Extending the Power of the Price Waterfall to Customer Value

Price waterfalls, by definition, deal with price.  While price and value should be intimately related, we know this is not always true.  By explicitly bringing value into the price waterfall, we can not only set prices and discounts more effectively, we can improve price communication and perception.  We do this with a construct we call the Value-Price Waterfall.

Price waterfalls provide a powerful way to visualize transaction pricing performance.  The same graphic technique powerfully illustrates differential value, helping companies measure, communicate and capture value when designing products, implementing pricing policies, or negotiating deals.

In most situations, we are not simply justifying price based on absolute benefit, but on benefits and price relative to other alternatives.  This differential value is (Our Benefit – Our Cost) – (Competitor’s Benefit – Competitor’s Cost), where “cost” to the buyer is “price” to the seller.
In theory, every element of the price waterfall bears a direct relation to an increase or decrease in value.  In practice, price and value often become dissociated.  In other words, list price may not truly reflect the value delivered, to any particular segment.  An expedited shipping charge may not capture the value of faster delivery.  A discretionary discount, in theory a way to equalize value with a competitive offering, in practice represents guesswork at best; a cave-in and profit sink at worst.  By bringing value explicitly into the price waterfall, we can address these areas more effectively.

To create a Value Price Waterfall, we must:

1. Define customer segments.  This segmentation should come from how customers value our offering, not simply from overt characteristics such as size or location.

1. Define value buckets.  Value buckets identify the areas where customers may perceive value. This may include simply characteristics related to a product (“faster transactions from a new computer system”), as well as secondary characteristics (“24×7 support”, “fewer customer complaints”).  Consider potential areas of value outside the immediate features of your product, including delivery, warranties, installation, repairs, and the broader impact of your offering on your customers’ business.  While we can often name many areas where we add value, we must also note buckets that represent negative value, including switching costs and training.  “Noting the negatives” improves credibility with the sales force and the buyer, and helps sales and product management take steps to mitigate the downsides for the customer.

1. Populate the value buckets.  This is where the hard work comes in.  You have to know how much value you contribute to your customer segments in each bucket, relative to another alternative.  There are several statistical techniques for estimating differential value, each with its own strengths and weaknesses.  We recommend that you use statistical models to refine existing value price waterfalls-without putting in the effort to understand your customers’ needs, it is hard to perform surveys that are statistical significant and that actually get to the heart of perceived value.  Note that each Value Price Waterfall will have a bucket for your price (which will be negative to the buyer) and the price of the alternative (which will be a positive for your offering).

1. Communicate the value.  Value Price Waterfalls are most effective when you can share them with your sales teams, partners, and customers.  You may want to be selective about the level of detail you share with certain audiences.  In addition to helping to communicate value about a particular offering or deal, Value Price Waterfalls can also guide development of future offerings.  You can uncover where changes to your offering would provide the most incremental differential value-or close value gaps with competitors.

Value Price Waterfall Example

In this case, we look at a software company providing a hosted solution, competing with traditional onsite solutions.  Note that our price is a negative on this chart, while our competitor’s price is a positive.  Positive blue bars (such as for Hardware Savings and Offsite Backup) indicate value we add to the customer.  Negative orange bars, such as for Installation Ease and Our Final Price (cost to a customer) indicate were we subtract value from the customer.  The last bar represents the differential value.  In this case, the bar is green, indicating positive value.  Red would signify negative value-a very real possibility as we will see later.  One nice aspect of this presentation is that price becomes a small part of the overall value equation.

Looking at Other Customer Segments

Large companies, with the largest potential cost savings, were not buying.  When we examined the appropriate Value Price Waterfall, the reason became apparent.  They already had solutions to some of many these problems.  They already did automatic offsite backups, had the hardware on-hand, and had established processes.  In addition, the seat-based licensing approach would cost them a lot more money, even with volume discounts, compared to their current solutions.   To get achieve the right differential value, we would have to cut prices to the point that sales costs (higher in these firms) would negate the value of sales, or change the nature of the offering and its pricing.
(Note the red bar at the end of the Value-Price Waterfall below, indicating a negative value.)

Knowing when you do not have a good value proposition is not the same as hearing good news, but knowing is half the battle.  Now you can decide whether to attempt to fix the problems or simply get out of that market.  Perhaps most importantly for the bottom line in the short term, you can prevent crushing pricing pressure in one segment from depressing prices across the board.

Practical Aspects

Collecting value information is not trivial even for a single offering.  A range of offerings sold to a handful of customer segments against a handful of competitors can quickly create a multidimensional problem with too many moving parts, especially if any of these elements change frequently.  However, for most companies, a small set of products and markets supply the bulk of the revenue, and 80-120% of profit.  Focus on key competitive match-ups that have the most impact, and expand your “coverage” over time.

What and Why

The traditional Price Waterfall is a powerful tool that shows us what is happening with our pricing.  The Value-Price Waterfall offers insight into why.  In addition, it can provide guidance for employees, partners and customers in communicating value.  Taken together, the two ways of using the waterfall paradigm are a powerful combination for making pricing more effective.

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References

. See Managing Price, Gaining Profit, Harvard Business Review, Marn and Rosiello, 1992.