What is Value Based Pricing?
Almost all businesses offer some value, but only a few get the pricing right.
Setting a price for a product without understanding its value to customers is like navigating a ship in a storm without a compass.
Just as a ship’s captain needs a compass to determine direction during a storm, a company needs to understand the value its product provides customers to determine the right price.
From a 2020 study that Zuora contributed to, McKinsey & Company outlined, “Customers are increasingly demanding a shift from flat monthly pricing models to those that align better to the specific business value of the purchase…Our research shows nearly three-quarters (73 percent) of revenue from higher-growth companies comes from value-based billing, compared to only 44 percent of lower-growth companies”
This is where value-based pricing comes in handy. Without understanding this, businesses, especially B2B SaaS, risk setting a price that leaves money on the table or alienates customers–it’s just like navigating a ship in a storm.
This article will discuss everything you need to know about value-based pricing. We’ll touch on its implementation, how to measure it, and the common pitfall to avoid with this pricing strategy, and so on.
What is value-based pricing?
Value-based pricing is a pricing model where the price of a product or service is based on a customer’s perceived value of that product or service. Put simply, if your customer feels your product or service offers them high value, they will be willing to pay a higher price for it.
This pricing model is not suitable for every type of business. Companies commonly use value-based pricing in highly competitive and price-sensitive markets or when selling add-ons to other products or services.
According to one Twitter user, Dan Martell, value-based pricing tops the list of eight ingredients that will turn your SaaS pricing into a valuable asset.
Businesses that offer unique or high-worth products and services are better positioned to take advantage of the value-based pricing strategy. Some industries that use value-based pricing schemes include SaaS, cosmetics, technology, and fashion.
High-end luxury brands are well-known for leveraging value-based pricing. For example, a designer watch may cost marginally more than a non-designer watch to make, but the status held by the designer brand raises the perceived worth of the watch accessories. Several corporations benefit from this notion, raising their margins considerably without really affecting their sales volume.
A similar method is also utilized when the buying decision is emotionally oriented. For example, a great artwork may sell for millions of dollars at an auction, but the cost of making that painting is worthless relative to the sale price. The worth and price are determined by the artist’s prestige and other emotional qualities that the consumer may relate to.
Watch a 60-sec video explanation of value-based pricing by Nic Barnhart of Pareto Labs.
Types of value-based pricing
There are two types of value-based pricing:
- Good value pricing: The product is priced based on the value it offers to the customer. This strategy entails offering an adequate balance of quality and service at a considerable price.
- Value-added pricing: The price of a product or service is a function of how much is ‘value-added’ to the products for the customer. It involves attaching additional features and services to a product or service offering and charging higher prices.
Sounds a bit confusing, right? Let’s take a look at the table below for the differentiation between both.
|Good Value Pricing
Offering low prices for good quality
Offering higher prices for enhanced features or additional value
Emphasizes benefits and features
Attracting price-sensitive customers
Differentiating from competitors and capturing higher margins
Apple, BMW, Starbucks
How is value-based pricing different from other pricing strategies?
As explained earlier, setting pricing based on customer value defines Value-based pricing. In contrast:
- Cost-based pricing establishes the price of a product or service according to the cost of production and targeted gross margin without considering the perceived value to the customer.
- Competition-based pricing sets the price of a product or service according to competitors’ prices with less regard for the unique value proposition of the product or service.
- Market-based pricing is when the price of a product or service is modified based on supply and demand for the same or similar product without evaluating the product or service’s core worth to clients.
How to implement value-based pricing
As effective as this pricing strategy may be in theory, the bulk of success it gives is only obtainable in its implementation. Although different companies may practice value-based pricing differently, our focus is on the practical steps in implementing value-based pricing. These steps include:
- Understanding your customer base.
- Determining your unique value proposition.
- Setting a price that reflects the value you provide.
- Communicating your value to your customers.
Step 1: Understand your customer
First, you must understand what your customers need and how your services can fill those needs. This step requires research about customers’ backgrounds and surveys, interview potential customers, and even conduct focus groups to create detailed customer insights.
Step 2: Determine your unique value proposition
Next, determine your unique value proposition after ascertaining your customers’ market needs. At this stage, you can consider and state what benefits or outcomes your service has that are specific to your customer’s needs.
