What is value-based pricing?
in Monetization and Pricing
November 28, 2022
Value-based pricing strategy is focused on maximizing the potential and profits of a business. We explain how it works and how to implement it.
If you have ever stepped foot in a museum, you must have wondered at least once:
“How much is that painting worth?”
In other words, how much would someone pay for this piece of art?
As you probably know, in terms of paintings, the best way of finding out is to auction them, so the process is easy. The auction ends, the painting goes to the highest bidder, and whoever owns it gets the money. Most importantly, gets the highest price possible. No analysis, no strategizing, just maximum profit. We all wish we could do that with our companies.
Unfortunately, there usually are no auctions in regular businesses. But there are other ways to determine the optimal prices of products or services and maximize profits. One of them is value-based pricing.
Let’s talk about the basics of the pricing strategy that helped many modern businesses reach a completely new level.
Value-based pricing basics
The idea of value-based pricing comes down to determining a product's or service's value to customers and how much they are willing to pay for it. To get the correct number, it’s necessary to consider many factors that influence a product's perceived value, from customer behavior to competition.
The goal is to understand a given product’s place in the market and how it responds to clients’ needs. And with that information, we can estimate the willingness to pay (WTP), the maximum price a client is ready to pay for a product or service. In value-based pricing, estimating WTP is the cherry on top, allowing us to make accurate final decisions.
Raising the difficulty, raising the prices
Without a doubt, value-based pricing is a complex pricing strategy. It requires a lot of research and takes much more time than other strategies, such as cost-plus pricing or competitor-based pricing. It takes much more than calculating all costs or taking a sneak peek at competitors’ websites. It’s thorough, multi-dimensional, and never really stops because all the factors that influence the value of a product constantly change. Without the proper tools or expertise in the matter, it can be impossible to implement.
However, this difficult approach can bring significantly more profits to the company. With value-based pricing, we can more accurately determine the maximum price that customers will still happily pay.
The idea of value in value-based pricing
To understand value-based pricing, it’s good to take a step back and think about value first. How do we define it, and what factors make something valuable?
For example, let’s take an electric guitar as an example and try to figure out what aspects may increase (or lower) its value:
- What brand is it? What’s the brand reputation?
- Is it popular among guitarists?
- Which famous guitarists use them?
- How many of them are available on the market?
- How is it advertised?
Of course, it could get much trickier if we took a vintage guitar as an example. We would have to turn into a series of questions about its condition and even who owned it before. Still, with any guitar, the process is fairly straightforward, but, as you see, many aspects other than the product itself affect its value. And now, it’s the right moment to introduce the term value drivers.
Value drivers are all activities or capabilities that add profitability, reduce risk, and promote growth in accordance with strategic goals. The more we understand the value drivers of our product, the better we’ll be able to price it. Ideally, we should be able to quantify our value drivers, but, of course, it might not be possible with everything.
To explain it adequately, we’ll take an example closer to our world. Let’s say we have a trailblazing AI-based CRM tool that sells on its own. To determine its price in a value-based fashion, we’ll try to briefly go through a couple of examples of its value drivers.
So, if we’re saying that our solution reduces costs, what are we talking about exactly?
- How many work hours can our clients save thanks to our tool? How expensive would those work hours be? (e.g., how much money would cost 1000 hours saved for the sales team and additional 200 hours for the HR team per year?)
- How much money can our clients save on resources and software? (e.g., what other subscriptions/applications our software replaces, and how much do they cost?)
The more we delve into details, the more precisely we can communicate the actual value created by our product or service. Of course, we have to remember that we might never be able to fully communicate those values due to the intangible nature of many of them. But as long as we’re trying, we’re getting closer to the price and the maximum WTP.
To sum up, using value-based pricing, we’re trying to take the client’s perspective and precisely communicate all the crucial factors because they can play a part in a customer's final decision and perceived product value of the product.
Due to this complexity, the strategy can be far more challenging than cost-plus or competitor-based pricing, but it leads to more precise (and profitable) results. For companies that haven’t dealt with any similar approaches to pricing previously, it can even be a little shocking at first. It provides a fresh look at their business and a better perspective on how their products or services are used and perceived. The focus on value often results in better product development and overall product or service quality.
Why is value-based pricing getting so popular recently?
The idea of pricing items based on customer value isn’t new and trailblazing. However, the recent advancements in data analysis and a better understanding of customer behavior allow the approach to blossom. Previous to that, the implementation costs were far too high, making it unprofitable in many cases.
But the biggest reason why value-based selling has become so widely appreciated is that it works. Simple as that. As an company that helps implement this strategy, we see how it maximizes profits while keeping customers satisfied. In some cases, it can genuinely redefine how businesses see their customers and products, primarily thanks to a better understanding of various data types.
Why is value-based pricing so perfect for many modern businesses?
Value-based pricing utilizes the newest research and tools that weren’t available previously. It provides answers based on large amounts of data that modern companies collect and often don’t even use. More often, value-based pricing becomes the only strategy that makes sense due to its WTP-oriented nature. Other approaches lack a broad perspective and are far less accurate, which causes companies to miss many potential profits.
Is value-based pricing a good solution for all businesses?
Value-based selling is often the best solution for modern businesses, especially in the service and digital industries. However, many traditional B2C companies, particularly those retail-based, can’t afford to use such complex strategies for their products. Most FMCG companies have too big product portfolios to approach pricing this way. On the other hand, in many of them, cost-plus pricing, often combined with competitor-based pricing, works perfectly well.
The value-based approach to your products and services
Maximizing profits is usually the main reason why companies implement value-based pricing. But the approach brings to the table much more than just that. It provides a lot of information and often changes how companies run their business. The shift in philosophy affects prices, products, processes, and priorities.
However, it can be challenging. Value-based pricing requires knowledge, experience, and commitment. But, as a team of firm believers and practitioners of this strategy, we can help you implement it seamlessly.
Arrange a call with me, and let us help you find the true value of your product.