Dr. Thomas (Tom) Nagle founded the Strategic Pricing Group (now part of Monitor Deloitte) in 1987 soon after publication of the first edition of The Strategy and Tactics of Pricing. For more than three decades, he has advised companies, primarily in B-to-B markets, on how to manage more profitably the five elements of pricing strategy: Value Creation, Value Communication, Price Structure, Pricing Policy, and Competitive Price Setting.
In this episode, Tom shares how value is perceived and measured by customers, emphasizing the distinction between economic value and willingness to pay. He also delves into the complexities of pricing negotiations, highlighting the importance of understanding customer perceptions and effectively communicating the impact of products or services on their business outcomes.
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Why you have to check out today’s podcast:
- Understand the intricacies of value-based pricing, distinguishing between economic value and willingness to pay, and providing real-life examples illustrating these concepts effectively
- Delve into these two critical decisions buyers make to help you better understand and influence customer purchasing behaviors
- Find out practical advice on handling price negotiations, emphasizing the importance of “gives and gets” and strategies to avoid undermining your pricing integrity
“Don’t ever believe what the customer is telling you upfront about what their value is. They may believe it, but they don’t know the impact.”
– Tom Nagle
Topics Covered:
01:29 – His early experiences with pricing influenced by his grandmother and how he got into pricing professionally
03:16 – How it is more effective to focus on market response to price changes and gather qualitative insights from clients than just precisely measuring elasticity
08:49 – Important thoughts on why pricing didn’t matter much then before its deregulation
11:28 – Explaining the concepts of value and value-based pricing with an example illustrating the point
16:56 – The need to create policies to maintain price integrity and managing negotiations to prevent undermining value capture
23:25 – Discussing the concept of value-based pricing and sharing an insightful example where a service’s value was evaluated against the status quo rather than a competitor
26:16 – Tom’s best pricing advice
Key Takeaways:
“The goal is not to try to put a line between them that’s a weighted average of the high prices and the low prices, and call it a demand curve. The goal is to figure out why we have all this variation and use that variation to create segments that eliminate the trade off between price and volume.” – Tom Nagle
“The value isn’t in the product. You can study the product from now until kingdom come, and you are never going to understand the value by studying the product. You have to study how the products’ benefits impact the customer’s income statement.” – Tom Nagle
People/Resources Mentioned:
- Financial Analysis for Profit-Driven Pricing: https://sloanreview.mit.edu/article/financial-analysis-for-profitdriven-pricing/
- Walmart: https://www.walmart.com
- DuPont: https://www.dupont.com
- Malcolm Baldrige National Quality Award: http://asq.org/quality-resources/malcolm-baldrige-national-quality-award
Connect with Tom Nagle:
- LinkedIn: https://www.linkedin.com/in/thomas-tom-nagle
- Email: [email protected]
Connect with Mark Stiving:
- LinkedIn: https://www.linkedin.com/in/stiving/
- Email: [email protected]
Full Interview Transcript
(Note: This transcript was created with an AI transcription service. Please forgive any transcription or grammatical errors. We probably sounded better in real life.)
Tom Nagle
Don’t ever believe what the customer is telling you upfront about what their value is. They may believe it, but they don’t know the impact.
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Mark Stiving
Welcome to Impact Pricing, the podcast where we discuss pricing, value, and the essential relationship between them. I’m Mark Stiving, and our guest today is the Godfather of Pricing, Tom Nagel. Here are three things you want to know about Tom before we start. He started out as a professor at Chicago and Boston University. He founded the Strategic Pricing Group in 1987. Many of you were probably not even born yet. He wrote the first edition of The Strategy and Tactics of Pricing in 1987. It’s now in its seventh edition. It’s like the Bible in pricing. And I taught an MBA class in the 1990s at Ohio State from the second edition of that book. It was fun. Welcome, Tom.
Tom Nagle
Great to be here, Mark.
Mark Stiving
Hey, it is going to be fun. I’m practically giddy if you want to know. So, let’s start with the basic question. How’d you get into pricing?
