Whether you’re a property manager trying to find tenants for an apartment building, a home builder trying to land new clients for construction projects or a developer working your next big real estate project, one of the most important things to consider is how much to charge for your services. You don’t want to set your prices so high that clients and tenants look elsewhere. At the same time, you don’t want to set your prices so low that you barely break even and struggle to stay afloat.
One approach to take when setting your prices is to think about the price people would be willing to pay for your product or service. Value-based pricing sets the price of a service or product based on what you think a customer would be willing to pay for it. It offers several advantages when compared to other pricing strategies.
What Is Value-Based Pricing?
Value-based pricing puts the focus on the customer or consumer. The strategy determines prices based on how much value a particular customer is likely to assign to a product or service. One way to understand value-based pricing is to compare it to other pricing strategies, such as cost-plus pricing and competitor-based pricing.
You could say that cost-plus pricing is the simplest pricing strategy. To establish a price using cost-plus pricing, you first need to calculate how much a product or service costs you. You might add up the costs to:
- Purchase the item
- Ship the item to your company
- Hire people to package or otherwise work with the item
For example, if a construction company were to use cost-plus pricing, it would add up the cost of materials and supplies, the cost of labor and any overhead costs. It would then add a profit margin to that amount so that it would earn a profit on each of its projects.
Cost-plus pricing works better in some industries than in others. For example, a retail store would most likely benefit from using a cost-plus pricing strategy. The store could examine how much it pays for the items it sells and add a percentage to that amount. If widget A costs the company $5 each, the store could add 50% to that cost and charge $7.50 for each widget.
This pricing strategy involves setting the price of a product or service based on what competing companies charge. Companies that sell similar products often set their prices based on how their competitors set their prices. Setting your prices based on what other similar companies charge can give you the chance to differentiate your business.
For example, a company that sets their prices lower than the competition might be trying to earn a reputation as the business that offers the best or lowest prices on products. A company that decides to price their products or services higher than other companies might be trying to set themselves up as the luxury leader or the higher-end pick.
While cost-plus pricing uses the cost of the item to create a price and competitor-based pricing uses the price established by competitors to determine the appropriate price for a product or service, value-based pricing looks to the consumer to determine the most suitable price for an item. Value-based pricing uses what a customer thinks the value of a product or service might be to set the price of that product or service.
Using a value-based pricing strategy, you figure out how much people are willing to pay for whatever you’re offering, whether it’s an apartment rental, a new home or a renovation, then charge them that amount. The pricing strategy works best for companies that offer a particular or unique service, rather than for companies that sell mass-produced products or that offer cookie-cutter services. Among those who use value-based pricing are attorneys, real estate agents, developers and other specialized service providers.
To get a sense of what people are willing to pay for a particular product or service, you need to have some basic information. Although value-based pricing isn’t the same as competitor-based pricing, it does help to know what the competition is charging for a similar product. It also helps to know what makes your product or service different from the competition. One way to figure that out is to calculate the True Economic Value (TEV) of what you’re offering. The TEV is the cost of your competitor’s product or the product or service that is the closest alternative to what you’re offering, plus the value of any features that differentiate your product.
For example, if you manage an apartment complex, you can look at the rent charged by a nearby apartment building for similar units, then calculate the extra value your building offers, such as a swimming pool on the property, Wi-Fi included in the rent or a fitness center.
What Are the Advantages of Value-Based Pricing?
Value-based pricing has several advantages for the right company.
It Can Increase Profits
With cost-plus pricing and competitor-based pricing, you are limited when it comes to the amount of profit you can earn. In the case of a cost-plus pricing strategy, your prices are connected to the amount you’re paying for supplies, labor and overhead. If any of those costs go up, you can either keep your prices the same and earn less profit or increase your profits and risk alienating potential clients. Since most customers don’t particularly care how much lumber or labor costs you, they might not be sympathetic to you if you tell them that you’re raising prices because of an increase in costs.
In the case of competitor-based pricing, your profits are at the whim of the companies around you. If you’re currently striving to be the best contractor with the best prices, and another contractor decides to beat your prices, you might find yourself having to reduce what you charge even more, eating into your profits.
With value-based pricing, you’re charging the highest price possible from the start. You’re more likely to earn more as time goes on and you get an even better sense of what your clients value. You can begin to add more valuable products and services, giving you more opportunities to raise your prices and earn more profit.
It Frees You From Hourly Constraints
When you use a value-based pricing strategy, you are typically charging your clients a fixed rate, rather than charging for your services on an hourly basis. Charging a flat rate helps a client get a better sense of what a product or service genuinely costs them. For example, if you charge a person $10,000 to renovate their kitchen, they will feel that their new kitchen is worth $10,000. But if you charge an hourly rate, such as $500 per hour to design the kitchen and complete the renovations, a client doesn’t have as good of a sense of what their project is worth. There might always be the thought in the back of their head that you could have worked more quickly, reducing the cost of the project.
