Value-based pricing

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.[1][2] Where it is successfully used, it will improve profitability due to the higher prices without impacting greatly on sales volumes.

The approach is most successful when products are sold based on emotions (fashion), in niche markets, in shortages (e.g. drinks at open air festival on a hot summer day) or for indispensable add-ons (e.g. printer cartridges, headsets for cell phones). Goods that are very intensely traded (e.g. oil and other commodities) or that are sold to highly sophisticated customers in large markets (e.g. automotive industry) usually are sold using cost-plus pricing.

Value-based pricing in its literal sense implies basing pricing on the product benefits perceived by the customer instead of on the exact cost of developing the product. For example, let’s consider the pricing of a painting. A painting is priced much more than the price of canvas and paints. The price in fact depends a lot on who the painter is. Painting prices also shoot up with variables like age, cultural significance, and, most importantly, how much benefit the buyer is deriving. Owning an original Dalí or Picasso painting elevates the self-esteem of the buyer and hence elevates the perceived benefits of ownership.

Value-Based Pricing VS. 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 competitors’ charge (Macdivitt and Wilkinson, 2012). Thus, prices are to be set according to the value that the business provide for its customer, instead of deciding without considering the value the business can benefit. To maximize the profitability of the product provided by the business, the business has to measure the benefit that the product they provide to the customer, survey the criteria for the customers’ buying decision (speed of delivery, convenience or reliability, etc.) and also identify the value of the benefits you provide to your customer.

a. Cost-Plus Pricing

Cost-plus pricing is known as percentage of the cost, which is the total of the cost of producing the product or service adding up the amount the business needs to make a profit［1］. Cost-plus pricing is the most common pricing strategy used by business companies. Every product sold by a business company has a cost base, and by adding up the cost and the money the company spend for getting the product to the customer makes the price that you obtain the profit by adding up to a certain price. For example, in a retail store, a person buy something for $5, and he/she sells it for $10 to customer, this is called cost-based pricing. However, the willingness for customer pay is limited by the benefits they can receive: “Benefits are net benefits, where any cost that the customer firm incurs in obtaining the sought benefits, apart from purchase price, are included” (Anderson and Wynstra, 2010,31).[3] Thus, the customer-perceived value is different between the net benefit they received and the price the customer paid, the supplier will not make any profit if the products are sold below the cost.

b. 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),[4] as value-based pricing depends on the strength of benefits that a company can prove and offer to their customers. Thus, value is the most important driving force in every business decision as value focuses on the price the potential customers are willing to pay based on the benefit offered by the business[1].[5] 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[2].[6] Thus, the customer might not be happy about the overcharged price given by the plumer, at the same time there are possibility that the plumber will lose their customer, so it is important to measure the value of a product before setting the price too high. On the other hand, if the company has a clear-defined benefit that gives you an advantage over the competitor, the company is able to charge according to the value that is offered to the customers. Thus, this is a very profitable approach as it can break off potential customers who are driven only by price and also attract new competitors.

c. Comparison of Value-based pricing and Cost-based pricing

A few factors that affects the willingness of the customer to pay a 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. However, by focusing at an extreme way might leave customer with a feeling of exploited, leaving negative results towards the company. However, in long term, prices based on value-based pricing are always higher or equal to the prices taken from cost-based pricing, but in another words, if the prices are lower, customer might think that the actual value perceived by the customer is lower than the cost of producing the good plus a profit margin, companies will not be interested to produce and sell the product at that price in 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 on early stage of product development.

Implementing Value-Based pricing

a. Resolving competing objectives

The conceptualization of sales strategy (Panagopoulos and Avlonitis, 2010)[7] is an essential for companies to sell in a more strategic way rather than operationally selling their products. However, the focus of B2B (business-to-business) pricing method has transformed into the concept of appreciating and raising the value of a product in a market, such as value creation and value capture (Aspara and Tikkanen, 2013).[8] One of the reason 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 higher 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 the competitors in the same field. Thus, this will provide a benefit of dominating the targeted market for the company, hence, sustaining the segmented customers that the company is targeting.

b. Understanding customer segmentation

There are many ways of approaching value-based pricing. However, segmentation between companies decides and affects which segment of customer the company is attracting or aiming for. Generally diving segments, there are customers who just go for the lowest price product, or value buyers who are willing to pay more to purchase products that worth the price. Thus, types of segmentation like value buyers are value–based pricing companies aiming for. In reality, each and every product in the market is sold in different prices, for more or less similar product, however, charging the same product different prices are often illegal, because it is known as price discrimination or treated as unfair. For example, if customer A and customer B purchased the same item but charged at different prices, this is perceived as unfair. Hence, two of the strategies to go around the market and still to charge more from one segment than another are fencing and versioning. Fencing is a way to fence price buyers from convenience buyers. Companies to define the segment customers from convenience buyer or price buyers use coupons found in newspaper to segment people. Thus, coupons is a way to fence price buyers from convenience buyers. For example, convenience buyer only goes to a store and purchase the product they want to get in full price. However, price buyer wants a low price, so they would clip out the coupon they got from the newspaper and redeem the coupon in the department 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 price point. By capturing the willingness to pay from price buyers with a low-end offering, and at the same also segmenting convenience buyer. Thus, companies are able to charge a much higher price in convenience buyer segment, so profit increases by serving different segments in different price points.

