Value-Based Pricing and other approaches
Generating a lot of ink and debate, ‘Value-Based Pricing’ is often deemed the ideal way to set prices. But its relevant usage is limited to contexts in which demonstrative product differentiation, i.e., real innovation, can be shown.
We’ll start by taking a look at how Value-Based Pricing is defined. Despite its being the subject of much discussion, there is some lingering confusion – both among marketers and pricing experts – about what the concept actually means. We’ll then follow-up with a quick definition of alternative pricing approaches seen in the market today.
“Value-based pricing is the method of setting a price by which a company calculates and tries to earn the differentiated worth of its product for a particular customer segment when compared to its competitor.”We particularly like this definition, due to its clarity and brevity, penned by by Utpal M. Dholakia1 in an article2 published in the Harvard Business Review in August of 2016.
Also referred to as Value Pricing, this pricing concept focuses on features that add value to the customer and that can be converted into money. As a pricing strategy, it is highly dynamic and customer-focused while bearing no resemblance to current market prices. When Value-Based Pricing is practiced correctly, it should help companies to massively increase profitability. However, as Mr. Dholakia points out: “Just because the differentiated worth is $150 doesn’t mean the company will get it all. In many situations …, there will be a negotiation process, and the marketer may have to share the differentiated worth with the customer.” Even if the case, the value created by this differentiation should translate into a significant margin increase and the competitive advantage it confers is likely to drive growth in volume and gains in market share.
Value-Based Pricing is particularly relevant when selling innovative product features, where it is possible to demonstrate differentiation and evaluate the value of this innovation for the customer relative to the next best alternative product available from the competition. In practice, it requires that the seller have an in-depth understanding of his customer’s processes and cost structure in order to be able to convince them that the products/services in question deliver additional, quantifiable value relative to what is on offer (whether from the competition or previously proposed by the seller), thereby justifying the higher prices.
In Mr. Dholakia’s article, he offers a commentary on the evaluation of differentiated value, namely, “The method’s focus is on features that add value to the customer … Features such as “longer-lasting by X%,” “faster by Y hours,” “less likely to break down by Z%,” all work nicely because they can be easily converted into money. But it’s much harder to deal with a brand’s value this way. This is why brand value is left out of the equation with value-based pricing.”
Unfortunately, Value Based pricing is quite difficult to put into practice and for most companies it only applies to a small fraction of total revenues. As a result, they usually implement one or more of these alternative pricing methods, frequently leaving money on the table as a result:
- A ‘Cost-Plus’ pricing strategy involves a homogeneous markup on direct costs and is frequently seen in process industries. By definition, it is not aligned with the company’s business strategy and yet is still too frequently seen in B2B industries. It can generate significant value leakage by leading simultaneously to loss of market share due to overpricing on the one hand and to loss of value due to underpricing on the other hand. In following this approach, the company risks confronting lower utilization of its production capacity, selling its most technical products at very low margin levels and overall seeing its profitability erode over time.
- A ‘Market Pricing’ strategy is one in which price is driven by an external and public rate resulting from supply and demand equilibrium in a given market. It concerns most true commodities, such as raw materials and numerous in-process goods, covered by market and trading platforms such as the CME (Chicago Mercantile Exchange) and the LME (London Metal Exchange). In such cases, companies need to focus as much as possible on “de-commoditizing” their offering through tangible services offered around their products (after sales service, etc.) and other measures of qualitative differentiation. However, in general such differentiation rarely translates into a price premium. Companies must, in this case, provide the sales force with the right price guidance in order to strictly control compliance and protect margins through indexing, thereby functioning as a pure price follower only for products deemed ‘real commodities’ not for their entire line of products and services.
- A ‘Competitive Pricing’ strategy is basically the imitation of the competitor’s price in one or more market segments. At first glance, it seems a simple approach as it’s just a matter of being a follower. However, obtaining the competition’s prices is not a simple exercise. In reality, a public B2B price is only an imperfect reflection of the pricing strategy of the competitor, often masking significant disparities in discounting from one customer to the next. As well, the data collected on the competitor’s pricing by the sales team is often unreliable. This approach can also be used in a more proactive way as when the company sets very aggressive prices on a limited number of products familiar to its customers. This reinforces its price image without putting its margins at risk. Or also to prevent a targeted competitor from successfully launching a sales campaign, for example by blocking the launch of a new product by initiating a series of promotions. In any case, competitive intelligence is a key component of any pricing strategy.
- A ‘Price Elasticity’ pricing method is one in which prices are set to maximize mass margin on variable costs, thereby defining the best theoretical price. In effect, when the price drops, there is an increase in volume due to the elasticity of demand (negative elasticity). Thus, there exists an ideal price which balances lower margins tied to volume and higher margins tied to price. It has limited applicability in B2B markets where there are frequently a lack of comparative data and limited price transparency. In addition, in most B2B industries, it is critical to take into account fixed/capital costs and capacity constraints. Nevertheless, by simply analyzing their own sales data, in particular win rates vs. price/discount levels, B2B companies can already achieve some very relevant insights. In any case, to define a coherent pricing strategy, it is necessary to have an in-depth understanding of price drivers and customer willingness to pay.
- George R. Brown Professor of Marketing at Rice University’s Jesse H. Jones Graduate School of Business
- Article published in the “Harvard Business Review” on August 19, 2016: A Quick Guide to Value-Based Pricing