Value-based pricing as a cost-of-ownership comparison run backwards: the parity price, the components of differentiation value, and how much of it to keep.
Economic value to the customer (EVC) is the price of the customer's next best alternative, plus the value of everything your product does better, minus the cost of anything it does worse, including switching. On an illustrative industrial part that lasts 2.5 years against a competitor's 2.0 at 400.00, the EVC is 605.00 a unit: 205.00 for the longer life, 100.00 for the energy saving and minus 100.00 of switching cost. Splitting the 205.00 of net value equally prices the part at 502.50, against 350.00 by cost plus.
Worked in full in Pricing Strategy by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Value-based pricing is often described and rarely calculated. The calculation is not difficult: it is a cost-of-ownership comparison run backwards. Instead of asking what the customer saves at a given price, it asks at what price the customer would be indifferent between the two products. That price is the ceiling. The price actually charged sits somewhere between it and the reference, and where it sits is a decision, not a formula.
| Input | Reference product | Our product |
|---|---|---|
| Price per unit | 400.00 | to be set |
| Service life, years | 2.0 | 2.5 |
| Installation labour per change | 120.00 | 120.00 |
| Downtime per change (2 hours at 150.00) | 300.00 | 300.00 |
| Energy cost per year | 300.00 | 260.00 |
| One-off switching cost per unit (trials, requalification) | 0 | 100.00 |
| Our variable cost per unit | 250.00 |
The performance figures must be ones the customer accepts, ideally from their own trial. A life advantage claimed by the seller and doubted by the buyer is worth nothing in a negotiation, however carefully it is priced.
Annual cost = (price + cost per change) / life + running cost per year
Parity price: set our annual cost equal to the reference's and solve for the price
EVC = parity price − switching cost
In Excel: =(RefAnnual-OurEnergy)*OurLife-ChangeCost for the parity price, with RefAnnual=(RefPrice+ChangeCost)/RefLife+RefEnergy.
Step 1: the reference's annual cost. Each change costs the part plus 420.00 of labour and downtime, 820.00 in all, every 2.0 years: 410.00 a year. Add 300.00 of energy and the customer spends 710.00 a year on this position today.
Step 2: value of the longer life. At equal energy, our part matches 410.00 a year of capital cost when (price + 420.00) / 2.5 = 410.00, so the price is 605.00. The extra half-year of life is worth 205.00 over the reference price. Most of it comes from avoided changes, not the part: every change avoided saves 420.00 of labour and downtime.
Step 3: value of the energy saving. Our part saves 40.00 a year. Over a 2.5-year life that is worth 100.00 more on the price, taking parity to 705.00.
Step 4: subtract the negative differentiation. The customer must trial and requalify a new part, a one-off 100.00 a unit charged against the first purchase. EVC = 705.00 − 100.00 = 605.00.
| Component | Per unit |
|---|---|
| Reference price | 400.00 |
| Longer life (fewer changes) | 205.00 |
| Energy saving | 100.00 |
| Switching cost | −100.00 |
| Economic value to the customer | 605.00 |
The net differentiation value is 605.00 − 400.00 = 205.00. Priced at 605.00 the customer gains nothing by switching and has no reason to. Priced at 400.00 the seller hands all 205.00 to the customer. Sharing the value equally gives a price of 502.50, a premium of 25.6 per cent over the reference, with 102.50 left on the customer's side of the table and 252.50 of margin on ours.
Cost plus tells a different story. A 40 per cent markup on a variable cost of 250.00 gives 350.00, below the competitor's price. The customer gains 255.00 a unit, the seller earns 100.00, and 152.50 a unit of margin is given away to a buyer who would have paid it gladly.
EVC is a ceiling, not a target. The share kept by the seller depends on how credible the claims are, how visible the downtime is to the person signing the order, and how readily the competitor can close the gap. A first order often needs a larger share for the customer than a repeat one.
| Seller's share of 205.00 | Price | Customer gain | Seller margin |
|---|---|---|---|
| 25% | 451.25 | 153.75 | 201.25 |
| 50% | 502.50 | 102.50 | 252.50 |
| 75% | 553.75 | 51.25 | 303.75 |
| Our life, years | Life value | EVC | Price at a 50% share |
|---|---|---|---|
| 2.25 | 102.50 | 492.50 | 446.25 |
| 2.50 | 205.00 | 605.00 | 502.50 |
| 3.00 | 410.00 | 830.00 | 615.00 |
The life assumption moves the answer more than anything else. A three-year life doubles the life value, because each extra year spreads both the part and the 420.00 of change cost. That is why the trial data matters: every quarter-year of life the customer believes is worth 102.50 a unit in life value alone, before the energy it also saves.
The common mistake is to add up the benefits without discounting them. The energy saving and the avoided changes arrive over years; the price is paid today. Rerun with an 8 per cent cost of capital, using the capital recovery factor, r / (1 − (1 + r)−life), in place of 1 / life, and the reference costs 759.83 a year, the parity price falls to 673.54 and the EVC to 573.54: 31.46 a unit lower than the undiscounted figure. The longer the life advantage, the larger the gap. The second mistake is to leave switching cost out altogether. It is real money to the buyer, and a value proposition that ignores it will be priced back down in the negotiation.
Once the price is set, what reaches the seller after discounts and allowances is a separate question, worked in how to calculate pocket price from list price, and the trade-off between price and volume in what a 1 per cent price increase is worth. The book's models for a book of business, with every input open, are in the free workbook for this case on the Pricing Strategy companion page.
EVC is the maximum a rational customer would pay: the price at which switching leaves them no better off. The value-based price sits below it, leaving the customer a share of the gain. In the illustrative case EVC is 605.00 against a reference of 400.00; keeping half of the 205.00 of net value sets the price at 502.50 and leaves the customer 102.50 a unit.
Yes, as negative differentiation value. Trials, requalification, retraining and stock write-offs are real costs to the buyer. In the illustrative case a one-off 100.00 a unit takes the parity price of 705.00 down to an EVC of 605.00. A seller who leaves it out quotes a ceiling the customer knows is too high.
When the benefits arrive over years, yes. Replacing 1 / life with the capital recovery factor at the customer's cost of capital spreads the price correctly. At 8 per cent the reference costs 759.83 a year rather than 710.00 and the EVC falls from 605.00 to 573.54, a difference of 31.46 a unit that grows with the length of the life advantage.
This article is one calculation from Pricing Strategy. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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