Pricing is a core pillar of any business and that is no news. One percent price improvement may generate multiple percent in profit improvement. And value based pricing is one of the best tools to help a business optimize its pricing, when done correctly.
Even if this is the pricing strategy that can bring in the most revenues, the reality shows it is also one of the most misunderstood concepts. And as a consequence less used. Because companies refrain from exploring it and opt for more approachable strategies.
What is Value-Based Pricing?
Value-based pricing is a price strategy that focuses on the customer. It is a method to establish prices based on the perceived value of a certain product/service from customers’ point of view. Companies calculate the value of their product by taking into consideration primarily the differentiation elements of that product compared with the competing products, in the perception of a certain segment of clients.
Companies that sell high end products and services or those that propose products with strong differentiation elements are in the best position to profit on the value based pricing.
In general, these are markets that propose high caliber life experiences or items that highlight the customer’s lifestyle status.
Value-based pricing is most often used in situations like:
- Highly competitive markets. A higher price should be justified for the value provided otherwise interested buyers would look for a better deal.
- Captive products or add-ons for other products. Supplementary items to improve the functionality of the base products.
- Products with inelastic demand. These are products for which the demand is high enough that a price reduction will have low or insignificant impact on the sales.
- High end and luxury products. Here the markups are high to show the exclusivity and prestige of a product.
Examples of value based markets are the luxury industry, the fashion industry, cosmetics, personal care, pharma.
How value based pricing works in reality?
To clearly understand how value based pricing functions let’s look at an example.
Let’s consider company X who wants to launch a new version of their smartphone. The company’s purpose is to set the right price for their new smartphone with improved photo camera capabilities like 64 Megapixels resolution and pro features added. At the moment of the launch this is the best photo camera for a smartphone. The direct competitor, company Z has recently introduced to the market a smartphone with 48 Megapixels camera resolution priced at $999. The rest of the features for both smartphones are similar.
The real life application of the value based pricing:
1) Target just one segment of clients. Remember value based pricing focuses on a specific segment. Company X targets smartphone clients interested in qualitative photography, not all smartphone customers. Value-based pricing is catered for each segment of clients.
2) Identify the best existing alternative from competition and make the comparison. Value based pricing strategy works best when there is a direct competitor product that clients may choose instead. Why? Because this alternative product serves as a pivot point when calculating the value-based price.
3) Gauge the value of the differentiation features. The next step is to identify which are the unique features that are different compared with the direct competitor product. In our example, the differentiation features are those related to the new capabilities of the camera.
4) Put a price on the differentiation features. This is probably the most difficult phase of the value based pricing method. You will have to come up with the answer to the following question “How much are customers willing to pay for 16 Megapixels in plus for their smartphone camera and some other professional features?” Once this question is answered, you simply add the identified value to $999 (the price of the direct competing product).
Let’s say you identify that customers are willing to pay an extra $200 for these unique features. Your final value based price will be $1,199. To determine the value of the differentiator, usually companies use conjoint analysis, focus groups or qualitative interviews with the potential customers.
It’s worth noting that there will be situations when the company will not be able to capture the whole value of the differentiation features. Such situations are promotions and negotiations.
The exact steps to determine value-Based prices
Value-based pricing reflects the value you are providing to the customer via your product/service and not its cost.
The steps to follow are:
- Identify your direct competitor product from the competition. What alternative do your customers have for your product?
- What is the price of the direct competitor product?
- Identify the differentiation elements and advantages of your product in comparison with the best option from the competition. Assign a price estimate that you consider the clients are willing to pay for the differentiation elements.
- Identify the advantages and differentiation elements of the direct competitor product. Define how much are worth these differences from customers’ point of view. Be objective.
- Calculate the price:
- consider the price of the direct competitor product;
- add the price of your differentiation elements;
- subtract the price of the differentiation elements belonging to the direct competitor product.
The perceived value expresses the amount of money clients are willing to pay for a certain product.
Value based pricing is not exact science, but the price can be established with various marketing techniques.
In comparison with other pricing strategies, value based pricing implies some supplementary tasks like:
Detailed customers’ analysis – Since the central point of your pricing strategy will be the perceived value of your products from customers’ point of view, you need to know which is exactly that value. Your market segment is composed of clients that are interested in your differentiation elements. The very first step is to question existing clients concerning the value they assign to your products/services.
Research and analyze the entire market segment. It’s not enough and not a balanced approach to analyse just the existing customers. You have to gather data about the willingness of new clients to pay for your products. You have to clearly identify which are their expectations, to attract them towards your business. Customers who buy your products value them differently from those who don’t buy them. So, put in place market research sessions to find out concrete information about these differences.
Analyze your competitors. If you lack the resources to make a proper market research, you have the option to look at your competition and depict how your market segment values similar products.
