Adopting value-based pricing can have a significant impact on your firm’s profits. Do you take a strategic approach to set prices based on customer value or are you still using cost-plus?
How you set prices for your products not only impacts profitability, but it also plays an important role in branding and positioning.
Few companies are strategic and proactive about price setting. As a result, they don’t achieve their full profit potential and their positioning can be hurt as well.
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 marketing and financial decisions about product pricing to achieve financial goals and marketing objectives. This also means developing a formal process for how pricing decisions are reached and thinking about who should be involved.
Leaving it up to the sales force or distributors means not taking advantage of the strategic power of pricing and potentially jeopardizing not only profitability but also the firm’s brand and positioning.
It is important that the marketing and finance departments work together in finding 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-Plus Pricing – Too Low or Too High
Cost-plus pricing is a commonly used approach because it appears to be based on sound financial considerations. However, cost-plus pricing 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-plus pricing goes like this:
In this sequence, the company starts out from the product and determines its cost. Then, using a somewhat arbitrary margin or markup, a market price is established. This price is then wrapped into some kind of ‘value’ narrative and presented to the target market. Unfortunately, this does not necessarily reflect the customers’ actual value perception of the product.
Cost-plus pricing ends up either too high, resulting in lower demand and missed sales or too low, resulting in the firm leaving money on the table. Rarely is cost-plus pricing ‘just right’.
Value-Based Pricing for Higher Profits
Unlike cost-plus pricing which is an ‘after-the-fact-approach’, with value-based pricing the process of setting a price starts much earlier in the product development cycle. Ideally, it involves determining what customers would be willing to pay for a particular solution when the product is still in the early stages of development.
A value-based pricing approach follows these steps:
- Investigate what the customer’s problems are
- Determine how much they value a solution
- Find out what price they’re willing to pay
- Determine the cost of producing the solution
- Find out if the product can be sold at a profit
If the gross margin that the firm expects to earn meets targets, then you can start the development of the product.
However, if the gross margin is too low, the product cannot be sold profitably. In that case, it makes no business sense to invest further in product development. You may be able to go through a cost reduction effort to simplify the product, but this is likely to have an impact on customer value as well.
The key takeaway 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?
You can generally earn higher profits because the value-based approach requires you to deliver a solution that is highly valued by your target customers who are willing to pay a premium for your product.
Create More Value for Your Customers
A customer-centric approach results in a better solution with a strong customer perceived value, improving branding, positioning, and 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 approach creates a powerful differentiation in the marketplace.
Price Changes Impact Demand and Profitability
The value-based pricing concept goes hand-in-hand with evaluating the impact of price changes on demand and profitability. A value-based approach starts by asking these questions:
- At a lower price, which volume increase is needed to earn higher profits?
- At a higher price, which volume decrease will 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 costs can be incurred and still earn a profit?
- Is our pricing justifiable given customer perceived value?
- How to 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?
- Which marketing programs are needed to win market share cost-effectively?
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. If you’re thinking about introducing value-based pricing and taking a more strategic approach to product pricing, consider these steps:
- Review your current pricing process
- Review your customer segmentation and target markets
- Carry out market research to determine perceived customer value
- Review segment refinement 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
Improve your company’s profitability by taking a strategic approach to pricing. Don’t let it be an afterthought.