Organizational Performance Part 42: Managing Workflow at the Operation Level | Operational Excellence Quick Hits

Quick Hits share weekly tips and techniques on topics related to Operational Excellence. This week’s theme relates to managing workflow at the operation level. We hope you enjoy the information presented!

In this session, we’re going to continue on the theme of change in mindset in order to get breakthrough improvement in the organization. And today’s topic, we’re going to talk about price and a relationship to cost. A lot of organizations believe that they need to determine the cost of their product or service, and based on that cost, they come up with the price. So, they’re using a cost plus pricing model and the price that many people associate with the product or service is determined by the labor cost that goes into it, material costs, delivery costs, any direct related costs, plus some overhead costs that are usually a percent of direct labor. So, we take all those costs and we add some margin and that’s the price we need to charge to the market to make a profit. We really want to look at it from a value perspective and what value is, it’s the benefit that someone receives from acquiring a particular good or service.

If we look at value, it’s quantified by someone’s willingness to pay, usually measured in some currency. Of course, there’s a market perception and then what people are willing to pay might be different things distinct from market value, which can be higher or lower, depending on other factors like perception of value and market supply. So, if something’s in short supply, of course its value is much higher. If it’s in not short supply, its value might be lower. But what is perception of value? So, it’s a customer’s own perception or desirability to them, especially when comparing to a competitor’s product.

Perception of value is a component of price, what the market is willing to pay for a good or service. Customers perceive value as based on a notion of expected benefits that it will bring by acquiring that product or service. So, value is all about the benefits that it brings to the customer.

So, I want to look at this graph. And we have the graph on the horizontal access, we have perception of value and on the vertical access, we have the number of perspective customers. And we don’t know what this graph looks like, but I just drew this graph here because one thing that we do know, if there’s zero perception of value, there’s probably very few customers or no customers. And also, as the perception of value gets larger and larger and larger, the number of perspective customer that see that value gets less and less and less. So, it starts out small. It grows to some level and then starts to decline as the perception of value gets higher and higher and higher.

So, let’s look into the insights of perception of value. What are some of the insights? So, someone who thinks a product or service value is zero is not a prospect. Also, someone who thinks a product or service has infinite value doesn’t exist. No one believes that any product or service has infinite value. By establishing a price, this identifies the need and the magnitude of the need. So, maybe you don’t know it, but when you establish the price, you automatically segment the market. And what do we mean by that? Let’s take the graph that we had here of the perception of value. And let’s just say, we establish the price here. So, when we establish this price, you automatically segment your market into three groups. The first group, if we just draw this line someplace at a lower perception of value, the first group is going to be this group here where the prospects that don’t buy.

So, they’re going to say, “There’s no way I’m paying that price for that product or service because it doesn’t bring me that’s much value. So I’m not even going to buy.” So when you set the price, there’s prospects that believe, “Oh, that’s way too expensive for the value it’s going to bring to me.” Then there’s a second group here. That’s prospects that complain, but they probably will buy. So they’re like, they don’t like to pay that price, but it does bring some value to them, but they buy it and say, “Geez, it’s like, man, that company’s expensive, and I’m probably not going to buy from them unless again, they bring me more value.” And then we have a whole nother group up here that our prospects that are willing to pay more, but they say, “Oh, this is a great deal, so I’m going to or buy at this price because it brings me huge benefit for that price.”

So when we do this, we have these three groups, and we have this group here that if we could understand their needs and package our product or service in a way to provide more value, we could charge more and get paid more from these customers that are willing to pay more. So, how do we capture these different markets? Price has a big influence on how much value we’re going to get from the market. If we can raise that perception of value, of course we can bring in more prospects. So, let’s talk about value and price. Value is only meaningful when expressed in terms of a specific product or service, which meets the customer need at a particular time. At one time, someone might be willing to pay more and another time they might not. It depends on the specific circumstances. So, the degree to which the organization meets the customer needs defines the value that the organization provides.

Price is determined by how much the customer’s willing to pay based on that level of value that the product or service provides at a specific point in time. Price has nothing to do with the cost. The customers don’t care about your cost. So, the key here is to understand the value and the price that you want to charge, and what’s the market segmentation look like when you establish that price. And then, how can you capture more market share from the different prospects in your market? And if we look at the value/cost trade-off, the value/cost trade-off is the view that a company has of a choice between creating more value for its customers, but a higher cost or a reasonable value for customers at a lower cost. A great example of this in history was IBM. And so, at for Future State Engineering, we say, why not both?

Why can’t we get great value for customers that are willing to pay a higher cost and reasonable value for customers that want a lower cost? And IBM was a perfect example how they segmented the market. What they did is with their AS/400, they had one high-end unit. And what they did is they reduced the speed of that unit to different market segments, so the customers that didn’t need high speed, they sold the product at a lower cost and gave them less performance. The customers that wanted a medium speed and didn’t want to pay high-end cost, they gave them more speed, but at a higher price than the low price product. And then they had the high-end user that they could charge a higher price and capture that market. And they segmented the market and gave three different levels of value for the same product.

So, think about your own organization. How can you take the same product and offer it at different value points to the customer so you can charge different prices based on the value that you bring to different markets?

That’s our session for today. The paradigm shift: cost has nothing to do with price. Companies that get crazy about trying to figure out what their costs are so that they can determine what to price their product, but the customers don’t care about the cost. All they care about is the value that it brings for that price. In next week’s session, we’re going to talk about the mindset of in order to increase profitability, we need to increase the margin in our products.