Tom Nagle
Yeah. Well, that’s interesting. First, as a kid, I had a Scottish-Irish grandmother who would take me and my cousin. And on Thursdays we’d check all the newspapers and she’d decide what we’re going to buy in certain places, and we’d run them around. So, this whole idea of the pricing was something important, came at a young age. But then what happened is that the timing was just perfect. I got my doctorate in 1978. And that was just at the time that massive amounts of the US economy was being price deregulated. Most young people these days don’t realize that we had a semi-socialist economy from the time of the Great Depression until the late seventies, early eighties. But prior to that time, telecommunications, prices were regulated, all transportation.
The government set the airline prices. They set trucking prices. they set the prices for long distance transport and pipelines. They set the price of natural gas. When these regulations came down, all these companies fought for this, and they said, oh, you, and we’re going to keep doing cost-plus pricing. What we’re going to do is, once we’re in authority, we’re going to all raise our prices. Well, that didn’t work out so well for them. And then there was this great interest in pricing, and at the University of Chicago then said, we’ve got to find an economist, because it has to be an economist. If you’re in Chicago, we have to find an economist to hire who will be a split between the econ department and the marketing department, and try to solve this problem to meet this demand for pricing experts. So, that’s how I ended up getting the job and starting to do that.
Mark Stiving
Was your PhD in economics?
Tom Nagle
My PhD was in economics. And you’ll see that in the first two editions of the book before I wised up. And not that the stuff I learned in economics was wrong, but that the stuff I learned in economics was far short of what was necessary to deal with this problem. What economists teach people to do and what they were telling me, the telecom phone company and the airlines and all of these others is, oh, you need to just, you need to go out and estimate your elasticity of demand. And when you have that elasticity, then Tom will help you optimize it because it’s simple mathematics. But what happened is, when I went out to talk to people, I found two things. Either they had a lot of data on demand, but they had never had much variation. So they really couldn’t draw from the data elasticity. Or they were in a situation where they just didn’t have data. Like when you look at trucking companies and things like that, they didn’t have the kind of data that was going to enable them to do this. So then the question became, well, what do you do? So, I come back and, they say, oh, well, you go out and you do demand estimates.
So I start investigating that and soon discover that when you try to estimate demand, it is not this stable thing that economists assume. It’s all over the map. It can be different from morning, day, and afternoon. It’s certainly different week to week. And the idea that you measure elasticity and then go out and put a strategy together for the year is a farce. So I’m really starting to worry about this. It’s like, I’ve got this job to do something, but I don’t really have the preparation to do it. So I start thinking about this and I’m talking to clients, and suddenly I realize you don’t have to have the elasticity of demand at a particular point if you have a lot of soft data, all you need to do is calculate what do you need elasticity to be?
How much do you need the market to respond to a higher price or a lower price in order to make a price move profitable? So I started using that with, I ultimately published an article on this with Gerald E. Smith and Sloan Management Review, and I think it was 1995. It was called Financial Analysis for Profit-Driven Pricing where what I’d do is go into a client and I’d say, okay, you’ve got this problem here, you need more volume here at this time when demand is slow. So maybe we want to think about a lower price. On this other time over here you have excess demand. Maybe we want to think of a higher price. But the question is, what sort of market response are we going to get? So let’s do a calculation. If we do this lower price, how much volume do you need to gain?
And amazingly, and then where are you going to gain it? Well, amazingly, all these people who say, I don’t know what my demand is, I don’t know what my elasticity demand is, suddenly know a whole lot. They’ll say, well if you’re going to, the sales reps can say, well, these guys I know will have to keep paying the higher price. But if we raise the price, but these guys here, I’m sure won’t pay it because they’ve got a different application and they start talking and you’re starting to get all this data, which isn’t quantified but it’s very well done. So that when once you’ve got all this data, you can go back and you can say, forget about a demand curve, which condenses all that information. When we look out in the world, there’s a cloud of different responses even from the same customer.
