Excerpt from Get Your Price!: Value-Based Strategy for Capital Equipment Companies
It’s time to turn the concept of value into some hard numbers. In the preceding chapters, you learned three important value-based strategy principles:
- Capital equipment value is pure economics.
- The customer determines value.
- Value is relative to competing alternatives.
You are going to use these principles to develop a financial expression of value. It will be the foundation from which you
- Determine the market value of your equipment,
- Develop product strategies that produce compelling value propositions, and
- Develop marketing strategies that ensure customers pay you prices that reflect your value.
This financial expression of value is called the value metric.
Introduction to the Value Metric
Suppose a fix-’n’-flip real estate investor just bought a house that he intends to sell quickly for a profit. To fetch the highest-possible sales price, he decides that the house is going to need a fresh coat of paint. He wants to purchase the brand of paint that will produce the most profit for him. The financials of this investor’s paint purchase are shown below.
|Comprehensive Value Expression:|
|Delta House Price – [$Paint + $Labor+ $Other]|
|Delta House Price||= Increase in house price as a result of fresh paint|
|$Paint||= Cost of paint|
|$Labor||= Cost of labor to paint the house|
|$Other||= Other costs associated with painting the house|
The expression above is called the comprehensive value expression. It’s comprehensive because it captures all the economics of painting the investor’s house. It covers everything.
A comprehensive value expression is a financial expression that captures all the economics associated with a purchase.
As a paint seller, you are most interested in how this real estate investor is going to make his paint-purchasing decision. You need a financial expression that gets right to the heart of the matter. You want all signal, no noise. This can be derived from the comprehensive value expression by choosing only those factors that are both
- Critical to the buyer’s economics and
- Different between competing solutions.
Continuing with our example, suppose that the paint seller’s market research has revealed the following:
- All brands of paint have the same effect on the selling price of a freshly painted house.
- Nonpaint and nonlabor costs, such as paintbrushes and drop cloths, are insignificant and also not affected by the brand of paint selected.
- Available paint brands exhibit different prices and coverage per gallon.
- Also, paint brands vary in the coats required for full coverage, which affects labor costs.
From this data, you can see that not all factors in the comprehensive value expression are necessary to make the most profitable paint-purchasing decision. We can eliminate the change in house price (paint brand doesn’t matter), as well as other costs (insignificant and not different across paint brands).
After we eliminate these, the remaining expression is the value metric for this investor’s paint-buying decision:
|Eliminate factors:||Delta House Price – [$Paint + $Labor+ $Other]|
|Value metric:||$Paint + $Labor|
It’s true that the investor will make some additional profit as a result of painting the house before he sells it. It’s also true that there will be some other costs besides paint and labor. But according to the data in this example, these don’t matter to the paint-buying decision; only paint and labor costs do. Therefore, only these factors belong in the value metric.
The value metric a concise financial expression that expresses the economics of your customer’s buying decision.
Capital Equipment Value Drivers
Countless types of capital equipment exist. Each has its own specific use cases and target markets. However, capital equipment buyers do represent a market segment that we can clearly define. They are organizations that buy equipment to provide a service or to make, market, keep, or transport products.
All capital equipment buyers derive value from their purchases in a similar way. At the highest level, value drivers for capital equipment buyers are the same, whether they’re buying manufacturing equipment, bulldozers, or jet airplanes. These value drivers are shown in Table 8.
Table 8: Capital equipment value drivers
|Revenue/unit||Revenue that the buyer can achieve from each unit of the product or service that the equipment is used to produce|
|Throughput||The rate at which the equipment processes the unit|
|Yield||The percentage of good units that the equipment produces out of the total processed|
|Uptime||Percentage of time that the equipment is available for use and not in a repair or maintenance state|
|Operating costs||All costs associated with running the equipment, such as utilities, maintenance, and consumable materials|
|Capital expense||Equipment purchase price (or period depreciation expense)|
Capital Equipment Comprehensive Value Expression
From the universal value drivers above, we can create the comprehensive value expression for capital equipment purchases. See Figure 13.
Figure 13: Capital equipment comprehensive value expression
This comprehensive value expression describes the revenue that your customer can earn with your equipment, divided by the cost of producing that revenue. It captures all the gains and costs associated with a capital equipment purchase.
This expression is in the form of output over cost. You may recognize this as similar to the reciprocal of equipment cost of ownership, which is usually expressed as cost over output. The reciprocal is used here for no reason other than to make bigger numbers indicate more value.
Pay Attention to Units
The capital equipment comprehensive value expression and its simpler cousin, the value metric, represent actual economics. Therefore, these expressions must be in a form that an accountant would recognize. You have to pay attention to units.
