The simplest way of thinking about a process is that there are a set of inputs, some form of transformation occurs, and then there are some outputs.

A book combines the inputs of authors, designers, editors, proof readers and type setters (OK, with modern software, designers and typesetters are pretty much the same thing), along with glue, paper, ink and sometimes a bit of string. That is for a physical book of course. An e-book is a string of 1s and 0s that can generate pixels when used with the right software and device. Inputs, outputs, What do you price?

Much of pricing is the result of frozen accidents. Someone set a price one way at some point in the past and no one has ever gotten around to changing it. Books and eBooks are a good example of this. Hardcover books are traditionally priced at 3-to-5 times the manufacturing cost. This gave a reasonable returns to author, publisher, distributor and retailer. (There is even a profit calculator from major book distributor Ingram that helps you do the calculations). The hardback book sets the reference price for the trade paperback and in most cases for the eBook.

Think about that for a moment…

The cost structure of a hardcover book sets the reference price for an eBook with a totally different cost structure. This pricing maintains itself because of the power of framing effects. The hardcover book, which few will buy or read, frames the price of all other versions for historical reasons.

Cost based pricing, as we saw above with books, uses the inputs to set the price. Market based pricing uses the outputs. Value based pricing uses the outcome of using the outputs, usually in some other process.

Value based pricing is a way of linking together processes to reflect the exchange of value across the process.

Are we really talking about a linear process? Not in most cases. We generally need to be thinking of webs rather than linear inputs and outputs, just as ecologists now speak of the food web rather than the food chain, we need to be thinking in terms of value webs rather than value chains. Just as food webs are about the transfer of energy, value webs are concerned with the transfer of value.

Pricing is how each node in the web captures its share of value.

Of course it is not that simple. Let’s look at the most common pricing metric in the SaaS world, number of users. Is this an input or an output. Neither really. It is just a measure of how many individuals can access a service. Is this a measure of value? Not usually. It is removed from the web of processes in which value is created. To understand value one must look at the role a service plays in a series or processes and compare the service you are trying to price with the competitive alternatives (the other paths through the value web that can get you to the same place).

Value-based pricing puts the service in the context of the role it plays on a specific path through the value web and compares it to other paths that lead to the same place. It is a form of value path analysis with a focus on how much value can (and should) be captured along each step of the path.

The counterargument is that users are the agents that create the value so it makes sense to use the number of agents acting in a system as a proxy for value. Very few services are delivered without people getting involved. Even the most automated service is frequently in aid of some work that is being performed by humans (there are exceptions of course, and the number of exceptions is likely to increase over the next decade, but that is a story for another day). So there are arguments in favour of user based pricing.

User based pricing makes most sense when two criteria are met.

1. Each user gets their own unique view of the data or makes their own unique view of the service. If sharing accounts and co-mingling data would reduce the value of the service, then user based pricing may make sense. For example, I do not want my health records to be jumbled up with those of others.

2. The actions of each user create unique value that needs to be traced back to that user. When I write, I often want to be able to author my own documents, and not just dump them into a shared file with no attribution. (Think about the difference in value between a signed work of art and a generic work that could have been made by anyone).

So how do we proceed? One way to think about pricing is to look at how a service functions in a value web. What value does it provide in the web and how does it impact the pooling of profits? (Value webs compete with each other for market share, but they compete within the web for profit share).

Six steps to optimizing the value web while maximizing your profits

1. Choose the right scale. This is often the most difficult part of any analysis. How granular is the process map? In pricing work, we are most in the places where value is exchanged between two different organizations (ignoring for the moment transfer pricing, which works by different rules). A value web is a map of value exchanges.

2. Map the value web. Look at the inputs, processes and outputs for each step (node). Ask how value is created. Here is the tricky part, you have to go back far enough to pick up the alternative paths that reach the nodes you are most concerned with (the nodes where you are an input to how another node creates value).

3. Price your outputs as inputs to the node where you are creating value. The key to value-based pricing is to look at the impact of your prices on the next step in the web. When your output is the input into several different processes you have a strong indication that you are serving more than one market segment.

4. Consider other paths to the same outcome. Pricing disruption most often happens when there is an alternative path to the same downstream outcome. Zoom out and look at all of the other paths that could lead to downstream outcomes. These are the real threats to your business. On the other hand, when you zoom out and look at the wider value web, you may find new places to insert your own service.

5. Design your service to maximize the value of downstream outputs. The more value created in the value web the more opportunity you have to capture profit. Price to enhance downstream value of the value webs you participate in (optimize value to the customer or L2V).

6. Price to capture the largest profit possible. Once you have figured out how to optimize value in the value web, you want to price to capture as much of the profit as possible. Value webs compete with each other for market share but within the web for profit share).

There are different strategies one can apply to value web pricing. Apple is focused on a cost/pricing strategy that maximizes its own profit share, and as a result claims the largest share of profit in the entire mobile ecosystem. Google has taken a very different approach. Its pricing and design strategies (the two go hand in hand) are meant to maximize the value of the total value web, and it is happy to see profit distributed across that web rather than trying to make sure that profit pools at Google. (Of course it can do this because it has massive profits from its core search advertising business).

If a company like Huawei or Samsung try to replicate Google’s strategy with Android they will fail. Their place in that value web is very different from Google’s. Huawei, under pressure from the US government and not currently able to access Google apps, is said to be planning to replicate the Google led value web (see The Economist’s Sept. 20, 2019 article on this). This is the wrong strategy. If they remain locked out of the Google ecosystem, then they are more likely to succeed by building a new ecosystem around 5G where they control how profit pools (indeed, they are moving in this direction in the overall 5G market).

Key lessons

1. Price your service as an input into the next node in the value web

2. Have a clear strategy for how to maximize the value created by the value web(s) you participate in

3. Understand how you will design your service and pricing to make sure as much profit as possible sticks to you