Sometimes they’ll pay a premium, sometimes they won’t. The goal is not to try to put a line between them that’s a weighted average of the high prices and the low prices, and call it a demand curve. The goal is to figure out why we have all this variation and use that variation to create segments that eliminate the trade off between price and volume. Because we’re going to give everybody a price that they’ll pay. Now, it’s not going to be everybody, it’s going to be by segment. But you start talking to these people, and when they say, oh, these guys will pay, why will they pay? Oh, because they never, they’re lousy planners so that they always need rush orders. Bingo, yes, I’ve got it. We’re going to have a rush order charge. Oh, well we already do rush orders but only for our best clients.
And I say, what do you charge? Well, we don’t because they’re our best clients. Well, why would you be giving away this valuable thing that causes them to pay higher prices to your best client? Oh, because they do lots of volume. Oh, volume, you mean the commodity that you’re selling. Yeah. And how much are your largest customers playing for that commodity? You can’t run your business on those margins. By just calculating what you need demand to be or your reaction to price to be you can then start these great discussions with a client that starts drawing out the segments that enable you to then move toward value-based pricing.
Mark Stiving
Yeah. And so if I were to articulate what you just said, you essentially said, look, you went into this thinking, hey, I’ve got to use economics and demand curves. And in the end, we focused on value and individual buyers, and where does each individual buyer get value from what we do? But what I’m really curious about, before deregulation, there were still a lot of companies that did pricing in a deregulated way. Why wasn’t pricing important before then?
Tom Nagle
That’s an interesting question that I’m not certain I can answer, but there was a research study by a guy, Lancellotti, in 1960, and it was to all business to business. It was all business to business companies. But he had a very large sample. And he said, what process do you use for setting prices? More than 90% of them said cost-plus. And this was like, how can this be? But I think back to the time, this was before the Japanese were eating the auto industry’s lunch. And you didn’t have these powerful grocery chains you have right now that could beat up on people. So you didn’t have a Walmart, things like that. So I think it was just a very different world post World War II. And companies needed to be facing competition before they realized that cost-plus was just not going to work.
Mark Stiving
Yeah. I think what’s funny though is, we’re many, many years beyond deregulation. And most companies say the words value-based pricing, but I still see a ton of cost-plus, especially in industrial and manufacturing.
Tom Nagle
Yep. But it’s cost-plus adjusted a bit for demand because those same people are doing cost-plus. Not that I think this is good, I hate it, but what I hear them saying, a client I’ve been working with and I’ve been trying, and I’ve been in a strong market, I’ve been getting them to raise prices to certain segments and they’re making more profit. And then you move into a more recessionary environment, demand falls by 10, 15%. And suddenly, and I’m hearing this guy say to his people, we’ve got to protect our share. We’ve got to meet our sales goals and I want to shoot myself. This is how Lucent, how they blew up Lucent, how he went like, 30 some quarters that always having hit his goal. And it’s like, I don’t care if there’s a recession, we’re going to hit our sales goal. And he destroyed the market for telephone switches.
Mark Stiving
Yeah. So first off, thank you so much. I love the history, I love the stories. Can we talk about some basic definitions? Because I often get into conversations with other pricing folks about basic definitions and I said this before the call, but I’ll say it to everybody else. If you and I disagree, I’m sure everyone’s going to believe you instead of me, but that’s okay.
Tom Nagle
Alright.
Mark Stiving
So first off, I want to define the words value and the words value-based pricing. And you could do it in whichever order you want.
Tom Nagle
No, no, that’s really important because it’s being used in two very, very different ways. So there’s a whole group of people out there who do fair value pricing and those models. And for them, value is pricing in proportion to product performance. The classic example is, O-rings that DuPont was making with or DuPont was licensing someone to make with Kevlar. And those O-rings were so much better, say, they’re three times as durable as what was available before. So, the fair pricing people, these people who do that performance-based pricing would say, well, if they have three times the performance, three times the durability, they should have, the fair price should be three times as much. And that whole concept has been widely adopted by like the hospital buying groups. That’s how they evaluate suppliers. The Defense department evaluates suppliers that way and the Malcolm Baldrige Award evaluates suppliers, are they doing good value because their prices are proportional to performance.