Figure 14 shows the units of the capital equipment comprehensive value expression.
You’ll derive the value metric for your particular capital equipment product and target market from this expression. The numerator will end up being expressed as either $/Time or Units/Time, depending on whether the $/Unit factor is present after you reduce the comprehensive value expression to your value metric.
The place where you are most likely to get tripped up is in the denominator.
You just need to remember that operating costs are usually expressed over a period of time, most commonly on a per-year basis. If operating costs exist in your value metric, you must express equipment price in terms of period depreciation expense. For example, a $5M equipment purchase depreciated over five years would have a $1M-per-year depreciation expense. Expressing equipment price as period depreciation expense is necessary so that the units in the denominator match and can be summed.
In cases where operating costs do not make it to your value metric, you can use the actual capital expense (i.e., equipment-acquisition price) in the denominator. See Figure 15.
Figure 15: Capital equipment comprehensive value expression units with no operating cost in denominator
Without operating costs there, you don’t have to worry about expressing the acquisition price as a period expense. Just be aware that the value metric no longer expresses output divided by costs; it expresses output divided by capital expenditure.
This is a very common form of the value metric, and it’s the one you’ll see in the example we use throughout the rest of this book.
Six Steps to Create Your Capital Equipment Value Metric
The capital equipment comprehensive value expression is just a starting point for the capital equipment value-based strategy practitioner. It needs to be reduced to a value metric that expresses the economics of the buying decision for your specific capital equipment market segment.
To do that, just follow this six-step process:
- Start with all the value drivers in the capital equipment comprehensive value expression.
- Select the value drivers critical to the customers’ economics.
- Determine where meaningful differences exist among market alternatives.
- Keep only value drivers that are both critical and different.
- Never remove the price of your product.
- Ensure the result is a valid financial expression.
Value Metric Definition Example
Mr. Melty is the fictional piece of capital equipment that will be used to demonstrate value-strategy applications throughout the next several chapters of this book.
Mr. Melty is a multicrystalline silicon ingot growth furnace sold to silicon-wafer manufacturers who sell these wafers to photovoltaic (PV) solar-cell makers.
An ingot growth furnace turns polysilicon feedstock into PV-grade multicrystalline ingots. The polysilicon is melted at over 2,000°C. Then, it is slowly cooled to precipitate out contaminants and form a multicrystalline ingot. These ingots are later sliced into wafers that are used in manufacturing PV solar cells. See Figure 16.
Figure 16: Ingot growth-furnace operation (Images used with permission)
From the information above, it’s clear that an ingot growth furnace sold to PV-wafer manufacturers fits the definition of capital equipment. That means that you can use the capital equipment comprehensive value expression’s value drivers (step 1). See Table 9 for the description of each value driver as it relates to ingot growth furnaces.
Table 9: Value drivers for ingot growth furnaces
|Value Driver||Description for Ingot Growth Furnace|
|Revenue/unit||Material quality affects ultimate solar-cell efficiency and ultimately the revenue that can be derived from each kilogram of material produced|
|Throughput||The amount of material (charge size) divided by the time it takes to process it|
|Yield||The percentage of good material in each ingot produced; called mass ingot yield|
|Uptime||Percentage of time the furnace is available for use and not in a repair or maintenance state|
|Operating costs||All costs associated with running the equipment, such as crucibles, utilities, and maintenance|
|Capital expense||Furnace purchase price (or depreciation expense)|
Now suppose that after extensive engagement with the market that you have determined the following:
- The price that the PV-wafer manufacturer gets for each wafer has a big impact on his profitability. Material quality from ingot growth furnaces determines wafer pricing.
- The total output of each ingot growth furnace is very critical to the PV-wafer manufacturer’s economics. This means that the equipment must produce acceptable material, process it quickly, and be reliable.
- Melting the polysilicon consumes an enormous amount of electricity. It’s one of the largest costs associated with producing multicrystalline ingots.
Given this information, you are able to determine which value drivers in the comprehensive value expression are critical to ingot growth furnaces’ economics (step 2).
Continuing with our example, suppose competitive analysis has revealed the following:
- All ingot growth furnaces on the market produce the same-quality material.
- There are big throughput differences among ingot growth equipment suppliers.
- The amount of good material vs. scrap material produced from each furnace run also varies across equipment suppliers.
- All ingot growth suppliers use similar resistive-heating technology, so no meaningful electricity consumption differences exist.
- Equipment reliability across all suppliers is roughly the same.
From the above, you can determine where there are meaningful differences among ingot growth furnace suppliers (step 3). Now you are sufficiently armed to determine the value drivers that belong in the ingot growth furnace for PV-wafer manufacturers’ value metric (steps 4 and 5). See Table 10.
