Here’s a challenging question from a reader: “Value-based pricing” has made a buzz in the dialogues of pricing practitioners and academics. Should all companies change their pricing strategy to value-based pricing? What about companies with an everyday low price (EDLP) strategy?
My answer, “Yes!” Kind of. My first reaction was the emphatic “yes,” until I read the part about EDLP. That caused me to pause and think for a bit. As a specific example, should Walmart use value-based pricing? I’d argue they do, but let’s get there more slowly.
First, we need to agree to a definition of value-based pricing. Here’s mine:
Value-based pricing means charge what a customer is willing to pay. This is impossible. However, the goal is to always get closer and closer. In the realm of EDLP companies, I’ll use the low bar of whether their pricing methodology is more effective than simple cost-plus pricing.
Groceries, big-box retailers, distributors, and many other retailers have two characteristics that make value-based pricing more difficult. They offer thousands or hundreds of thousands of SKUs and they don’t negotiate prices with customers. Let’s look at each of these.
It is simply impractical for a company to look at each of thousands of SKUs (stock keeping units) and attempt to estimate buyers’ willingness to pay, especially trying some of the tools we typically use on larger priced B2B items. However, the large quantity of customers and purchase data they accumulate enables them to use statistical models to estimate optimal pricing. The act of watching demand fluctuate as prices fluctuate is capturing at an aggregate level what buyers are willing to pay.
These companies are also in take it or leave it (TIOLI) markets, meaning they don’t negotiate with individual buyers. This means they will never have the ability to set a price at exactly what a buyer is willing to pay. They set one price and each buyer decides whether or not to buy at that price. In these types of markets, companies should be estimating the range of behaviors of the buyers and choose the price where they earn the most profit. The statistical models referenced previously do precisely that.
The last, possibly most important, part of pricing methodologies by these types of companies is how to get buyers into their stores instead of their competitors’ stores. Think of this as value-based pricing the entire store. They typically do this by knowing which products buyers use to compare stores and making sure those prices are priced appropriately. Surely, you’ve heard of groceries advertising milk as a loss leader just to get shoppers into their store. EDLP retailers must be good at this to obtain and maintain the reputation of a low-priced outlet.
Does Walmart use value-based pricing? Absolutely, at least the way I’ve described it here. They don’t use a single markup percentage for every item in the store. They have category managers determining how to price different products within a category. They surely use sophisticated statistical demand models to determine how to price. They absolutely know what products people use to compare stores.
How is this for another definition of value-based pricing? Price closer to your buyers’ willingness to pay than you are today.