c. 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. Periodically, some marketers have eliminated their competitors by driving down cost or developing upsetting technologies (Paranikas, Whiteford, Tevelson and Belz, 2015).[9] Thus, market has been segment out to set up different levels of discounts. Although market has a list price but no one ever pays the full list price, in fact, price negotiation turns into discount negotiation. For instance, the biggest challenge faced by market nowadays is giving too many discounts without getting anything in return. This proven that pricing is often a pain management, where when customer 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.

d. Understanding price negotiation and fear

Price management and price psychology is related from one to another [3].[10] Companies often transform from a freelancer that sells into large company with multibillion-dollar contract at stake, which this relates to price anxiety or on the other hand, price confidence. For example, when buyer knows that the seller will win a deal in any cost, the seller will get it at any cost, meaning, the price will go down. Thus, in another way, the moment when the seller fears a price negotiation and on the other side there is an experienced buyer, the price will go down. This is often said that fear is the most expensive feeling in a company. Additionally, it is often to be seen that companies, salesperson, entrepreneurs or freelancers are so anxious to lose a deal when customer just takes the price down. Pricing confidence is an essential organizational characteristic which allows teams to sell the product confidently and believing in the price worthy value of a product (Liozu et al., 2011).[11] Therefore, it is important that companies build up pricing confidence in a team, showing the team a better insight, creating more value on the product, and the product is worth the price. Furthermore, this leads to price confidence that leads 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 leads to commodization. Commodization happens when the product a seller offer is as good or as bad as the competitor is offering, where it proves that the seller has no right to sell the product in a higher price. However, customer to drive down the price of a product during a negotiation often uses commodization. Thus, it is really important to convince buyers that the seller is not selling commodity when you understand the value and the price the product is worth for [4].[12]

References

  1. ↑ "Price your product or service: Cost-plus versus value-based pricing". Retrieved 2012-08-07.
  2. ↑ Information Rules: A Strategic Guide to the Network Economy (Google eBook), Carl Shapiro and Hal R. Varian. Retrieved 2012-08-07.
  3. ↑ Anderson, James C.; Wynstra, Finn. "Purchasing Higher-Value, Higher-Price Offerings in Business Markets". Journal of Business-to-Business Marketing 17 (1): 29–61. doi:10.1080/10517120903000363.
  4. ↑ Hinterhuber, Andreas. Value delivery and value-based pricing in industrial markets. pp. 381–448. doi:10.1016/s1069-0964(08)14011-x.
  5. ↑ Price your product or service: The difference between cost and value. http://webarchive.nationalarchives.gov.uk/20120823131012/http://www.businesslink.gov.uk/bdotg/action/detail?type=RESOURCES&itemId=1073790695
  6. ↑ Price your product or service: Cost-plus versus value-based pricing. http://webarchive.nationalarchives.gov.uk/20120823131012/http://www.businesslink.gov.uk/bdotg/action/detail?type=RESOURCES&itemId=1073790697
  7. ↑ N.G. Panagopoulos, G.J. Avlonitis (2010). Performance implications of sales strategy: The moderating effects of leadership and environment. International Journal of Research in Marketing, 27 (1) (2010), pp. 46–57
  8. ↑ J. Aspara, H. Tikkanen (2013). Creating novel consumer value vs. capturing value: Strategic emphases and financial performance implications. Journal of Business Research, 66 (5) (2013), pp. 593–602
  9. ↑ P. Paranikas, G. P. Whiteford, B. Tevelson, D. Belz. (2015). Harvard Business Review. Supply Chains: How to Negotiate with Powerful Suppliers.
  10. ↑ 5 Psychological Studies on Pricing That You Absolutely MUST Read https://blog.kissmetrics.com/5-psychological-studies/
  11. ↑ S.M. Liozu, R.J. Boland Jr., A. Hinterhuber, S. Perelli (2011). Industrial pricing orientation: The organizational transformation to value-based pricing. Paper presented at the International Conference on Engaged Management Scholarship, Case Western Reserve University, Cleveland, Ohio (June 2011)
  12. ↑ Value-Based Pricing with Stefan Michel. http://www.lynda.com/Business-Enterprise-Marketing-tutorials/Value-Based-Pricing/195827-2.html
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