What is value-based pricing?
If you’ve ever tried to sell a car, a house, original artwork or secondhand goods, you’ll have discovered that they’re only worth what people are prepared to pay for them.
This is the principle behind value-based pricing: it’s a strategy that businesses use to price their goods and services at an amount they think customers are willing to pay.
The most famous example of a successful value-based pricing campaign was created in 1947 by advertising agency NW Ayer for the De Beers diamond company.
The price of diamonds had plummeted through a series of pre-war and postwar economic slumps, and NW Ayre was briefed to make them desirable again.
With the genius slogan, ‘A diamond is forever’ they persuaded young men that the size and quality of the diamond in their fiancées’ engagement rings were directly proportional to their love. And thus the value, and price, of diamonds (worth so much more than money) skyrocketed.
The value-based pricing model is customer-focused, and relies heavily on consumers’ perceived value of the goods or service.
To develop your own value-based pricing, you’ll need to:
- understand your customers
- have a good relationship with them
- have open communication channels
- elicit and act on regular customer feedback
Value-based vs. cost-based pricing
Cost-based pricing sets a price based on the total cost of:
- markup percentage (to give profit margin)
It’s a system that’s simple, less risky contractually for the customer, and justifiable, if the price needs to rise because of, say, raw materials becoming more expensive.
However, it doesn’t take account of what the competition is doing, and there’s a risk of pricing too low and losing potential profits, or pricing too high and only achieving smaller revenues.
There also may be cost overruns; a contracted project may take longer than originally agreed or require more materials, and the company will have to absorb that hit. But the main pitfalls of cost-based pricing are that it ignores value, and gives no consideration to the customer.
Here’s an example: an energy-saving LED lightbulb may only cost $1 to get to market, but it retails for $10. Why?
This is because it is likely to save the buyer in excess of $10 in electricity usage, making it valuable to the consumer.
With cost-based pricing your business would be getting $1 a bulb, whereas with value-based pricing, you’ll be getting $10. Without taking the customer benefit into consideration, you would lose yourself $9 per bulb sold.
Value-based pricing sets the highest price possible, but based on:
- what the goods or service are worth to the customer
- demand, as an economic principle
- data from your target audience
As you can see, value-based pricing is much more nuanced than the comparatively blunt instrument approach of cost-based. Pricing correctly is critical; it’s the most important factor affecting profitability.
The pros and cons of value-based pricing
Companies that adopt value-based pricing will experience the following benefits:
- More outward-looking: instead of considering only the internal variables (materials, labor, overheads, profit margin), you’ll be keeping an eye on the externals (customers, competitors, the market as a whole) and striving to differentiate yourself within your market.
- Better understanding: Value-based pricing requires extensive market research, and every bit of this helps you understand your customers, audience, market and competitors better.
- Drives innovation: By understanding customers, competitors and the market better, you’ll notice gaps that you may be able to fill through innovative product development or new services.
- Greater profits: Because you’re asking for the maximum that your audience is prepared to pay, you capture as much of the consumer surplus as possible, thereby making more profit. Where perceived value is high, your markups can be higher.
- Ability to increase perceived value: through targeted advertising and branding campaigns that emphasise how valuable the product is.
- It’s complicated (but becoming easier): value-based pricing is much more complicated than adding up materials, labor, overheads and profit margin
- You’ll need to invest in research and data analysis.
- It takes time: Time to set up the systems and time to gather, collate and analyze feedback accurately.
- It’s flaky: You won’t be able to control economic, cultural or technological factors, and a value could decrease over time.
How to do value-based pricing
Once you’ve decided that value-based pricing is the way to go for your business, you’ll need to build a strategy. Most of your strategy will involve research, into your customers and your competitors, then you’ll determine the value of your products and craft your marketing campaigns accordingly.
1. Conduct market research
You don’t determine how valuable your product is – your customers do. And the only way to find out how they rate it is by asking them what their perceptions are. First, segment your customers. Then, collect demographic information about them and combine this with qualitative and quantitative data from surveys. Collect feedback at every touchpoint along the customer journey and analyze what your buyers are saying about the product.
You can also use product pricing research tools. These use one or more of the following methodologies to ask survey respondents:
- Van Westendorp price sensitivity meter is a type of direct pricing research that asks survey respondents four simple questions to gauge whether your product is too expensive or a bargain
- Gabor-Granger pricing methodology uses predefined price points to determine the highest price a respondent would pay for your product
- Conjoint analysis gives respondents a choice between product packages and then asks them to choose one of the feature/price configurations to create the ideal option Each option comes with trade-offs
2. Conduct competitor research
Your product or service is only valuable relative to your market (and thus your competitors) so you need to know what it’s doing.
You need to keep your product holding its value above that of your competitors so customers will buy yours over theirs.
Review your product against your competitors’, asking questions like:
- Is it more expensive than the market average?
- Is it more expensive to produce than the competitor’s?
- Are there better features?
- Is it better made, from higher quality materials?
- Will it last longer than the closest competition?
The answers to questions like these will give you pointers about which features to emphasize to keep your product competitive.
3. Analyze the market
Although your customers’ perception matters, you’ll need to track the market to keep an eye on ups and downs.
There are five key market areas that can impact your price and profitability:
- The power of buyers
- The power of suppliers
- The threat of substitute products
- The threat of new entrants
- Competitive rivalry
4. Calculate the value
Once all your data is in, you can start calculating the value to your customer, in monetary terms (money saved, money generated). These calculations can include:
- Peace of mind (hard to put a price on, but valuable)
- Visibility of risks (e.g. is there a good warranty or guarantee?)
- Cost management (is the product cheaper to run/maintain?)
- Less admin (does it save valuable time?)
5. Test your prices
You’ve calculated your pricing, and the only way to see if it works is by taking it to the market and testing it. You won’t necessarily get it right the first time. Find out if it’s working by eliciting feedback.
You’ll be able to refine it so that you reach the best price point to convince customers, while still delivering the highest profit possible for your business.