Value-based pricing

Value-based price (also value optimized pricing and charging what the market will bear) is a pricing strategy which sets prices primarily, but not exclusively, according to the perceived or estimated value of a product or service to the customer rather than according to the cost of the product or historical prices. When used successfully, it improves profitability by generating greater prices without reducing sales volume greatly.

The method is most successful when products are sold based on emotion (fashion), in niche markets, during shortages (e.g. drinks at open air festival on a hot summer day) or for complementary products (e.g. ink cartridges for printers, or headsets for cell phones). Goods which are traded very competitively (e.g. oil and other commodities) are often sold using cost-plus pricing. Goods which are sold to very sophisticated customers in large markets (e.g. automotive industry) have also in the past been sold using cost-plus pricing, but thanks to modern pricing software and pricing systems and the ability to acquire and analyze market data, pricing is becoming increasingly market- or value-based.

Value-based pricing in its literal sense implies basing pricing on the product's benefits perceived by the customer instead of on the exact cost of developing the product. For example, a painting may be priced as much more than the price of canvas and paints: the price in fact depends greatly on who the painter is. Painting prices also represent factors such as age, cultural significance, and, most importantly, how much benefit the buyer would derive. Owning an original Dalí or Picasso painting increases the prestige and self-esteem of the buyer and hence increases the perceived benefits of ownership.

Value-based versus cost-based pricing

Price should be controlled within the value of the benefits that one business provides for its customer, while at the same time considering the price that their competitors' charge. To maximize the profitability of the products sold by a business, the business has to measure the benefit of the product that they provide to their customers, survey the criteria for the customers' buying decision (speed of delivery, convenience or reliability, etc.) and also identify the value of the benefits provided to the customer.

Cost-plus pricing

Cost-plus pricing is a method which begins with the total cost of producing a product and adds some amount to allow the business to make a desired rate of profit. For example, merchants desiring a general profit of ten percent would sell their products for ten percent more than the cost to themselves (i.e., the merchant adds a markup of 10%). This may not match what customers are willing to pay: if the merchant's markup is too great, the merchant will not receive much business; if the markup is less than what most customers would be willing to pay then the merchant would not gain the profit that might have been gained from a greater price.

Value-based pricing

Value-based pricing is defined based on the value that a product or service can deliver to a predefined segment of customers which are the main factor for setting prices (Hinterhuber, 2008, 42), as value-based pricing depends on the strength of benefits that a company can prove and offer to their customers. Thus, value is an important factor for every business decision.

A benefit is typically meant in regards to achieving specific business goals. If the offered product or service helps to achieve these goals, it is typically valued more greatly. The basis of value-based pricing is therefore to understand the customers' goals and the values used to achieve these goals.

For example, the cost for fixing a pipe at a customer's home for a plumber is $17.50 with the cost of travel, material cost and an hour's labour. However, the plumber may decide to charge a total of $50 to benefit from this business. Thus, the customer might not be happy about the overcharged price given by the plumber, and it is possible therefore that the plumber will lose the customer, so it is important to measure the value of a product before setting the price. However, if a company has a benefit that gives it an advantage with respect to its competitor, the company is able to charge according to the value that is offered to the customers. Thus, this is a very profitable method as it can abandon customers who are driven only by price and also attract new customers from competitors. For example, Starbucks increased prices to maximize profits from price insensitive customers who prefer their gourmet coffee while losing customers who wanted cheaper prices to McDonald's.

Comparison with cost-based pricing

Several factors affect customer willingness to pay certain prices; for example, the difference of needs between countries, individual customers' needs and wants, and the usual customer facing different occasions (actual and present needs) - hence a plan to suit all time value-based pricing is impossible. An extreme emphasis on value might leave the customer feeling exploited, resulting in negative affect towards the company. In practice, prices based on value-based pricing are generally greater or equal to the prices set by cost-based pricing - if the prices were any lower, the customer might perceive the actual value to be lower than the cost of producing the good plus a profit margin. Companies will not be interested in producing and selling the product at that price in the long term. Despite being difficult in implementation of both pricing techniques on companies, there should be consideration of values on products and market positioning brought out to the customers in the early stage of product development.

