This post should be read after the post on “The Categories of Value”.
Suppose you like to have a new pair of glasses. How much are you ready to pay for the best fit glasses?
This is certainly a difficult question because there are several variables that impact the translation of value to money.
- Considering the practical need: what limitation the new glasses reduces?
- Considering the status value: what people would think of me wearing these glasses?
- Considering my own pleasure when I look at the mirror – what is the value of me liking my look with those glasses?
- How much money I have? Can I afford the truly best fit glasses? Would I have to give up something else? If so what is the value of that?
- What is the “fair price” for the glasses? We all hate to pay more than what we have to.
The first three parameters state the difference between the three categories of value. Personally I assume the practical need is the most important in this case. But, it seems others value it quite differently.
The decision, involving all the five key parameters above, has to be done every time we face a choice. When we face a complicated decision we should always look for the inherent simplicity. The last parameter, the not-too-rational question of whether the price is “fair”, poses a major simplification of the decision process. The reason is that instead of translating our perceived value to money we rely on universal “fair price” as representing the value.
Establishing a fair price requires finding a reference-price. What could be the common reference price for a pair of glasses? As there could be a variety of practical-need features (multi-focal, anti-scratches etc.) as well as a variety of esthetical parameters and variety of brand-names (important for the status), there are several price-references, like $15, $200 and $800 for a combinations of features and brand-names. When a specific choice is considered one is able to “tolerate” a certain deviation from the reference-price when there is a justification. In other words, the reference represents the worth of the average value, and when a specific product is perceived as somewhat ‘better’ than the average, all the customer has to do is to validate that the additional value is worth the deviation from the reference. This justification works when the deviation from the reference is relatively small. When the deviation is significant there is a need to find a new reference, like the multi-focal glasses has different reference than regular glasses.
Marketing has to face the reference-price and find the justification for charging more, or establish a new reference, which covers the added value of the specific product/service. When the main value is based on practical-need the rational should be the unique value of the extra practical-need that the product yields. Status has its own rules and opinion-leaders and if they give the product a nod it is possible, even desirable, to charge much higher price. The real difficulty lies with the category of value of pleasure, because not only the client has a real difficulty to translate value to money, she is not going to tell us what she thinks. Presenting the product image as significantly higher than the reference is a real marketing challenge.
The good news about the reference-price is that it limits the negotiations between sellers and buys. When there is no reference, like when the product is actually a project, developed according to the specifications of the client, then both sides fall into the trap of cost-plus. This is a natural lose-lose situation. I’m afraid we still do not have a universal solution for a win-win. Do you?
Eli Schragenheim 
Wow! It’s a real insight! Many years, many entreprenyers said that it’s desirable situation when there is no reference. And you here say that it’s “lose-lose” situation and it sounds reasonable.
It’s food for thinking. Thank you!
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Would building a piece of custom software or a custom factory fall into the category of no reference price and as such a lose – lose situation if cost plus is used?
In such custom cases, does other parameters than price suddenly become the reference point to which the value of the product is measured? Such as lead time, level of customization, service etc.
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Rasmus, suppose there is an agreement that the customized software would yield to the client organization $10M additional profit per year for the next 5 years. Suppose also that developing that software, using your very highly talented software engineers, require about 200 man-hours – maybe up to 300 man-hours.
You offer great quality, service and response. I agree that those can add something to the agreed price.
What price can you hope for?
Can you get $3M? After all the agreed value is far-exceeding that figure. Don’t you think that asking $10K per one hour is a barrier? Just think how the CEO would deal with having to justify the cost to the board!
How about trying to convince the client that actually your team would need 10,000 hours to develop the software. You might need to add a lot of features (not truly needed) to justify the overall price tag of $3M. Of course, to deliver software after 10,000 man-hours takes quite long time.
Rasmus, seriously, how would you handle such a case?
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Well I know how my current company would approach it.. Hourly rate plus profit margin would be the approach as that leaves everyone happy that they achieved the budget or their performance measures. But it would be a lose for our company as we gave the customer a tremendous amount of value for only a small gain, but as you point out, if the only way to justify a more equal sharing of value, is to bump up the number of hours it is even worse because we now have a lose – lose, we spend more time than needed, time that could have been spend on completing additional projects and the customer receives a longer lead time.
But even for a highly customized project like this there would always be competitors right? Even if we don’t have a public reference price, we would still be thinking about how they would price the same project.. but you are basically saying that no competitor would ever submit the bid stating an expected 200-300 hours were to be used on the project, they would always inflate the number as otherwise they would be leaving too much value on the table?
If we have a case, where a focused 300 hour engineering project would yield an annual return of 10M$ for 5 years, would paying 10.000$ per hour really deter the customer from hiring us? Wouldn’t they look at their ROI and say “Why haven’t we started this project yesterday?”. Is it any different than the situation where a plant shuts down and you need THE GUY to be flown in to fix it at an astronomical hourly rate, but the lost revenue every hour far exceeds that?
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Rasmus, the cause for companies to refuse a great value-offer in spite of the high value is personal fear of the decision makers. When there is a gap between the reference “fair” price and the offer, the decision maker puts himself as target to vicious criticism and thus in too many times he will reject the offer.
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[Where was the reference price in a Viable Vision proposal to a company? If the value is much, much greater than the cost (price), then the benefit to the buyer is great, even if there is no reference, yes?] Reference prices are a marketing tool — I create, choose, and publicize a “reference” price that is favorable to me, the seller. When 3M sells 3M (premium) brand Post-It Notes and Highland (economy) brand Post-It notes, this is just good marketing. Together, the two products generate more throughput than either alone would.
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Reference price is absolutely needed for US to make up our mind to buy or not to buy. Marketing tries hard to change the reference, but it is very challenging mission. Goldratt tried to change the reference for consultancy projects by moving into the VV. It was not very successful, just to demonstrate how difficult this is.
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