There are many approaches to pricing. These include cost-based, going-rate, target profit, cost-plus, and break-even approaches. When you think about it, all of these approaches to pricing a product are based on the company and its cost structure or on how the competition prices it products.
The Economic Value to the Customer (EVC) approach focuses instead on the customer and how the customer perceives the value of a product. With this view, the purpose of price is not to recover costs, but to capture the perceived value for the product in the mind of the customer.
One way to think about this concept is as follows:
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How much of the value-cost gap can you recover?
At the highest end of price is the perceived value of a product to a customer. This represents the price ceiling. Clearly, you can't price a product for more than a customer values it (except in perverse circumstances). At the other end is the price floor, and this is represented by the firm's costs. You won't want to price a product below costs (again, except in special circumstances, like when you have patient venture capital).
The question becomes how much of the gap between the perceived value and the costs you can recover? As you will see, this depends on a number of factors, including the prices of competitor's products and the extent to which customers have information.
Identifying the firm's costs is relatively easy, and one could (and should in many cases) use the variable costs of producing a product as the price floor. But how do you determine the price ceiling, or the EVC? A simple example will help illustrate this process.
DETERMINING THE EVC
Imagine you have a technology that perform a function. An example might be a splicing tool that joins cable together (think about your cable company that needs to repair breaks in their cables from time to time). With this tool you need to buy splicing rivets that are inserted between the cables and then the two cables clamped together via the rivet with the spicing tool.
Consider an old technology for doing this, and assume that the useful life of the splicing tool will allow for 16 splices. The lifetime costs to the customer consist of the labor to use the technology (assume this is $48) and the price of the splice themselves (assume this is $16 for the life of the splicing tool, thus the rivet cost $1 each). Assume for this example that the costs of the splicing tool is negligible (remember, this is an example).