Implementation

Resolving competing objectives

The conceptualization of sales strategy (Panagopoulos and Avlonitis, 2010) is an essential for companies to sell in a more strategic way rather than operationally selling their products. However, the emphasis of the B2B (business-to-business) pricing method has transformed into the concept of appreciating and increasing the value of a product in a market, such as value creation and value capture (Aspara and Tikkanen, 2013). One of the reasons for some companies not applying value-based pricing is that they do not know their own advantages and capabilities. Next, the objectives of the company are not aligned. It is a typical conflict of objectives in companies is market share versus profitability, because in a business tradition, the greater your market share, the more profitable the company is. Hence, to implement value-based pricing into a company, the company has to understand its objective and the advantages that stand out among its competitors. Thus, this will provide a benefit of dominating the targeted market for the company, hence, sustaining the segmented customers that the company is targeting.

Understanding customer segmentation

There are many ways of implementing value-based pricing. However, segmentation between companies decides and affects which market segment the company is targeting. Some customers simply buy the lowest priced product; value buyers are willing to pay greater prices to purchase products that are worth the price to them. Thus, value–based pricing companies are targeting value buyers. In reality, each and every product in the market is sold at different prices, for more or less similar products. However, selling the same product at different prices is often illegal, because it is regarded as price discrimination or treated as unfair. For example, if customer A and customer B purchased the same item but were charged different prices, this is perceived as unfair. Hence, two strategies to charge more from one segment than another are price fencing and versioning. Price fences are criteria which customers must meet if they are to qualify for a lower price e.g. fencing price buyers from convenience buyers by offering a lower price to shoppers who use coupons found in local newspapers. A convenience buyer only goes to a store to purchase the product they want to get at full price. However, a price buyer wants a low price, so they would clip out a coupon from a newspaper and redeem the coupon in the store for a discount. Thus, fencing and versioning are just the ways of how we can address different segments with the willingness to pay at different prices. Thus, companies are able to charge convenience buyer segments a greater price; profit increases by serving different segments at different prices.

Using pricing as pain management

However, coupons cannot be given out blindly before understanding which customers are willing to pay more when buying in large quantities. Some marketers have eliminated their competitors by reducing cost or developing upsetting technologies (Paranikas, Whiteford, Tevelson and Belz, 2015). Thus, markets have been segmented for different levels of discounts. Although a market has a list price no one ever pays the full list price, in fact, price negotiation turns into discount negotiation. For instance, the greatest market challenge nowadays is giving too many discounts without getting anything in return. Thus pricing is often a type of pain management, where customers ask for discount or to purchase a product in lower price, customers have to give something back in return to get lower price or discounts. Hence, every discount should have a pain associated with it, because if customers do not suffer from the pain for asking to get a discount, they will just ask for more discounts.

Understanding price negotiation and fear

Price management and price psychology are related to each other. Companies often transform from a sole entrepreneur into a large company with multibillion-dollar contracts at stake, subject to both price anxiety and on the other hand price confidence. For example, when a buyer knows that a seller wants to win a deal at any cost, the buyer will offer less money. It is often said that fear is the most expensive feeling in a company. Additionally, it often happens that companies, salespersons, entrepreneurs, or freelancers are anxious about losing a deal when a customer decreases the price offered. Pricing confidence is an essential organizational characteristic which allows teams to sell the product confidently and believe in the price-worthy value of the product (Liozu et al., 2011). Therefore, it is important that companies build up pricing confidence in a team, showing the team a better insight, creating more value from the product. Furthermore, this results in price confidence that results from the confidence a seller has in the product they are selling. However, when the seller is not confident about the price or product they are selling, help from others to access your product that has the value for the price is possible as well, and this results in commodization. Commodization happens when the product a seller offer is as good or as bad as the competitor is offering. In these scenarios, the seller will find it difficult to sell the product at a higher price. Customers often use commodization to drive down the price of a product during a negotiation. Thus, it is valuable to the seller to convince the buyer that the product is not a commodity when you understand the value and that the price of the product is justified.

See also

• Demand-based pricing
• Dynamic pricing
• Premium pricing or Price premium
• Pricing
• Pricing science
• Pricing strategies
• Relationship-based pricing
• Time-based pricing
• Value-based purchasing