Value-Based Pricing 101

Despite abundance of available and accessible literature, value-based pricing (VBP) as a concept remains mystified.  The key reason is the difficulty of implementation.  This article’s aim is to provide the reader a concise review of the ‘do’s and ‘don’t’s of VBP.  The content is derived from two major sources: my understanding of the existing literature and my own case notes as a VBP practitioner.

Value-based pricing in its literal sense implies basing pricing on the product benefits perceived by the customer instead of on the exact cost of developing the product.  For example let’s consider the pricing of a painting.  A painting is priced much more than the price of canvas and paints.  The price in fact depends a lot on who the painter is.  Painting prices also shoot up with variables like age, cultural significance, and most importantly how much benefit the buyer is deriving.  Owning an original Dali or Picasso painting elevates the self-esteem of the buyer and hence elevates the perceived benefits of ownership.

Of course paintings as a product are at one end of the spectrum where the buyers usually are in favor of shelling out more (and definitely publicizing the same) and there is a direct sense of achievement associated with ownership.  At the other end of the spectrum we have commodity products, which are priced based on the market situation (buyer-supplier equation).  In between comes everything else – where there is some possibility to earn more by pricing on value.  However, in order to capture that value, it is important to understand the situation the business (or a product/service) is facing:

It is also important to understand the exact meaning of the diagram axes:

1. Level of Commoditization – The devaluation of differences in goods and/or services

The factors enhancing the level of commoditization are listed below –
A. Similarity between the competing products and services in the market place
B. Short industry-response time (Number of supplier firms increasing quickly)
C. Customers successfully leveling the playing field for suppliers

With increase in level of commoditization the product eventually heads towards a single market price.

2. Perceived Benefits of Product Ownership – Essentially the customer is purchasing the product for one or more of the following benefits:
A. Increase in earnings (for B2B)
B. Reduction in expenses (for both B2C and B2B)
C. Functional benefits of ownership (for both B2C and B2B)
D. Emotional benefits of ownership (for B2C predominantly)

Hence from the value-based pricing context the following should be the product-line targets:
1. Increasing product differentiations
2. Increasing the market-entry barrier
3. Successful communication of value drivers to the customers

In my understanding the key road-blocks to successful VBP are tactical needs.  Being overly focused on increasing revenue, market-share, mind-share, et cetera restricts VBP to just a good theory.  Very often the discussions on product benefits are overshadowed by discussions on accepting or trying hard to accept the customer’s target price.  Hence the first step towards success is liberating the pricing strategy from other needs.  This is possible if, at the organizational level, the pricing team is not reporting to the sales hierarchy.

Once the tactical needs are kept aside we can concentrate on the most important point: understanding the product and the applications.  Applications of the same product may be multiple, and for each application there may be a different value that can be passed on to the customer.  Let’s consider a hypothetical product A that has 3 major features – X, Y, Z.  For a certain application X might be important.  For another feature X may not be important, but Y and Z are required.  Now imagine that feature X is not offered by any competing solution (next-best alternative), but Y and Z can be achieved using multiple methods.  Hence in cases of applications that require X, the product A is of more value to the customer.

To illustrate, let’s assign place-holder attributes to all the variables introduced above –
A: A memory chip
X: World’s fastest access speed
Y: Low power consumption compared with industry standards
Z: Error Correction Code (ECC)

The application of Customer 1 requires reads and writes to be done in the shortest possible time.  The application of Customer 2 needs low power consumption and ECC, but doesn’t require the fast access speed.  In such a case, Customer 2 will see not much value of using A over the competing chips.  However for Customer 1, product A has great value.  The question is should we charge them the same price for the product?

Going back to the discussion on “level of commoditization”, we can observe that Y and Z don’t serve as product differentiators and therefore are not reducing the level of commoditization.

Once we understand the product, application, and the level of commoditization of a product–our task gets even more complicated.  We now need to assign a monetary figure to the value.  The monetary value is very often the opportunity cost.  Going back to the example above, let’s list down what are the alternatives available to Customer 1 (the guy who needed fastest reads and writes):

1. Use Product A
2. Use an alternate solution: Maybe coupling multiple memory chips (slower) in parallel
Hence effectively the value of product A is the cost of the “multiple slower memory chip” and the other added costs of using more than one chip (more interfacing pins, more power consumption et cetera).

Discussions on value monetization are often tough ones, and are characterized by immense contradictions.  However when done in the right way there is scope of observing returns.

At the end however a question remains unanswered: Do we charge separate prices for the same product to different customers?  If yes, how?

I will explore this question in details in the sequel to this article: Art of Discrimination.