Deconstructing the value function.
Whether you are a business owner or you are an employee for a company, a lot of your time would be spent in addressing the above question. We need to know this because we would like customers to buy more of our product and to fix problems if customers start buying less. There are many tactics real companies use to address those problems: discounting, advertising, public relations, engagement activities and so on — but because they are tactics there are situations where they work and those where they don’t. In order to increase one’s success rate above pure chance, one has to have an underlying theoretical basis from which the appropriate tactic can be derived. This post offers one such theory of the value function.
A value function is a function with which people as consumers consider the value of buying — which is to exchange hard-earned money for a product or service. We know instinctively that this function exists because we buy things all the time and presumably there is some sort of logic that we use to make that decision, yet it’s harder to define it precisely.
The Value Function
So for a naive version of this value function, one might write it as such:
Net Value = Perceived Offering Value — Obtaining Cost
If net value is positive then a person will buy the offering and if it is negative they will not. If there are multiple offerings, they will buy the one with the most positive Net Value. Simple. Except it isn’t. There are some problems that prevents companies from simply manipulating this function to achieve more sales.
- Perceived Offering Value constantly changes
This is the most straightforward conclusion one can draw from the value function. Cost to obtain a particular good/service tends to be similar in a market at a particular time. The price of a bottle of Coke in a supermarket is the same for anyone who wish to buy there, yet not everyone who enters the supermarket buy it. Therefore it can be concluded that the perceived value of a bottle of Coke is not the same for each supermarket goer. More to the point, if you’re thirsty you might buy that bottle of Coke but after you drink it you might not be inclined to buy a second bottle even though the product and price are exactly the same.
2. Obtaining Cost is more than price
Companies can set the price at which they offer their products, yet monetary price is but a single factor in determining Obtaining Cost. We can define Obtaining Cost as anything one must spend in to get from the point of need to the point of consumption. In addition to offering price this includes the price of transport to the relevant market, the value of time they spend in doing the transaction, the value of the physical or mental effort the transaction needs, etc. To simplify we can put all of these disparate costs into a single term, transaction cost. Obtaining cost is therefore transaction cost + offering price. In a theoretical efficient market transaction cost would be zero, but in the real world it never is.
In order to generate sales, companies must figure out a way to deploy their resources to solve one or both these problems so as to maximise the Net Value figure for as many customers as possible. Therefore the smart company needs an understanding of their perceived offering value and obtaining cost in order to design initiatives to affect each one. In this article I will look at the first problem of perceived value.
Increasing Perceived Value
One might read the term “Perceived Value” as value that is “not real” but it is very real. It’s just that it is multidimensional and subjective. It is why a single initiative to increase value will not work for every customer. The whole domain of Marketing is focused on how to transmit as much perceived value as possible out of a product, hence the focus on segmentation and communication strategies. However, marketing efforts tends to happen after the product is on the market so there’s a limit on how much value can be added through it. Ideally, the value addition should happen from the start through product management.
One of the best theories that I know on understanding how customers value products differently is the Jobs to be Done framework put forward by Harvard professor Clayton Christensen. He posits that instead of traditional segmentation in which a product’s value is the same for all members of that segment, a product’s value is determined by the its suitability to do the “job” that the customer is hiring it for.
A bottled water can have many jobs
Let’s take for example a bottle of drinking water. How can segmentation help in increasing value of drinking water? Everyone needs drinking water — is anyone more likely to buy if a company sells Water for Men, or Water for Children? They can try, but if the branding effort does not translate to more sales or sales at higher prices than generic drinking water then why bother?
In actual fact higher priced drinking water does exist and they are good business. How does expensive water make sense in a market where lower priced alternatives exist? It can only be that there are some jobs that necessitates the attributes that expensive water have. For example one might need drinks to serve to VIPs in an important meeting. In this case the bottled water’s job is not only to quench thirst but also to project an aura of sophistication to the event. For the former job a generic plastic bottled water might suffice, but for the latter only a premium brand with fancy glass bottles will do. The customer is not the difference maker here — the event organisers or the VIPs themselves will also happily choose lower-priced water if their job to be done is to quench thirst after a run.
Therefore in order to maximise value a company has to consider:
- What jobs does the product get hired for?
- What attributes are the customer considering in order to select products for doing each job?
If you want more in-depth material in order to do the above analysis I highly recommend The Innovator’s Solution by Clayton Christensen and Jobs to be Done: A Roadmap for Customer-Centered Innovation by Farber, Wunker, and Wattman. For this article I want to focus on a different question: Given a set of attributes that we can improve, how can we select the optimal attributes to improve that will lead to the customer’s willingness to pay higher prices?
Let’s dissect this: If there is a specific subset of attributes that we should focus on, it must mean that each attribute satisfies different dimensions of the job and the customer has different price sensitivity on the improvements on each attribute. In simple terms, a customer will want to pay higher for improvements in attribute A, while not so much on attribute B assuming the same level of increase. For example, a car has the attribute of quickness and fuel economy. Should we make a car 10% faster or 10% more fuel-efficient? That depends on whether the car is hired for racing or day-to-day transportation.
How to determine the price sensitivity that the customer will have for an attribute? For existing products, historical market data. Simply compare the sales data for products that perform the same job and see what attribute advantage does the highest-selling one have. For new products or products in which the market is not yet mature, the differentiating attributes might not be easily spotted.
To predict what attributes the customer will be willing to pay more for I propose using Maslow’s hierarchy of needs framework.
A job can be thought of as fulfilling several layers of needs in Maslow’s hierarchy.
Any job a customer hires a product for can be expressed on the dimensions of fulfilling these many needs. The more levels a job entails, the more valuable is that job for the customer and they will be happy to pay higher prices for them. Why are they willing to pay higher prices? Because as you go higher the job gets more specific — less people will have them and less products can fulfil the requirements for that job. A job might not involve every layer in the hierarchy but it remains that improvements in a higher layer will be more highly valued.
For example, let’s look at the various jobs a sneaker might be hired for.
Different jobs have different main attributes that satisfy a need layer
As you go higher up the hierarchy price sensitivity lowers and the customer has less and less knowledge of the degree to which the product fulfils the need. It’s easy to tell if your feet is adequately protected, but can you tell exactly how high a sneaker lifts your self-esteem? As the difference between degrees of fulfilment gets harder to tell, difference in price also gets harder to judge accurately. This is where branding comes in. People associate brands with those harder to judge higher attributes. This is why we pay for brands — they represent a simple heuristic to search for products that solve our higher level needs.
Should companies then go straight to addressing a higher need layer at the expense of lower ones? They might do so at their peril. A premium water brand with a fancy bottle design will not sell if it turns out that the water contained within is not safe for consumption. No, they should figure out the level at which any lower would be a deal breaker for that layer. After that level has been surpassed, only then can they consider satisfying a higher level need.
To summarise, to effectively maximise the profitability of their products companies can do the following:
- List all jobs their product is being hired for.
- Elaborate their product’s value for that job by listing which attributes satisfy which needs layer in Maslow’s hierarchy.
- Increase perceived value by focusing on improving attributes that satisfies a higher need layer.
There are still many things of interest that rise as a consequence of the value function such as its effects on market competition and the role of technology in perceived value. I also haven’t addressed the second part of the equation which is Obtaining Cost and how to minimize it. There’s also how can one design experiments to test improvements in perceived value. Yet this post has gone well past the 7 minutes mark so I will address those points in future posts.
Thanks for reading and I’d love to hear your thoughts on this. Connect with me on LinkedIn or shoot me an email at jendra -at- gmail.