To a large extent, your pricing strategy determines sales and revenue. A mere 1% improvement in price results in as much as 11% increase in revenue.
Warren Buffett said:
“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10%, then you’ve got a terrible business.”
The truth is, choosing the right pricing strategy for your products is challenging. One of the most common, yet confusing and misunderstood pricing model is the value-based pricing.
In this in-depth guide, you’ll learn what a value-based pricing really is, why it matters, how to adopt it, and what to expect once you’ve implemented a value-based pricing strategy successfully.
Let’s begin with the basics.
What is Value-Based Pricing?
The simple definition of value-based pricing is the price based on how much customers are willing to pay for your product considering the value it offers.
A more authentic and reliable definition comes from the Utpal M. Dholakia, the Professor of Marketing at Rice University.
“Value-based pricing is the method of setting a price by which a company calculates and tries to earn the differentiated worth of its product for a particular customer segment when compared to its competitor.”
When using this pricing model where you’re able to determine the differentiated worth of your product in a specific segment market and then based on the worth (value), you can choose a price that customers will be willing to pay – compared to your competitors.
It’s totally different from, or almost the reversal, of traditional cost-based pricing model. It’s focused on customer perception of value that your product offers, and based on the value, you determine the price, and adjust the cost.
Dholakia points a few crucial considerations and steps for value-based pricing model.
i). It focuses on a single market segment. You can’t target everyone across all the segments with value-based pricing. You should choose a different value-based price for each segment if it has to be implemented in all the segments.
ii). This pricing model will only work if your target audience in that segment has an alternative product from one of your competitors. This is because the value of your product will be determined based on your competitor’s product (which is the best alternative available to your customers). If there is no competitor in a segment, you can’t apply value-based pricing model.
iii). The differentiated feature must be unique. It shouldn’t be available in the competitor’s product. You have to understand the value of the differentiated feature of your product.
iv). Assign a dollar value to the differentiated value. This is the final and the most challenging part of the entire process.
To show you proofs that value-based pricing works, here are some examples:
Value-Based Pricing Examples
I know it’s hard to digest everything stated above. It’s too much of theory — so here is a practical example of a value-based pricing model as used by a large European supermarket chain to launch a new version of its private-label yoghurt.
The company used data and information from the cost of goods to set a retail price of €1.99 which was quite reasonable as compared to their competitor (a branded product) priced at €2.99.
This was, however, not the right selling price since it ignored the customer’s perception of the value that their product offered.
The company used a 4-step process to come up with a value-based pricing model.
- The company examined the value of the branded yoghurt (competitor) and their own yogurt.
- Customer surveys and interviews revealed that parents preferred private label yoghurt because it’s perceived to be less damaging to teeth.
- A monetary value of €0.30 was assigned to this value.
- After considering price sensitivity, market reaction, and running several simulations, the price was set to €2.49.
The new price was €0.50 higher than the original price of the company but this worked extremely well. The higher price resulted in an increase in sales and the company exceeded the sales target easily with profits as high as sixfold.
Another example comes from Starbucks which increased its beverage prices by 1% across the US for small size brew in 2013. Customers accepted the price hike and it resulted in a whopping increase in net income by 25% for the quarter.
So how did Starbucks do it without losing any market share?
Well, it used value-based pricing smartly because it knew Starbucks is perceived as a high-value brand as compared to its competitors such as Dunkin Donuts. The value was assigned a dollar value and was added to the price.
Benefits of Value-Based Pricing
So why should you really care about value-based pricing? Why not just stick to cost-based pricing model or any other?
The following benefits will make you realize the real power of value-based pricing and why it’s so important.
Value-based pricing is customer-focused. Instead of creating the product first, this pricing model requires you to start with customer perception.
It starts with a simple question:
What do customers value in my product?
This helps you understand your customers in a particular market segment which will help you with marketing and creating buyer personas. You have the product with the features that end-users can’t resist – what’s better than this?
2. Better Product
One of the best things about value-based pricing is that it always leads to the development of a better product unless you’ve created one already.
You can’t apply value-based pricing model without offering ‘value’ to the customers. The value element is what makes your product better.
The philosophy behind value-based pricing is that you come up with a feature that no one else in the market is currently offering. When you do so, you’re actually making a product that’s better than everyone else in the market.
In the long-run, you’ll have a portfolio of highly valuable products/services which will make your brand better than your competitors.
Value-based pricing doesn’t ignore competition in the market. You must offer something better than your competitors. This involves market research and competitor analysis. Imagine all the wealth of information that you get from the competitor analysis?
