Any successful company must price its products or services to cover costs and make a profit margin. But how can you maximize profits and avoid margin erosion? Value-based pricing is a strategy commonly used in markets where the cost of producing a product or service is far less than the perceived value and what the customer is willing to pay. It can be incredibly effective in industries with vast differentiation between brands and high brand prestige. Let’s take a closer look.
What is value-based pricing?
When a company sets a price for its products or services based on perceived value instead of marking up the cost of production or following competitors, they are using a value-based pricing strategy. For example, the price a customer is prepared to pay for a painting from a well-known artist is far more than the cost of producing it.
Who is value-based pricing for?
Most types of businesses can apply a value-based pricing model. However, it is typically used in markets with one or more of the following conditions:
- Brand names and prestige are important for personal status, e.g., luxury cars.
- There is marked differentiation between the competition in quality and experience, e.g., fine dining vs. fast food.
- The value to the customer is much greater than the cost of production, e.g., SaaS.
- Demand is inelastic, i.e., reducing the price of the products doesn’t create more demand, like with the housing market in many places.
How do I set a value-based price?
How do you establish what your customers are willing to pay for your product or service? A value-based pricing model requires a deep understanding of your customers and the market you operate in. Here are the basic steps to understanding perceived value and implementing a value-based pricing strategy.
1. Create customer segments
The Harvard Business Review stresses that value-based pricing should only ever apply to a single segment, or in the case of B2B industries, this could be a single customer. Perceived value fluctuates depending on the characteristics of various customer groups, so the first step is to Identify and analyze your customer personas. Group your potential customers into cohorts and deep-dive into each category. You may consider demographic customer data like age, employment status, job type, income, homeowner, and family status.
2. Conduct customer market research
A surface-level glance at your customer personas won’t cut it — you must conduct in-depth customer research to gain qualitative and quantitative data. On the quantitative front, you could employ customer surveys and benchmarking tools like Net Promoter Scores (NPS) to gather valuable customer feedback about how much they want or need this product. Qualitative market research like focus groups and product trials can produce insights into what your customers want from your product and what they are willing to pay for it.
3. Run a competitive pricing analysis
Now you know the perceived value amongst your customer segment, but what are your competitors charging? While value-based pricing differs from competitor-based pricing, it is still wise to conduct a competitor-pricing analysis. This way, you can ensure you’re not over or under-pricing your products or missing any potential gaps in the market. The easiest and quickest way to do this is with a pricing tool like the Flintfox Pricing Engine. According to the Harvard Business Review, the most critical question to ask is: What would this segment buy if my product wasn’t available? This is your key point of comparison.
4. Consider your product or service offering
How does your product or service stack up in terms of quality, features, branding, and value? You must consider your product’s differentiated worth, i.e., how much your customers are willing to pay for the features you offer. If it provides the customer more than your direct competitors, you can safely set a higher price, but if your competitor’s product is superior, you must price according to value.
5. Test and review the market
Now it’s time for the rubber to hit the road with your value-based pricing model. Set and advertise your prices and see how the market responds. Once your product has had sufficient time in the market, gather your sales and customer data, and analyze how the product performed. Customer feedback can help you find the optimal price.
Types of value-based pricing
There are two main types of value-based pricing: good value pricing and value-added pricing.
1. Good value pricing
The definition of good value pricing is providing a price for goods or services that is considered fair and “good value” by customers based on the features and benefits offered. Good value pricing must be agile as changes to the economic environment, including inflation, wages, and the cost of living, must all be considered when determining what customers will consider good value.
2. Value-added pricing
When a company provides extra features in exchange for a higher price, they are using value-added pricing. This type of value pricing model considers what a customer is willing to pay for a product or service based on its perceived value superiority versus the competition. For example, a company can charge more for a product with an extended warranty and a free servicing period.
Value-based pricing examples
Let’s illustrate how value-based pricing works in the real world with a couple of examples.
Housing is a classic example of value-based pricing because demand is often inelastic. This means that demand doesn’t increase markedly as the price decreases. In some markets, the cost of building a house is considerably less than the price of buying a house, so the price is determined by what the highest bidder is willing to pay on the day.
Housing markets can also fluctuate rapidly based on changing social and economic circumstances. For example, during the pandemic, housing prices outside major cities increased significantly as more people switched to working from home. This created a situation where buyers put more value on regional housing because it could afford them a better quality of life.
