For many companies, the traditional way to set prices has been some form of cost-plus pricing. In other words, they calculate their costs, slap on a margin, and there they have a price. However, this pricing scheme has come under increasing pressure as of late, and exploration is underway into other pricing schemes.
The most prized goal at the moment is often value-based pricing: determining the value the customer is able to create with the service and adjusting the price accordingly.
In this post, I will look into what value-based pricing is and how a more sophisticated understanding of what value is can help companies on their journey towards value-based pricing.
One of the key concepts in pricing is price discrimination. It means that identical or largely similar goods are priced differently by the same provider depending on the customers’ willingness to pay (WTP). Providers typically love to be able to employ some form of price discrimination, because it enables them to improve their profits: if you can sell with high price to people who really want the product and at a lower price (still covering your costs) to people who do not want the product quite as much, you can maximize profits.
There are three types of price discrimination:
First-degree price discrimination (personalized pricing). The firm can price its products to perfectly match each customer’s willingness to pay. Project business is the most classic example of where this is possible, although it is becoming increasingly common to do this on consumer markets over the internet as well – Amazon began experimenting with this in the early 2000s, showing different prices for different people for the same products, but the big consumer backlash forced it to stop that practice back then. However, the practice has gained more prevalence as of late.
Second-degree price discrimination (menu pricing). The firm offers different deals, e.g. combinations of price and quality/quantity, and the customers self-select the deal they want. Examples of this include non-linear pricing (volume discounts), versioning (economy/business class flights; student versions of software), and bundling (PS4 with The Last of Us; Word and Excel in MS Office bundle).
Third-degree price discrimination (group pricing). The firm is unable to determine individual willingness to pay, but it can determine rough estimates for different groups. The groups can be identifies, for example, based on work status (student discounts), location (soft drink at a supermarket or at an airport), region, country, or time (travel in peak season or off-peak season).
In order to use value-based pricing effectively, it is vital that the company is able to use some form of price discrimination, preferably the first-degree variant. However, it is important to note that just because a company uses some form of price discrimination, it does not necessarily do this on value basis.
Value-based pricing is based on recognizing the value of the service, and sharing the gains created in its use by all involved parties.
Traditionally, a value-based price is formed from four building blocks:
- Reference price. The market price of the alternative service the customer could buy.
- Net revenue gain. The net revenue gain for the customer compared to the competing service. This has to be realistic and take into account possible revenue losses as well.
- Net cost reduction. The net cost reduction for the customer compared to the competing service. This has to be realistic and take into account possible cost increases as well.
- Emotional contribution. The most difficult piece to quantify, this refers to things such as reduced risk, better trust, and user preference.
Together, these form the maximum value-based price. Of course, if the price eats up all of the added value, then the customer does not have a particular interest in buying this service over any other. Therefore, there is a negotiation corridor with which the price is set somewhere between the reference price and the maximum value-based price. Based on research into ultimatum games, the company can generally expect to be able to capture a bit less than half of the added value, and significantly less if there is stiff competition.
What does it take to get started with value-based pricing?
In order to take value-based pricing out of the lab and into the field, there are four steps that need to be taken:
- Understand your customer: Without understanding the customer, you cannot differentiate.
- Know your differentiation: You also need to understand the competition, in order to know where you can differentiate.
- Quantify the differentiation: Without quantification, you cannot come up with a value-based price.
- Communicate your differentiated value: If you don’t tell the customer how you are different, the customer will never know, and selling value becomes impossible.
Another perspective on value: the four dimensions
I recently read Pekka Puustinen’s FinancialServiceLogic: In the Revolution of Exchange in Banking and Insurance, in which he uses a more granular framework of value, originally proposed by Timo Rintamäki, Hannu Kuusela, and Lasse Mitronen in their 2007 paper Identifying competitive customer value propositions in retailing.
In this framework, value consists of four dimensions that are hierarchically structured from the most objective and practical to the most subjective and social/psychological. The higher in the hierarchy the company can interact with the customer, the greater are the sacrifices the customer is willing to make at the lower end of the scale – an observation Puustinen highlights by pointing out that people often purchase goods even though they may be “a little too expensive”, “impractical”, or “unnecessary” on the basis that they are “so cool.”
These four dimensions of value, from the most objective to the most subjective, are as follows:
- Economic value. The monetary value of the product. While this is the most objective form of value, even economic value is not the actual objective value of the service in use, but compared to a reference price the customer has in mind, whether from a real alternative or from a mere perception of an alternative.
- Functional value. The ease and convenience of the service. Economic value and functional value are often present in the financial calculations in B2B environments, whereas consumers sometimes fail to value their own time and effort sufficiently.
- Emotional value. The positive feelings and experiences evoked by the service. Examples of companies that provide emotional value include bookstores that create a cozy, cafeteria-like atmosphere or many flagship stores, such as Apple stores.
- Symbolic value. The positive consumption meanings attached to self or communicated to others. There is symbolic value in owning, say, a Ferrari, or to take an example closer to most of us, to using products that have not been tested on animals. This symbolic value may be openly displayed, as in the case of the Ferrari, but it can also only be known by the customer.
How common is it for people to appreciate emotional or symbolic value over the more easily quantifiable dimensions of value? In his book, Puustinen gives an example from the finance market: in a survey conducted by an investment magazine, 38% of investors said they were willing to give up a higher return in order to obtain pleasurable experiences from investing. This result is particularly notable when taking into account that this was self-assessment (possible rationalization of behavior should reduce this figure) and that the subject was investment, which is perhaps the field most focused on economic value.
Combining the four dimensions of value with the value-based pricing framework
The traditional buildings blocks of value-based pricing remain correct as such. The four dimensions of value do not replace them, but rather complement them by providing another lens through which to determine the actual value.
Economic value and functional value ultimately form the reference price, net revenue gains, and net cost reductions. Emotional value and symbolic value are a more granular view into the emotional contribution already present in the traditional framework.
What the four dimensions of value provide is an improved understanding of the components of value that can therefore guide practitioners into more accurate quantification of value.
One final observation: In the transaction, it is not only the company that enables the customer to create value along these four dimensions, but also the customer can enable the company to create value for itself along the same four dimensions. This is something to take into account when determining the price. Your customers may even make such arguments, so be prepared. For example, when I arranged for a relocation company to ship our stuff from Finland to Denmark during our move, I emphasized how they were already packed and stored in a mini storage equipped with pallet jacks and freight platforms, thus increasing the convenience of picking them up. In B2B contexts, the discussion is often centered on the right to use a customer as a public reference, which creates value for the seller. Obviously, if the customer is unaware of the value you gain, you can get a better deal, but the main goal of value-based pricing is not to get an upper hand, but to create genuine win-win situations by understanding all the value that is being created.