Analyze your business and your value proposition. In value-based pricing, the value proposition plays a central role. It’s the fundament of this pricing strategy. And provides the leading guidelines, consistency and strategic tactics for price decisions.
The main purpose of the value proposition is to calibrate and identify the equilibrium among production costs, reference prices and customer perceived value. Value proposition and value based pricing are intrinsically related, a business cannot have a profitable value based pricing strategy without having a strong value proposition.
Characteristics required to use value-based pricing
- Top quality products/services
- A product or service that has differentiation features in comparison with the direct competing products
- Updates, improvements and new features are added periodically based on clients’ needs and desires
- Solid relationships with clients and open communication strategy
- Strong research capabilities to find out which are the exigencies of the clients
Value based pricing strategy has the great advantage of taking into consideration the client, his needs and perceptions. The other popular pricing strategies neglect in majority the client and focus more on internal aspects of the business. But, the reality is the client pays and he is not at all interested in how much a business spends to make a product. The client is interested in the benefits and value he can obtain while using a product.
Aiming for value based pricing implies lots of research and work to determine how much worth the differentiation elements in clients’ perceptions.
Competitive analysis for value based pricing
Today there is no product or service that can sustain it has no competition. On the contrary. The competition becomes harsher and harsher. And you, as a business, have to do everything in your power to gain the race for the customers’ money.
First, think about the intangible assets you detain:
- Wider experience
- Clients consider your business more reliable
- Your business delivers results faster
- Customers consider your business is more responsive
- Your business is easier to reach
- There are clear proofs that your business is more creative
- Your business satisfies better a certain need
- Your know how reflects better in ROI improvement
You have to have intangible advantages, the more you have the better, as you have the opportunity to ask for higher prices.
Second, consider the tangible value you deliver. This may translate into an expenses reduction or an increase in revenue.
Again the more tangible value you deliver, you are in a better position to charge more.
Third you have to analyse how a value based pricing strategy impacts on your capacity to serve better your clients and deliver more value faster. Which are the exact benefits for which the clients are willing to pay you extra?
You will obtain the best price for your products/services when you can sell the value they provide.
Value based pricing strategy is a key pillar to help you scale your business.
Misconceptions Related to Value-Based Pricing
With value based pricing the success is guaranteed.
This misconception leads to false expectations, usually high expectations. Value based pricing will not bring huge results no matter the circumstances. First, you base your price on that of a direct competitor. If that price is not wisely set and you use it blindly, you are on a straight way to disaster. If the competition, for example, sets a dumping price, a price that is under the production cost and you use that level you have all the chances to lose money.
In the above example, if the price of the competitor smartphone would have been set to $500 instead of $999, would a price of $700 still be profitable for you? Hard to believe!
You have to calculate and evaluate the price for each feature.
This pricing strategy implies the calculation of the customers’ perceived value for each characteristic. It is a misconception. Because in reality you have to calculate the price just for the differentiation elements. Most products have dozens of features, so calculating all of them is a sort of Sisyphus work.
Brand’s value is included in the value based pricing.
The value based pricing relies on the differentiation features that add value and can be translated into money. But it’s very difficult to evaluate a brand in this manner. Consequently value-based pricing does not take into consideration the value of the brand.
It’s one of the reasons why value based pricing is preferred by B2B businesses that stress less on brand value.
Value based pricing strategy is a great tool to expand profits, if it relies on intelligent pricing decisions.
Migrating to Value Based Pricing
Modifying your current pricing model and switching to value based is not that difficult as you might expect.
You just have to be confident enough to do it and communicate that confidence efficiently to your customers.
If you are not able to properly communicate the value you can bring for the clients, value based pricing will not reach its potential.
To migrate to a value based pricing follow the next steps:
List your intangible advantages based on the provided value
Intangible advantages that you bring for the client are your unique features that the competitors are not able to deliver. They differentiate you from the competition and are the elements for which the clients are willing to pay in plus.
These intangible advantages might be wider experience, higher trustworthiness, better communication, superior responsiveness, faster services/products delivery, etc
For clients, some of the intangibles will be more valuable and prioritary compared to others.
Quote clients based on value not an cost or working hours
As a general idea, renounce mentioning costs and hours of work when approaching a client. Unless the project has particularities that involve large supplementary costs (like the need to rent new equipment to produce a product with specific characteristics).
You have to stress on the value you provide for the client and completely ignore factors like costs and number of working hours.
Identify the client’s main pain point
Customers come to you because they have a problem, a pain they want to solve. This pain is the core element that together with its circumstances generates the value of your product/service.
You should be able to determine exactly the pain of the customer and the right context to be able to quote the right price.
Use these types of questions to help you:
- How will my product/service help my client’s business?
- What impact will my product/service have on the client’s business during the next year?
- Since when is the client searching to solve this pain? (If you are among the first providers to send a quote, the client might want to see some other offers and will need some supplementary information on the value provided)
- When does the client want to start?
