Why good pricing strategy starts with market segmentation

by Karen Chiang

A solid pricing strategy necessarily needs to be based on an understanding of your customer and their alternatives. There are a lot of tools that can be used to gather this information. At Ibbaka, we use everything from 'Jobs to be Done' interviews, Economic Value Estimation studies, and surveys. All of this leads to a great deal of unwieldy data that has to be organized. The way that it gets organized is by market segmentation. Market segmentation is the foundation of pricing. You cannot craft an effective pricing strategy without a good market segmentation.

At Ibbaka, our goal is to help our customers create and communicate differentiated value and to then capture their fair share of that value through excellent pricing. Value-based pricing is the best pricing methodology for most innovative offers. We share Tom Nagle’s view that value creation is the source of pricing advantage. As such, understanding how your offering creates value for your customers is THE “essential initial input to pricing strategy.”

Value is always tied to a specific customer segment and value is relative to an alternative. To tackle value-based pricing you need to be able to understand who your customer is, how they get value from your offer, and then to compare this to the customer’s next best competitive alternative. Many companies have not developed a systematic approach for how to understand value and determine price. I would even argue that many companies are challenged because they do not have the right framework to integrate the science, math, data and art to justify—even validate—their pricing decisions.

Where to start? As value is tied to a specific segment the place to begin is with market segmentation. Many of our projects that begin with a question about pricing go back to segmentation before looping back to develop the pricing strategy.

Too often, when we ask our clients for their segmentation, we get back firmographics (demographics for companies) such as the industry classification, size and revenue. This method of segmentation fails to link the segment to how a customer gets value or how they buy. Consequently, it is not a good foundation for pricing decisions.

A more powerful approach is described by Tom Nagle in his book The Strategy and Tactics of Pricing. Dr. Nagle recommends we look at

“value-based segmentation models that facilitate pricing commensurate with actual value perceived and delivered to customers.”

Unlocking this, will enable us to ensure that we understand each segment’s ‘willingness to pay’ and that we can develop our pricing accordingly. From there, we are able to also determine the most attractive segments and to validate the size of the opportunity.

To do this type of segmentation, we need to identify those groups of customers where we can provide differentiated value (differentiated from the next best competitive alternative that is). Segmentation is the process of understanding the underlying pattern of needs, attitudes, and behaviours among customers who may appear similar but who are actually quite distinct groups. What matters in segmentation are needs and attitudes but these are hard to observe. On the other hand, firmographics are easy to observe but have little meaning.

 

 

At Ibbaka, we begin by looking for segments that get value in the same way and that buy in the same way.

Our typical process for doing segmentation involves:

1.     Building & validating a preliminary Economic Value Estimation, EVE, model to guide research

2.     Designing a data model to capture and connect data on value to customer, usage and possible pricing metrics

3.     Segmenting the market using value drivers and the customer buying process. What are the purchase motivators? Interviews and surveys are designed to capture relevant data

4.     Connecting firmographics to segments to estimate opportunity size

5.     Using influence maps, opportunity size, cost to access and cost to serve to identify target segments

Once we have built this foundation, we can build a compelling pricing model. This pricing model will have a pricing metric that connects to the value metric, a pricing architecture, pricing levels and pricing policies. This is an iterative process of course. As the customer segments come into focus, we get a better understanding of value. With this understanding, we can give better guidance on pricing. Also, markets change so segmentations need to evolve. It is important to monitor price acceptance, behaviour across pricing tiers, competitor response and respond accordingly.