Adopting value-based pricing has a significant impact on your firm’s profits. Do you take a strategic approach to set prices based on customer value or are you using a cost-plus method?
Your company’s pricing strategies directly impact profits but also play an important role in your firm’s branding and positioning.
Unfortunately, few companies take a proactive, strategic approach to price setting. As a result, they don’t achieve their full profit potential.
Price Setting – Marketing and Finance Working Together
The difference between simply setting a price and value-based pricing is the difference between reacting to competitive pressure and proactively shaping the market.
A comprehensive strategic approach involves the coordination of both marketing and financial decisions about product pricing to achieve financial goals and marketing objectives.
Pricing is a key element of a smart marketing strategy. If you leave pricing up to the sales force or distributors you’re not taking advantage of the strategic aspect of price-setting. To make things worse, salespeople usually focus solely on closing the deal, at any price, not the profitability. The practice of steep discounting is not uncommon. Of course, this not only cuts into your profits but also jeopardizes the firm’s brand and positioning.
Setting prices should be done at the managerial level. The marketing and finance departments need to work together to find the right balance between the customer’s desire to get a great deal (low price) and the firm’s goal of maximizing profits (high price).
Cost-Based Pricing, Too Low or Too High
Cost-based pricing is commonly used because it appears to be based on sound financial considerations.
However, the cost-plus method leads to prices that are too high in weak markets and too low in strong markets. Of course, this is exactly the opposite of what you want to achieve with a good pricing strategy in the first place.
The typical sequence for cost-oriented pricing looks like this:
In this approach, you start with the product or the design and determine the cost. Based on this cost and a somewhat arbitrary margin or markup, a market price is then established. To justify the price, some kind of ‘value’ narrative is then created and presented to the target market. Unfortunately, the company’s idea of what is value does not necessarily reflect the customers’ perceived value of the product.
Typically, with the cost-plus method the price ends up being either too high, resulting in lower demand and missed sales, or too low, resulting in the firm leaving money on the table. The cost-plus method is rarely ‘just right’.
Value-Based Pricing for Higher Profits
Unlike cost-plus pricing, with value-based pricing the process of determining a price starts much earlier in the product development cycle. Ideally, it involves finding out what customers would be willing to pay for a particular solution when the product is still on the drawing board or perhaps just a concept.
A value-based pricing approach follows these steps:
- Find out what the customer’s problems are
- Determine how they value a solution
- Figure out what price they’re willing to pay
- Establish the cost of the solution
- Find out if the product can be sold at a profit
Now, if the margin that the firm expects to earn meets targets, you can start the development of the product. But, if the projected margin is too low, the product cannot be sold profitably.
Needless to say, it makes no business sense to invest in developing a product that cannot be solid at a profit. Now, you may be able to modify the product and change features to bring the cost down. But this is going to impact customer perceived value as well. Obviously, it takes some iterations to get value, price, and product content just right.
The key to remember is that value-based pricing starts with the customer, their needs, and how they perceive the value of your solution. You don’t start with the product.
Why Use Value-Based Pricing?
In most cases, value-added pricing leads to a higher price and a better margin.
The value-based approach forces you to create a solution with a higher customer perceived value. These customers pay a premium for your product.
Create More Value for Your Customers
A customer-centric approach produces in a better solution with a strong customer-perceived value, improving your firm’s branding and positioning. As a result of creating a better product, you’re likely to increase customer loyalty.
Source of Differentiation – Avoid the Commodity Trap
With the entire organization focused on providing value to the customers, you can prevent your products from becoming commodities. The value-based approach creates a powerful differentiation in the marketplace.
Price Changes Impact Demand and Profitability
Adopting value-added pricing is directly connect to the need for evaluating the impact of price changes on demand and profitability. A value-based approach starts by asking these questions:
- If we lower the price, what volume increase do we need to earn higher profits?
- If we increase the price, what volume decrease can we accept and still earn higher profits?
At the root of these questions is how demand changes with price (price elasticity of demand)) and how product cost is impacted by changes in production volume. The assumed overarching objective is the company’s desire to maximize profits, not sales revenue.
Related to this issue are questions that deal with marketing strategy, branding, and perceived customer value:
- Which marketing strategy keeps volume changes within an acceptable range?
- What cost increase is acceptable?
- Is our pricing justifiable given customer perceived value?
- How can we communicate product value to justify the price?
- How to segment the market for effective price differentiation?
- What level of sales or market share can we most profitably achieve?
- What cost-effective marketing programs result in market share gains?
Start by Reviewing Your Pricing Process
By now, it should be clear that there’s a lot more to price setting than simply adding a markup to the product cost.
Follow these steps to introduce value-based pricing to your organization:
- Review your current pricing process
- Review your customer segmentation and target markets
- Carry out market research to determine perceived customer value
- Refine customer segments based on customer value and price sensitivity
- Conduct detailed profit analyses of customer segments and products
- Determine your pricing power
- Establish value-based price levels
- Introduce value-based pricing to the market
- Monitor the impact on profitability and positioning
Value-added pricing is an important facet of marketing strategy and improves your company’s bottom line. Don’t let price-setting be an afterthought.