Value-based pricing begins with knowing the customer’s willingness to pay based on the perceived value of your product.
You can charge less than a customer’s willingness to pay, and they feel like they’ve received an excellent deal. You can charge exactly for their willingness to pay, and the price is fair. However, if you charge more than their willingness to pay, then you’ll lose a sale.
Here’s a simple example:
It’s a hot day, and someone is in the market to purchase water. If that person is at a park and there is a concession stand selling water, they might be willing to pay $4 or $5. If that same person is driving and can easily stop at a local convenience store, they might be willing to pay $2 or $3 for the same bottle of water. At home, they’d expect it to be essentially free from the sink in their kitchen.
Another quick example:
A customer wants a watch. The essential function of a watch is to tell time. One person might spend $10-$20 for an inexpensive watch that does exactly that. Why might another person spend $200 and another spend $52,000?
The answer is how the watch is valued by the customer.
Of course, the $52,000 watch probably costs more to design with high-quality elements (e.g. gold wrist bands instead of leather), but it’s unlikely that both sellers have the same percentage of profit margin.
In the first example, we see value change based on location, and in the second example, value changes based on status perception.
In neither scenario, does the cost of creating the product dictate the final price, which is the essence of value-based pricing.
Let me guess what you’re thinking: “This sounds great and all, but how do I determine value?”
Step 1: Value-Based Pricing Starts with Segments
Segmentation is the starting line for determining value. Based on both of the above examples, for a company to understand its value it first has to understand the customer.
If we are selling water bottles, we have to know the customer’s environment. Are they at the park or taking a road trip? If we are selling watches, we have to know the customer’s income, lifestyle and job title. Can they afford an expensive watch? Does the customer care about demonstrating wealth through style?
You can use fencing methods to help with segmentation. Price fencing is when companies determine the eligibility for purchase at a specific price based on specific systems or rules.
For example, coupons or promotion codes can help companies sell to both price-sensitive segments and convenience buyers at different prices at the same time. The price-sensitive buyer will act when there is a “deal” on the table and they often are actively looking for those opportunities. The convenience buyer might not invest time or effort in looking for ways to reduce the cost of your product.
Another example of fencing is how Adobe can offer lower prices to educators and students who register for their products using a .edu email address. They also offer a percentage discount to nonprofits after submitting the 501c3 tax information. But, if you are a for-profit company or an individual, you’ll pay a higher premium.
So companies can segment their markets based on persona, willingness to pay, geography and other relevant categories
Step 2: Compare Value Not Prices
Once you have your segments identified, then you’ll do a little competitive research.
Keep in mind that supply and demand play a significant role in value-based pricing. If customers have an abundance of options and there is a low demand for those products or services, value is often perceived as lower. In contrast, value is higher if there is high demand for products and services but few available vendors provide them.
Answer the question, what is the next best option for my segment.
Let’s continue with the Adobe example. If you’re thinking about software that could help your small team produce some marketing materials or sales tools, Adobe is certainly one option.
What’s the other options? There is Canva, which has a much lower subscription cost. But if that’s not it, you could also choose Visme, which has excellent data visualization capabilities. There are even more options with varying price points: Easil, Stencil, Snappa and Crello. These are just design alternatives. There are also other photo editing, illustration and video production alternatives.
If you asked, “why should we choose Adobe for our company?” Adobe isn’t likely to respond, “Well, we have the lowest price or the best price.”
Instead, depending on the segment they’re selling to, they might talk about the customization of Adobe products, the robust editing tools, cloud storage for teamwork, immersive experiences, regular software updates and a library of professional training resources.
Additionally, we (humans) feel loss more viscerally than gains. So, an excellent Adobe sales person might talk less about all the features you’ll get when you choose them over their competitors. Instead, they’ll likely explain all the features you’ll lose when you go for cheaper, less robust software.
But first, the only way Adobe can know its value in the market is by knowing the market, which is why competitive research is crucial to establishing an effective value-based pricing strategy.
A cautionary note: if you stop your value-based pricing journey at this step, you’re likely to fall into competition-based pricing. This isn’t an ideal strategy because it can quickly lead to a race to the bottom.
Step 3: Know the Product’s Impact
Value-based pricing also requires knowing the impact the product or service will have on the user. Are you saving them time, money, resources or increasing their profits? If so, how much?
Let’s say that your product is accounting software for small companies. You might save your user time trying to track expenses. Or, save them money because the software is cheaper than hiring a CPA. You might increase their profits because you provide an easy-to-use invoicing system.
In this scenario, you’ll need to understand how many hours are small companies spending on accounting instead of doing the work that grows their business? How much is hiring a CPA compared to the software? How many invoices are late or unpaid because of delays and/or lack of reminders?
When you have this kind of insider information, you can craft your sales tools and marketing assets around those valuable features that speak directly to the customer’s problem.
How do you find this information? Start with NIHITO visits.
NIHITO stands for “nothing important happens in the office.” One of the most important activities you can do that’ll support your pricing efforts is to conduct market visits to learn more about your customers and what they value.
Why Value-Based Pricing Wins
Value-based pricing doesn’t weigh the cost of your product or service because the customer doesn’t care about your costs. They do, however, care deeply about how the product or service will help them achieve their goal.
For example, in the service industry, you might hire a cleaning company for your home. They could say, each month the cost of our cleaning supplies for your home is $40, gas to and from your home is $30, our hourly rate is $30 and it’ll be 10 hours of cleaning per month, and the company charges an additional overhead fee of $60 per month (revenue) — so you’re monthly cleaning bill is $430.
Or they could say, every month after you hire us, you can remove doing laundry, cleaning your kitchen and bathrooms and vacuuming from your to-do list. As a result, You’ll have approximately 30 hours to reinvest on hobbies and spending time with your family (or whatever brings you joy). The cost is $430.
Suddenly, you’ll discover you’re having a conversation about value not price with your customer.
Want to Learn More About Pricing Strategies?
Pragmatic Course: Pricing | $1,195
Learn more about pricing segmentation in the Price course. You’ll also learn how to determine market value and how to maximize your profit while minimizing discounting.
You’ll be introduced to several pricing tools including
- Product Portfolio Worksheet
- Isoprofit Tables
- Pricing Ownership Matrix
- Value Matrix
Pragmatic Learning Network: Accelerate Your Subscription Business | $500
Pricing expert Mark Stiving brings his expertise on subscription models to our Pragmatic Learning Network to help product teams improve their subscription businesses and drive growth.
In this self-paced course, students will learn:
- The three revenue buckets and how they drive prioritization
- The three levels to pull to create and capture more value
- Which growth strategies are best based on the life cycle of a product
- The four ways to grow revenue from a single customer