The Anatomy of Willingness to Pay: Part 1

The previous article in this series introduced the concept of Willingness to Pay as an effective approach to quantify and justify a higher price for your products and services in complex B2B sales. It can never be determined precisely, but you can certainly impact the range of acceptable alternatives to put you in a better position to negotiate a mutually acceptable price. If your goal is to move the WTP number as high as possible (and sustainable), the more you know about the factors that determine it, the more tools you will have at your disposal to shift the range, ideally before you show up at the negotiating table.

Ironically, while WTP is “real”, the actual number arrived at is the result of a complex and shifting combination of many different factors. In general, these factors fall into two main categories, economic and psychological. I express them this way:

(ECONOMICS) x (PSYCHOLOGY)

Or, to put it another way: hard vs. soft, tangible vs. intangible, objective vs. subjective, even System 2 vs System 1, etc.

ECONOMIC CONSIDERATIONS

Although willingness to pay is elastic, it’s not unlimited. The broad limits of its range have to be based on some real economic considerations. There is a “hard” core of value that exists and is the basis for a fair market price. That hard core begins with understanding how the customer will use the product to improve their situation.

Utility: In business to business sales, utility is the unquestioned number one factor that determines willingness to pay, because it is the fundamental reason that customers spend and invest, and it is often the factor over which you have the most objective and tangible control.

In economic terms, an asset is worth the present value of its differential cash flows. In plain English, that means that business buyers pay dollars in the expectation of getting more dollars in return, or preventing a greater loss.

The expectation of future cash flows is based on how the buyer uses what you sell[1] to either increase cash inflows or reduce outflows[2]. They do this by being able to be more effective—through some combination of more production, sales or higher prices—or by being more efficient, through using fewer inputs of labor, physical inputs or time.

Your customer may know exactly how to use what you sell to increase cash flow, but often the buyer is not the best judge of how to use your product to help them improve how they do business. It may be an infrequent purchase, or an unfamiliar new technology, or the purchaser may not be the actual user, so they are not experts in the use of it. Sometimes they’re not even aware of what your product can do for them.

That’s why you have so much control over the customer’s utility; you can be the expert who helps them use your product in the most efficient and effective way to realize maximum value.

Other Economic Considerations

Besides utility, there are other economic considerations that may affect the customer’s WTP:

• Economic/market conditions and expectations: Depending on whether the customer expects changes in supply and demand that will affect the trend of prices.
• Purchasing power: The rich always expect to get richer by being able to pay lower prices.
• Affordability: They may have real limits that affect their ability to purchase, regardless of their willingness.
• Purchase terms: Timing and amount of payments can affect affordability.

If we leave it at that, then it’s clear that:

WTP = UTILITY

Available Alternatives

If utility is the main engine affecting WTP, available alternatives can be seen as the brakes. To illustrate, imagine that you sell a product that is absolutely essential to the customer’s business. Without it, they could not run their operations, or even maintain a livable work environment. Clearly, it has tremendous utility to your customer, but there’s a good reason that you can’t get any price you want for it, because that asset is water. If you jack up the price, your customer can easily find a substitute. The range of available alternatives subtracts from the utility value.

Since water is readily available almost everywhere, let’s use a more appropriate example. Consider the computer screen you may be reading this on. In some ways, it’s priceless, because you would not be able to do so many of the things you do in your work and personal life without it. It’s the tool that gives you access to the internet and allows you to communicate with customers and friends. But its price is limited by competition. If the vendor raised up the price too high, you could easily find an acceptable substitute.

So, available alternatives are also a critical factor in determining WTP, but you have no control over what your competitors offer.

Maybe not, but you do have a lot of control over the perception and even the choice of available alternatives. To the extent that you can convince the buyer that one of your unique features has special and valuable utility, you can constrict the number of alternatives that are available to them. The other point is that there is a cost to finding available alternatives: it takes time, effort, some expense, and information. You may be able to raise the cost or perceived cost of finding alternatives.

Even when other alternatives can be found, the customer might have to deal with switching costs. They may have to make modifications to existing systems and processes, train people, rearrange space, etc.

So at this point, let’s summarize the economic factors that affect willingness to pay:

WTP = UTILITY – ALTERNATIVES

We could stop right here, assume that buyers are completely rational in their purchasing decisions, and we would have a rich set of levers available to influence WTP. But wait, as the late night infomercials tell us, there’s more! In the next article of this series, we’ll start unpacking the fascinating and complex psychology that’s at play when buyers decide how much they are willing to pay to buy your solution.