Updated July 4, 2023
What is Value-Based Pricing?
Value-based pricing is a pricing strategy that sets the price of a product/service based on the perceived value it provides to the customer rather than on its production cost or market competition.
By charging a price that reflects the value that the customer receives, a company can differentiate itself from competitors. Thus, it can potentially command a premium price for its products or services, leading to higher profit margins and customer loyalty.
For example, the diamond industry rests entirely on perception. Even though they are one of the most common gems in the world, their price makes them seem rare and valuable. Here, the diamond industry has created an illusion of the stones’ preciousness. Hence, customers are willing to pay more, allowing the retailers to charge hefty margins.
- Value-based pricing is a pricing strategy where the basis of the price determination of the product is the value it delivers to the customer.
- It focuses on the value a product provides to the customer rather than its production costs.
- Companies determine the price of their product based on how much customers are willing to pay, which can result in higher profit margins.
- It requires a deep understanding of the target customer, their willingness to pay for the product, and the competitive landscape.
- It can help companies create a strong brand image and differentiate themselves from competitors.
- However, it can be challenging to implement, and businesses must carefully evaluate its suitability for their product and market before implementing it.
How does Value-Based Pricing Strategy Work?
To deploy this strategy, a company should consider the following factors:-
Focus on the Customer Segment
- A critical aspect of this strategy is targeting a particular segment of customers.
- For example, Brand A has come up with a 700 liters refrigerator, which is one of a kind of refrigerator available in the market. Now Brand A’s target segment is big-capacity refrigerator buyers and not all buyers. A person can call it segmentation of the target audience for setting up this strategy.
Comparison with the Next Best Alternative
- It involves evaluating the product’s value proposition relative to its closest substitute or competitor in the market.
- For example, Brand B may compare the quality of materials, craftsmanship, and unique features of its watch to those of its closest competitors to ensure that its pricing reflects the added value it provides.
- This comparison helps to justify the premium price of the watch and ensures that customers are willing to pay more for its benefits compared to other high-end watches in the market.
- When the company has a reference, it is essential to understand the difference between its product and its competitor’s product.
- The company needs to identify differentiated features and assign them a dollar value to create perceived value.
- For example, suppose the competitor’s 600-liter refrigerator has a price tag of $799. In that case, the company can add $100 to the competitor’s price by offering a 700-liter capacity refrigerator at $899 because it provides 100 liters of extra capacity compared to its competitor.
- A survey of the targeted segment of customers is an essential part of this strategy.
- Based on this strategy, customer feedback on price is necessary before launching a product and should continue even after launch.
- A continuous survey will help the company price the product better as a game of perception that can quickly change.
Value-Based Pricing Examples
#1 Luxury Handbags
Luxury brands such as Louis Vuitton, Chanel, and Hermes offer products that are not just well-made and high-quality but also carry a premium brand image and exclusivity. These brands understand the perceived value that their customers place on the brand, quality, and image, and they set their prices based on that value.
While the production cost of a Louis Vuitton handbag, for example, might not be significantly higher than that of a less expensive handbag from a different brand, Louis Vuitton can charge a much higher price because of the perceived value that its customers place on the brand.
#2 Software Industry
In the software industry, companies like Salesforce and Microsoft offer different pricing plans based on the features and functions that their customers need. By offering different pricing plans, these companies can ensure that their customers pay for the features and value they need rather than a one-size-fits-all solution. This method helps to explain why more advanced software packages cost more since customers are willing to pay more for the extra value and benefits they get.
#3 Healthcare Industry
Primarily, in the healthcare industry, manufacturers set the prices for medicines on factors like hospital reimbursement, production volume, and more. Thus, the prices were extremely high. However, recently the Centers for Medicare and Medicaid Services (CMS) announced that the prices for prescription drugs will be as per the value they provide to the patients.
How to Calculate Value-Based Pricing?
Setting pricing based on value is not a fixed formula but a flexible one that requires ongoing market research, customer feedback, and an assessment of market conditions. Instead of just using the cost of production to set prices, this pricing system tries to determine how much a product or service is worth to customers.
Step #1 Determine the Customer’s Perception of Value
It involves understanding the customer’s needs, preferences, and expectations for the product or service, as well as the benefits that the product or service provides.
Step #2 Evaluate the Competition
Knowing the prices and value propositions of competing products or services can give you essential information about what the market will bear and how customers value similar products or services.
Step #3 Set the Price Range
Using the information you got in steps 1 and 2, set a price range that accurately shows how much the customer thinks the product or service is worth.
Step #4 Set the Final Price
One should set the final price within the price range determined in step 3, considering factors such as the company’s cost structure, profitability goals, and market conditions.
#1 Coffee Machine
A company sells a high-end coffee machine that can brew coffee in multiple ways, including espresso, cappuccino, and latte. Determine the price that the company can charge.
#1 Determine the machines value for the customers that drink coffee
Customers value the ability to brew high-quality coffee at home with various brewing options.
#2 Evaluate other brands manufacturing a similar product
Coffee machines from brands like yours cost between $500 and $1000.
#3 Decide the price range for the coffee machine
Based on how the customer sees the value and how much competition there is, the company decides that their coffee machine should cost between $600 and $900.
#4 Select the final price for the coffee machine as per the value
The company sets the final price at $850, considering its cost structure, profitability goals, and market conditions.
#2 Yoga Classes
A company offers a high-end yoga class service that includes personalized instruction, a private studio, and access to high-end yoga equipment. Determine the price that the company can charge.
#1 Determine the perception of the value of the classes for the yoga students
Customers value personalized instruction, private studios, and high-end equipment and are willing to pay a premium for a premium experience.
#2 Evaluate competitor yoga classes by other trainers
Competitors offer similar premium yoga classes for $100 to $150 per session.