Software as a Service (SaaS)
From freelancers to enterprise companies, SaaS products, like cloud accounting tools, marketing platforms, and graphic design software, have become the norm for businesses. They can streamline internal processes, save time and resources, and increase the speed and accuracy of work.
Value-based pricing is commonly used in this industry because the value to the customer far outweighs the cost of producing the software. Most of the costs associated with creating SaaS products are incurred up-front during the development phase. Still, the provider continues to take regular payments for each new account or subscription. While SaaS providers have ongoing costs to consider, like software updates, sales and marketing, and customer service, they are essentially selling the same product each time without the need to reproduce it.
The luxury motor vehicle market relies heavily on value-based pricing to sell cars. The German prestige automaker Porsche is famous for its fast cars and expensive price tags. According to Bloomberg, Porsche makes an eye-watering $17,225 profit per car, compared to Mercedes Benz and BMW, which make about $5,000 profit per vehicle. One of the main pricing strategies employed by Porsche is value-added pricing. Porsche is famous for charging large premiums for special packages and upgrades, so a car that sells for $50,000 may cost the customer $100,000 or more after they choose the added extras.
The Apple iPhone has become one of the most lucrative consumer products of all time. According to the latest figures, it costs an estimated $570 to produce the iPhone 13 Pro, and the phone retails for upwards of $1,000. The company has been incredibly effective in using branding and marketing to drive its value-based pricing strategy. Each year Apple releases a new version of the iPhone with a huge marketing push around new features and upgrades. Its value-added pricing model has been so effective that people will queue up for days outside its stores to be the first to get their hands on a new model.
Advantages of value-based pricing
Value pricing is a popular pricing model that has several advantages.
Pricing your products based on what customers are prepared to pay instead of what it costs you to produce them means you can yield the maximum price per unit. Value-based pricing means you set the optimal price and don’t leave any margins on the table.
Increased brand equity
Price is an important indicator of quality in the minds of consumers. Using value-pricing can also lend prestige to your brand as customers consider it “better” than the competitors. This must be used wisely, as a brand that doesn’t deliver on quality and experience will not justify a higher price. Customer satisfaction is vital.
Value-based pricing is inexorably linked to the customer and what they want. Using value pricing means you are obligated to gain a deep understanding of your customers and respond to their needs. This relationship can result in increased product innovation and gaining a competitive advantage.
Disadvantages of value-based pricing
Value pricing isn’t a one-size-fits-all silver bullet for businesses. There are some disadvantages to consider.
Value is in the eye of the customer, and the world can be a volatile place. Fluctuations in economic and social circumstances can lead to swift changes in consumer needs and preferences. They can also affect a customer’s ability to pay for certain products and services. Companies that use value-based pricing must be agile and ready to adapt to changing market conditions.
Despite access to swathes of pricing and customer data, value-based pricing is not an exact science. Unlike cost-plus pricing, which considers the cost of production and adds a simple markup, value pricing relies more heavily on customer-perceived value and external market factors, which are subject to change.
Time and money
Implementing a value-based pricing strategy requires significant resources to gather, process, and analyze data. Conducting customer surveys and focus groups is a significant commitment that not every business can afford.
Perception vs. reality
If you intend to price your products higher than the competition, you must deliver on your customer promises. This will likely require greater investment in product development, branding, marketing, and customer service. Perceived value is the final word in value-based pricing.
What’s the difference between value-based pricing and cost-based pricing?
Cost-plus pricing is one of the simplest and most common pricing models, though it’s not always the most suitable. With cost-plus pricing, companies consider the cost of production and add a markup percentage, which becomes the profit margin. For example, it costs you $10 to produce a pair of sunglasses, then you add a 50% markup and sell them for $15, making a $5 profit on each pair.
Value-based pricing must also consider the cost of production for the company to be profitable. However, this pricing model looks at various consumer factors, including how much the customer is prepared to pay for the product to set the optimal price.
Take your pricing strategy to the next level
Drowning in data and can’t see the wood for the trees? Let Flintfox help you find the magic in the margins. In today’s complex markets, you need a sophisticated pricing strategy without the headaches. Whether you plan to adopt a value-based pricing strategy or another type of pricing model, Flintfox’s innovative Pricing Engine can process up to 5,000 prices per second to deliver the insights you need when you need them.