There’s another advantage of using a fixed-rate, value-based price. You won’t feel that you need to take a long time on a particular project to make sure that you do earn a profit. If you estimate that a project will take 40 hours, then it ends up taking 30, you miss out on 10 hours of worth of payments. On the other side of the coin, your clients might not be pleased if they expected to pay for a 40-hour project and then end up having to pay for a 50-hour project.
It Can Increase Customer Loyalty
Since value-based pricing is determined by the perceived value of a product or service, using it is likely to make your customers more loyal to you and more likely to come back when they need your services again. Loyal customers are more likely to recommend your company to their friends and family.
There is a big caveat to consider when it comes to increasing customer loyalty. Your clients and customers need to truly believe that they are getting the best product or service at the best possible price for the pricing strategy to work. In the case of renovations, if a customer decides that a competing contractor does a better job on a remodeling project at a better price, they are more likely to choose them for their next project than to come back to your company. A value-based price needs to genuinely reflect the value of what you’re offering.
It Can Help You Develop the Services or Products Your Customers Want
One last benefit of value-based pricing: It helps you tailor your products or services to what your clients want. When setting your prices, you likely performed a fair amount of research to determine what similar companies offer and to learn what people are willing to pay for extra features. From there, you can begin to add additional features or services to your projects or product packages. For example, if you learn that tenants are willing to pay $100 extra per month in rent for a unit with heat included, you might decide to add free heat to your rentals.
What Are the Disadvantages of Value-Based Pricing?
Value-based pricing can help to increase your profit margins and break the cycle of having to set your prices based on fluctuating costs. There are some potential drawbacks to using a value-based pricing formula, though. Understanding the potential risks or disadvantages of this pricing strategy can help ensure that you can maximize your company’s profits.
It Requires Research
Value-based pricing typically requires more extensive research than other pricing structures. In many ways, it requires you to get into the heads of your clients or customers and figure out how much they are willing to pay for what you’re offering. You need to develop buyer personas to understand clients’ pain points, needs and wants.
Although you aren’t fully basing your prices on those of competitors when you use value-based pricing, it is still important to know what competing businesses are charging. You then need to identify ways your company is different and calculate the value of those features.
Competitors Can Affect It
Not only is it important to understand what your company’s competitors are charging when you use a value-based pricing strategy, but it’s also important to understand how your competitors can affect your prices or the perceived value of the products and services you offer. If there is a competing contractor in your area who regularly charges way-below-market rates, their pricing strategy can affect yours.
By setting their prices so low, the competitor is making it look as though the product or service you provide is only worth that much. Their low prices are affecting the perceived value of your company’s products or services. In an alternative situation, you could charge more, but since the benchmark has been set so low, your profits can suffer, as can the profits of similar businesses.
It Can Require Some Trial and Error
When you use value-based pricing, the price might not be right the first time you set it. You might set the price too low, which can lead to more people using your company but also make it challenging for you to earn a profit. On the flip side, you might set prices too high in relation to what people think your service or product is worth. This mistake might cause them to stay away, making it challenging for you to get a foot into the door.
The trial and error needed when using a value-based pricing strategy can put extra pressure on your accounting team or finance department. An accounting firm can step in and help you determine which prices are the most appropriate based on a variety of factors.
How to Create a Value-Based Pricing Strategy
There are several steps to follow when you calculate value-based pricing. As you work through the steps, it’s worth remembering that the process can be ongoing. You might need to repeat it or revisit it as needed to make sure your prices remain in line with what people want or expect to pay.
- Identify the niche. The first step when calculating value-based pricing is to determine who you’re targeting and what product or service you’re pricing. Think about the product specifications, then consider the features you offer with it and whether you always offer the features or not.
- Do research. Once you have your niche, the next step is to jump in and do research. Look at what competitors are offering and what their prices are. Compare their services or products to yours. What to do they offer that you don’t? What do you offer that they don’t? Make sure you’re looking at similar products. You don’t want to compare the price of a bathroom remodel to the price of a kitchen renovation, for example.
- Get to know your customers. Next, develop personas or buyer profiles for your clients. Figure out who they are, where they work, what their income is and any other detail that will affect the price they are willing to pay. The more you know about your hypothetical customers, the better.
- Put the pieces together. Now it’s time to look at the numbers. If you’ve used a different pricing strategy in the past, compare your previous prices to those charged by your competitors. Then, look at the numerical value of the extra features your products offer compared to those of your competitors. For example, if your kitchen renovation services also include hauling away old cabinets, a service your competitors don’t offer, people might be willing to pay $500 more for that.
- Price your products or service. Finally, it’s time to assign a price to your products. One simple way to do that is to add the price of a competing product to the perceived value of your additional services. If a competitor charges $5,000 for a kitchen renovation, you can price yours at $5,500 with haul-away.
- Analyze and adjust, if needed. After you introduce your new pricing strategy, keep tabs on its performance. Compare your sales or rentals during one quarter to the previous quarter. Ideally, you won’t see a significant decline in profits. If you do, you might need to adjust your prices to make them better align with people’s expectations. On the other side of the coin, if you notice an increase in business after you introduce your new pricing strategy, you might be able to raise your prices even more.
Written by Pasaban