You can use the same information for decision-making, developing a better marketing strategy, and it can help you get a competitive advantage over your competitors.
4. High-Profit Margin
Customers are willing to pay a high price for a better product that includes the feature they love the most. This increases profit margin.
In most of the cases, the profit margin increases but it doesn’t happen every time. For instance, if the cost of adding the valuable feature to the product is too high, you might end up losing money.
It can backfire too.
If the cost of production increases the maximum price customers are willing to pay, then it won’t help much.
The cost should be kept low if you wish to increase profit margins with value-based pricing.
In reality, the cost of production reduces significantly as you switch to value-based pricing because you’ll eliminate all the features that customers don’t like and will add only the most valuable features. This will help you train your workforce and develop effective processes for the production of a valuable product.
This will eventually reduce the cost of production in the long-run. In the short-run, you might suffer loss but it pays off in the long-run.
Misconceptions of Value-Based Pricing
The value-based pricing model isn’t without misconceptions. Since it’s still new, therefore, marketers and businesses have a lot of misconceptions about it.
Before you proceed with a value-based pricing strategy, be sure you don’t have any misconceptions about it.
1. Value-based pricing will always be successful even if competitors haven’t rightly priced their products
According to Dholakia, this is the most lethal misconception.
Value-based pricing doesn’t always lead to high-profit margin and it’s not always successful. The profitability of this pricing style depends on several factors. One among them is how smartly competitors have priced their products.
If the market price is reasonably low, you can’t do anything but lose money.
For instance, you’re a TV manufacturer company. You’re planning to launch a new TV with an unbreakable screen. There is no TV available in the market at this moment with an unbreakable screen. Your main competitor introduced a new TV for $500. Both the TVs share all the features except that your TV will have an unbreakable screen. You price your TV at $700 considering assigning $200 to the additional feature that customers will be willing to pay.
Imagine, if your competitor has priced its TV at a ridiculous price of $200. You’ll still have to charge $200 for the unbreakable screen because this is what the new feature is worth. You’ll end up selling your TV at a fairly low price because your competitor is not using intelligent pricing.
Value-based pricing, in all such cases where competitors don’t use smart pricing, can’t really do much.
2. You’ve to assign dollar value to each and every product feature
Marketers believe that they have to calculate the value of every product feature, assign a monetary value to each, and then adding them all will give the price customer is willing to pay.
This is not how you’ve to assess the value-based price of your product.
Instead, you just have to assess the value of the additional feature(s) that your product is offering. Leave all the common features that are available with the next best alternative.
In the TV example, you just have to assign a dollar value to the unbreakable screen of your new TV. Since all the other features of your TV and the next best alternative are common, and customers are willingly paying $500 for that TV, there is no need to recalculate. Even if you do, they won’t pay anything more than $500.
You just have to find the feature differences and assess the customer perception of the additional feature. Assign a dollar value to the differentiated feature(s) only.
This is much easier than assessing and assigning a value to every single product feature. It is tedious and won’t work.
3. Brand value should be added to value-based pricing
This is yet another common misconception. Businesses assign a monetary value to the brand value and add it to the price.
This is a wrong technique, according to Professor Dholakia.
Actual product features that provide value to the customers should be converted into dollars. Brand value, since it doesn’t provide any value to the customers, should never be added to the price.
Refer to the TV example. If you add $200 for the unbreakable screen and an additional $100 for brand value, your TV will be priced at $800 and this will harm your sales.
Because your brand name doesn’t provide any additional feature and value to the customers. The customers will evaluate your product with reference to the next best alternative that’s available to them. If the price difference is more than what they can pay, they will buy the alternative product.
So don’t overcharge by adding brand value.
Developing A Value-Based Pricing Strategy
The section below will guide you on how to develop a value-based pricing strategy. The strategy development is a five step process.
1. Develop buyer personas: The process begins by creating buyer personas.
A buyer persona is a fictional character that represents your ideal customer for this particular product.
Value-based pricing can only be applied to a specific market segment. You can’t do it for all the segments. If you’ve to, you should identify a different next best alternative for each segment.
Each segment should have a different buyer persona because your ideal customer might behave differently in different segments due to the difference in alternatives.
You can have multiple buyer personas for a single market segment. In fact, it’s a recommended approach to have more than one buyer personas.
Some of the important questions to answer in your buyer personas are:
- What is the single most valuable feature that the buyer loves?
- What is the most appropriate next best alternative that the buyer prefers?