Mark Stiving
But there’s so many different performance characteristics that you could use.
Tom Nagle
Right, and you can wait. They go to customers and they say, okay, what are all the performance characteristics? Take a hundred points, apply weights to them. Then our engineers will evaluate our product versus each of the competitive products and tell you relative to that competitive alternative what your price should be based on performance. The problem with this is it has nothing to do with value and it’s wrong. So think about the O-rings again. So now you have to replace the O-rings. So therefore the money you were going to spend on the inferior O-rings now, you’ll spend three times as much on an O-ring with Kevlar. But now, take a look in, well, according to that model of prices related to performance. If DuPont’s charged four times as much or five times as much, they shouldn’t get any sales. Well, it turned out they got a lot of sales at like five times as much when the product was only three times. Now why would that be? You’re a smart guy, Mark, why would that be?
Mark Stiving
I’m guessing there are things like the maintenance to change the O-rings. There’s a lot of overhead involved, and each time we have to replace an O-ring, the failures when an O-ring fails, the cost of the failure.
Tom Nagle
And having to shut down the plant in order to, so the plant is down while we’re replacing. So we’ve not only replaced having to buy three inferior O-rings, we have at the same time given the plant more uptime and reduced a bunch of labor costs that we have to have to replace the O-rings. So, the point of this and what these people miss and it tends to be companies with a real engineering mentality. What they miss is that the value isn’t in the product. You can study the product from now until kingdom come, and you are never going to understand the value by studying the product. You have to study how the products’ benefits impact the customer’s income statement. You have to show me where on that income statement, I’m either reducing the customer’s costs or driving revenues for the customer.
And if I’m not doing one of those two things, then I don’t have value. If I do, I could have a lot more value. Now, the other thing that’s really interesting to observe, that example I just gave you, it turns out there are multiple segments for the O-rings. There are the people who are operating very close to capacity. So for them, that’s really valuable. The ones who are shut down for a week every month, anyway, because they don’t have enough volume on that line, it doesn’t matter. So now, you’re getting these very differences in value across different segments. So, what do I consider value? I think in terms of, and as I stated in the book, economic value where there are two parts to the value. One is the commodity value, which is what you would’ve paid for the commodity O-rings instead of ours, which is three times as much.
Mark Stiving
And that commodity you can get just by looking at market prices. You don’t have to do a study with the customer other than find out what the customer’s best alternative is, but it’s that other value. It’s that keeping the plant operating, not needing labor to deliver that you don’t have to pay for the commodity product. You would’ve to pay for the commodity product. You don’t have to pay for ours. And that’s the differentiation value. And that’s the thing we have to try to figure out how we can capture in our pricing.
Mark Stiving
I absolutely love that story. And so one of the things I often say is that in B2B, which is what we’re talking about here, right? In B2B, value is measured in incremental profit. So how much incremental profit are we making our customers when they buy and use our products?
Tom Nagle
Exactly.
Mark Stiving
So that was beautiful. But I don’t think I’m done with value yet because here’s an argument that I would make. Value could be incremental profit, but value could also be what’s the buyer willing to pay? So if you could convince them that they’re going to make another million dollars, they’re not going to pay you a million dollars, right? So how much do they value your product?
Tom Nagle
Yes. And I have to admit that is a squishy thing. because what I would do with a client is I would say, okay, what’s that performance-based value? And that should be your floor. What’s the economic value that should be your ceiling? Now, let’s try to understand, some customers are very close to the ceiling. Many more of them are very close to the floor. How can we move them from that floor and capture a reasonable percentage of that economic value? Because if we could somehow guarantee with a hundred percent certainty that they’d get that impact on their income statement, we’d have almost everybody at 90% of the value going into our pocket, but it’s not.
