is exactly like the appraised home, but each will be similar in size and features — close enough to justify the valuation.
Businesses are often valued using the Market Approach too.
The price to earnings (P/E) ratio for any public company reflects the confidence the market has that the company will earn profits in the future. P/E of 20 means the market values the company at 20 times its last year’s profits.
By averaging P/E ratios across an entire category of companies, we get what’s called an industry-specific average multiple.
How does this work?
Let’s say a medical equipment company generates $20M in annual profits and medical equipment companies have an industry average multiple of about 39 times earnings. That tells us the company in this example would be valued at roughly $780M ($20M x 39) using the Market Approach.
Income Approach/DCF & NPV
Some businesses or investments produce a stream of income.
The Income Approach uses that stream of cash flow and the time/value of money principle to determine value. The idea here is that money in your pocket today is worth more than money in the future — a lot like the “bird in the hand” idiom.
As a result, one hundred dollars today will be worth more than a contract for that C-note next year. This is due to historical factors like inflation and general uncertainty.
To estimate a future cash value, we take today’s value and apply a discount. Using a discount, we could estimate that next year’s $100 is only worth $95 today.
Using a real life scenario, let’s say you own an apartment building and your tenants pay rent. The rent payments every month create a stream of cash flows. Adjusting those future payments to reflect their value today, we apply an ever-increasing discount the further they are in the future.
All future cash flows properly discounted give us a set of discounted cash flows (DCF). Then we can use the formula for calculating net present value (NPV) and voila! we have a value based on the Income Approach.
It’s very interesting that over the past two decades, software companies have largely transitioned from the Market Approach, to the Income Approach by moving away from one-time desktop or on-premise installations to subscription-based SaaS models.
Why would they do this?
Because the Income Approach, while more sophisticated and complex, establishes a basis for a much higher valuation.
4b. Value-Comparison Approach
The Value-Comparison Approach is different from the previous three.
Tomasz Tunguz describes Value-Based as a distinct pricing philosophy from cost-based approaches. And here’s why.
The Asset, Market, and Income Approaches all attempt to objectively identify value, to peg the WTP for the entire market.
The Value-Comparison Approach acknowledges that a product may be worth more to one group of people than another. Rather than seek the global WTP for the entire market or the granular WTP of individuals, the Value-Comparison Approach looks at a middle ground, the WTP for groups or segments of the market.
It relies on data about market segmentation and WTP for each segment. Then prices products accordingly.
Now you know what the four methods are, but how do you decide which is the right one to use? That’s up next.
How to choose the right pricing method
Pricing methods aren’t a choice between equals.
Some methods will be just plain wrong for your business model. So, it’s easy to start by ruling out any methods that don’t fit.
Let’s take them one by one.
Is the Asset/Replacement Approach Right?
Cost-plus pricing is the most common form of the Asset Approach.
Ask yourself if it makes sense to price your product by adding a markup to your cost (essentially its replacement value).
To analyze cost-plus pricing, let’s be clear about the definitions of price and cost:
Cost = wholesale cost
Price = retail price
Price minus cost (P-C) is our gross margin. To calculate margin and markup as a percentage use the following:
Margin (how much profit we make) = P-C/P
Markup (how much we add to our cost) = P-C/C
If your margin is low it may be appropriate to keystone your price based on your cost. If it’s high, however, you may find that cost-plus tends to lead you to undercharge and another method might be better.
Is the Market Approach Right?
The Market Approach is almost always at least an option.
In fact, in competitive markets, this may be your only choice. The comparison to other products may simply be too influential with customers for you to break with trends.
Similarly, if you’re valuing a startup company, it may have no assets or significant cash flows yet. The Market Approachcould be the only one that doesn’t unfairly discount the value of the company.
Is the Income Approach Right?
Many products don’t produce repeat transactions or the stream of cash flows needed for the Income Approach.
In that case, the Income Approach isn’t an option.
As a side note, if you’re a SaaS company, I recommend spending extra time to really understand how the dynamics of this method impact you.
Is the Value-Comparison Approach Right?
The Value-Comparison Approach relies on precise information about your customer’s WTP.
Without that information, this approach is useless to you.
Madhavan Ramunajam, author of Monetizing Innovation, goes so far as to say you should determine the price customers are WTP before even developing the product.
So how do you get WTP data?
There’s always trial and error. You can present a price, then watch how many people buy. T&E is a classic method for discovering the unknown.
But what if we could do it with less… you know, error?
And expense.
If you’ve spent millions in product development and have a lot (including perhaps your job), riding on the success of a new product launch, can you really afford to just price randomly? Could a little research give you the confidence that you’ve nailed your pricing before you launch?
An effective marketing research tool for discovering WTP is to ask your customers via surveys.
Surveys
WTP surveys aren’t a silver bullet.
There are limitations. For example, customers don’t always know their
WTP. If someone asked you to share your precise willingness to pay for something, would you be able to tell them?
I probably wouldn’t. At least not exactly.
Furthermore some survey takers may think (perhaps correctly) that their responses will influence the final price. This might cause them to under report their WTP.
So surveys aren’t perfect. But despite the limitations they’re very useful.
When we got serious about our pricing conversations at GoReact, I read two articles from First Round Review, The Price is Right: Essential Tips for Nailing Your Pricing Strategy, by Patrick Campbell, CEO of ProfitWell (formerly Price Intelligently) and It’s Price Before Product. Period. By Madhavan Ramanujam of Simon-Kutcher.