#3 Determine the yoga course’s price range
The company sets a price range of $120 to $140 per session based on how the customer sees the value and how much competition there is.
#4 Set the final price for the yoga class
The company sets the final price at $135 per session, considering its cost structure, profitability goals, and market conditions.
Types of Value-Based Pricing
|Particulars||Good Value Pricing||Value-based Pricing|
|Definitions||Good value pricing refers to a pricing strategy that offers customers a reasonable and justifiable price, considering the benefits the product provides.
|Value-based pricing refers to pricing a product based on the perceived value of its additional features to a customer.|
|Purpose||It aims to offer customers a product that delivers the expected benefits at a reasonable price, resulting in a good value proposition.||The purpose of this pricing system is to set a product’s price based on the value it provides to the customer, which can lead to increased profits and customer satisfaction.|
|Examples||A restaurant’s lunch combo of a sandwich, fries, and a drink costs $10, which is fair and reasonable given the quality and amount of the food. It’s a good deal for customers.||A brand’s new mobile model has an advanced camera feature that costs $100 more than their previous model. As people like the features, the brand sets the price of their new phone considering the value of the new features.|
Difference Between Value-Based Vs. Cost-Based Pricing
|Value-Based Pricing||Cost Based Pricing|
|Value-based pricing sets prices based on customers’ perceived value of the product or service.||Cost-Based Pricing is a pricing strategy that sets prices based on the cost of producing and delivering the product or service.|
|It emphasizes the customer’s perspective and willingness to pay.||Emphasizes the company’s costs and expenses.|
|It can lead to higher prices for high-quality or unique products.||Leading to lower prices for commodities or low-quality products.|
|It focuses on creating and communicating value to the customer.||Focuses on recovering costs and making a profit.|
|It encourages companies to improve their products and services continuously.||Encourages companies to control costs and minimize expenses.|
|It may result in increased customer satisfaction and loyalty.||It may result in lower customer engagement and loyalty.|
|Examples: luxury goods and premium services.||Examples: food, essential goods, and services.|
Value-Based Pricing Advantages
There are various benefits of this pricing strategy are as follows:
It may lead to a higher profit margin for the company
- This strategy works in favor of the seller when a person considers the products prestigious.
- While buying a luxury product, buyers only look at the value of the product and ignore the actual possible cost of the product.
- Thus, they are ready to pay a high markup leading to an increase in profit margin for the company.
Possible increase in the brand value
- As affection and positive perception grow, it leads to the promotion of brands and an increase in brand value.
- Customers are the company’s advertisers, leading to more reach of the company’s products.
It leads to better production efficiency
- In this strategy, there is a constant effort to incorporate the customer’s feedback to include the same in future products to increase the perceived value.
- Hence, it leads to a better quality of production over time.
- When companies ask their customers about their preferences and expectations, it helps them gain their customers’ confidence.
- Thus, customers become more loyal.
Balance in supply and demand
- It gives the company an estimated market demand for its goods.
- It gives them an idea of the number of buyers who can afford to purchase their product and are ready to pay a premium price.
- Knowing the market demand for a product allows a company to develop supply correspondingly.
Disadvantages of Value-Based Pricing
Some of its disadvantages are as follows:
It is not always stable
- Perception is the basis of pricing based on the value. The most significant disadvantage is that it can change due to external economic, cultural, or technological factors out of the company’s control.
- Relying on it to increase profit margin can backfire if a competitor comes with a better product at a competitive price.
Require significant time & resources to fetch customer data
- It depends on customer feedback. The company has to constantly spend to get customer feedback and incorporate it time and again in the product.
- It applies not only to the features of a product but also to the pricing.
- Also, companies trying to create pricing based on the value spend a lot on marketing to make the correct product perception.
- One of the disadvantages of pricing based on value is that a company can only target a restricted number of clients who can purchase your goods.
- A market has a specified number of customers who can afford the high pricing.
- A small number of consumers indicates that business growth is finite.
Difficulty in business expansion
- It is appropriate for smaller firms that sell highly specialized items.
- A person can only apply this strategy to a smaller audience, making it the least desirable option for organizations looking to expand their business.
- Another significant disadvantage of pricing based on value is market competition.
- When a company charges high prices, its competitors can make and sell the same product at a lower price.
- As a result, it will share its already limited consumer base and impact its profit.
Increased production costs
- Producing customized products is more expensive.
- To provide high-quality items, a company will need highly skilled workers.
Setting a value-based product price can be challenging since a single price may not work for all customers. However, it can be a powerful tool for building brand value and generating high markups. Before adopting this pricing strategy, businesses must evaluate its suitability for their product. The most effective method lies somewhere between cost-plus and value-based pricing. A good strategy can be to start with cost-plus pricing to cover production costs, build brand value through marketing, and switch to pricing based on value.
Frequently Asked Questions (FAQs)
What is value-based pricing?
A pricing strategy that determines a product’s price based on the value it offers to customers rather than its cost is referred to as value-based pricing. The aim is to establish a price that mirrors the product’s perceived value to customers, resulting in increased profits and brand value.
What is value-based and cost-based pricing?
Cost-based pricing bases a product’s price on its production cost plus a markup to cover expenses and make a profit. Value-based pricing bases a product’s price on the value it gives to customers.
Why is Starbucks value-based pricing?
Starbucks is the master of deploying a value-based pricing strategy. They set the target price using research and customer analysis, and each product they sell to customers adds value.
How to determine whether value-based pricing is right for your business?
Value-based pricing works well for businesses whose leaders are sure that their product stands out because it has features that other products on the market don’t have. But more importantly, it is correct when a company has spent sufficient time in the market and created its brand value.
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