When to price using revenue value drivers, when to price using cost value drivers
Steven Forth is a Managing Partner at Ibbaka. See his Skill Profile on Ibbaka Talio.
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TL:DR
Many solutions support both revenue increase and cost reduction value drivers.
Price so that both value drivers are impacting price. There are two ways to do this:
Find variables that track both revenue increase and cost reduction and use as pricing metrics
Have hybrid pricing metrics, one for revenue increase, one for cost reduction
Consider having one package for revenue increase and one package for cost reduction.
Remember that the reason for buying, and the buying decision maker, is not always the same as the reason for renewal and the renewal decision maker. Plan value communication and documentation across the customer value journey.
Of the six categories of value driver most solutions rely on either revenue increase or cost reduction. Many solutions are able to speak to both of these value drivers.
How do you decide which value driver to use in the design of pricing metrics?
Which value driver will be more important in sales and value communication?
Do some buyers make the initial buying decision for one reason but then renew for another?
THE SIX CATEGORIES OF VALUE DRIVER
A value driver is an equation estimating the impact of your solution on your customer’s business.
Revenue Improvement: Helps your customer increase revenues.
Cost Reduction: Helps your customer reduce costs.
Operating Capital Reduction: Helps your customer reduce operating capital requirements.
Capital Investment Reduction or Deferral: Helps your customer reduce or defer capital investment.
Risk Reduction: Helps your customer reduce business risk.
Optionality: Helps your customer develop options (which increase resilience and adaptability).
Before diving in to how to combine revenue improvement and cost reduction value drivers, let’s look a little closer at each of these critical value driver categories.
The Revenue Improvement Value Driver
Revenue value drivers often have the biggest impact on a business and can be the easiest to quantity (contrary to popular belief, many people believe that revenue value drivers are the most difficult to validate).
The key here is to work with the key variables that determine revenue growth.
Funnel Metrics
Number of New Opportunities (Marketing Qualified Leads or MQLs, Sales Qualified Leads or SQLs and Product Qualified Leads or PQLs)
Conversion Ratio between each stage in the sales funnel
Velocity (time an opportunity spends at each stage of the sales funnel)
Contract Metrics
Average Contract Value
Revenue Composition (different types of revenue are valued differently)
One Time Revenue
Implementation Fees
Integration Fees
License Fees
Professional Services
Repeat Revenue
Subscriptions
Transactions
Usage
Parts and Supplies
Maintenance
Support
Data Feeds
For SaaS and other subscription based businesses, one can also consider unit economic metrics such as the Lifetime Value of a Customer (LTV), Net Dollar Retention (NDR) and Customer Acquisition Costs (CAC).
LTV is driven by contract value, revenue composition and renewals; for net LTV one also needs to consider cost to serve, a cost reduction value driver
NDR depends on increasing the value of a contract with existing customers (upsell and cross sell), minimizing contract contraction and reducing churn
CAC are the sales and marketing costs associated with winning a new customer
LTV/CAC is one of the key ratios used in measuring the health of a SaaS business and generally needs to be greater than three.
Note that in SaaS businesses many of the key metrics and ratios integrate both revenue and cost value drivers. This is one reason pricing for B2B SaaS is its own discipline.
The Cost Reduction Value Driver
Many people concentrate on cost reduction as they feel it is more concrete than revenue reduction. This is false. In many cases it is just as easy or easier to quantify revenue value drivers. But in a slow economy, some buyers are more concerned with costs than revenues and some solutions are directly focussed on cost reduction.
Solutions can impact costs in three ways, through their impact on resource requirements, throughput and quality and rework.
Resources - do more with less
Reduce the amount, quality, cost of inputs into the production process. Labor savings are often quantified in this way, but there are many other examples, such as being able to get the same quality output with a lower cost input.Throughput - get stuff done faster
Process speed can have a big impact on costs and the value that a production process is able to provide. Many solutions deliver value by improving process speed. A current example is data ops for AI solutions.Quality and Rework - reduce Muda, Muri and Mura
(to use the Lean Manufacturing framing)
Muda (無駄) or waste
Mura (斑) or unevenness, non-uniformity, and irregularity (often captured as quality issues)
Muri (無理) or excessive effort and overwork (using a machine beyond 100% of capacity for example)
See The Lean Way for complete descriptions.
Quantifying the value of cost reductions requires a good understanding of current inputs, processes and their costs. There are often hidden interactions and one needs to be careful of double counting.
How do you decide which value driver to use in the design of pricing metrics?
Given that your solution can impact both revenues and costs, how do you go about designing pricing? Here is a simple step-by-step process.
Define the value drivers for both sales and costs
See if there are any shared variables that are driving both revenue increases and cost reductions
Test how each variable impacts revenues and costs at different scales and look for interactions between variables
Compare the economic value for each value driver at different scales
Check for interactions between the variables, are there positive or negative feedback loops
If there are shared variables (the same variable occurs in both the revenue value drivers and the cost value drivers) then test these as pricing metrics
If there are no shared variables, consider hybrid pricing, in which there is a revenue related pricing metric and a cost related pricing metric
You may also want to address the revenue value driver vs. cost value driver by packaging. Can you design one package to support revenue increase and another to support cost reduction, even if each package is based on essentially the same functionality? One way to fence different packages (a fence is a way to guide buyers to the package that best suits their needs) is with the pricing metric. Having two different metrics, that can let you tell two different value stories, can be a powerful way to organize value communication.
Which value driver will be more important in sales and value communication?
Different buyer roles will have different needs. They are often responsible for different parts of the profit and loss statement, are accountable for different business processes, and are measured by different KPIs (Key Performance Indicators).
One way to get at this is to build a simple stakeholder map with the role on the X-Axis and the value drives on the Y-Axis.
Some buyers are more interested in one value driver category and do not care about the others, some buyers have a cross functional role and are concerned with more than one type of value driver.
Build a value story for each buyer role (or persona) that features that value driver.
If you can, translate the value driver into the impact on each role’s typical KPIs so much the better.
Do some buyers make the initial buying decision for one reason but then renew for another?
Another challenge for subscription businesses is that the reason for the initial purchase the reason for renewal are not always the same.
“They come for the fashion but they stay for the comfort.” is a catch phrase used by one Japanese fashion brand.
Renewals are often driven by the customer success team, but these teams lack intermediate metrics that help them frame and document what value is being delivered and who it is being delivered for. Customer satisfaction (CSAT) and Net Promoter Score (NPS) are not good predictors of renewals. Usage data is more useful, but it needs to be translated from raw usage to value delivered. To set customer success up for success begin by mapping out the stakeholder map for renewals.
Who makes the renewal decision?
What value drivers do they care about?
Do they care about the same value drivers that drove the initial purchase?
What evidence do they need that value is being deliverd?
How is that value communicated to each stakeholder across the customer journey?
TL:DR - Summary
Many solutions support both revenue increase and cost reduction value drivers.
Price so that both value drivers are impacting price. There are two ways to do this:
Find variables that track both revenue increase and cost reduction and use as pricing metrics
Have hybrid pricing metrics, one for revenue increase, one for cost reduction
Consider having one package for revenue increase and one package for cost reduction.
Remember that the reason for buying, and the buying decision maker, is not always the same as the reason for renewal and the renewal decision makes. Plan value communication and documentation across the customer value journey.