Step 3: Set a price that reflects the value you provide
Once you are done gathering and analyzing the data, you can set a price that reflects the value you provide. This, of course, entails understanding that a single price won’t fit the different persona. Create a different pricing tier that reflects the value of different personas. You may need to experiment with different prices to find the right one that aligns with the benefits of your offerings.
Step 4: Communicate your value to customers
To complete your value-based pricing implementation strategy, you need to communicate not just your price to your customers but also the benefits and outcomes of your service, particularly how the pricing highlights the value that the customers stand to gain.
Stefan Michel, a Prof. of Marketing and Service Management at IMD Business School, in his lecture on Pricing strategy, emphasizes the need to communicate on three levels with your customer to increase their willingness to pay.
“This value needs to be communicated through your value proposition, your sales pitch, and your branding. These three steps help you to increase the customer’s willingness to pay”
How to measure the success of your value-based pricing strategy
To accurately determine the success or ROI of any pricing system is shrouded in a web of complexity. However, there are certain metrics to look out for when evaluating the impact of value-based pricing on your company’s bottom line:
- Customer lifetime value (CLV): This indicator measures the entire value a customer offers to the business throughout the business relationship. If this value increases, it shows customers are satisfied with your offer.
- Average revenue per user (ARPU): Similar to Customer Lifetime Value,ARPU is another metric that can determine the success of a value-based pricing strategy. It measures the average income you generate from each customer’s patronage. Observing an increase in your ARPU indicates that customers are finding value in your pricing system.
- Customer acquisition cost (CAC): On the other hand, CAC measures the effectiveness of value-based pricing in terms of its impact on acquiring new customers for your software services. Unlike the previous metrics, CAC is measured inversely. In other words, spending less on acquiring new customers means that customers find your prices fair and respond positively to your marketing and sales efforts, indicating a successful pricing strategy.
- Upgrades: This metric focuses on how customers upgrade from basic packages to premium ones. If a significant number of customers voluntarily upgrade without coercion, it suggests that both your service values and pricing are aligned, indicating a successful value-based pricing strategy.
- Customer satisfaction: Another way to measure the success of your pricing strategy in alignment with your service value is by considering customer satisfaction. How satisfied and happy are your customers after using your software services? If your key performance indicators related to customer satisfaction are high, you deliver value and pricing appropriately.
- Customer loyalty: Measuring customer loyalty is also important in evaluating the success of a value-based pricing strategy. Customer loyalty can be increased by providing high-quality products and services worth the money. If customers continue to use your services over time, it may signal that your value-based pricing strategy is effective.
- Revenue: The overall revenue your company generates is the ultimate yardstick to determine the success of your value-based pricing, as it directly impacts your company’s overall goals. If you can capture more of the value you provide customers through improved revenue, your value-based pricing system is successful.
- Gross margin: This measure is the profit after the product or service cost. It is what is left after subtracting the price of the products delivered.
Avoiding common pitfalls in value-based pricing
To avoid common pitfalls in value-based pricing, approach it cautiously. Because value-based pricing is not an exact science, understanding these pitfalls is crucial for developing a solid pricing strategy that reflects the value you provide to your customers.
Overestimating customer value
Overestimating customers’ perception of your product is a popular mistake regarding value-based pricing. Overcharging can increase your business churn rate, resulting in lower financial returns. To prevent this mistake, it’s essential to analyze your target market in depth to understand their desires and preferences and what they are willing to pay for the value you offer.
Ignoring competitor pricing
Some businesses make the mistake of ignoring their competitors when implementing this strategy. They believe since it’s customer-based pricing, there’s no need to pay attention to their competitor.
This can’t be farther from the truth! It’s essential to look at what your competitors ask for similar products just so you’re in the same ballpark — especially if your target market is cost-sensitive. Keep tabs on your competitors’ prices, and adjust your pricing plan to stay competitive.
Underestimating your costs
Value-based pricing can sometimes lead companies to overlook their costs instead of focusing solely on the value they provide to customers. Assigning value to the benefits your product provides customers is important. Equally important is factoring the costs associated with production, marketing, and distribution. Failing to do so can lead to charging prices that ultimately do not generate the profits necessary to sustain your business.
When you avoid the pitfall above, you increase your odds of developing a successful value-based strategy that reflects the true value of your product and remains competitive in the marketplace.
Remember, pricing shouldn’t be static but rather an interactive process. Therefore, don’t be afraid to adjust your strategy as you gather more data and customer feedback.