- Is the buyer cost-sensitive?
- Which product(s) the buyer loves and why?
- What are the biggest fears in terms of product and price?
- The average monthly spending?
- The biggest goal in terms of product you’re offering?
- What is the most realistic price the buyer is willing to pay?
Once you’ve the buyer personas created, move to the next step.
2. Talk to your customers
It’s time to collect data from customers.
You cannot gauge the value of the additional feature and how much your target audience is willing to pay for it without talking to them.
This is the most crucial part of the strategy.
It calls for intensive market research. Conduct surveys, interviews, focus groups, analyze social networks, and collect as much data as possible.
To get started, use buyer personas created in the previous step as the reference. Only reach out to those potential buyers who you think, will be interested in your product, the additional feature, and will be willing to pay for the differential feature.
You have to collect data on the following variables:
- The product that they buy now. This is your next best alternative. Your price should be based on this product.
- The feature that they miss the most.
- Perceived value of the feature that you’re offering in your product.
- The maximum price they’re willing to pay for the ‘feature’.
These are the four basic questions that you must ask your customers.
3. Determine a value-based price
You’ve got the data, it’s time to evaluate and make sense of it.
The purpose of collecting data from target market was to determine the value-based pricing. You should have data about following:
- Maximum and minimum price of the value that customers can pay
Based on these three factors, you’ll determine the price of your product.
Evaluate the gap: Evaluate the gap in terms of biggest challenges that the customers are facing — relating to price, product, features, etc.
The gap will be different across all the buyer personas. You have two options to deal with it.
- Amend each buyer persona for the target market to incorporate all the gaps.
- Prepare a separate list of all the gaps and arrange them in terms of their relative importance to the buyer or to relative cost.
You can follow both the approaches for better understanding of the gap.
Evaluate the value: This is the crux.
- What does your proposed feature mean to the buyers?
- Are they really interested in the feature?
- Do they really need it in the first place?
You just have to evaluate the proposed feature at this step. You’re not calculating its price now. If the majority of the customers don’t like your proposed product with the feature, you should drop it.
If it’s not a valuable feature, you shouldn’t go for it.
If they don’t value it, they won’t pay for it.
It might be that the data reveals that customers value a different feature than what you’ve proposed, go for that feature. Evaluate it in terms of cost, business strategy, etc.
Refer back to the TV example. Assume, that you offered customers a TV with an unbreakable screen but results show that the most valued feature that customers are willing to pay for is a large screen size.
Evaluate the demanded feature.
See what is the maximum screen size that the next best alternative is offering. If it’s 50 inches, consider offering a TV with 55 inches screen.
Now you don’t have to offer unbreakable screen feature because it doesn’t mean anything to the customers.
You must design your survey in a way that you collect as much data as possible so that you can easily evaluate all the possible product features, in case your proposed feature is not valued.
Else, you’ll have to collect data again.
Setting the price: Based on the maximum and minimum price that customers are willing to pay for the differentiated valuable feature, set a price for the product.
There are multiple factors that have to be considered at this stage such as:
- Maximum price that customers are willing to pay
- The minimum price that you must charge to meet the cost
- Competitor marketing strategy
- How the new product will fit into the marketing mix
- Other internal and external factors
Assign a dollar value to the feature based on all these factors. Add this dollar value to the price of the next best alternative to get the price of your product.
Price of next best alternative + Price of the differentiated feature = Price of the new product
In the TV example, the price of the next best alternative is $500. The calculated price of the differentiated feature was estimated to be $200. That makes the price of new TV with unbreakable screen $700.
You should terminate the feature irrespective of its value if:
- The ceiling price is less than floor price.
- The cost of production is way too high.
- You don’t have the necessary resources (equipment, processes, etc.) to offer the valued feature.
Also, consider the misconceptions about value-based pricing discussed above at this stage to avoid issues.
4. Design the product
After the price has been set, you’ve to do two things:
- Optimize cost of production
- Create a product that actually delivers the desired value
Start by optimizing the cost. Set target cost to stay within the ceiling price. Optimize your processes to meet the cost target without hurting the product.
The actual product must deliver the desired value to the customers. Don’t cheat.
In the unbreakable TV screen example, you must create TV with an unbreakable screen, not just a poor screen that stands on the false claim. It should be unbreakable by all means.
Once the product design has been finalized and the target cost has been met, consider following before moving you begin the production.
- Value has been defined and quantified.
- At least one market segment is willing to pay for the value.
- You have the resources to reach and target that segment.