So what we have to do is understand why that customer is hesitant? Well, the customer’s hesitant because you can make all the promises you want, but despite your promises, it may still fail. And this is going to blow back on me, so I’m not going to pay you for promised economic value. Oh, okay. So, they need an ironclad guarantee. Now what? So, what we do, we test. What does a guarantee do to them and this is where I would use something like a conduit. What does a guarantee do to their willingness to pay? Then they come back and they say, oh, and there could be something entirely different. They know what the economic value is, the purchasing person knows what it is, but he also knows that he has other friends in the purchasing business.
And when he is at a conference, they talk about how they hammer the suppliers. And he knows that if he just says, no, he’s going to get a better deal than if he rolls over and says, oh yeah, I see the value. And so because we’ve educated him that people who are more resistant get better prices than people who are less resistant. So what we have done is just killed our ability to capture economic value, and created a set of policies on how to deal with the purchasing person who’s pushing back. And when the purchasing person says, I like your deal. But I’m going to have to have, we have a goal to take 5% out of cost this year, I have to have 5% lower costs. And the sales rep…
Mark Stiving
You got to sharpen your pencil.
Tom Nagle
Yeah. Sharpen your pencil. And if the sales rep says, well, I don’t have the authority to do that. I have to go talk to my boss. And he may have the authority, but if not, he’ll talk to his boss and I’ll see what I can do. Your sales rep has just totally shot your ability to capture value because you’ve told him that you have a process for giving people a better deal. The question is whether you are going to get it. And if you say to come back and say, he isn’t going to get it, I guarantee you he’s going to call his friends, find out what they’re doing differently and say, oh, I get it. And then he is coming back, and the next time you go in, he’s going to say, and this has happened.
The next time the sales rep goes in, he’s going to say, you can now bid for only half our business. We now have a new rule, a second supplier. Why? Because everybody he called where there was a second supplier was getting better prices than he was getting. So we need to set that up. And the question then becomes, what should the sales reps deal with? The sales rep should say, oh, but only if we’ve had had some price integrity along the way where we don’t give people the same product and same service level and lower price, but if we haven’t been doing that, now when the guy says he wants a lower price, you say, oh, okay.
There are some people who get lower prices, but let’s talk about, you do a lot of rush orders, and we’ve been letting those go by. Now, if you gave us orders 30 days in advance, I can go back and make an argument that that would justify that 5% lower price sheet. Well, I’m not sure I can do that. Well then, we’ve got a problem, right? What can you do? And then you start working with the purchasing agent on what the trade-offs are going to be. And what he gets educated in is, there has to be a point where I don’t push this because every time I ask for a price concession, I have to get in this whole discussion about what we’re going to give up. And I have to negotiate that with the people down on the plant floor and everything else in order to, and that is a pain in the butt. So now, we’re giving him a reason not to keep pushing back.
Mark Stiving
Yeah, I think that’s brilliant. We always have to have the gives and gets, right? Salespeople always have to get something when they’re going to give a discount. Always.
Tom Nagle
Yes. But not a lot of companies realize. I’ve actually walked in, had situations where we have our most important negotiation with our packaging supplier, and we only have one pack, and we’ve got enough and we want you to come and work with us. So I get there and they say, well, let’s give you some background in preparation for this meeting. Our sales rep went out and asked the sales rep what he needed? And he says he needs a 5% concession this year. So that’s what we’re starting and they’ve already blown it up. It’s like, oh my God.
Mark Stiving
Yeah. It’s tough when you have the big contracts and don’t, we as in our clients don’t talk about value when they’re not having these negotiations. What’s the relationship look like? What have we done for you over the course of the last year? And so we miss that.
Tom Nagle
And very often the purchasing person who, because that’s who we communicate with, we think that’s the buyer. And very often the purchasing person has no idea how the product is used and has no idea what the differential value is. He’s been told over the years, we’ve always been happy with Acme. We’ve had trouble with other people buying Acme, but get it at the best possible price. And that’s what he’s doing. And you have to force him to go back and do one of two things. Either he has to educate himself or he has to allow us to go back and talk to those people on the plant floor or whatever, and get them to make a recommendation and whatever.
