What Is Value-Based Pricing?
Value-based pricing is founded on the concept that value and price are not the same. There is a clear distinction between the price that anyone (be it a person or a company) pays for a given product or service and the inherent value that is received as a result.
When we talk of value, we must be clear that this has nothing to do with what we think our product offers to our customers, e.g., speed, flexibility, good looks, etc. These are just features that address a specific need for a customer, these needs when satisfied will become benefits and these benefits give way to value when leveraged.
If you think of value as a proposition for a business opportunity, it doesn’t matter what the cost of that opportunity might be if the outcome of capturing the said opportunity delivers a higher return on that investment. Same for any product or service that we want to price based on that value proposition.
And that is really the first step: understanding the value proposition, the measure through which we know how much our customers will be able to gain if they buy our product or service. But what is it really?
What Is a Value Walk?
Imagine a map with directions to go from point A to point B, in most cases, these directions will clearly indicate where to turn and in some cases, it will provide information related to the way such as elevation, any hazards to be encountered along the way and even if there are alternate routes.
A value walk is pretty much the same. It is a picture that represents what is the value that a customer will obtain from your product or service with information on what else is out there, how our offering is different than that of the competition, and the inherent cost of obtaining it.
So, we talk about three components in a value walk:
- Value to the customer
- Is our offering enabling our customers in new business opportunities? Is it increasing their margins by reducing their cost of operations?
- Competition in the market
- What is the next best alternative for my customers? If I was not part of the market, where would they go?
- Willingness to pay
- Okay, I have a product that my customers seem to like, what do I do with this?
Only after understanding these three main components, can we talk about how to use value-based pricing as a strategy.
How Do I Find “Value” as My Customers Perceive It?
There are many ways that this can be determined but it really boils down to two simple questions:
- Are we enabling more business opportunities for our customers?
- Are we making it cheaper for our customers to run their business?
While it is possible to talk about value as something entirely subjective and non-measurable (e.g., the value of bragging about having the latest iPhone) most companies will not evaluate options for products and services in anything less than greater revenues/margins or lower costs.
So, the question really is: How is your product or service driving any benefit to the customer in either of those use cases?
Answers to these questions can be all over the place:
- A lighter window-pane that increases fuel efficiency due to the lower total weight in a car
- A one-click registration process for an event planning company that cuts the time process for attendees to register for conferences by more than half
- A new 3D printing nozzle that delivers finer detail for industrial applications thus reducing scrap and rework time
At the end of the day, the answer is objective, measurable, and trackable. And all these cases it is important to consider that there will always be an alternative and that our offering has to differentiate vs. that next best alternative.
Doing Nothing Is a Valid Next Best Alternative
This is probably the Achilles heel of value-based pricing, oversight of this simple fact can drive organizations to lose deals left, right, and center.
Consider the following: Most companies that could be evaluating your product or service have been in business for enough time to make it past the point of just trying to survive. What this means is that their current solution to their needs (while costly and maybe inefficient) works, it doesn’t work as well as it should and it causes numerous issues, but it works. So why should I, a company that has been in business for years, need to spend any amount of money on anything if the way I do it today, while painful, is enough?
Clear differentiation of our product or service against a competitor is key, but so is being able to deliver significant value to our customers vs. doing nothing.
What Willingness-to-Pay Is and Why It Is Not the Same as Price
Remember the last time you purchased a bottle of water, whatever the price you paid for that bottle of water was a function of your geographical location and, quite likely, your state of physical wellbeing.
If you were out on an errand on a hot day and still had to visit a few more places before getting home, you probably drove to the closest convenience store and purchased a $2 20 oz bottle of water just to get you through the rest of the afternoon. But what if you were in an amusement park in the middle of summer with 104 degrees in the shade after waiting two hours for the latest ride? You will offer little resistance and pay the $5 that someone pushing a cart with beverages will charge for a 16 oz bottle of water.
Same here, being able to understand if our customers are “comfortably driving their business with the AC on” or if they are “sweating at the seams to stop the leakage and correct course” is imperative, otherwise we will be finding ourselves in one of two cases:
- Pricing ourselves out of the market, or;
- Leaving money on the table
And neither of those prospects is enviable.
But then, why is value not the same as price?
Let’s assume that our product can enable our customers to achieve $100,000 of additional margin due to cost reduction. Can we charge them $100,000 for our product? Definitely not. Can we charge them $99,000 instead? I’m going to go on a safe bet here and say a big no again.
We have to remember that the value to our customers has to be greater than the cost of enabling this benefit, in other words – there has to be a visible and interesting gap between how much it’ll cost our customers and what the ultimate benefit will be.
Advantages and Disadvantages of Value-Based Pricing
So, the advantages are clear, right? Value-based pricing is the way to go because it enables us to set prices that our customers are willing to pay when compared to the next best alternative.
And while that is true in most cases, it should be clear that doing the work of establishing such a strategy is not for every product or service.
Value-based pricing is best suited for customer-focused offerings because the amount of time and effort needed to develop the level of understanding of that customer’s needs and the benefit they can derive is significant.
These are going to be products and services of higher quality because of this customer focus, it will also drive higher customer loyalty and brand recognition.
But it’s not great for things like commodities. It’s incredibly hard to try and sell value on an item that can be found anywhere. Price setting can be hard over time as the value of our offering changes and also the alternatives in the market keep evolving.
The time investment can make it really hard for products that require significant time to develop and produce because the value and price that was determined at the beginning of its life cycle might not be valid anymore at the time of being released to the market.
And as a strategy, it requires a lot of research and ample time and resources to conduct the necessary analysis and evaluation of all the components we’ve discussed.
So, in short: value-based pricing is a fantastic undertaking to command higher prices for opportunities that drive higher value to our customers, but it is not a one-line formula that can be executed for every product or service out there.