Value-Based Pricing can have a significant impact on corporate profits. Do you take a strategic approach to set prices for your products and services?
Value-Based Pricing Increases Profits
Pricing not only impacts short-term profitability, but it is also a key element of the marketing mix that impacts not only profitability but also branding and positioning.
Few companies are strategic and proactive about price setting. As a result, they don’t achieve their 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 or proactively shaping the market.
A strategic approach involves the coordination of marketing and financial decisions to price for achieving company goals. This means thinking about when and how pricing decisions are made and who should be involved in the process.
Setting prices at a strategic level requires management to take responsibility for establishing pricing policies and procedures, consistent with financial, branding and positioning goals. Leaving it up to the sales force or distributors to set price levels 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 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 Doesn’t Work
Traditionally, Cost-Plus pricing is the most 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. This is exactly the opposite of what good pricing should be doing.
The typical Cost-Plus approach follows this sequence:
Here, the company wants customers to buy their product at a price that does not necessarily reflect the customers’ perception of ‘Value’. Price levels end up either too high, resulting in reduced demand or too low, resulting in the company leaving money on the table. Rarely is the cost-plus based price ‘just right’.
As a result, when sales volumes then remain below expectations, prices are dropped to improve demand, but at the expense of lower margins.
Value-Based Pricing for Higher Profits
Value-based pricing involves anticipating what customers are willing to pay when the product is still in the early stages of development. Product development and pricing decisions based on customer needs and their perception of value follow this sequence:
The company produces what customers want to buy and at a price that they are willing to pay based on the value perceived. A Value-Based Pricing approach includes these steps:
- Investigate what the customer’s problems are
- Determine how much they value a solution
- What price are they willing to pay for this solution?
- What is the cost of producing this solution?
If the anticipated gross margin meets targets 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 in further product development. In some cases, you may be able to go through a cost reduction effort to simplify the product, but the approach remains the same. Start the assessment with the customer, their needs, and the perceived value of a solution.
Questions to Ask Before Changing Prices
You should take a similar, strategic approach when you’re considering price changes of existing products and services. A value-based approach starts by asking the right questions:
- Which increase in volume produces higher profits at a lower price?
- Which decrease in volume lets us earn more profits from a higher price?
The answers to these questions depend on how product demand changes with price and on the relationship between product costs and production volume.
Additional questions to consider deal with marketing strategy, branding and customers’ perception of value:
- Can we deploy a marketing strategy to keep sales volume changes within an acceptable range?
- What costs can we afford to incur, given the price levels in the market, and still earn a profit?
- Is our price justifiable given the customers’ perception of value?
- How can we better communicate the product value to justify the price?
- How can we better segment the market to justify pricing differently when the value is different?
- What level of sales or market share can we most profitably achieve?
- Which marketing tools should we use to win market share most cost-effectively?
Review Your Pricing Process
Take a fundamental look at your price setting by following these steps:
- Review your current pricing process
- Review your customer segmentation and target markets
- Identify opportunities for segment refinement based on price sensitivity and ‘value perception’
- Conduct detailed profit analysis of your customer segments and products
- Determine your Pricing Power
- Increase your value and Pricing Power
Pricing decisions have a direct impact on your bottom line. You can improve your company’s profitability by taking a strategic approach to pricing. Don’t let it be an afterthought.