Mark Stiving
Yeah. Tom, we’re going to run out of time, but I really want to ask one more question before I get to the last question. What is, in your mind, what does value-based pricing mean? And let me set it up. I know that you teach EVE, and maybe someday we’ll have a chance to talk about EVE and some nuances of that, but is it always relative to a competitor or can it be relative to the status quo? And I think of that as willingness to pay more than I think of it as the next best alternative.
Tom Nagle
Mark, that is really insightful, because I will tell you that recognizing that it doesn’t have to be the competitive alternative, which is what my book will say. But recognizing that it doesn’t have to come about just like four or five years ago when I’m doing this program for a company. We did a bunch of training, and then they all had to go away and do an EVE and this one guy, like, I’m sympathetic to him because he’s got a commodity and I’m thinking, how in the world? But it’s a commodity service that we do for him every three years and it’s budgeted by finance for every three years. And he did an EVE to say, what’s the economic value of doing it every two years versus every three years? Still with us. So, our own service was the identical service, just doing it every three years rather than two years.
And he created this beautiful EVE, corporate finance said, no, we only do this every three years, but the local store managers who were responsible for year to year increases in or decreases in sales they took some of their discretionary money and paid to get it every two years because we had demonstrated to them the impact of of having this done every two years on the stores. It was just a great example. So, I agree with you now. I wouldn’t have agreed with you until he pulled this off. That was great.
Mark Stiving
Nice. So I often think of that as, I say the buyers typically make two decisions. First one, am I going to buy something in the product category? And then they say, okay, yes, which one am I going to go buy? Yeah. And so when they’re making that ‘Will I’ decision, it’s an inherent value. What’s the value of solving the problem? And when they’re making the “Which One’ decision, it’s what’s the value relative to the alternatives?
Tom Nagle
Very nice. Like that.
Mark Stiving
And sometimes buyers only make a ‘Will I’ decision, right? So popcorn at the movie theater is a ‘Will I’ decision. Last gas in the middle of the desert is a ‘Will I’ decision.
Tom Nagle
Right, because there’s really the extra value of the station that’s right here versus the one that we might make it to at the other end of the desert.
Mark Stiving
Exactly. Right. It’s just too high. And so if we try to do value-based pricing on those, then I look at it as what’s the value of solving the problem, whether that’s economic value or willingness to pay, what’s the value of solving the problem?
Tom Nagle
Yes. That’s a situation where essentially it’s nearly a monopolist.
Mark Stiving
Yeah. Nice. Tom, I am having so much fun. I could do this for an hour or more, but we’re going to have to start wrapping up. Final question for you. If you could give one piece of pricing advice to our listeners, what would it be?
Tom Nagle
Wow. I would say, don’t ever believe what the customer is telling you upfront about what their value is. I’m not saying they’re lying to you. They may believe it, but they don’t know the impact. Like this assumption that we just need to survey the customers because they know the impact of our product in their business. They don’t, they only know the impact when it’s not there. But if you really want to understand the impact, you have to educate them unless of course they’ve been repeat buyers for years and years and years and they’ve been through having a situation where it wasn’t there.
Mark Stiving
Yeah, I think that’s absolutely perfect. And in fact, even buyers who have used your product for a long time probably don’t use it completely and perfectly well. There’s probably value that they’re not picking up in places. Because we haven’t taught them how to do it or held their hand while they did it. Yeah.
Tom Nagle
Mark, this has been wonderful fun. I’ve enjoyed it.
Mark Stiving
Oh, thank you, Tom. I really have as well. If anybody wants to contact you, how can they do that?
Tom Nagle
Mark Stiving
We’ll certainly have that in the show notes as well. And to our listeners, thank you for your time. If you enjoyed this, would you please leave us a rating and a review? Send me a note that says you want to have Tom back, and I’ll invite him back and see if we can get him to come back. Finally, if you have any questions or comments about the podcast or pricing, feel free to email me, [email protected]. Now, go make an impact!
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