Price Boundaries
Balancing Profits and Customer Acquisition

by Tim Smith, PhD, 4 February 2004

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At what price should your product or service be sold? When releasing new products or services or reviewing existing practices, executives address pricing with many uncertainties. Nailing the perfect price schedule is the golden mirage which we chase. Reaching a strong price schedule will require multiple steps. The first should be an examination of the price boundaries defined by the upper and lower limits.

There are two hard and two soft boundaries for pricing. The hard boundaries are defined by the Total Customer Value to Consumption for your offering at the upper limit and the True Marginal Cost to produce at the lower limit. The two soft boundaries lie within the hard boundaries. For the upper soft limit, the Total Customer Value to Consumption is reduced by costs borne by the customer in making a choice to change their consumption patterns to include your product or service. This soft upper boundary is referred to as the Customer Value Less Purchasing Barriers. For the lower soft limit, the True Marginal Cost is increased to include other factors required in running a business and is referred to as Marginal Cost Plus Overhead.

Conceptually, these price boundaries provide a means to quantify your value proposition and determine the potential of your business.

Customer Value Determines Upper Limits on Prices

Upper limits for pricing are determined by understanding the value proposition from the customer’s perspective.

The Total Customer Value to Consumption determines the hard upper limit on the price that you can charge for your product or service. This boundary can be quantified by answering the follow question: What is the full quantifiable value that a business customer receives in purchasing your offering? In asking this question, executives serving business markets are framing the value proposition from the customer’s perspective. They are challenging themselves to quantify the financial impact of their product or service.

There are many sources of value that can be quantified. In business markets, these sources of value are usually framed with respect to four issues. Below are listed the four key issues and some supporting questions that can be asked in determining your value:

• How does our value offering improve productivity?
  • Can the business customer achieve the same results with fewer resources thereby driving cost reductions?
  • Can the business customer achieve greater results with the same resources thereby opening up new opportunities?
  • Can the business customer achieve the same results with the same resources and free-up time of the resources to be productive elsewhere?
• How does our value offering improve revenue?
  • Will our value offering enable customers to enter new markets or take a larger share of the existing market?
  • Will our value offering enable customers to penetrate their client base with more products and services?
• How does our value offering affect cycle times?
  • Can the value offering speed up time-to-market therefore enabling business flexibility?
  • Can the value offering affect management reaction times therefore preventing business errors or enabling new opportunity detection?
  • Can the value offering affect inventory levels or manufacturing process changes to lower costs and improve flexibility?
• How does our value offering affect quality?
  • Does it decrease error rates therefore increase customer satisfaction and provide for cost structure decreases?
  • Does it improve the customer’s product quality enabling them to move up their value chain?

Framing your offering with Total Customer Value to Consumption enables two key business activities. One, it defines the hard upper limit on the potential price that you can charge for your value offering. Two, it quantifies the value of your offering for the customer, forming the groundwork for the development of a sales message based upon the strategic value of acquiring the asset and the hard financial return on investment (ROI) that your offering will deliver.

The Total Customer Value to Consumption forms the hard upper boundary because no intelligent customer will pay more for an item than that which it provides in value. Yet this boundary also shouldn’t be made equivalent to the price of a product or service. There are many factors that will lower the price that customers will be willing to pay for an item. Including these factors into a pricing framework creates the soft upper limit on prices of Customer Value Less Purchasing Barriers.

Customers must receive value in excess of the price that they pay for the item. This price to value difference can be significant in and of itself. The size of the price to value difference is largely dependent upon bargaining power between your company and your customers, but providing customers with a cushion of value isn’t the only determinant for quantifying the Customer Value Less Purchasing Barriers.

Other business related factors will drive a wedge between the Total Customer Value price limit and the Customer Value Less Purchasing Barriers price limit. Internal to the customer, some of the factors would include the costs of business process reengineering, worker retraining, and systems integration. At the interfaces of the business customer, purchasing from a new vendor will create costs from switching away from the current solution set and creating new vendor relationships.

Combined, the Total Customer Value to Consumption and the Customer Value Less Purchasing Barriers form the hard and soft upper limits to pricing respectively. To enable transactions, the price that should be set will be at or below the soft lower limit.

Costs Define Lower Limits on Price

Lower limits on pricing are determined by your costs to doing and developing business. The True Marginal Cost to produce determines the hard lower limit to pricing. The term “True Marginal Cost” is used rather than “Unit Costs” because unit costs often include the costs of overhead. Overhead costs are real business costs, but they do not reflect the true marginal cost to produce. The True Marginal Cost is the real business cost to produce one more unit of the service or product.

To account for other business costs in framing prices, the Marginal Cost Plus Overhead is calculated and becomes the soft lower limit. This price boundary includes all direct and indirect costs. Research and development costs, sales and marketing costs, executive overhead costs, and asset utilization costs are all included in the Marginal Cost Plus Overhead price boundary.

The True Marginal cost is the hard lower-limit to pricing because any price below this limit implies that, on the margin, the business is loosing money by supplying their value offering at any price below this limit. The Marginal Cost Plus Overhead is only a soft lower limit to pricing. Overhead allocations can usually be reduced as unit volumes increase, thus the Marginal Cost Plus Overhead can decrease with increasing volumes. It is also a “soft” lower limit because, on the margin, the company is making more money than it would otherwise as long as it is selling products above the True Marginal Cost, which is below the Marginal Cost Plus Overhead.

While strategically, the business should never price below the soft lower limit of Marginal Cost Plus Overhead, tactically, a business may drop this requirement to close a tactical sale and marginally increase revenues. As long as the price is above the True Marginal Cost, the business is marginally better off closing the sale even though pricing below the Marginal Cost Plus Overhead is unsustainable.

Using the Boundaries

Putting it all together, optimal prices are set above the soft lower limit of Marginal Cost Plus Overhead and below the soft upper limit of Customer Value Less Purchasing Barriers. Tactically, prices may vary within the wider band determined by the hard limits of True Marginal Cost and Total Customer Value to Consumption.

In creating an understanding of the price boundaries, executives are also creating an understanding of the range of profit margins and the potential customer acquisitions. Within these price boundaries, any price points will enable customer transactions and profit.

The largest challenges executives face in quantifying price boundaries are usually associated with understanding the value of the offering to the customer’s business. Data required to create the lower price limits is typically available from internal accounting audits, but data required in defining the upper price limits will require strong customer perspective understanding. Perhaps it is because customer understandings are difficult to create that a large number of firms unfortunately adapt cost plus pricing mechanism. These pricing mechanisms may “ensure” profits, but they also leave money on the table when acquiring customers. Optimal pricing requires customer understanding.

Further Efforts to Improve the Price

Developing an understanding of price boundaries is only one step in the process towards best practice pricing. Potential further steps will include an evaluation of substitute and competitive solutions and calculating your value differential relative to these solutions. Narrowing the price band through customer research and advanced market research approaches may also deliver better results on the margin. Moreover, the above steps may define the correct price for a given set of customers, but broadening the price to become appropriate for a wider set of potential customers will require the development of a pricing mechanism that is dependent upon usage patterns or customer specific factors.

The use of price boundaries may not nail the perfect price for your value offering, but it can take executives a far distance towards understanding where that good price may lie.

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Author
Tim Smith, PhD is Editor of the Wiglaf Journal, Principal of Wiglaf LLC, and Adjunct Professor at DePaul's Kellstadt Graduate School of Business.

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