- What is the client’s expected budget?
- What happens if the client skips on solving this pain? (Insist on receiving the correct information on the negative effects and eventual missed opportunities, and their corresponding magnitude on the client’s business)
Sell in a different manner
Once you have clearly depicted all the details you have to communicate to the client and sell.
Outline for the client their pain point, highlight what opportunities they will miss if they do not act. Expose the intangible value they will receive in their own circumstances. Indicate the tangible benefits and value they will obtain while working with you. Bring timelines into discussion.
Infuse confidence in your speech and make the client realize how your collaboration will be profitable for them.
You have to be personal and clearly explain and make obvious why you are worth more.
Reveal your offer
Communicate confidently your offer to the client. Be open to solve objections and negotiate.
Remember, value-based pricing is most of the time subjective. Your task is to get your client conclude with objectivity that your price is worth it.
If the customer comes with objections, it’s your duty to answer them. Usually that means bringing again into discussion your tangible and intangible advantages and the lost opportunities they may incur for them.
You have the possibility to reduce the price, but you should reduce proportionally the features offered, or you could add some supplementary bonuses.
Advantages of the Value-Based Pricing Strategy
Helps improve profits
If correctly implemented, the value-based pricing strategy leads to increased profits, more balanced prices with the value provided and less money left on the table.
Value based provides real data that guide your business towards profit generation.
Provides a solid base to ameliorate the quality of your products/services
Besides the more accurate pricing, the process of implementing the value based pricing strategy will reveal your products’ advantages and disadvantages in comparison with the concurrency.
Being customer centric will reveal what clients expect from your products. And offers you the opportunity to improve your products to respond better to their expectations.
Leads to superior customer service
Gathering data for value-based pricing means direct interaction with clients via interviews or surveys. Clients appreciate this type of approach. Plus, this attention to their needs and opinions will translate into more personalized products. And in return the customers’ loyalty will tend to increase.
May generate higher markups
Your markups may increase massively, if the perceived value is high enough. If a product is seen as exclusive, prestigious or rare, most often buyers will pay for its high value, no matter its cost. Customers will pay the price for the intangible benefits that accompany such products. Think about an outstanding piece of jewelry (diamonds), rare luxury cars, designer clothes.
Increases the perceived value of your business
Even if value is a subjective concept in the perception of your clients, you can make efforts to raise the level of this perceived value. Running branding campaigns to position your product as elitist and exclusivist, or available in limited edition can increase its value in the target market’s eyes.
Disadvantages of the Value-Based Pricing Strategy
It’s resources and time consuming
Value-based pricing implies a more laborious process than many other pricing strategies. It comprises detailed market research and knowledge about your products and those of the competition.
Some businesses consider it difficult to apply and think that only already large and established companies can afford such pricing strategies.
This is not rocket science
It’s rather difficult to assess which value has a product in the eyes of the customers. And there is no straight path to do it right. Moreover if the product is dedicated to different segments of market, buyer personas, regions, etc.
Cannot be applied in any industry
Value based pricing works best for the products and services that display clear differentiation elements. To justify the price difference. But that is not possible for all industries or niches. For example, businesses selling commodities or basic goods, cannot add a very high markup as the market does not allow it.
Value based pricing is a continuous process, it does not work with the “set and forget” mindset. The perceived value modifies in time due to many influences that are beyond your control, like economic, cultural or technological ones. So, you have to update your pricing periodically.
You can be forced to reduce the prices if a competitor releases a better product or if the clients get accustomed with your product and perceive it as less valuable.
Value-Based Pricing Examples
This is the best and world wide known example of value based pricing. They brought the value based pricing to the state of art. Apple’s iPhone is one of the most used smartphones across the globe and has a price established based on its value, not costs. With this pricing strategy Apple exploited masterly their product that fits perfectly the value based approach and their loyal customers base.
They focused on the client and their brand is by far more valuable then their product.
The diamonds industry
Diamonds are notoriously perceived as being extremely expensive and exclusive. Not to mention rare. And they symbolise the ultimate luxury. Even if more and more buyers are aware that their perceived value is inflated, the price has constantly increased across decades. The scarcity of a product can be actual or created, in the case of diamonds, one can argue that their high prices are a direct result of (until recently) strict supply and processing control.
There is also a global monopoly or duopoly to a certain extent. A strong communication and marketing around the direct association of diamonds as the “Symbol of Love” and direct link with key consumer’s life moments which are marriage and engagement. Besides these more structural points, there is also an art, tradition and in certain countries a very old craftsmanship.
This is an example of a product that relies heavily on the value based pricing.
As all luxury brands, Dior adopted value-based pricing as a strategy. Their famous founder distinguished himself through his creativity and ingeniousness and succeeded to infuse all these intangible advantages to the brand that carries his name. Clients continue to perceive Dior’s products as exclusive and luxurious and are willing to pay for it.