Here you have two of today’s best pricing experts both recommending something called a Van Westendorp survey.
Van Westendorp
In a Van Westendorp survey, respondents are asked four questions.
- What price is TOO HIGH you would never consider buying?
- What price is GETTING EXPENSIVE, but you would still consider it?
- What price is a GREAT DEAL, you would buy this right away?
- What price is TOO LOW that you would question the quality of what you were getting?
The resulting graph is called the Van Westendorp Price Sensitivity Meter, and typically looks something like the image on the next page.
The intersecting lines create a characteristic diamond shape, which represents the Zone of WTP.
The Van Westendorp in Action
In 2017, GoReact (where I was CMO) was charging $19.95 per user.
That price had held steady for two and a half years — a lifetime in SaaS. During this time the company had seen 700% growth in revenue and a similar increase in customers.
We’d added significant features. We felt these features added real value but had not introduced any change in price.
Which is to say, we didn’t really know how most of our customers valued the product. We had a gut feeling that we should raise our prices based on the lack of friction we saw with new sales, but we didn’t know.
We were basically blind to WTP.
The team agreed that finding the sweet spot for value-based pricing, or the maximizing approach, is what we wanted. We chose to run a Van Westendorp survey with the following learning goals:
- Is WTP greater than our current price? If so, how much greater?
- Is WTP different from one customer persona to another? What is the difference?
- Is there increased WTP attached to new features we intended to release later that year? If so, how much?
We surveyed two cohorts.
Prospects were surveyed about the price of GoReact in general. And we surveyed existing customers, asking them to rank the new features in order of importance. For the most important features, we asked the Van Westendorp questions.
We did our best to account for confirmation bias, potentially leading questions, and outliers.
The results of our survey are plotted on this chart (above).
From this we learned several things: Our hunch that the current price did not reflect maximum WTP was confirmed. None of the respondents indicated the current price was the max they were willing to pay.
We were priced at $19.95, while the average WTP was $27–30.
We learned that there was WTP for the new features we were adding to the product. And you can see from the chart below that WTP data manifested in clear bands.
This gave us valuable insight into the price plateaus evident for our customers, indicating that we should probably evaluate multiple price points to maximize WTP.
Also, WTP varied between customer personas. Some personas were more likely than others to fall into a lower-price WTP band.
A significant number of comments (48%) showed concern over changes to the price. Even some who might be willing to pay more might lose enthusiasm and (we believed) evangelism for the brand. We risked losing some customers if we raised prices.
This was our revenue maximization sweet spot.
But perhaps most importantly, the data showed us the trade-offs. At $29 we might lose up to 30% of our customers BUT would gain 50% in revenue.
Other survey types
Van Westendorp isn’t the only type of pricing survey.
Marketing Psychology pro Nick Kolenda, provides in-depth instructions and sample spreadsheets for three survey methodologies Van Westendorp, Gabor Granger, and Conjoint Analysis in his online pricing course (which I highly recommend).
All three aim to uncover the same thing. What is the WTP?
Gabor-Granger
Gabor-Granger and Conjoint Analysis both require a little more technical execution than Van Westendorp.
Gabor-Granger (named for its two inventors) surveys prospects by showing them a product and a corresponding price and asking if they would purchase.
If the prospect says yes, the question repeats at a higher price. If they say no, it repeats at a lower price. This continues until the prospect is willing to buy at one price, but unwilling to go any higher — and now we have their WTP.
Over multiple responses we can ascertain the likelihood that any group of respondents is WTP. By analyzing the percentage of those who would buy against the profitability of each price point, we can discover the profit-maximizing price.
An advantage over Van Westendorp is that prospects don’t have to come up with the pricing number on their own. They are shown a number and only need to record their yes/no decision about whether they would buy.
The disadvantage is that presenting a number from the outset may bias the response.
Conjoint Analysis
This method is named for the technique used to analyze the data. Similar to Gabor-Granger, survey takers are presented with a product and a price. What’s different is that this approach presents them in pairs.
Two products with different quality or features are presented at different price points. Respondents are then asked which he or she prefers.
After each choice, a new combination is presented. Ultimately those data are analyzed using the Conjoint Analysis technique. This gives us not only data about WTP for a given product, but also how much certain features or quality attributes impact the purchase decision.
An advantage of Conjoint Analysis is that it offers insights into complex purchase decisions and quantifies the trade-offs buyers are making.
Another survey technique, MaxDiff Analysis presents features and asks prospects to rate their most preferred and least preferred options. This doesn’t tie directly to WTP, but does underscore which features are the most relevant in the purchase decision.
Next, we’ll take a look at how various ways of structuring or presenting your prices may impact how much buyers are willing to pay.
Additional Reading:
A wonderful treatment of Value-Comparison pricing is Malcolm Gladwell’s 2004 TED talk Choice and Happiness, which is all about… Spaghetti Sauce.
How To Price Your Product: A Guide To The Van Westendorp Pricing Model — by Rebecca Sadwick Shaddix in Forbes
25 Companies Show You Their Best SaaS Pricing Models, by P. S. Kullar
Mastering SaaS Pricing: How to price your product from the seed stage through IPO, by Kyle Poyar of OpenView Partners