Table 10: Value metric construction for ingot growth furnaces for PV-wafer manufacturers
|Step 1||Step 2||Step 3||Steps 4 & 5|
|Value Drivers||Critical to Economics?||Major Differences between Suppliers?||Include in Value Metric?|
The last column in Table 10 marks the surviving value drivers that will constitute your value metric. To create it, you just have to eliminate all the others from the comprehensive value expression. See Figure 17.
In the case of an ingot growth furnace, throughput can be further refined as the charge size divided by process time. Also, we do not have operating expenses in the denominator, so we can use “Price” instead of depreciation expense. Figure 18 shows the final value metric expression.
The last step is to make sure the result is a valid financial expression for measuring the economics of an ingot growth furnace purchase decision by a PV-wafer manufacturer. No issues. Our value metric expresses the amount of material per unit time divided by the price paid to acquire the equipment. Your accountants would approve.
How to Determine Capital Equipment Market Value
For the capital equipment maker, market value is defined as the price at which your equipment produces the same economic outcome for your customer as the next best alternative in the market.
The market value of your equipment equals the price of your customer’s next best alternative plus your added value. See Figure 19.
Figure 19: Value-pricing model
The value metric makes it easy to calculate market value. To illustrate, let’s again turn to Mr. Melty. Suppose we know the following about Mr. Melty and its next best competitor. See Table 11.
Table 11: Mr. Melty vs. competitor’s value-driver performance
Given this information, you can calculate the market value of Mr. Melty by following these five steps:
1. Make two copies of the ingot growth furnace value metric.
2. Place them on either side of an equals sign.
3. On one side, enter all values for Mr. Melty except price.
4. On the other, enter all values for the competitor’s product.
5. Solve for Mr. Melty’s market value.
Figure 20 shows the result of taking these steps to calculate Mr. Melty’s market value.
Figure 20: Mr. Melty full market value calculation
Value-Based Pricing Defined
Value-based pricing can be thought of occurring at three different levels:
1. Price at full market value
2. Price higher than the reference competitor’s price but below full market value
3. Price at or below the reference competitor’s price
The value-pricing model in Figure 21 indicates these three possible pricing levels.
Figure 21: Value-pricing model with three potential value-price levels shown
The appropriate level for your value-based pricing will depend on the value your solution produces for the customer and your market share objectives.
In the scenario where you price your equipment at full market value, the customer’s economic outcome is the same whether he purchases from you or the reference competitor. Both your customers and your competitor’s customers would likely remain with their current supplier. You would not gain or lose market share if you priced here. This could be perfectly fine if you are already the undisputed market share leader and have no ambition to capture new customers.
Pricing higher than the market reference price but below full market value can produce market share gains if these two conditions exist:
- Your product performs better than the reference competitor on customer-value drivers.
- Your total value advantage (including price) is sufficient to attract your competitors’ customers.
Pricing below the market reference can also be a value-based price.
Consider a first-time novelist launching a three-book series. Even if the value of her books equals the value of those of more established writers, busy people will be reluctant to risk their precious leisure time on an unknown author. She must provide disruptive value to get attention. One way to do that is to give away the first book in the series to quickly establish a following. Once she clears that hurdle, she can then expect follow-on books to sell at prices closer to full market value.
The dynamic can play out in a similar fashion for equipment makers. Imagine that you are a new equipment supplier with no installed base. You’ve developed a new product that outperforms the current, well-entrenched market leader on the customers’ value drivers. Despite your performance advantages, your target customers are reluctant to team up with an unproven supplier. In this case, you might have to price your equipment equal to or even below the price charged by that entrenched competitor to secure your first few customers. Once you’ve proved your capability in the market, you could price your equipment closer to its market value.
These scenarios illustrate that value-based pricing can actually be any price that is a function of the value your solution produces for the customer and your market share objectives. Therefore, for the value-based strategy practitioner seeking more customers and higher prices
Value-based pricing is the maximum price that you can charge relative to market references for your added value and still achieve your market share objectives.
Don’t be Seduced by the Value Metric’s Simplicity
The mechanics of the value metric are deceptively simple. Don’t be seduced by this. The math is easy, but getting the definition right for your particular market requires keen insight into your customers and competitors.
Your value metric is the foundation for your entire value-based strategy. Cavalier value-driver selection will all but guarantee failure. Your value metric must truly reflect
- The buying behavior of your target market and
- A financial expression an accountant would recognize.
Otherwise, it will not work. Take the time to define your customers and your competitor as described in previous chapters. Use this insight to draft your value metric. Then, continually validate it with your target market to make sure that you have it right.