Price the Differential

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In the early 1980s, two very different approachesto modeling customer value emerged in management practice.

These two models make substantially different assumptions

about customer behavior and have different implications for

how to set price for a differentiated product. Both, however,

are commonly cited in marketing literature and used by

practitioners and consultants, as if the choice between them

were merely one of convenience. But since only one can be

right, the practical implications of picking the wrong one

can be very costly.

The first model, customer value mapping (CVM), emerged

from the total quality management movement, in which firms

endeavored to measure and deliver superior quality at a

competitive price. The second model, economic value modeling

(EVM), stemmed from the industrial purchasing world, where

By Gera ld E. Smith and Thomas T. Nagle

DifferentialPricing the

Mark Shaver/Veer


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M M M a y / J u n e 2 0 0 5 29

Customer value mapping leads you to capture

less of the value you create.


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firms estimated the economic savings of buying one firms

product vs. the products of other competitive suppliers.

Of the two, CVM has been more broadly applied by mar-

keters in many contexts and by a variety of value practition-

ers, including early developers of the Malcolm Baldrige

National Quality Award. These practitioners have applied this

methodology in contexts such as telecommunications (AT&T),

transportation (United Van Lines LLC), consumer packagedgoods (The Gillette Company), medical products (Johnson &

Johnson), pharmaceuticals (Parke-Davis Pharmaceuticals

Ltd.), and many others. CVM has become a conceptual pillar

of consulting firm McKinsey & Co.s strategic marketing and

pricing practices.

EVM similarly has been applied in a variety of contexts, but

its application has been limited mostly to B2B environments.

Rarely does one see EVM applied to consumer product envi-

ronments. And with good reason: EVM usually involves very

detailed mathematical estimates of the economic savings and

gains customers receive from using a product compared to

competitive substitutes over the life of the product.

Such estimates are often analytically

rigorous and require a deep understand-

ing of how buyers use and derive eco-

nomic benefits. It assumes that buyers

seek economically rational decisions to

maximize the monetary value of the

benefits received from their expendi-

tures. In contrast, CVM asks customers

for their subjective judgments about

product performance along a variety of

dimensions, including price. It assumes

that customers seek to purchase prod-

ucts that give them the highest benefit

per unit price. (This benefit may be

quantified in monetary terms, but itneed not be.) The ability to avoid con-

verting benefits to monetary terms

makes this approach analytically sim-

pler, which no doubt accounts for some

of its popularity.

In this article, we are particularly

concerned about the implications of

CVM on pricing decisionshow firms

set price for products and services based

on the CVM methodology and the extent to which these prices

appropriately capture the level of benefit customers receive in

exchange for purchase. We have performed numerous pricing

studies in a variety of industry contexts. A key finding from

our work is that pricing based on CVM would prescribe set-

ting prices consistently and often considerably lower than the

economic value benefits would justify. The magnitude of the

difference for any particular brand depends on the extent ofthe differentiated benefits not obtainable simply by purchas-

ing more of the undifferentiated competitive brands. This

finding applies in both B2B and consumer products contexts.

Customer Value MappingCVM is based on the premise that customers purchase from

suppliers based on value and that they choose the supplier

perceived to deliver the greatest value. Customer value equals

quality relative to price. According to Bradley Gale (1994,

Managing Customer Value, New York: The Free Press), quality is

determined as a composite of judgments about all non-price

attributes, such as product attributes and customer service

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Customer value mapping (CVM) and economic value modeling (EVM) are held up as alter-

native means to setting price. But their use leads to very different pricing outcomes. In this

first of a two-part series, the authors show that CVM results in a series of consistent pricing

biases that lead firms to get paid less for the differential value they create, especially with the market introduction of

new, highly differentiated products, features, or services.

EXECUTIVE

briefing

Exhibit 1

Endo-surgery vs. traditional open surgery for hernia repairs

Ratios based on estimates of performance scores from 1 to 10. Adapted from Managing Customer Valueby Bradley T. Gale.

