Value-based pricing: Finance’s implementation role
Management accountants have a substantial role in working with sales, marketing, and pricing executives across the business to introduce value-based pricing.
Pricing is a vital business function, and the theory of pricing has advanced significantly since the late 20th century. Value-based pricing, which is based on what the customer is prepared to pay, has become increasingly important as an antidote to the traditional emphasis on cost-based methods.
Management accountants can and should have a vital role to play in value-based pricing, but they must expand from their traditional, internally focused concern with costs to an external, customer-focused concern with value. This article outlines the technique of economic value to the customer (EVC), the cornerstone of value-based pricing, and then shows how management accountants can contribute to the implementation of EVC in value-based companies.
Economic value to customer
The starting point in calculating EVC is the identification of a reference product, possibly an existing product to be superseded or a competitor product that already has market share. The next, crucial step is to identify differences in value between the new product and the reference product from the customer’s point of view.
The most obvious difference in value would be a product or service that promised future cost savings for the customer. Such savings would create additional value for the customer and would justify an increased price compared to the price of the reference product.
As management accountants understand relevant cash flows, they are ideally placed to determine differential value between new and reference products.
If the product or service will generate savings or additional revenue into the future, then the differential value should be discounted to present value to determine the additional value that the customer derives from the product. The management accountant is well placed to assist marketing and pricing colleagues with key expertise, but, again, all involved must emphasise the customer’s importance. In determining present value, it is the customer’s discount rate that matters, and this, itself, may not be the customer’s cost of capital — the rate should reflect the riskiness of the investment from the customer’s point of view.
Two further points are relevant:
EVC reflects the maximum that a rational customer currently purchasing the reference product should pay for the new product. Any price above the EVC would, of course, make the reference product a better value.
Individual customers will estimate the differential value between the products differently, and this means that there will be a range of EVCs. Described later in the article is how the use of EVC can be linked with segmenting the market to good effect.
How to implement value-based pricing
EVC is a key metric that counterbalances cost-based methods. However, companies do not find it easy to implement. Three main technical issues must be overcome:
- Identifying a reference product;
- Segmenting the market; and
- Assessing differential value.
Crucially, implementation is likely to require an interdisciplinary team with product developers, marketers, and management accountants working closely together. The management accountant should be a vital member of the team, a facilitator and linchpin who pulls together information from both product development and marketing, organising it so that the team can understand the EVC calculations and the potential for the product or service.
For quantitative value differences, the management accountant will employ well-honed spreadsheet skills, but for more subjective issues, the marketing team needs an excellent understanding of what the customer values. As an example, a computer company’s managers could not understand why the company was losing market share, given the product’s superior features. A simple survey revealed that customers valued not technical features but hardware and software compatibility, reliability, and user support. The product was value-disadvantaged from the customer’s point of view.
Management accountants have the necessary skills to assist in assessing EVC, and they have the computational and presentational skills to support marketers and product specialists in demonstrating “value to the customer”. As the EVC technique becomes better known, management accountants can build relationships with marketing executives, working closely as business partners.
Linking value-based pricing with market segmentation
Once alerted to customer segmentation and pricing based on customer value, examples can be seen everywhere: Supermarkets sell value, standard, and premium ranges; in the UK the RAC offers basic, extra, and complete roadside assistance packages; and the Genealogist subscription-based website has starter, gold, and diamond options.
The aim is to provide products that target different market segments: value products for price-sensitive customers and premium products for price-insensitive customers who want the “best”.
Segmenting by customer value is easy to see in consumer markets but not so easy to demonstrate in business-to-business markets where confidentiality is important.
However, a classic example is the computer company DEC, described by John K. Shank in his book Cases in Cost Management: A Strategic Emphasis. DEC, the market leader, was under pressure at the low end of the “minicomputer” market. DEC sold its machine at a single price, but an analysis revealed that customers fell into three groups: those needing a high-speed machine; those focusing on price; and a group in the middle that wanted a medium-speed machine. Segmentation and value analysis showed that DEC’s product was good value for the high and middle customer groups but not for the price-sensitive group where Data General offered better value. The analysis indicated that DEC needed to consider a product to compete at the low end of the market without disrupting the higher-specification segments.
The value-based company
SKF, a global bearings manufacturer, provides a more recent case of a company that has focused all its efforts on providing value to customers. Todd Snelgrove, an expert in value and formerly global vice president–Value at SKF, said in the book he co-edited, Value First, Then Price, that what matters is not the product’s engineering features (though they might be important) but what customers value, and the aim is to demonstrate in numbers how the product can benefit the customer. He said metrics such as return on investment, net present value, and cash flow break-even might be calculated with the customer: an important reason for the inclusion of management accountants in the value-based pricing team.
Future trend
Value-based pricing is becoming increasingly important as companies realise the importance of segmenting their markets and targeting customer groups with products that appeal to them at the right price. Management accountants should be part of this trend and, having all the necessary skills, should become key business partners working with sales, marketing, and pricing executives to develop and implement effective pricing policies.
Editor’s note
This article is based on research supported by CIMA’s General Charitable Trust Fund and culminating in the author’s recently published book, Strategic Pricing and Management Accounting.
David Dugdale, ACMA, CGMA, is Emeritus Professor of Management Accounting at Bristol University in the UK. To comment on this article or to suggest an idea for another article, contact Oliver Rowe at Oliver.Rowe@aicpa-cima.com
AICPA & CIMA resources
Reports
Pricing Trends for Management Accountants, CIMA, May 2023
CGMA Case Study: Cost Transformation, AICPA & CIMA