Value-based pricing: improve profitability by not leaving money on the table.

Do you have a framework for how you set your prices? Have you engaged with your customers to understand the value they are getting out of your product? And if so, does that factor into the price you charge them? Value-based pricing puts your customers at the heart of pricing decisions and takes account of willingness-to-pay, and the difference between benefits and price (often characterised by next best alternative). This article provides a brief overview of pricing approaches and introduces how to start using value-based pricing as the base for your pricing strategy.

Three pricing approaches

Academic research converges on three approaches for setting the price of your products:

· cost-based pricing

· competition-based pricing

· value-based pricing (sometimes called customer value-based pricing)

Cost-based pricing works from a calculation of variable costs, plus allocation for fixed costs and profit margin mark up. Competition-based uses the pricing of other market participants to determine a price. Value-based pricing seeks to understand perceived value, which means identifying the attributes of the product or service that the customers find most important and setting the price based on the benefit that these features deliver.

Shown graphically, we can see how different pricing approaches may drive how the product is positioned in market.

Regardless of pricing strategy, it is important that you understand your costs and the market environment. We can see in the graph example that using an average of competitor prices, it may be possible to achieve a price point above the cost-based price. Both cost-based and competition-based pricing would, in this example, provide a reasonable return. However, only value-based pricing adjusts according to customer willingness-to-pay, which is show here across six segments. Segments 1 and 2 may not be worth selling to (or perhaps only for strategic benefit), but notably with segments 3 to 6, using a cost or competition-based pricing approach would leave money on the table. Here we can see how value-based pricing can be much more profitable for your business.

Set prices for segments

A challenging aspect of value-based pricing is that it is subjective in nature, and as such, it varies across every customer. For most companies there is a need to segment the customer base and look for commonalities that can drive the way product is priced and marketed to these sub-groups. Consider using needs-based segmentation: studying customers’ jobs-to-be-done and the problems they are trying to solve using your product. Developing a strong understanding of the product usage will enable you to classify your customer groups based on the segment needs. Also, knowing what it is about your product that is important to each segment will enable you to tailor pricing to them. This may also involve slightly differentiated versions of your product, or the service offering that goes with your product.

Quantifying value

As you build out your segments and gain an understanding of the product features they value most, you then need to quantify that value. Quantifying the value enables you to compare the product against the next best alternative and set a premium that forms your price, allowing you to get optimum returns for the product you are serving up. Depending on your product, this step can be difficult and is perhaps the reason value-based pricing is not widely adopted.

If you have a product that drives explicit cost savings or direct incremental revenue, then the key is to measure the savings or extra income and develop a clear model that your customers can use to calculate the benefit to themselves. For example, a home insulation company might give you a model that allows you to put your energy usage and cost in, with an output that shows the savings over time of better insulation driving reduced heating bills. Or perhaps a platform market place could highlight that using a ‘promoted listing’ product generates 3.2x more views and 1.4x more sales. These companies can then price their products to capture some of that benefit (while still leaving enough benefit to the buyer that they are motivated to use the product).

Where you can’t show clear savings or revenue generation, value-based pricing is more complex, but it is not impossible. The key is you must talk to your customers and seek data that informs your position. There are many ways you can engage with your customers, either informally (call them up or visit them), or more formally, as described by Anderson, Jain and Chintagunta (1992):

· Expert interviews

· Field value-in-use assessment

· Focus group value assessment

· Indirect survey questions

· Direct survey questions

· Importance ratings

· Benchmarks

· Conjoint analysis

· Composition approach

Conjoint analysis

Conjoint analysis is often cited as having the highest practical success. This involves a series of questions with only two options to choose from, for example:

· Feature 1 or feature 2

· Feature 1 or feature 3

· Product with feature 1 at high price or product without feature 1 at low price

· Etc.

This helps to both identify the features that customers value and also to quantify the value of specific attributes. In undertaking this research, as with using any other customer research technique, you should familiarise yourself with the fundamentals of the approach, how to ensure research reliability, sample sizes and research ethics.

Case studies

Sometimes (particularly in business-to-business environments) your customers will not be familiar with your value proposition or even how beneficial it will be to their business. In this case, you may need to enlist a pilot customer or use case. Strike a deal with a customer that allows you access to their business to gain feedback on how they use the product, what sort of value it generates and the benefits gained (strive for any metrics you can access that might be impacted by your product). You might have to pay them, or give them free access to the product but the knowledge you’ll gain will be vital to your pricing and sales process going forward.

Implement a pricing strategy

Once you get through the value-based pricing process, don’t stop there! Make sure you take steps to monitor your pricing performance, while making the process repeatable and understood within your business. Other articles discuss the pricing strategy concept more broadly.

Summary

Value-based pricing is complex but can be extremely rewarding by not leaving money on the table. You need a significant amount of customer data, and you should also be conscious of your cost and competitors pricing, but recognise that pricing gains (either setting higher prices or getting the sale without having to discount) flow more directly to the bottom line, so have a huge impact on profitability.

The information in this article is based on Masters level research, particularly focused on value-based pricing in software companies. For further reading see the following articles:

Anderson, J. C., Jain, D. C., & Chintagunta, P. K. (1992). Customer value assessment in business markets: A state-of-practice study. Journal of Business-to-Business Marketing, 1(1), 3–29.

Harmon, R., Demirkan, H., Hefley, B., & Auseklis, N. (2009). Pricing strategies for information technology services: A value-based approach. Proceedings of the 42nd Annual Hawaii International Conference on System Sciences, HICSS, 1–10.

Hinterhuber, A. (2008). Value delivery and value-based pricing in industrial markets. In A. Woodside, F. Golfetto, & M. Gibbert (Eds.), Creating and managing superior customer value (Vol. 14, pp. 381–448). Bingley: Emerald Group Publishing Limited.

Hinterhuber, A., & Liozu, S. M. (2012). Is it time to rethink your pricing strategy? MIT Sloan Management Review, 53(4), 69.

Liozu, S. M., Hinterhuber, A., Boland, R., & Perelli, S. (2012). The conceptualization of value-based pricing in industrial firms. Journal of Revenue and Pricing Management, 11(1), 12–34.