Typically - if you are offering a product that provides more value than the competing alternative, customers will choose your offering. If your offer provides less value than its competing alternative, customers look elsewhere.
A value-based pricing strategy determines how much money or value the product or service will generate for your customer, which could originate from factors such as increased efficiency, time saving, happiness or stability. Value based pricing is all about the customer and their willingness to pay. Generally, a value-based price is higher, yet the customer is willing to pay more because the product offers greater value.
On the other hand, cost-based pricing uses manufacturing or production costs as its basis for pricing. Cost-based pricing forgets about the customer. When a company uses cost-based pricing, it prices between the price floor and the price ceiling. Market conditions dictate where, between the floor and the ceiling, the company should set its pricing. Your people in charge of pricing justify their price points based purely on internal business reasons – or simply adopt existing market conditions.
My advice is to eliminate any uncertainty around your prices - they should reflect the value of your product in the eyes of your customers. Remember, a value-based pricing strategy should generate greater profit for your business.
How to identify the correct value-based price
To arrive at the optimum, value-based price, determine how highly your customers value your product or service. Value-based pricing requires market research, starting at the product development stage. Careful research of the market is necessary to determine how much the typical consumer values the product or service, as well as what particular attributes are valued the most. Research of products and services offered by competitors is also essential.
Value-based pricing also requires a fair degree of advertising to communicate the value of a product or service to the target market. This is especially true if a company is new to the market, or is introducing a new product. The focus of the advertising should be on the attributes of the product or service that provides the greatest perceived value to your target market. Will your customers save time or money by using your product or service? Is your product or service unique? Does your product or service help customers gain a competitive advantage? What does the competition charge? The answers to these questions will help you determine what customers are willing to pay.
Why Choose Value-Based Pricing
It provides real "willingness to pay" data that forces you into a profit generating price within your pricing strategy.
Value-based pricing allows you to implement price segmentation; by using this strategy you can capture a greater portion of the market and increase your profit margin.
It helps you develop higher quality products by revealing what it is your customers really want.
Products, additions and features will be driven by consumer demand, which raises the perceived value, thereby resulting in a potentially higher price – and more profit for you!
This attention to consumer needs and opinions will result in a more personalised and considerate service and your customers will keep returning because they trust your value and price.
Why you should move away from cost-based pricing
Cost based pricing is relatively simple but it's not smart pricing. You will need to figure out the costs of production or manufacture, set a desired margin for each unit, add that margin onto your costs and hey presto you have your price. However, here's why you could be losing out using this strategy:
1. Limits Your Ability to Use Price Segmentation
Cost based pricing limits your ability to price to different segments of the market. By setting a variety of prices based on how different customer segments value your offer (otherwise known as their willingness to pay) you capture a greater portion of the market, maximising revenue at each point on the demand curve.
2. Customers Don't Care About Your Costs
Customers don’t care about your costs, they only care about the attributes of your product and what value it offers them. For example, customers will be willing to pay more for a Smartphone that has the features that best meet their needs regardless of the manufacturing costs. If a customer’s willingness to pay is not based on the cost of goods, your price shouldn’t be either.
3. You're Giving Away Profits
You'll miss out on increased revenue and profit, which could be substantial. For example, a tyre manufacturer develops a more durable, longer lasting tyre. If this manufacturer implements a cost-based pricing strategy their prices would be about 10% higher than competitive products reflecting the higher cost of materials required for greater durability. This would result in the manufacturer missing out on millions in profit, because the price would only be 10% higher but durability is 100% better than competitive tyres. The manufacturer is not selling the true value of the tyre.
The goal in value-based pricing is to identify and charge the maximum price that the customer is willing to pay. Value-based pricing strives to price products and services in relationship to their competing alternative(s), taking into account the difference in benefits - both positive and negative - that your company's offering delivers in comparison to the alternatives.
Value based pricing should be a part of almost everyone’s pricing strategy, but this does not mean that you should avoid other strategies altogether. Where it is successfully used, value based pricing will improve your profitability due to higher prices charged without impacting negatively on sales volumes. If used correctly, value based pricing helps you generate the most profit and is the most recommended pricing technique by consultants and academics.
- The Challenge of Value, 2010 by Harry Macdivitt and Mike Wilkinson.
- Value-Based Pricing: Drive Sales and Boost Your Bottom Line by Creating, Communicating and Capturing Customer Value, 2011 by Harry Macdivitt and Mike Wilkinson.