Many people will have heard of the concept of value-based pricing but may not really understand what is meant by it. So what actually is value-based pricing?
Value pricing is a way of setting prices for your products and services based on the value your
customer derives from them, rather than the cost to deliver them.
Cost Plus versus Value-Based
Imagine a marketing agency that creates campaigns for clients that deliver more leads and increase sales. There are two pricing approaches they can consider:
1. Cost Plus Pricing. The agency calculates the number of days of work required to create and implement the campaign (50 days of work x internal cost rate of £500 = £25K cost to deliver). They want to earn a 50% gross profit margin so set the price to the client at £50K.
2. Value Based Pricing. During discussions with the prospective client, the agency established that if the campaign is successful, it will deliver over £1m in new sales for the client. The agency decides on a value price to capture a portion of that value – £100K.
In the cost-plus scenario, the price to the client is governed by the cost to deliver the service. However, in the value pricing scenario, the price to the client is governed by the value of the outcome of the service.
In a revised scenario, let’s imagine the cost to serve is not £25K and it is only £15K. In the cost-plus pricing approach, the agency would have charged £30K instead of £50K. In the value pricing approach, they would still have charged £100K.
Value-based pricing is a way of pricing your offering in line with the value of the benefits or outcome it provides to the customer, and in line with their willingness to pay. I like this definition of customer value because it’s so simple:
Value = Benefits – Price (V = B – P) 1
When you think of it like this, you quickly realise that price has got nothing to do with cost. Price is governed by the value your customer gets from the differentiated benefits that arise from your product, less the price the customer pays.
Simple in theory (but difficult in practice)
Value-based pricing is not a difficult concept to understand in theory, but it is difficult to apply in practice. There is no single formula that you can use to calculate a value price. Rather, it is an ongoing process of research, competitor monitoring and developing products and price offerings in line with a value-based philosophy.
Techniques and frameworks to help
- Willingness to Pay – using pricing research surveys can be a very powerful way of helping you decide what customers are actually willing to pay, based on their perceived value of your product.
- Economic Value Estimation – this is a framework that helps you understand, feature by feature, what the economic benefits are of your product compared to the nearest competitive alternative, and derive a price point that reflects the perceived value of your differentiated benefits.
- Customer Interviews – the simplest approach is to ask your customers what value they get from your product, and how it compares to your nearest rival. Make sure you probe to understand what the economic benefits are to their business of using your product or service.
Benefits of a Value-Based Pricing Approach
- Prices Aligned to Customer Value – this actually makes it easier to sell your products, rather than harder as some people might think. This is because you have carefully set your prices in line with their willingness to pay.
- Increased Profits – clearly value pricing is going to deliver a lot more margin than typical cost-plus pricing approaches. This quid pro quo is that you might not achieve the same level of sales volume as you do with cost-plus pricing.
- Differentiate Yourself from the Competition – when done well, value-based pricing helps you stand out from the crowd. Anybody can offer a cost-plus pricing model, but only a few businesses are great at value-based pricing.
Final Word
Don’t forget that to be great at value-based pricing, you also need to be great at value-based selling. This means uncovering, establishing and agreeing on the potential value of your offering with the prospect before they sign up.
( 1 Source: Smith, T. (2016), “Pricing Done Right”, Bloomberg Press, New Jersey.)