Why understanding customer perception of value is crucial for value-based pricing
Alluding to the famous quote of Ron Johnson, an American accountant, businessman, and serving politician, “Pricing is actually a pretty simple and straightforward thing. Customers will not pay literally a penny more than the true value of the product.”
If Ron Johnson’s words are anything to go by, it follows without saying that the chances are marginal for a business outlet to make sales — talk of making profits or scaling — if they fail to see value-based pricing from the customers’ point of view.
The reason for this is very simple — pricing does not exist in isolation but in the context of the consumer or customer. Pricing begins with the customers and ends with them.
For any company to understand customers’ perception of value and its connection to pricing, it must first be able to identify who its ideal customers are, what their pain points are, and how its service offerings address and satisfy these identified needs. This type of understanding precedes understanding how potential customers view your service’s value.
The next big question you are probably asking is how do I understand customers’ perception of value related to value-based pricing?
Well, no business venture can assume the role of a mind reader in this case, as there are mainly two practical steps businesses do this — quantitative metrics and qualitative customer feedback.
- Quantitative metrics include customer lifetime value and the cost of customer acquisition. By grasping this, you can nib down which customers are the most valuable to your business and which ones you should focus on with your value-based pricing strategy. Quantitative metrics may be speculative.
- Qualitative feedback is precise and more progressive because it directly captures what the customers feel about your company’s service, the price, and the value they derive from your offerings.
Pros and cons of value-based pricing
- Better alignment with customer needs: Value-based pricing centers around the value and benefits customers receive. Businesses align their offering with what customers are willing to pay.
- Control over pricing: unlike cost-based and market-based pricing, businesses using a value-based pricing model have more control over pricing since you get paid for the value you offer—more value = higher pay.
- Differentiation from competitors: value-based pricing enables you to package your product and service, including add-ons. This makes your products or service more unique and gives a competitive advantage.
- Customer satisfaction: Pricing products and services based on customer expectations improves customer satisfaction and loyalty.
- Boost revenue: Value-based pricing is the most effective pricing model for increasing revenue. The more efficient you become in terms of value, the more money you make.
- Difficulty in determining value: There is no quick fix for pricing, except for a product in a saturated market with lots of competitors where you can quickly get the market price. Consumers’ expectations keep changing; hence, you need to keep working on the price.
- Only work for some businesses: Because your customers need to perceive a specific differentiation of value from your business, value-based pricing only supports some businesses.
- Potential for pricing conflicts: Customer perceptions may vary based on regions and demography. It can be challenging to set a single price that works for all of them, which may lead to pricing conflicts.
- Risk of leaving money on the table: A company needs to be more skilled at accurately determining the value of its offerings to avoid leaving potential revenue on the table by pricing too low.
How to communicate the value of a product or service to customers
In value-based pricing, value communication with the intended customers is key. It inherently sells the product or services to potential customers by helping to lower the objection customers may have. Marketers swear by these three effective ways to communicate your product or service. They include:
Sell benefits not features
Outlining the unique benefits that a product or service delivers might assist customers in realizing the value that it gives. This can be done through marketing and advertising programs, as well as through other means.
Offer case studies
Presenting case studies or testimonials from pleased customers can assist in showing the product’s or service’s worth. It helps in developing trust and credibility with potential consumers.
Providing free demos
Giving free demos of the product or service can let customers feel the value upfront. This lowers the perceived risk of acquiring the product or service.
Is value-based pricing a one-size-fits-all strategy?
No, it’s not a one-size-fits-all strategy.
But with recent stats, according to a 2021 report titled Price Insight from over 2000 SaaS companies, it’s the most commonly used pricing strategy. The report shows that 39% (2 out of every 5) of SaaS companies used this strategy.
This is understandable as it allows the companies to place focus on the value of their product and service rather than the incurred cost.
While the adoption keeps spreading like wildfire, value-based pricing may not be suitable for commoditized items or services with a low perceived value. For example, a commodity product such as sugar may not be ideal for value-based pricing, as buyers may not perceive a major difference in value across brands.
On the contrary, a SaaS firm that provides project management software might employ value-based pricing by charging clients depending on the number of active projects or users needing access to the software. We have helpful resources to help your B2B subscription growth. Learn more about managing the transition to a new price system and continue the conversation.