Quality Weight Endo-surgery Open surgery Ratio Weight x ratioAttributes (1) (2) (3) (4) (5=3/4) (6=2x5)

Time back to 40 7days 22 days 2.00 80work and activity

Hospital stay 30 11 hours 18 hours 1.50 45

Operation time 10 108 minutes 85 minutes .90 09

Short-term 10 9 5 1.80 18complications

Long-term 10 10 5 2.00 20complications

Perceived quality 172score


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M M M a y / J u n e 2 0 0 5 31

dimensions. Since quality is a higher-level subjec-

tive attribute in practice, it is measured as

perceived quality.

Exhibit 1 shows a customer value model for anew endoscopic surgery method and associated

equipment, developed by Johnson & Johnson for

use in hernia surgeries. The new method is com-

pared to traditional hernia surgery along six qual-

ity attributes. For example, endo-surgery only

requires seven days away from work and normal

activities, compared to the 22 days required for

traditional surgery. Respondents were asked to

rate these performance levels on a scale from one

to 10 (not shown in the table). For any given

attribute, the ratio is the performance rating

given for endo-surgery divided by the rating

given for traditional surgery. With respect to

time back to work, endo-surgery was judged todeliver twice the perceived quality of traditional

surgery, and so on for all six attributes.

Respondents were also asked to provide rela-

tive weight by distributing 100 points across the

six attributes, with higher values representing high-perceived

importance. The weight x ratio column in Exhibit 1 repre-

sents the weighted perceived quality for each attribute, the

sum of which make the composite relative-perceived quality

ratio. The Johnson & Johnson endo-surgery method delivers

a market-perceived quality rating 72% higher than that of tra-

ditional surgery. Diagnostically, the model indicates that this

72% advantage can be attributed primarily to faster time

back to work (40%), followed by hospital stay (15%),

long-term complications (10%), and so on.

In other words, the Johnson & Johnson endo-surgery

delivers so much additional value to cus-

tomers that Johnson & Johnson should be

able to charge a substantial price premium

over the traditional surgery. How much of

a price premium? According to CVM, the

price premium is constrained by market

perceptions of fair valuethe perceived

quality received for the price paid.

For example, Exhibit 2 shows a graphi-

cal representation of this analysis with

market-perceived-relative quality on the

horizontal axis and the relative priceratio on the vertical axis. Endo-surgery costs about $3,400 vs.

$2,700 for traditional surgerya 26% premium. In Managing

Customer Value, Gale explains that the fair-value line indi-

cates where quality is balanced against price, meaning that the

relative price is linearly proportionate to the perceived bene-

fits received. In this example, price could increase by as much

as 72%, which would place endo-surgery along the fair-value

line. Along the fair-value line, the price per unit of perceived

benefit is constant. Thus, products priced above the fair-value

line should lose share, while those below it should gain share.

Exhibit 3 on page 32 shows a similar customer value model

recommended by consultants with McKinsey, interpreted at a

market-strategic level. Here, if market shares hold constant,

and perceived benefits and perceived prices are measured

correctly, then competitors will align along the diagonal called

the Value Equivalence Line (VEL). But markets change as

competitors introduce new products, features, services, or

capabilities that lead customers to perceive greater benefits.

Firm A provides greater benefits than Firm C for the same per-

ceived price, and the same benefits as Firm B for a perceived

lower price; hence, Firm Awill gain share vis--vis its direct

competitors because it has a value-advantaged position. For

the same reasons, Firm E will lose share because it has a

value-disadvantaged position.

Pricing ImplicationsCVM means a series of consistent pricing biases leads firms

to get paid less for the differential value they create, especially

with the introduction of new products, features, or services

Exhibit 2

Customer value map: endo- vs. open surgery

Pricing based on CVM would prescribe

setting prices consistently and often

considerably lower than the economic

value benefits would justify.

