What makes a good value model? Tom Nagle’s view
Steven Forth is a Managing Partner at Ibbaka. See his Skill Profile on Ibbaka Talio.
Tom Nagle introduced economic value models in his book The Strategy and Tactics of Pricing. The first edition was published in 1986 and co-authored with Reed Holden. The seventh edition was published in 2023 and co-authored with Georg Müller, Evert Gruyaert. From 2013 these models have been referred to as Economic Value Estimation models (EVE).
What is a value model in the EVE style?
Basically, it is a set of value drivers, each of which has a short written description and an equation used to estimate the impact on a customer’s business, their profit and loss statement or their balance sheet.
The standard visual representation is shown below.
The value drivers can be organized into six types (Ibbaka has extended this taxonomy to be more specific for work with value models and generative AI.)
Increase Revenue - a powerful set of value drivers when validated
Decrease Operating Costs - the most common value driver, one people are over-reliant on
Decrease Operating Capital - often overlooked but more important as the cost of capital increases)
Decrease or Defer Capital Investment -
Decrease Risk - important in a risky world
Increase Optionality -the ability to do more different things leading to a more adaptive and resilient organization, hard to quantify but of growing importance
What makes a good value model?
Ibbaka is built on and around value models. We are kind of obsessed with them: how to build them, ways to use them, what makes for a good value model. With this post we are sharing some of our research into what makes a good value model.
Over the next few months, we will be having conversations with many of the world’s top value modelers, including people who work with Ibbaka. We will also. be sharing quantitative studies and analysis of value models.
But we begin with where it all started, Tom Nagle.
Tom Nagle’s perspective on what makes a good value model
Tom's idea for EVE emerged from the need to create a structured framework that could quantify the economic value a product or service provides to a customer compared to their next best alternative. This approach was designed to address the challenges businesses face in differentiating their offerings and setting prices based on the perceived value to customers rather than just costs or market trends.
In the summer of 2024, we asked Tom ‘what makes an excellent value model?’ He responded …
“There is a bias toward building models based on features of the offer. So there is the reference value for the "commodity" alternative and then a value assigned to all the features that distinguish the offer from the commodity. The problem with focusing on features is that the same differentiating feature will be valued very differently based on the economics of the customer.
Better value models, in my opinion, quantify the value of differentiating benefits (revenue enhancements, cost reductions, risk reductions) that the customer experiences.”
Tom expanded on this in a recent podcast with Mark Stiving (Mark will share his own perspective on what makes a good value model in a later post). Insights into Value-Based Pricing Strategies for B2B with Tom Nagle. The whole podcast is worth listening to, multiple times, but the part most relevant here relates to the business value of the O-Rings used in large chemical plants.
“A common mistake is to associate value with product performance. If a product is 3X as good as the alternative on some critical measure it must be worth three times as much, right? Wrong. In the example from the podcast, DuPont has a kevlar O-Ring that lasts three times as long as a conventional O-Ring and that they were able to sell for 5X the price of a conventional O-Ring. How is this possible?
The value of Kevlar O-Rings is not just the labor and material savings costs from their longer working life. It also comes from cost avoidance and revenue generation. One of the most importance value drivers for Kevlar O-Rings turns out to be greater uptime.
This value driver works differently across segments. Segments, where uptime is important, will get more value and will have a much higher willingness to pay. Segments which naturally shut down their plants for other reasons, such as seasonal downtime or planned maintenance, will only be willing to pay for the reduction in material and labor costs. Markets should be segmented by how and how much value is provided.”
Distilling this down, here are some rules we can take from Tom’s approach to value modelling and value-based pricing.
Key Lessons from Tom Nagle
Understanding Value: Value is not inherent in the product itself but in how the product's benefits impact the customer's income statement and balance sheet.
Economic Value vs. Willingness to Pay: There is a distinction between the economic value of a product and the customer's willingness to pay. Economic value is the potential financial benefit a product provides, while willingness to pay is influenced by perceived value and other factors such as risk and uncertainty.
Importance of Segmentation: Variations in value to customer (V2C) create segments. This segmentation helps eliminate the trade-off between price and volume by offering different prices to different segments based on value.
Do not base price on product characteristics: price based on the impact those characteristics have on value in use.
The Ibbaka team would like to thank Tom for four decades of contributions to the strategy and tactics of pricing. He has given us all a basic toolset that we can go on to apply in new ways as new challenges, from climate change to generative AI change how we all think about value, pricing and the many business processes they touch.