The term “Value-Based Pricing” gets tossed around all the time. It suggests better pricing. It suggests pricing that reflects the value that you provide your customers. But what exactly is it?
Wikipedia defines it this way:
Value-based pricing (also value optimized pricing) is a pricing strategy which sets prices primarily, but not exclusively, on the value, perceived or estimated, to the customer rather than on the cost of the product or historical prices. Where it is successfully used, it will improve profitability due to the higher prices without impacting greatly on sales volumes.
Bleh! Great if you’re a college professor. But what if you’re a capital equipment professional trying to figure out exactly how to establish a value-based price?
First Define Customer Value
You can’t have value-based pricing unless you first define customer value. Customer value is the net of customer gains and the cost to acquire those gains. For non business-to-business commerce, customer gain is measured in terms of utility and/or emotion. For example, when a family with three pre-teen children seeks to make a car purchase, they hope to gain the ability to truck the family around town (utility) plus some measure of the pride (emotion) that accompanies new car ownership.
It’s a lot simpler in the case of business-to-business commerce. Customer gains are measured in terms of the customer’s profit. It’s that simple. For the capital equipment supplier, value is the customer profit gained as a result of the equipment purchase.
Second Define the Market Reference
Your value to the customer is relative to alternatives in the market. Those alternatives include:
- Direct competitors
- Alternative approaches to solving the customer problem
- A customer’s decision to not buy
Each of these competitors needs to be characterized in terms of the profit they produce for the customer. The competitor that you are most interested in for setting your value-based price is the one that provides the most value. This is the market reference.
Third Define Your Price at Full Market Value
The full market value of your product is made up of two components:
- The portion of value equal to the market reference
- Your added value beyond that of the reference
For the portion of your value that is equal to the market reference, your market value equals the price that the market reference charges. For the portion of the your value that is in excess of the market reference your market value equals your added value. Your full market value is the sum of the two. See the figure below.
Lastly, Define Your Value-Based Price
Your specific value-based price target will be a function of the total value that your solution produces for the customer and your market-share objectives.
For example, imagine your are a new entrant into a particular market. Your objective is to establish a market position quickly. You could price your equipment equal to or even below your lower-value competitor. Customers would flock to you to reap the huge value windfall you’re offering. Once you had a large share of customers, you would no longer need to overcome your customers’ cost and risk associated with changing suppliers. Therefore, follow-on sales could be priced closer to full market value.
Alternatively, consider the scenario where you price your equipment at full market value. In this case, the customer’s economic outcome is the same whether he purchases from you or the competition. Both your customers and your competitor’s customers would likely remain with their current supplier. You would not gain or lose market share, which could be perfectly fine if you are already the undisputed market-share leader.
These examples illustrate how value-based pricing can be any price that is a function of the value your solution produces for the customer and your market-share objectives. The key here is that pricing is set with a full understanding of your and your competitors’ ability to produce customer value. But you don’t want just any price; you want the highest price possible. Therefore, for the value-based strategy practitioner seeking more customers and higher prices, here’s your definition:
Value-based pricing is the maximum price that you can charge relative to market references for your added value and still achieve your market share objectives.