Value Decoder

At most companies today, prices are set using a mix of "marking up costs," "I need to make this margin," "matching competitors" (even if rivals sell inferior products), "that's the way we always do it," "back of the envelope analysis," and my personal favorite, "it just happens." While deeply ingrained and easy-to-implement, the problem is the resulting prices have absolutely no relation to what consumers are willing to pay. Few of us think to ourselves, "The most I'm willing to pay for a refrigerator is 2 times what it costs KitchenAid to manufacture it."

The key to better pricing is to think like your customers. The Value Decoder is a 6 step framework designed to help managers better understand the key determinants of - and how to set - the right price for their products and services.

Step 1: Target Customers

Be specific on the type of customer who is purchasing your product.

Example: Pricing Your Beachfront Condominium for Rental

Vacationers who want to stay right on the beach.

Step 1

To continue, please enter a value for fields marked in red:

Type of customers you are selling to:

Step 2: Price and Characteristics of Close Substitute

The primary insight of the Value Decoder is your product's price is based on those of close substitutes. You may own a diner restaurant that's thrived for years, but if a new diner opens on the same block (thus, a credible next best alternative for your customers to dine at) and sets ridiculously low prices, this will put downward pressure on the prices that you can set.

It's important to ensure that the product you identify as a close substitute is actually what many customers are (or considering) buying instead of yours. If the product you identify as a close substitute is priced so high that it is not selling well, it's not a bonafide rival to base your price on.

What is the price of your customers' next best alternative?

Example: Pricing Your Beachfront Condominium for Rental

The condo next door is available for rent for $1,500 per week.

Step 2

To continue, please enter a value for fields marked in red:

Your product's name:

Name of your product's closest competitor:

Price of your product's closest competitor:

Step 3.1: Characteristics Relative to Competitors

If your product is identical in every respect to its key competitor - it's a commodity and its price has to be the same (or lower) than the rival. Few products are commodities - most either have more bells & whistles or fewer frills than their rivals, or a unique style that appeals to an individual's unique taste (e.g., some people prefer retro style). So how does your product rate - in terms of characteristics - relative to competitors? Important characteristics to compare include brand, quality, attributes, service, ease of purchase, and style. Don't worry if your product isn't as high quality or feature-packed as the competition. If customers only wanted the best - we'd all be driving Rolls Royce automobiles.

Example: Pricing Your Beachfront Condominium for Rental

The next door condo is virtually identical except your condo has a private pool and a deck to view sunsets.

Step 3.1

To continue, please enter at least one attribute:

In terms of attributes (brand, quality, attributes, service, ease of purchase, style), how does differ from ? List up to 5 attributes (both positive and negative):

Price: $

("first cut" price at this stage)

Step 3.2: Valuing Relative Product Differences

If your product offers "more" (or a unique style), there's an opportunity to charge a premium over your rival's price. Using your rival's price as a base, add the amount that you believe the average customer will pay for the extra or unique features. Conversely, if your product is lower quality and has fewer attributes - price is the great equalizer - a lower price can entice customers. Using your rival's price as a base, subtract the amount that you think is necessary to entice the average customer to purchase your product over the more expensive competition.

Example: Pricing Your Beachfront Condominium for Rental

Your condo's private pool is worth an estimated $200 premium and the deck to view sunsets worth an estimated $50 premium.

Step 3.2

To continue, please enter a valid value for each attribute:

Comparing to , how much more (or less) should you charge for each of the below-listed attributes? To denote a discount, enter a negative number (e.g., - 100).

Price: $

("first cut" price at this stage)

Adjusting Forces

At this point, you've calculated what's called a value-based price by using the customer's next best alternative as a starting point and either adding a premium or subtracting a discount based on how your product compares to the competition. Once the value-based price is calculated, there are "adjusting forces" that you need to consider and be on the lookout for. Each adjusting force can influence your price in three ways:

Change overall demand. Each adjusting force can increase or decrease demand for your product - requiring that you recalibrate your price accordingly.
Change how consumers value your product's unique differentiation. When the economy is not doing well, for instance, consumers often decide that "good is good enough." Thus, consumers won't value premium attributes and quality as much as they do during better financial times.
Change how rivals set their prices. If overall demand changes - due to an adjusting force - your rivals may likely adjust their prices too. Returning to Step 2 - since your price is based on those of rivals' - this means also modifying your price.

To apply the finishing touches to your product's value-based price, keep in mind the following adjusting forces: Income, Price of Complementary Products, Market Environment Change.

Considering these adjusting forces may lead you to change the value-based price that you determined at the end of Step 3 - either through simply rethinking the value-based price ("perhaps I should lower my price because I'm worried about my customer's financial condition") or preemptively acting on an adjusting force (and/or rival price) change that's on the horizon.

Step 4: Income (Optional)

Your customers' incomes affect their valuations. Better understanding your customers' financial condition - and its effect on how much they'll pay for your product - is an important step in determining price.

Example: Pricing Your Beachfront Condominium for Rental

The economy is improving for your rental customers. Customers may be willing to pay more for your condo’s premium amenities (increase of $100).

Step 4

To continue, please enter a value for fields marked in red:

Enter by how much you should increase or decrease your price due to a change in your customers' income. To denote a price reduction, enter a negative number (e.g., -100). To denote no price change, enter 0 or leave blank.

Price: $

("first cut" price at this stage)

Step 5: Price of Complementary Products (Optional)

Prices of complementary products - those used in tandem with your product - affect value. As gas prices fluctuate between "surprisingly low" and "painfully high," the value of owning a hybrid car swings too. When gas prices are high, demand (and the price that you are willing to pay) for fuel efficient cars rises. Conversely, when gas is under $2, fuel efficiency is less of a concern. Be aware of how the prices of complementary products influence the amount customers are willing to pay for your product.

Example: Pricing Your Beachfront Condominium for Rental

Airfares to the local airport are rising - making it more expensive to visit, necessitating a discount of $75.

Step 5

To continue, please enter a value for fields marked in red:

Has the price of a product that affects demand for your product changed? If yes, how does this affect your product? How much should you increase or decrease your price due to changes in the prices of complementary products? To denote no price change, enter 0 or leave blank.

Price: $

("first cut" price at this stage)

Step 6: Market Environment Change (Optional)

Changes in the market environment (e.g., fad, new information, unexpected event, timing) can affect your product's value. The CBS news show 60 Minutes did a story on the French diet indicating that moderate alcohol intake could reduce the risk of coronary disease by as much as 50%. As a result, red wine sales in U.S. supermarkets skyrocketed - hence, an opportunity to boost prices. Returning to hybrid cars, a heightened social interest in being environmentally friendly can similarly boost demand.

Example: Pricing Your Beachfront Condominium for Rental

Several Hollywood celebrities are buying vacation homes in the area, making the resort area "hot" - add $100.

Step 6

To continue, please enter a value for fields marked in red:

Has something related to the market environment affected your price (e.g., fad, new information, unexpected event, timing)? How much should you increase or decrease your price due to market environment changes? To denote no price change, enter 0 or leave blank.

Price: $

("first cut" price at this stage)

Result

One insight that should be clear from this 6 step Value Decoder process is how little control you actually have on your price. A change in a rival's price, customer income, complementary product prices, and/or market environment directly affects the price you should charge. As a result, you should regularly do a quick Value Decoder analysis to determine if your price needs to be adjusted.