A company's strategy to set product prices can lead to its eventual success or failure.
When it comes to pricing, there are a lot of factors to consider—total production cost, markup percentage, competitive pricing, and more.
However, the most recommended strategy is to base pricing on a product’s perceived value. Value-based pricing is underpinned by the idea that a product is only worth what customers are willing to pay.
By knowing how potential customers value your product, you can set a price that is more likely to generate sales.
What is value-based pricing?
Value-based pricing is basing a product’s price on how much customers think it’s worth. Instead of using internal factors, like cost and markup, or other competitors, value-based pricing focuses solely on customers.
This requires a significant amount of market research, as value-based pricing looks at the customer’s perceived value of the product, its total addressable market demand, and even the brand’s reputation in the market.
Thanks to all this collected data, value-based pricing additionally aids a company in staying ahead of the competition.
Value-based pricing vs. cost-plus pricing
Value-based pricing and cost-plus pricing sit at opposite ends of the spectrum.
Value-based pricing starts with in-depth research and awareness of the company’s target market. It necessitates an understanding of customers, their pain points and needs, and what value they place on being able to meet those needs. With so many factors, value-based pricing is not as straightforward as cost-plus pricing.
Cost-plus pricing is set by calculating all the expenses incurred to make the product, and then adding a markup percentage. The typical costs include raw materials, packaging, labor, and overhead.
In this way, a cost-plus pricing strategy keeps things simple and easy to justify. It also ensures a company’s production costs will always be covered if the product sells.
Benefits of value-based pricing
Value-based pricing is a highly regarded pricing strategy that presents many business benefits.
Better product-market fit
Value-based pricing aims to increase a product’s perceived value, which entails adding and improving features to meet the target customer’s needs.
This constant innovation not only helps a company achieve product-market fit, but it also results in a better quality offering that’s highly differentiated in the market.
Potential for larger profit margins
Unlike sticking with a fixed markup percentage or following a competitor’s price, value-based strategies give companies the freedom to price products as high as customers are willing to pay. This is especially beneficial if the product is seen as a luxury or high-value item.
Moreover, with a value-based pricing approach, a company can stand to earn even more by adding to the value of your products.
Increased customer understanding and loyalty
As a result of the dedicated effort to understand its customers, companies that use value-based pricing may also see an increase in overall customer satisfaction and loyalty. Because this pricing strategy is unique in its priority to provide the most value, it inevitably leads to products and services more likely to result in customer loyalty.
Challenges of using value-based pricing
As with every pricing strategy, value-based pricing comes with its share of challenges. Here are some to keep in mind when planning to set your product price based on value:
Difficulty in determining prices
A product’s value hinges on customer perception, which is difficult to nail down without proper research and active engagement with customers. Even with the right resources, value-based pricing isn’t an exact formula and needs to be tested in the market. The ideal price isn’t always calculated on the first try and can take some trial and error.
Quickbooks Enterprise, which offers customizable and automated pricing rules, can help smoothen the pricing process.
Profits aren’t always guaranteed
Companies with a lot of competition and little differentiation may not always see enough profit with a value-based pricing method. In these instances, customers generally don’t place a high value on products because of their ready availability. This drives down prices and makes it challenging to generate enough profit to sustain a business.
Requires continued dedication
A major challenge with value-based pricing is that values are constantly changing. Unlike cost-plus pricing, which uses a fixed percentage, pricing by value is less formulaic. What’s considered valuable or not valuable is heavily dependent on cultural trends, the economy, and other external factors. Value-based pricing is a continuous process that’s prone to fluctuations and requires dedication to arrive at the right price.
When should a business use value-based pricing?
As indicated by the benefits and challenges above, there are companies more suited for value-based pricing. Here are some clear signs a business should price its products according to value.
There are adequate resources to optimize pricing
Value-based pricing only works if a company has the time to research and analyze customer data. Not only should there be systems in place for setting prices, but value-based pricing needs to be revisited regularly and requires more resources than any other type of pricing strategy.
The products are considered unique or high-quality
Specialty companies offer value much greater than the actual cost. This includes ones that have built a notable brand, focus on a specific niche, or create any product that isn’t easily accessible to mass markets. Companies in these cases are primed to use value-based pricing as it’s better representative of their products.
Four steps to setting value-based prices
Here are four steps companies can use to implement a value pricing model:
1. Define your total addressable market
Most products, even ones that are highly niched, cater to multiple customer segments. Value-based pricing starts by defining these segments early on, so a company has a clear idea of the potential markets and different buyer personas it aims to reach.
2. Research your customer segments
Once these customer segments are clear, the next step is to understand each one’s needs, motivations, and what they find valuable.
Whether this means asking existing customers or researching potential buyers, every segment will have a different perception of value and what they’re willing to pay. This comprehensive insight is essential to know what price a company should set for its product.
3. Do a competitive analysis
The perceived value of a product is tightly tied to the value of similar products in the market. If a product can be easily replaced by an alternative that serves a similar function, this can lower the value. Analyzing competitors helps a company better determine its value from a customer’s point of view.
While the competition’s price shouldn’t directly influence how a company prices products using this pricing method, it does help show how to target customers value similar products.
4. Set prices and frequently test
After all this research, a company should be able to consolidate its insights and arrive at the best possible value-based price for its product. Publish the product price and then observe new customer feedback. If sales aren’t as expected, a company can do more research to figure out another price or revisit its strategy.
Two examples of value-based pricing
With the increasing importance placed on product value, many products exhibit this pricing strategy. Below are two examples of companies that benefit from value-based pricing:
Apple iPhone
Apple is the perfect example of a company that prices products according to their perceived value. For example, while its cost to manufacture an iPhone 7 was reported at $224.80, the item started retailing at $649 at the time of release in 2020.
This 188.7% markup is far from a standard cost-plus strategy percentage. However, it’s a bar Apple helped set, thanks to its premium design, ease of use, and remarkable customer experience.
Rapha Cycling Clothing
Rapha is a favorite brand of cyclists. Thanks to its earned trust and its niche market, it can sell its bib shorts anywhere from $200–400. Other brands that offer the same product type offer it for less than half price.
But because of the high worth placed on Rapha, thanks to its niche market positioning and devout customer base, the brand has been able to grow the company while selling at a higher price point.
Final thoughts
A value-based business strategy bases product price on the customer’s willingness to pay a certain value for a product or service. While the method hinges on continuous research and dedicated resources, products priced according to a customer’s value are some of the most successful.
Even the most complex pricing strategy can be easily streamlined with QuickBooks Enterprise, which enables flexible pricing levels and automatic rules that make sure you’re earning on every transaction.