If these three conditions are met, then proceed with the product production. Else it will be useless.
For instance, if you don’t have any distribution channel in the target market that is willing to pay for the unbreakable screen, it won’t be a feasible approach moving to a whole new market with a new product. It might cost you a lot to get started in a new market segment.
5. Test and review your price
This is the final step where you’ve to test the value-based pricing you just set. Implement the pricing strategy and start promoting the value your product offers.
Value-based pricing is a concept so you’ve to monitor and review the pricing strategy by monitoring sales and customer feedback.
Considering revising your pricing strategy if the sales volume is lower than expected. This means either:
- The price is too high
- Customers don’t value the feature you’re offering
- Your marketing strategy is not focusing on the value
Pricing strategy is a continuous process. It never ends. Even if it turns out to be successful, you have to revise the strategy after some time because your competitors will follow.
You cannot stay at the top with the unbreakable TV screen. Your competitors will start offering the same feature, customer perceptions might change, the market value might change, etc.
Therefore, you must constantly monitor and review your pricing strategy to add new in-demand features.
Key Considerations For Value-Based Pricing
There are several key considerations for implementing a value-based pricing strategy. Before you create and implement the strategy, don’t ignore the following crucial considerations.
1. Justify price increase in terms of value: Don’t justify price increase with an increase in cost. Though it’s a natural phenomenon according to Bloomberg. The prices are constantly increasing and will continue to do so.
Your customers don’t care about the costs so don’t bother emphasizing on the cost of production rather justify the price increase in terms of value.
This is challenging.
And this is why brands don’t do this very often.
When you say that the price increase is due to the additional value that your product now offers. Customers will slap you if they don’t see that value. It has to be there.
It is hard to show value to your customers. They don’t see a redesign of your website as value.
In the unbreakable screen TV example, it’s easy to deliver value because we’re talking of a product that customers can experience and see. But in the service sector, it is hard.
Whenever you increase the price to offer an additional valuable feature to the customers, try to justify it clearly. This is how you’ll change the perception of your customers.
Boldly market your new product in terms of value and additional feature.
2. Train sales team: You can’t implement value-based pricing without full support from your sales team.
If your sales team is unable to explain and deliver the increase in value to the customers, it won’t work.
In reality, sales reps follow the least resistance approach when dealing with a price increase. They justify in terms of increase in cost. This is where value-based pricing fails and won’t boost sales. Sales reps who focus on delivering value outperforms their peers by a big margin.
Training sales team isn’t easy either. Training and development is the third biggest challenge of the sales reps.
Let’s put it this way, you cannot achieve your sales target without the full support of the sales team. You must take them onboard for value-based pricing.
They need to be trained so that they know what the new product is, what it does, how it is better than the next best alternative, and why the price has been increased.
Training and development is an ongoing process. Every time the pricing strategy is revised, the sales team must be trained.
3. Implement pricing strategy at the right time: When you implement the new value-based pricing strategy makes a lot of difference on how well it will perform and how customers will perceive it.
For instance, if you implement a value-based price in October or just before Christmas, your sales team requires a little time to justify it.
Secondly, it’s not the right time to implement a price increase strategy because your competitors will be reducing their prices and the customers are most price-sensitive during this time.
“Never plan price increase in October,” says Chris Sorrow.
The best time to implement a value-based pricing strategy is January because this provides ample time to the sales team for delivering the value to the end-user by providing clear justification.
Your brand will get all the time to justify the price increase.
If you cannot justify the value and the corresponding price increase, the strategy will fail and there is no turning back. Make sure to choose the right time to implement the value-based pricing strategy.
Plan it. Don’t just through it.
4. Value-based pricing is not a discount policy: Katelan Cunningham says:
“Value-based pricing doesn’t work as a discount policy or for maximizing company’s revenue pursuit. It’s a new commercial, a strategic concept that addresses the client and their needs, with a focus on the long-term relationship and offering the best solution vs. client budget.”
It is not a quick fix to deal with declining sales. It is not a short-term strategy to increase revenue.
It is a strategic concept that must blend with the business strategy at all levels. It does increase sales and revenue but not instantly so don’t use it to increase sales.
Don’t use it as a discount policy. If there isn’t any real value behind the price increase, it won’t work no matter how hard you try but for a short time.
Value-based pricing strategy is an ongoing process because the preferences of your target audience constantly change.
What they value today won’t be valued tomorrow with the same intensity. Recall the law of diminishing returns.
The whole idea is to continuously update your pricing strategy by delivering value to the customers.