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Step 3: Use Activities to Analyze Relative Willingness to Pay

The activities of a firm do not just generate costs. They also (one hopes) make customers willing to pay for the firm’s product or service. Differences in activities account for differences in willingness to pay and hence for competitive advantage and differences in profitability. In general, it appears that differences in willingness to pay account for more of the variation in profitability observed among competitors than do disparities in cost levels.²⁶

Virtually any activity in the value chain can affect customers’ willingness to pay for a product.²⁷ Most obviously, the product design and manufacturing activities that influence physical product characteristics—quality, performance, features, aesthetics, durability—affect willingness to pay.

Consumers pay a premium for New Balance athletic shoes in part because the firm offers durable shoes in hard-to-find sizes. In fact, by avoiding deals with superstar athletes and publicizing that its shoes are “endorsed by no one,” New Balance actively emphasizes to consumers that they should pay attention only to the physical characteristics of its shoes.

More subtly, a firm can boost willingness to pay through activities associated with sales or delivery—the ease of purchase, speed of delivery, availability and terms of credit, convenience of the seller, quality of presale advice, etc.

In the 1990s, for example, the catalog florist Calyx and Corolla commanded a premium because it delivered flowers faster and fresher than most competitors did.²⁸

Activities associated with post-sale service or complementary goods—customer training, consulting services, spare parts, product warranties, repair service, compatible products—also affect willingness to pay. For example, American consumers may hesitate to buy a Fiat automobile because they fear that spare parts and service will be hard to obtain.

Signals conveyed through advertising, packaging, branding efforts, etc. also play a role in determining willingness to pay. Nike’s advertising and endorsement activities, for instance, affect the premium it commands. Finally, support activities can have a surprisingly large, if indirect, impact on willingness to pay. The hiring, training, and compensation practices of Nordstrom create a helpful, outgoing sales staff that permits the department store to charge a premium for its clothes.

Ideally, a company would like to have a “willingness to pay calculator”—something that tells it how much customers would pay for any combination of activities. For a host of reasons, however, such a calculator is virtually always beyond a firm’s grasp.

Willingness to pay often depends heavily on intangible factors and perceptions that are hard to measure. Moreover, activities can affect willingness to pay in complicated (i.e., nonlinear and non-additive) ways. And when a business sells to end-users through intermediaries rather than directly, willingness to pay depends on multiple parties.

Lacking a “willingness to pay calculator,” most managers who analyze relative willingness to pay do so in a simplified manner. A typical procedure is as follows. First, the managers think carefully about who the real buyer is.   This can be tricky.   In the market for snack cakes, for instance, the immediate purchaser is a supermarket or convenience store executive. The ultimate consumer is typically a hungry school child. But the pivotal decision maker is probably the parent who chooses among the brands.

Second, the managers work to understand what the buyer or buyers want. The snack cake-buying parent, for example, selects among brands on the basis of price, brand image, freshness, product variety, and the number of servings per box.²⁹

The supermarket or convenience store executive chooses a snack cake on the basis of trade margins, turnover, reliability of delivery, consumer recognition, merchandising support, and so forth.

Marketing courses discuss ways to pinpoint such customer needs and desires through formal or informal market research.³⁰ It is important that such research identifies not only what customers want, but also what they are willing to pay for. Moreover, the research should reveal what the most important needs are and how customers make trade-offs among different needs.

Third, managers assess how successful they and competitors are at fulfilling customer needs. Figure 9 shows such an analysis for the snack cake market. The analysis helps us understand both the statics and the dynamics of the marketplace.

Betsy Baking stands out on an attribute that customers value highly, low price, while Collins is superior on none of the customer needs. This helps us understand the large shifts in market share. Ontario Baking enjoys the best brand image—a position it has paid for via relatively heavy advertising and promotion. (See Figure 8.)

Savory Pastries delivers the freshest product, reflected in its high manufacturing and raw materials cost. Further analysis, not carried out in the snack cake example, can assign dollar values to the customer needs. For example, it can estimate how much a customer will pay for a product that is one day fresher.

Fourth and finally, the managers relate differences in success in meeting customer needs back to activities. Savory Pastries’ high score on the freshness need, for instance, can be tied directly to specific activities regarding procurement and selection of ingredients, manufacturing, and delivery.

At this point, managers should have a refined idea of how activities translate, through customer needs, into willingness to pay.

They also understand how activities alter costs. Now they are prepared to take the final step, the analysis of different strategic options. Before we move on to that step, however, we should highlight some guidelines concerning the analysis of willingness to pay.

A major challenge in analyzing willingness to pay is narrowing the long list of customer needs down to a manageable roster. In general, needs that have little effect on customer choice can be ignored.

Needs that are equally well satisfied by all current and contemplated products can usually be neglected. If the group of competing products plays a small role in satisfying a need relative to other products outside the group, the need can often be removed from the list.

So far, we have treated all customers as identical. In reality, of course, buyers differ in what they want and how badly they want it. Some customers in a bookstore want novels while others look for business books. (This type of disparity, in which different customers rank products differently, is known as horizontal differentiation.)

Among those customers who want J.K. Rowling’s new Harry Potter novel, some are willing to pay for the hardback edition sooner while others will wait for the less expensive soft-cover version. (Vertical differentiation arises when customers agree on which product is better—the hardback edition, now—but they differ in how much they will pay for the better product.)

The analysis of willingness to pay is trickier, but more interesting, when customers differ in their preferences. The usual response is segmentation: one first finds clumps of customers who share preferences and then analyzes willingness to pay segment by segment.

In our experience, firms that identify segments pinpoint between two and twelve clusters of customers. The more diverse are customer needs and the cheaper it is to customize the firm’s product or service, the more segments a firm typically considers. Some observers have even argued that companies should move beyond segmentation to embrace mass customization.³¹

In this approach, enabled by information and production technologies, companies begin to tailor their products to individual customers. Thus, Blinds to Go receives up to 20,000 custom orders for window blinds and shades per day, and it promises to process each order within 48 hours. New approaches to customization have enabled it to build up a business with more than $100 million in revenues and 20% net margins.³²

Finally, we want to emphasize the limits to analyzing willingness to pay. In some settings, it is possible to quantify willingness to pay quite precisely. For example, when a firm provides an industrial good that saves its customers a well-understood amount of money, it is relatively easy to calculate willingness to pay. (Think of the Harnischfeger example.)

Calculations are much more difficult, however, when there is a large subjective component to buyer choice, when customer tastes are evolving rapidly, and when the benefits the customer derives from the product are hard to quantify. A wide range of market research techniques—surveys, hedonic pricing, attribute ratings, conjoint analysis, etc.—are designed to overcome such problems.

We remain leary, however, especially when the market research asks people to assess their willingness to pay for new products that they have never seen or for the satisfaction of needs that they themselves may not realize they have. Fine market research “proved” that telephone answering machines would sell poorly, for instance.³³ In some settings, creative insight may have to replace analysis. In all settings, analysis should serve to hone insight, not displace it.