Value-Based Pricing

What is Value-Based Pricing?

Value-based pricing is a pricing strategy based on the buyer’s perceived value of a product or service. With value-based pricing, businesses determine what customers are willing to pay for their products based on how much they believe it is worth.

The value-based approach goes beyond traditional cost-plus pricing, which simply calculates costs and adds a predetermined profit margin.

To determine a selling price using value-based pricing, businesses must gather and quantify customer data to make informed decisions. This allows them to price products according to what they think the customer is willing to pay for them, in addition to their production costs and preferred profit margin.

Companies offering specialized products, features, and services are best positioned to use the value-based model — those selling commoditized products and services tend to use more straightforward cost-based pricing strategies.

Synonyms

• Customer value-based pricing
• Value-based pricing model
• Value-based pricing strategy

Value-Based Pricing Examples

Value-based prices work best in markets where customers have one of the following needs:

• They want to look, feel, or be seen as special
• They’re looking for a life experience they can’t get anywhere else
• They need features that a regular product can’t offer
• The services they need are only offered by a few hard-to-find companies

However, most businesses use value-based pricing in one way or another. Even if they sell “regular” products, they use marketing to elicit an emotional response that creates a perception of brand value.

Value-based pricing isn’t an exact science, but here are some examples of how companies use this pricing model:

Luxury Automakers

Luxury car buyers seek performance, quality, comfort, and aesthetics. In addition to the quality of the car, they’re paying for a brand and social status.

Luxury automakers solicit feedback through market research and use this data to inform the prices of their cars, and the general expectation is that those prices will be considerably higher than similar vehicles from mainstream brands.

In the case of extremely high-end vehicles (e.g., Lamborghini, Ferrari), buyers are willing to pay exorbitant amounts for the highest performance and most limited vehicles on the market.

Software-as-a-Service (SaaS)

SaaS companies use an interesting value-based pricing method. Since software is produced once, scaled, and maintained, it doesn’t have the same production costs as something like a car.

Additionally, software generally runs with lower overhead, so SaaS companies sell licenses for comparatively low monthly or annual rates (relative to the business value they generate).

As such, many software companies use tiered pricing to differentiate features and services based on the customer’s needs. This allows them to charge different prices for their products according to the value they provide, helping them meet the needs of different customer personas.

Standard (Yet Expensive) Products

Several products and retailers use a combination of cost-plus and value-based pricing and product marketing.

Apple routinely launches new products at higher price points than most of its competitors — not because they’re particularly expensive to produce or technologically advanced, but mostly because people think the product is worth it.

Marketing is a big part of Apple’s brand perception strategy — customer perceptions are heavily influenced by Apple’s stellar copywriting, minimalist design, and well-crafted product launches.

Social Media Influencers

Influencers can sell a product placement based on their followers, engagement, and relevance — metrics that can easily be attributed to revenue growth for another brand.

Though influencer marketing is usually done ad hoc, it’s not unusual for brands to pay extremely high prices for a single post or mention.

These fees are usually based on the influencer’s reach and engagement, as well as the perceived value of their audience and exposure potential.

Advantages and Disadvantages of Value-Based Pricing

Advantages

Value-based pricing has several advantages for businesses:

• Higher prices. Since value-based pricing is based on the customer’s perception of what a product or service is worth, businesses can charge premium prices. If they can produce high-quality products efficiently, this helps them maximize profitability and increase revenues.
• Markup potential. When buyers value a company’s product, they’re likelier to pay full price (or more) for it. This lets businesses raise prices while remaining competitive in their respective marketplace.
• Real willingness-to-pay data. Compared to cost-plus and competitor-based pricing approaches, a value-based pricing model provides companies real-time data about what customers are willing to pay for their products.
• Higher-quality product. Companies build better products when they adopt a customer-focused pricing model. It also motivates businesses to build differentiated features that current customers want.
• Greater cash flow for product development. The higher prices associated with value-based pricing models give businesses more cash flow to reinvest in product development (i.e., making the product better and sourcing the best components).
• Customer loyalty. A value-based price drives customer retention by delivering a price that meets their expectations, not just one that offers favorable profit margins.
• Sales efficiency. Potential customers are more likely to buy from a vendor when they’ve already justified some or all of their product’s value in their heads.

