The Value of Value-Based Pricing

What Is Value-Based Pricing?

Value-based pricing is a strategy of setting prices primarily based on a consumer’s perceived value of a product or service. Value-based pricing is customer-focused, meaning companies base their pricing on how much the customer believes a product is worth.

Value-based pricing is different from cost-plus pricing, which factors the costs of production into the pricing calculation. Companies that offer unique or highly valuable features or services are better positioned to take advantage of the value-based pricing model than companies that chiefly sell commoditized items.

Understanding Value-Based Pricing

The value-based pricing principle mainly applies to markets in which possessing an item enhances a customer’s self-image or facilitates unparalleled life experiences. To that end, this perceived value reflects the worth of an item that consumers are willing to assign to it, and consequently directly affects the price that the consumer ultimately pays.

Although pricing value is an inexact science, the price can be determined with marketing techniques. For example, luxury automakers solicit customer feedback that serves to quantify customers’ perceived value of their experiences driving a particular car model. As a result, sellers can use the value-based pricing approach to establish a vehicle’s price going forward.

Characteristics Needed for Value-Based Pricing

Any company engaged in value-based pricing must have a product or service that differentiates itself from the competition. The product must be customer-focused, meaning that any improvements and added features should be based on the customer’s wants and needs. Of course, the product or service must be of high quality if the company’s executives are looking to have a value-added pricing strategy.

The company must also have open communication channels and strong relationships with its customers. In doing so, companies can obtain feedback from customers regarding the features they’re looking for in a product as well as how much they’re willing to pay.

Scenarios in Which Value-Based Pricing Is Used

There are countless scenarios in which value-based pricing may be an appropriate strategy. A few potential value-based pricing scenarios include:

• Convertible. A convertible is perceived as a prestigious, luxury vehicle that draws attention in a way that traditional automobiles typically do not. A luxury automaker may attempt to highlight the prestige of its brand by increasing the price as a signal for how exclusive its products are.
• Housing. Many housing markets are subject to inelastic demand, meaning that demand remains high for homes regardless of whether prices are relatively lower or higher. Particularly in a seller’s market, where buyer demand is especially high, lowering the price of a home will have very little impact on the likelihood that it will sell. In this case, buyers must consider the perceived value of a house before making an offer, as another buyer will likely swoop in if they don’t act quickly.
• Milk. Some products are subject to value-based pricing without being luxury goods or those with inelastic demand. Milk is a good example of a product in this category. Many different brands of milk are available for sale at most grocery stores, but the price across comparable products is usually quite close. A reason for this is that in a highly competitive, price-sensitive market such as milk products, the price of goods typically settles at what customers are willing to pay. Because one carton of milk is essentially interchangeable with another, sellers have incentives to sell for the lowest reasonable price.
• Swiffer pads. Branded products with add-ons or replacement components are another example of a value-based pricing opportunity. Customers who buy a Swiffer Sweeper will receive a small number of sweeping pads with the initial purchase. Once those run out, they will have to decide whether to buy additional Swiffer brand pads as replacements or look for alternatives in brands that may not fit their Sweeper. Swiffer can charge more for replacement pads if customers need to use that particular brand because they are the only ones that fit exactly.1

Types of Value-Based Pricing

There are two types of value-based pricing: good value pricing and value-added pricing. A brief description of each is below.

Good Value Pricing

Good value pricing refers to the practice of pricing a product based on its quality or the service that it provides to a customer.

Value-Added Pricing

Value-added pricing refers to the practice of pricing a product based on the perceived value that products and their features add for a customer. Sellers attempt to determine what customers believe the value of a particular feature of the product is worth and price the product accordingly.2

Common Misconceptions About Value-Based Pricing

Value-based pricing is very widespread, but there remain some misconceptions about this practice, such as:

• Value-based pricing is a guarantee of sales success. Companies engaging in value-based pricing should not assume that it will necessarily lead to success in selling their products. Even if a company engages in thoughtful value-based pricing, its success depends on a number of other factors as well; most importantly, how wisely their competitors have priced products.
• Value-based pricing means companies have to consider every single feature of a product. A common misconception is that value-based pricing means marketers assess customers’ perceived value of every single feature of a product, adding them all up to find a final price. This would be a monumental task for even the simplest of products. In reality, value-based pricing often uses assessments of different features among products to gauge perceived value. For example, if two computers have identical specs except for screen size, this feature may be the most important for setting value-based prices of these products.
• A brand’s value is key to value-based pricing. Perceptions of brand value tend to be difficult to assess relative to differentiated features. If a product is a certain percentage faster, longer-lasting, or more durable than a competitor, then these differentiated features can be assigned price values. It is more difficult to assess values based on brand alone.3

Difference Between Value-Based Pricing and Cost-Based Pricing

An alternative pricing method to value-based pricing is cost-based pricing, also known as cost-plus pricing.

Value-based pricing is dependent on the value that customers are willing to assign to or pay for particular products, features, and services. On the other hand, cost-based pricing assigns a selling price to an item by factoring in the costs associated with producing that item. Once those costs are tallied, a markup is added to the final price to generate a profit.

Advantages and Disadvantages of Value-Based Pricing

Value-based pricing offers a number of pros and cons for sellers. Some of the potential advantages include:

• May lead to higher price points
• Possibly increases brand value
• Promotes customer loyalty
• Establishes how much a customer is willing to pay for a product
• Helps to incorporate customer feedback in designing future products

Some of the possible disadvantages of value-based pricing include:

• Requires a significant investment of time and resources to collect customer data
• Perceptions of value can change over time
• It can be difficult to set a price that works for every customer
• It’s a process that is neither exact nor with guaranteed results

The Bottom Line

Value-based pricing is a powerful pricing tool that incorporates information about the value that customers perceive to come from a product, its various features, and related services. While value-based pricing is resource-intensive because it requires gathering and analyzing customer data, it can lead to advantages in sales, elevated price points and customer loyalty, and other benefits. On the other hand, value-based pricing is not a guarantee of sales success.

Source: Investopedia