How to organize an economic value model for use in pricing design

Value models are the foundation of value based pricing. They are how the value delivered to the customer gets connected to the amount they are charged, the price in other words.

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The uses of a value model

What is value based pricing

Your pricing model needs a value model

Value models are built up from economic value drivers. A value driver is a simple equation that describes the impact of a solution on a customer (or on a customer segment). A value model is a system of equations, the equations being the value drivers. There are thousands of possible value drivers, so we need to be able to organize them into some sort of taxonomy. Doing this makes the process of building and managing economic value models much simpler.

Let's explore three different ways one can organize value drivers: the conventional approach used by most practitioners, integrating value models using shared variables, and the possibility of organizing value drivers around key metrics that companies use to manage their businesses.

Conventional Economic Value Driver Categories Used in Pricing Work

Value drivers impacting the profit and loss statement

About 15 years ago Ed Arnold went through a collection of several thousand value drivers that had been collected by the Strategic Pricing Group ( Thomas (Tom) Nagle 's company) to find some common patterns. One outcome of this work was a standard taxonomy for value drivers:

• Increase Revenue - pipeline metrics, average revenue per unit (ARPU), renewals, etc.
• Reduce Operating Costs - labor and other input costs, throughput, rework
• Reduce Operating Capital Requirements - speed of collections, inventory reduction, work in process reductions
• Reduce or Defer Capital Investment - extend usable life, expand capacity, reduce investments, etc.

In subsequent work, Ibbaka has added two additional categories.

• Risk Reduction - as insurance or protection against low probability or unpredictable impacts
• Expanded Options - to improve resilience and adaptation

These latter two categories are most often used with businesses that already have formal ways to manage risk or portfolios. In the past this was areas like finance and energy, but with the growth of innovation management and innovation portfolios this is becoming more common.

Value drivers impacting the balance sheet

These value driver categories are all focussed on the customer's profit and loss statement. This accounts for the vast majority of pricing work, but there is another area that can be important. In some industries enterprise value depends on the balance sheet. This is true in energy and mining, where reserves are an important part of share value, and in the financial industry, where the size and quality of a loan portfolio can have a big impact on share value and regulatory requirements.

Integrating Value Drivers by Focussing on Shared Variables

A value model is a system of equations and in many cases one wants to connect value drivers that share variables. A value driver is an equation, and so is a combination of constants, variables and various mathematical operators. The variables are the customer (or segment) specific differences. Some variables show up in more than one equation. Organizing value drivers by means of their underlying variables can reveal important insights on how value is created. Software platforms like Ibbaka Valio can be used to track changes in these variables across customers and over time.

A simple example. A solution could lead to quality improvement. A process management software could reduce the number of errors that occur during a repeated process. This could impact both costs and revenues.

It could reduce costs by reducing rework and testing costs.

It could increase revenue by delivering a higher quality product that could be sold at a higher price.

This could even reduce the operating capital requirement by reducing returns.

The variables that show up in value driver equations provide an alternative way to organize collections of value drivers. One wants to be able to see all of the variables and then see all of the value drivers that use that variable.

Metrics Driven Value Drivers

When one is working with executives and boards one often begins by discussing pricing goals. At Ibbaka we have modified Roger Martin's Strategic Choice Cascade to make it directly relevant to pricing decisions.

The strategic choice cascade organizes choices into five levels.

The winning aspirations are often framed as key metrics. There are a number of metrics that come up again and again. The most important of these are ...

• Customer Lifetime Value
• Net Dollar Retention
• Gross Margin
• Revenue Growth
• Category Share
• Category Growth

In most cases more than one value driver will be in play. Let's look at one example, Net Dollar Retention or NDR. NDR is driven by three things:

1. Number of accounts renewing
2. Accounts expanding usage and increasing subscription value
3. Impact of price changes

It is unlikely that anyone value driver will impact all of these. But a collection of value drivers may. One can organize value drivers in terms of the metrics they impact.

Variables, Value Drivers and Pricing Metrics

Using a single value driver as the pricing metric is not generally effective. This can work in certain very narrow circumstances, but most solutions enable more than one value driver and basing pricing on a single value driver is too reductive. Let's remember the definitions of a value metric and a pricing metric.

A value metric is "the unit of consumption by which a user gets value." For example,

A pricing metric is "the unit of consumption for which a user pays." For example,

Look down into the variables to find pricing metrics and to make a compelling connection between value and price!