Value-Based Pricing in 7 Steps
Value-based pricing forces you to look at your products and services the way your customers would.
Setting prices that are not too high to risk losing customers but not too low that they eat away at your bottom line is often seen as a dark art. It does not need to be that way.
Value-based pricing is a method that determines the selling price of a product based on the perceived value a customer derives from it. The value can come in the form of, for example, prestige, time savings, or a particular flavor profile in food.
Unlike cost-based pricing, which calculates selling prices by adding a fixed markup to what you pay your suppliers, value-based pricing centers around how your customers perceive your products and services' value. Although this value is very subjective and can differ for each customer, commonalities can be found when looking at customer groups, so-called customer segments.
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Step 1: Segment Your Client Base
In my experience, a business rarely serves a homogeneous customer base. Often they are differences in the customer behavior and preferences.
If these differences are minor, they do not change your approach much, and you can group these customers in one segment.
However, some clients have preferences that will not fit this segment. For example, they could favor higher-priced products or a complete set of services with multiple weekly touch points instead of lower-priced products or a one-time service. As you would likely approach and retain these customers with a different marketing strategy to address their needs, you would group them into a separate segment.
Customer segments are a phenomenal tool to structure your business and simplify marketing activities. Think of these segments as each representing a typical customer. Pros even give these customer segments a real-person name to make them more lifelike when creating campaigns.
Step 2: Define the Preferences and Values (Per Customer Segment)
Each customer segment should have its unique set of preferences and values. If you notice that these preferences and values significantly overlap between two segments, you may want to consider merging them. That way, you avoid spending valuable resources on creating two different marketing strategies to address essentially the same preferences and values.
Step 3: Determine the Value Attributes for Each of Your Products and Services (Per Customer Segment)
Which attributes (features) of your products and services create value for customers?
Trying to answer this question usually leads to different opinions. They are welcome because this input is necessary for establishing appropriate price levels that align with the value your products and services create for your customers.
Step 4: Assign a Price Category to Each of Your Products and Services (Per Customer Segment)
Based on the value attributes of each product and service, try to come up with a selling price.
There is some guessing involved in this part.
But when you go through these steps again and fine tune them, you can adjust your initial selling prices until they feel coherent and logical.
Step 5: Compare Your Price Categories With Those of Your Competitors (Per Customer Segment)
Comparing the prices of your products and services with those of your competitors is a crucial not-to-skip reality check. You do not want to price your products and services too high and lose customers or too low and leave money you could have earned on the table.
Step 6: Calculate a Gross Profit for Each Product in a Price Category (Per Customer Segment)
In this step, you take the cost for each product or service and deduct it from its selling price. The difference between your selling price and your cost is your gross profit.
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After calculating the gross profit value and the corresponding percentage for all of your products and services, you can spot outliers in each price category.
When the cost of a product or service is higher than the other items in this price category, the gross profit percentage is lower.
Try to understand the reasons for this deviation and make adjustments if necessary.
Should this difference persist, you basically have two options: Either you live with a lower margin on this article, or you switch to a lower-priced supplier.
Step 7: Harmonize the Price Categories Across Your Customer Segments
In this final step, you harmonize the price categories across your customer segments to create a coherent pricing structure for all products and services at your company.
It will likely take you multiple rounds before your pricing structure shows some coherence and makes sense.
Take your time, welcome discussions, get as much input as possible, and continue to fine tune your product and service prices until your pricing structure is logical and understandable for an outsider.
Is Value-Based Pricing Right for You?
If value-based pricing is right for your business depends on three factors.
Your industry. Suppose you are a retailer reselling the exact same products your competitors are selling. In that case, value-based pricing is probably not the right tool, and cost-plus pricing might be more efficient. However, if your products and services are similar to your competitors but differ in many features, you could give value-based pricing a try.
The price elasticity of demand. If you can increase prices without decreasing unit sales, demand is considered price inelastic (price insensitive). Conversely, if you raise prices and your quantities fall off a cliff, demand is considered price elastic (price sensitive). It is best to use value-based pricing when demand tends to be more price inelastic to give you more room for price increases before you see reduced unit sales.
Exclusivity and prestige. If exclusivity and prestige are important factors in selling your products and services, value-based pricing can help you streamline your marketing message and create products with different features at various prices to capture a higher market share across multiple customer segments.
As a rule of thumb, if your business operates in an industry with less price-sensitive customers, an industry where the features tend to set your products and services apart from the competition, then value-based pricing can be a good option.
What I like about the value-based pricing method is that value-based pricing forces you to look at your products and services the way your customers would. Bringing this outside perspective into a company generally shortens many lengthy internal discussions, potentially leading to more innovative products and better customer service. And that part alone already is priceless.