Disadvantages

Disadvantages of the value-based pricing approach include:

• No guarantee of perceived value. Buyers shy away from paying premium prices for products they don’t understand or see value in. This means businesses have to be extra careful in marketing and selling their goods, especially if they have a high degree of product complexity.
• Profitability issues. One of the key benefits of cost-plus pricing is its guaranteed profits. If price optimization doesn’t align with production and sales costs, companies forfeit some or all of their potential profits.
• Time and resource requirements. Implementing value-added prices requires a lot of market research, customer data, and analysis to ensure prices reflect true value — something that’s not always easy or straightforward.
• Customer perception risks. Value-based pricing is often based on perceived value — meaning it can be difficult (or even impossible) to get right in some cases. Some factors, such as fashion trends or tech innovations, can profoundly impact a product’s value in customers’ eyes.
• Price elasticity. Businesses walk a fine line between how much a customer is willing to pay and how much is too much. Although value-based pricing can often bring in more revenue, pushing customers past the tipping point results in significant revenue loss.

Types of Value-Based Pricing

There are two primary types of value-based pricing: good value pricing and value-added pricing.

Good Value Pricing

There are two primary types of value-based pricing: good value pricing and value-added pricing.

Good Value Pricing

Good value pricing is based on the premise that customers are willing to pay a fair price for a product as long as it meets or exceeds their expectations. The idea behind good value pricing is that the vendor shares the value creation with its customers while they enjoy the best price for their money.

For example, Amazon often sells its products at lower prices than many other retailers — thanks to its efficient logistics and distribution network, as well as its focus on continually improving the customer experience.

A “fair price” could also be a combination of factors such as convenience, quality goods, and premium customer service. Premium airlines, for instance, charge considerably higher prices than economy carriers, but passengers happily pay the difference for a better travel experience.

Value-Added Pricing

Value-added pricing involves bundling services or features with the main product to offer customers more value for their money. This is commonly used when companies have a unique offering and want to differentiate themselves from competitors.

For example, subscription-based businesses often offer additional features or services to customers willing to pay for them.

These value-added features, such as access to exclusive content or priority customer support, can be a major factor in convincing customers to sign up for a more expensive plan — even if they didn’t initially need the extra features.

Difference Between Value-Based Pricing and Other Pricing Models

The main distinction between value-based models and other common pricing methods is that the customer’s perceived value of a product drives its price, not just cost or competitor-based factors.

Value-Based Pricing vs. Competition-Based Pricing

Competition-based pricing (also called competitive pricing) is a pricing strategy where companies set their prices based on what their competitors are charging. It’s often used when an industry is dominated by a few large players, and the price of each company’s product is virtually identical.

Businesses would use competitive pricing over value-based pricing in the following scenarios:

• A company is starting out and doesn’t have enough data to determine value-based prices.
• Competitive intelligence shows existing pricing models to be the most profitable.
• There is very little differentiation between competitors’ products (e.g., similar features or quality).
• The market is saturated, and the perceived value for price is already clearly defined.
• The company wants to match or beat others’ prices to remain competitive.

In some cases, companies may use a combination of value- and competition-based pricing strategies.

Airlines are an excellent example of this — although they use dynamic pricing to give travelers a good value, they generally keep their pricing close to direct competitors and only use a higher price point when they offer more value.

Value-Based Pricing Vs. Cost-Plus Pricing

Businesses using the cost-plus pricing strategy set their prices based on the cost of making and delivering their products, plus an additional percentage for profit. This pricing model ensures guaranteed profits, but it doesn’t consider customer perception or value.

