Willingness to pay (WTP) is one of the most frequently abused concepts in pricing. Many people try to use it as a proxy for value. It is not. Other companies claim they can estimate willingness to pay through surveys. This is too simplistic. Why?
Willingness to pay is determined by framing and by the value delivered to the customer relative to the alternative. To measure willingness to pay without taking these into account is wasting an opportunity to really understand your customers and position the value you are providing.
This is one of those metrics that obscure more than it reveals. For it to be actionable one has to dig under the surface to understand the different value drivers that determine the emotional and economic value a specific customer (or customer segment) gets from an offer relative to an alternative. Rather than starting with some sort of high level estimate of willingness to pay and then trying to decompose this is to approach the problem from the wrong end, one needs to begin with value and then build up to willingness to pay for specific customer segments.
Willingness to pay is determined by framing, the context in which it is presented. The most important framing is the pricing model. Pricing models are the design of packaging, pricing metrics and fencing. Getting the right pricing metric can change willingness to pay by orders of magnitude.
Let’s define some terms.
Willingness to Pay is the maximum price at or below which a consumer will definitely buy one unit of a product. It is frequently presented as a range.
Framing is the way a person or organization frames a transaction to determine the utility they receive or expect. This concept is used in prospect theory, and many mental accounting theorists adopt that theory as the value function in their analysis. It is important to note that the value function is concave for gains (implying an aversion to risk) and convex for losses (implying a risk-seeking attitude). This can influence the way people evaluate transactions.
Value Driver: Value drivers come in two flavours, economic and emotional. Both are important, even in B2B. Value drivers are also relative to the customer’s ( or the segment’s) alternatives. Gathering, validating and managing a database of value drivers, and understanding how they apply to different segments is the foundation of pricing.
Value Metric: The value metric is the unit of consumption by which a buyer gets value. Value metrics track value drivers.
Pricing Metric: The pricing metric is the unit of consumption that determines how much the customer pays. One can have more than one pricing metric and combine them using some sort of pricing formula. One can also have different pricing metrics for different market segments. Willingness to pay measures how much a set of customers are willing to pay for a specific pricing metric.
Good pricing metrics track value metrics.
Fences: Fences are what guide a potential customer to the offer that best suits them. Value drivers not used as pricing metrics are often very effective fences. Offer to the segments value they care about, and do not spend money delivering value to a segment when the segment does not care deeply about it.
Two other important questions, that cannot be separated from pricing, are packaging and bundling.
Packaging is the functions that one includes in an offer. Packages are designed (or should be designed) for specific segments. You do not need to provide all functions to all segments. In fact, you should not. Give each segment the offer that maximizes the differentiated value you provide while minimizing your customer acquisition costs and cost to serve.
Bundling is the combination of different products and services into a comprehensive offer. Packaging generally covers only things under your direct control. Bundles can also combine offers from different lines of business or even from different partners. Back in the old days, it was also referred to as the whole product solution.
Putting all this together, it is clear that willingness to pay is too general a metric to inform the critical pricing choices, and if your pricing strategy is built around this metric you are almost certainly being led down the wrong path. Top down, generalizing metrics like willingness to pay, obscure how value is created for, communicated to, and then collected from specific customers. Instead of starting with a broad metric like willingness to pay, build your pricing strategy from the bottom up using value drivers and value metrics. Start your pricing research by going deep into value and figure out who cares most about each of your economic and emotional value drivers.
The best examples of pricing innovation are not about measuring or tweaking willingness to pay. They are about finding a new pricing metric that ties a value metric to a pricing metric. Here are three classic stories.
Power by the hour: as jet engine manufacturers like General Electric and Rolls Royce invested in improving engines and reducing the maintenance burden they wanted to capture the value of these innovations into price. But airlines were sceptical. They were not convinced that the maintenance claims were real and did not want to take the risk (in the form of higher prices) that they were not. The jet engine manufacturers responded by offering a new pricing metric and new business model. Instead of selling engines, they would lease them to the airlines, who would only have to pay for the time the engine was powering a plane. This change in the pricing metric transformed the airlines willingness to pay. Today, as energy costs and climate change are becoming a bigger and bigger issue, the engine manufacturers are evolving into providers of end-to-end propulsion services, that include the cost of the energy and its climate costs.
The Tonne-Kilometre (TK) model: Famed tire maker Michelin responded to competitive pressure from lower priced suppliers by shifting the terms of competition. Rather than selling tires, it began providing tires for trucks and other heavy equipment by charging tonnes per kilometre. This shifted risk from the trucking companies (for whom tires are a significant operating cost) to Michelin. This worked because Michelin could collect and analyze data on millions of tires and understood the performance parameters. It was able to realize a roughly 20% increase in revenue per tire. You can explore how this approach has evolved and get a better understand of the economic value drivers by using one of Michelin’s fuel and mileage calculators. You don’t need to be operating a fleet of trucks to learn from this, as Michelin provides saved scenarios for you to explore.
Pay per click: One of the most successful pricing innovations of this century is pay per click. One of the inventors of this pricing model Bill Gross of Goto.com (later Overture) realized that traditional pricing models based on ‘impressions’ failed to discriminate between people who were interested in an ad or search term and those who were not (read a good summary of this fascinating story on Slate). By switching the pricing metric to pay per click they brought the pricing metric and the value metric into closer alignment. Google later adopted this model and used it to create one of the world’s most valuable companies.
These examples have three things in common.
Their inventors (new pricing models are invented) began by getting a deep understanding of the value drivers in specific market segments.
One reason they are so successful is that they transferred risk from the buyer to the seller. They could do this because they have a deeper understanding of the real risks than the customer. Accepting risk based on a deeper understanding of the data and value drivers is a winning proposition.
Willingness to pay was the outcome and not the cause. You cannot understand a causal chain by beginning at the bottom. You have to work to understand all of the factors that shape willingness to pay. By doing this, you will be the one shaping the customer experience that determines willingness to pay.
Pricing does not depend on willingness to pay. It depends on your differentiated value. Value includes economic and emotional value drivers. These can be used to understand the value metrics. The most successful pricing models are designed to connect price to value, to gather the data needed to manage and align risk, and to frame offers in a way that communicates value to target segments.
Start from the bottom with value, and build up to pricing.