If you are reading this, there is probably a good chance you have heard of the term “Value Based Pricing”. You might have also heard that this is considered best practice in the majority of pricing scenarios. Hopefully this post will give you a good overview of what Value Based Pricing (VBP) is before we go into more detail in further posts.
So, the gist of VBP is to price things based on the perceived value of the product or service by your potential customers. The key here is to work out what the perceived value is of your product or service. And, that is something that’s simply not a spreadsheet task based on internal metrics. You will have to engage customers and potential customers to work this out using a variety of techniques. In its simplest form, you are simply trying to work out what people would pay for your product or service without knowing the cost or price.
A common error here is companies calculating "perceived value" without engaging customers. For example, lets say you have Product A and you are fairly comfortable that the price is aligned with perceived value at $100. You then decide to release Product B, which your product managers tell you is 40% more valuable than Product A, based on various metrics, such as "It is 40% faster" or "It is 40% smaller" or "It adds 40% more output". These are all known as Absolute Value, which is what your stats tell you the difference in products are. The issue here is that you can't assume that you customers will value things the same as your stats. They might not care that Product B is smaller or faster or add more output. Or, they might care 3x about speed, but only 0.5x about size.
There are a few different ways to measure perceived value, which we will go into in detail in a further post, but the essence is trying to tap into the minds of your customers and what elements they value or not, and by how much. This will vary from customer to customer, but you should be able to work out an average to base your price on. Of course the range also matters, particularly if it is quite wide-spread. You might also find some natural segmentation in groups of customers and how they value your product. Maybe customers with red houses value it twice as much as customers in blue houses. That is something you may be able to tap into with differentiated pricing, particularly if it is based on objective criteria.
Once you have a good idea of the perceived value of your product, you then need to decide how to take it to market. Will you be pricing above the perceived value (skimming), around the perceived value (neutral), or under the perceived value (penetrating). This depends on a variety of factors such as competitive strategy, supply availability, and marketing budget. You might also find that the strategy changes over the life-cycle of the product, such as pricing high for early adopters and then dropping price over time to maximize market share.
Another key point in this is that you need to be able to deal with shifts in perceived value. Lets say you work out that the perceived value of Product B is $150. Then a competitor introduces a similar product with a large marketing campaign at a price point of $100. This doesn't necessarily mean the perceived value will shift on your product, but it might, so could be worth re-checking. If the perceived value of your product has decreased, then you should consider dropping your price to maintain alignment, or finding out a way to increase the perceived value of your product. The point here is that many companies see VBP as simply a way to increase prices easily and it is not that straight-forward. It can help you for sure, but it can also sting you if you don't keep an eye on fluctuations in how your customers value your product.
Similarily, you might occasionally find that the perceived value of your product is less than the end-cost of the product. This can be a difficult situation to be in, but ultimately you need to figure out how to increase the perceived value of the product. Sometimes consumers just need to be better educated about the value, or maybe it just needs more marketing behind it. However, there can be instances when customers simply don't value the product highers than what it costs to make it and get it to them. In this instance it may be the right decision to can the product or delay the launch of the product until this view changes.
It is important to keep in mind that Value Based Pricing isn't perfect for all instances of pricing something, but it should be for the majority, particularly if it is in the B2C (business to consumers) space. It can also be the right call in B2B (business to business), but this will vary depending on instances, such as if this is a distributor or if it involves procurement teams that only care about the hard metrics. However, even in those instances, you might find that value based pricing creeps in. A customer might put more emphasis on one metric than another and you should leverage that to your advantage.
All in all though, Value Based Pricing is an excellent way to price most products if you are trying to optimize revenue and profit.
*Header photo by Larry W. Lo