Businesses might choose cost-based pricing over value-based pricing in the following instances:

• The company wants to guarantee a profit regardless of customer demand or perception.
• The market is not price-sensitive, and customers are willing to pay whatever the company charges.
• The product has a high cost of production and requires significant amounts of capital investment.
• A company is selling a commodity product (e.g., oil or wheat) where pricing is determined by global demand and supply.
• A company’s product is heavily influenced by the market price of a commodity product, causing its price to fluctuate with it.

Plenty of companies develop and sell their products efficiently, then charge prices that meet value-based and cost-plus criteria.

Implementing cost reduction and process automation initiatives internally can make this easier to achieve.

How to Create a Value-Based Pricing Strategy

1. Identify and analyze current customers

The first step to creating a value-based pricing strategy is understanding your current customer base and their needs.

Start by determining your ideal customer profile (ICP). Your ICP will help you define the type of customers you want to target and make it easier for you to create a pricing strategy that’s tailored to their needs.

After determining your target customer, create buyer personas for each customer segment, including data points such as the customer’s age, gender, location, income level, and other demographic information.

In the case of B2B sellers, include firmographic data like the size and type of company they represent, internal structure, and industry vertical.

2. Survey your customer base and analyze data

Talking to customers in your target market is the best way to understand their needs and preferences (and eventually develop valuable products and reasonable price points).

There are several ways to do this:

• Surveys. If you have an email list, you can survey its members asking them about product features, user experience, and pricing preferences.
• Focus groups. Collecting qualitative data from groups of customers can provide invaluable insights into customer behavior and preferences.
• Interviewing. Conduct one-on-one or group interviews with pilot users or current customers to hear firsthand how your most critical users interact with your product.
• Sentiment analysis. Social listening tools, such as Hootsuite, can help you track customer feedback about your brand in the public domain.

Analyze the data you collect to determine your customers’ willingness to pay for different features or services, what perceived value they expect, and the overall demand for each item.

3. Analyze your total addressable market

Your total addressable market (TAM) encompasses your entire potential market share, rather than just competitive factors and potential customer values.

Analyzing your TAM helps you determine the number of users and potential revenue you can expect to bring in.

Researching market trends, such as average customer lifetime value (CLV) and penetration rate, will let you know if the demand for your product is worth pursuing or not.

4. Conduct competitive research

Competitors can tell you just as much as your customers. In addition to assessing their product pricing, look at which features they offer (or don’t offer), customer reviews, and how effectively they market their products.

Competitive research can also help you benchmark your product’s performance against the competition so you know what value you need to provide to compete.

When researching competitors, it helps to compare your company, its target market, and its products to theirs in a Venn-diagram-like fashion.

Although there is some overlap, competitors offering seemingly similar solutions still have their own target buyers. Understanding these factors can help you determine how relevant their pricing model is to your organization’s needs.

5. Assess your viability for a value-based approach

Not every company benefits from a price based on customer value. After analyzing your total addressable market and competitors, assess the following:

• Availability of perfect (or near-perfect) substitutes
• Operating costs
• Product costs
• Cost of customer acquisition
• Market demand
• Sales and marketing budget

In general, value-based pricing only makes sense if you offer a differentiated product with relatively high demand and have the sales and marketing infrastructure to communicate its value.

6. Build pricing tiers 

Pricing tiers should be based on the different types of customers you serve. You can offer a freemium or low-cost version to budget-conscious customers, basic or mid-level services for customers who don’t need to use all your product’s features, and a complete version for customers who would benefit from its full functionality.

Consider your product’s full abilities (i.e., your high-end features). Distinguish your essential features that all tiers should contain from your premium features that only customers who pay the highest amount should get.

For example, a company that sells automated invoicing software could keep features like branded invoice and PO creation and reporting in its basic tier while offering more advanced options like payment and customer analytics and international processing in its premium version.

7. Test and review

Ultimately, the only way to truly know how your target market will respond to your pricing is to start selling. That’s why the most important part of developing a value-based pricing strategy is testing and reviewing it.

As you carry out your sales process and run marketing campaigns, collect customer data that shows you how the market responds to your pricing.

Use this data to fine-tune the price according to customer sentiment or demand, and monitor it regularly for any changes in customer behavior.

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