Open surgery

Endo surgery

Higherprice

Relativeprice ratio

Lowerprice

2.0

1.5

1.0

.5

.0

.0 .5 1.0 1.5 2.0 2.5

Market perceived quality ratio

Adapted from Managing Customer Valueby Bradley T. Gale.

Fair-

valu

elin

e


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into the market. It is based on the premise that customers seek

to minimize the price per unit of benefits or the price per unit

of performance delivered. Many firms talk about value in

terms of the price-performance relationship where firms

should be able to charge X% more for a product innovation

that delivers X% more performance benefits than its competi-

tors. In the simplest case, if performance is one-dimensional

and a firm introduced a new model that enabled customers to

achieve 25% gains in productivity relative to other competi-

tive suppliers then, according to these models, the firm should

be able to charge a price premium of up to 25% to compensate

for the enhanced productivity benefit. A 25% premium would

keep the brand on the McKinsey value equivalence line.

On its face, these conclusions seem logical, but the logic

breaks down when one considers examples. Consider thevalue of a painting device that enabled one to paint a house in

half the timea doubling of productivity. The value equiva-

lence logic would say that a customer should be willing to

spend no more than twice as much for the device as for a

paintbrush or a rollereven if productivity were weighted

100% as the benefit of greatest importance. Obviously, howev-

er, for anyone whose time is valuable, the value of doubling

productivity could be many times the value of a brush. Unless

using two brushes at once could produce a doubling of pro-

ductivity, a buyer might well be willing to pay four times as

much for the new device, making its cost per unit of produc-

tivity benefit twice as high.

First, customers dont pay for benefits; they pay for theworth of the benefits they receive. That is, they cognitively

convert benefits into monetary terms so that they can judge

how much they should pay for the worth of the benefits they

receive. If a 25% gain in productivity yields monetary gains

that well exceed 25% of the cost of the competitive product,

then any rational consumer seeking the best purchase option

will pay more than a 25% premium for it.

Second, in a free market, a seller cannot usually capture the

same price per unit benefit for all benefits that a product or

service produces. The reason that some benefits must be

priced lower than others is that some benefits are subject to

competition and others are not. If multiple competitors offer

customers the same benefits, then those benefits are commodi-

tized. A customer need not pay anything close to a productsworth to them because they can get the product elsewhere.

(Economists call this difference between the real value of a

product and its market price consumer surplus.) There is,

however, a portion of value of some products, produced by

unique differentiating features that customers cannot get else-

where.

In the example cited, a unit of productivity gain (hours

saved painting) easily could be worth many times the cost of a

paintbrush. Manufacturers of paintbrushes cannot capture a

significant share of that value because of competition.

However, manufacturers of the differentiated painting device

could capture a much higher share of the economic value of

increased productivity caused by the device. Without competi-

tors who offer that same level of productivity, customers who

do not choose to buy the device there must do without it.

The bottom line: CVM underestimates the value of the

more differentiated products in a market and overestimates

the value of the less differentiated products.

Beyond CVMSo how do companies allow the differentiated benefits of

their products to get commoditized by their competitors? And

how can managers better determine the real differential value

they deliver vis--vis their competitors, and then set prices

that reflect the true differential value? In the next issue of

Marketing Management, well examine these questionsand

show an alternative model that emphasizes the real worth ofthe differentiation value that separates your product from

your competitors.

About the Authors

Gerald E. Smith is the chair of the marketing faculty at the

Carroll School of Management, Boston College. He may be

reached at [email protected]. Thomas T. Nagle is chairman

of the Strategic Pricing Group in Waltham, Mass. He may be

reached at [email protected].

32 M M M a y / J u n e 2 0 0 5

Exhibit 3

McKinsey value map

Perceived

price

Customer-perceived benefits

Valuedisadvantage

Valueadvantage

VEL

From Ralf Leszinski and Michael V. Marn, Setting Value, Not Price,

The McKinsey Quarterly(1997), 1, 98-115.

E

D

C A

B


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Price the Differential