Value-based pricing

Value-based price (also value optimized pricing) is a pricing strategy which sets prices primarily, but not exclusively, according to the perceived or estimated value of a product or service to the customer rather than according to the cost of the product or historical prices. Where it is successfully used, it will improve profitability through generating higher prices without impacting greatly on sales volumes. Value-based price (also value optimized pricing) is a pricing strategy which sets prices primarily, but not exclusively, according to the perceived or estimated value of a product or service to the customer rather than according to the cost of the product or historical prices. Where it is successfully used, it will improve profitability through generating higher prices without impacting greatly on sales volumes. The approach is most successful when products are sold based on emotions (fashion), in niche markets, in shortages (e.g. drinks at open air festival on a hot summer day) or for complementary products (e.g. printer cartridges, headsets for cell phones). Goods which are very intensely traded (e.g. oil and other commodities) are often sold using cost-plus pricing. Goods which are sold to highly sophisticated customers in large markets (e.g. automotive industry) have also in the past been sold using cost-plus pricing, but thanks to modern pricing software and pricing systems and the ability to capture and analyze market data, more and more markets are migrating towards market- or value-based pricing. 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, a painting may be priced as much more than the price of canvas and paints: the price in fact depends a lot on who the painter is. Painting prices also reflect factors such as age, cultural significance, and, most importantly, how much benefit the buyer is deriving. Owning an original Dalí or Picasso painting elevates the self-esteem of the buyer and hence elevates the perceived benefits of ownership. Price should be controlled within the value of the benefits that one business provides for its customer, while at the same time considering the price that their competitors' charge. Thus, prices are to be set according to the value that the business provides for its customer. To maximize the profitability of the products sold by the business, the business has to measure the benefit of the product that they provide to their customers, survey the criteria for the customers' buying decision (speed of delivery, convenience or reliability, etc.) and also identify the value of the benefits provided to the customer. Cost-plus pricing is an approach which takes the total cost of producing the product or service and adding some amount to allow the business to make a profit. For example, in a retail store, if a merchant buys something for $5, and they sell it for $10 to a customer, this is called cost-based pricing. However, the willingness for the customer to pay is limited by the benefits they can receive: 'Benefits are net benefits, where any cost that the customer firm incurs in obtaining the sought benefits, apart from purchase price, are included' (Anderson and Wynstra, 2010,31). Thus, the customer-perceived value is different between the net benefit they received and the price the customer paid, the supplier will not make any profit if the products are sold below the cost. Value-based pricing is defined based on the value that a product or service can deliver to a predefined segment of customers which are the main factor for setting prices (Hinterhuber, 2008, 42), as value-based pricing depends on the strength of benefits that a company can prove and offer to their customers. Thus, value is the most important driving force in every business decision as value focuses on the price the potential customers are willing to pay based on the benefit offered by the business. For example, the cost for fixing a pipe at a customer's home for a plumber is $17.50 with the cost of travel, material cost and an hour's labour. However, the plumber may decide to charge a total of $50 to benefit from this business. Thus, the customer might not be happy about the overcharged price given by the plumber, at the same time there are possibility that the plumber will lose their customer, so it is important to measure the value of a product before setting the price too high. On the other hand, if the company has a clear-defined benefit that gives you an advantage over the competitor, the company is able to charge according to the value that is offered to the customers. Thus, this is a very profitable approach as it can break off potential customers who are driven only by price and also attract new customers from competitors. For example, Starbucks raised prices to maximize profits from price insensitive customers who depend on their gourmet coffee while losing customers who wanted cheaper prices to McDonald's. Several factors affect customer willingness to pay certain prices; for example, the difference of needs between countries, individual customers needs and wants, and the usual customer facing different occasions (actual and present needs) - hence a plan to suit all time value-based pricing is impossible. An extreme focus on value might leave the customer feeling exploited, leading to negative affect towards the company. In the long term, prices based on value-based pricing are always higher or equal to the prices taken from cost-based pricing - if the prices were any lower, the customer might perceive the actual value to be lower than the cost of producing the good plus a profit margin. Companies will not be interested in producing and selling the product at that price in the long term. Despite being difficult in implementation of both pricing techniques on companies, there should be consideration of values on products and market positioning brought out to the customers in the early stage of product development. The conceptualization of sales strategy (Panagopoulos and Avlonitis, 2010) is an essential for companies to sell in a more strategic way rather than operationally selling their products. However, the focus of B2B (business-to-business) pricing method has transformed into the concept of appreciating and raising the value of a product in a market, such as value creation and value capture (Aspara and Tikkanen, 2013). One of the reasons for some companies not applying value-based pricing is that they do not know their own advantages and capabilities. Next, the objectives of the company are not aligned. It is a typical conflict of objectives in companies is market share versus profitability, because in a business tradition, the higher your market share, the more profitable the company is. Hence, to implement value-based pricing into a company, the company has to understand its objective and the advantages that stand out among the competitors in the same field. Thus, this will provide a benefit of dominating the targeted market for the company, hence, sustaining the segmented customers that the company is targeting. There are many ways of approaching value-based pricing. However, segmentation between companies decides and affects which market segment the company is attracting or aiming for. Generally driving segments, there are customers who just go for the lowest price product, or value buyers who are willing to pay more to purchase products that are worth the price. Thus, value–based pricing companies are aiming for types of segmentation like value buyers. In reality, each and every product in the market is sold at different prices, for more or less similar products. However, selling the same product at different prices is often illegal, because it is regarded as price discrimination or treated as unfair. For example, if customer A and customer B purchased the same item but charged at different prices, this is perceived as unfair. Hence, two of the strategies to go around the market and still to charge more from one segment than another are price fencing and versioning. Price fences are criteria which customers must meet if they are to qualify for a lower price e.g. fencing price buyers from convenience buyers by offering a lower price to shoppers who use coupons found in local newspapers. A convenience buyer only goes to a store and purchase the product they want to get in full price. However, price buyer wants a low price, so they would clip out the coupon they got from the newspaper and redeem the coupon in the department store for a discount. Thus, fencing and versioning are just the ways of how we can address different segments with the willingness to pay at different price point. By capturing the willingness to pay from price buyers with a low-end offering, and at the same also segmenting convenience buyer. Thus, companies are able to charge a much higher price in convenience buyer segment, so profit increases by serving different segments in different price points.