Pricing innovation and value drivers
Steven Forth is a Managing Partner at Ibbaka. See his Skill Profile on Ibbaka Talent.
Pricing and Innovation
A series of three posts on why and how value and pricing experts can get involved in innovation.
Part 1 When should pricing get involved in innovation
Part 2 Pricing innovation and value drivers (this post)
Part 3 Pricing AI content generation
Pricing innovation and value drivers
Pricing and value management can play a key role in giving direction to innovation. Value drivers are one way to do this. Value drivers come in three flavours: emotional (how the innovation makes people feel about themself and others); community (how the innovation increases positive externalities or decreases negative externalities); and economic, which is the focus of this post.
An economic value driver is an equation that quantifies the economic impact of an innovation on a customer’s business. Economic value drivers are generally organized into six categories:
Increase Revenue
Decrease Costs
Reduce Operating Capital Requirements
Reduce or Defer Capital Investment
Manage Risk
Increase Optionality (the potential to take different actions)
See Core concepts: Value driver.
For more on how one can organize value drivers, see How to organize an economic value model for use in pricing design.
Value drivers get organized into Value models. These models are the foundation for value based pricing and other value based approaches. Without a value model you are only pretending to execute on value-based pricing.
See Your pricing model needs a value model.
The critical questions around innovation and value drivers are …
Does the innovation augment an existing value driver or create a new one?
Does it do this for existing users or for new users?
Understanding value is the key to successful value creation and capture.
Pricing and value drivers for the three modes of innovation
There is more than one type of innovation. Some innovation is focussed on wider community issues, creating value for society and environment, or is trying to increase positive externalities or reduce negative externalities. Other innovation work is exploration, meant to expand the range of the possible.
Pricing is more often concerned with product and solution innovation, and this comes in three different forms.
Category Creation - create a whole new category of solution, solving a problem that is not generally recognized and for which no solution currently exists. This is closely related to ‘Blue Ocean Strategy.’
Disruptive Innovation - using a new technology or approach to solve a recognized problem in a new way and/or for a new set of users. This is the framework introduced by Clayton Christensen.
Sustaining Innovation - incremental improvements to existing solutions for existing markets. Most innovation investment is directed to sustaining innovation. Incumbent vendors generally win competition based on sustaining innovation as they know the market, the customers and the foundational technologies.
The interaction of value drivers and users defines these three types of innovation.
Pricing and value drivers for category creation
There is a lot of excitement around category creation these days. The companies that succeed with category creation get to define the terms of competition and can often win large market share and are rewarded with much higher market caps. Recent examples of category creation include Tesla for electric vehicles, Dall-E for AI image generation, or Gainsight for customer success. The best book on category creation is Category Creation by Anthony Kennada, who was the Chief Marketing Officer at Gainsight when they built the customer success category.
In category creation, the focus is on developing the value metrics for the new category and then finding a pricing metric that connects price to value. The basic links between value drivers, value metrics and pricing metrics need to be established.
Value metric: The unit of consumption by which a user gets value.
Pricing metric: The unit of consumption for which the buyer pays.
See Pricing and value for category creation.
Pricing and value drivers for disruptive innovation
Clayton Christensen reimagined how we think about innovation in a series of now classic books: The Innovator’s Dilemma: When New Technologies Cause Great Firms to Fail (1997) and The Innovator's Solution: Creating and Sustaining Successful Growth (2003) and The Innovator’s DNA (updated 2019).
Christensen wanted to understand why incredibly successful companies could fail when faced with certain innovations. These are generally innovations based on new technologies that initially underperform relative to the established category. By focussing on their most demanding users, who are often their most profitable users, the incumbents fail to see the relevance of the new technology and let it grow in performance until it overtakes them and eventually supplants them. This is not limited to what we now think of as the technology industry. One of Christensen’s examples is how hydraulic backhoes came to replace cable excavators (see Industry Disruptors: Excavator Case Study).
At the same time, the incumbents, with their focus on profitable users, often ignore whole segments at the low end of the market, who are generally underserved or not served at all. Think of the way that smartphones have brought digital photography to everyone.
From a value perspective, there are two ways to understand the value of a disruptive innovation and to design pricing.
Develop new value drivers that are not currently supported in the category
Find ways to apply existing value drivers to new market segments
Pricing is critical to disruptive innovation. One compelling way to disrupt is to introduce a new pricing metric that better tracks value. A classic example of this is Google Adwords, where the pricing metric was changed from impressions to click throughs, with click throughs being a much better proxy for the value an advertiser wants to pay for.
Pricing and value drivers for sustaining innovation
Most innovation is sustaining innovation. In sustaining innovation the focus is on existing value drivers for existing customers and only occasionally includes the addition of a new value driver.
A value driver is an equation and so has mathematical operators, constants and variables. Generally the variables are customer or segment specific and the constants define value across broad groups of customers. Sustaining innovations is focused on the constants, custom configurations and professional services on the variables.
As an example, let’s consider revenue value drivers. Revenue value drivers come in four flavors:
Increase the average contract value
Increase the number of opportunities entering the pipeline
Increase conversion rates
Accelerate the movement from one stage of the pipeline to the next (shorten the time to sale)
Innovations meant to expand revenue should focus on one of these. If an innovation will improve both conversion rates and pipeline velocity (which is common) one should have two interacting value drivers. The innovation will improve the constants in the value driver equation.
In fact, economic value drivers are not about revenues per se, the gross margin also needs to be considered. The measure of economic value is at the level of gross margin. So an innovation that improves gross margin also impacts the value of revenue. This can be a cost value driver (this is why the value model is a system of equations), but it could also be a value driver that allows one to increase price while holding other factors constant. A price increase can directly increase gross margin, thereby increasing the value of revenue.
Pricing and value in the product development process
Getting value and pricing involved early in the innovation process changes product development. One moves from an anti-pattern, where one begins with the product (or even the technology) and then goes to cost and price (cost plus pricing) to a pattern where one begins with the customer, finds new ways to create value and then uses that value to set price.
Value drivers and value models emerged from the world of value-based pricing, but they have far wider applications. The value based approach now extends to
Value-based innovation (what this post is about)
Value-based segmentation (a good market segment is a set of potential customers that get value in the same way)
Value-based marketing (using market segmentation and the value model to tell value stories)
Value-based pricing (the pricing metric tracks the pricing metric)
Value-based sales (sales begins with value, differentiated value for the customer, and uses this to frame price)
Value-based customer success (customer success is responsible for delivering and documenting value and uses this to ensure renewals and to drive upsell and cross sell)
Innovation is the ground for success in a changing environment. Without innovation there is no adaptation. A value based approach can guide successful innovation.