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What is value-based pricing and why you need it

Welcome to the third post in a five-part series on the main pricing methodologies, highlighting the pros and cons of each. Check out the first post on cost plus pricing and second post on competitor based pricing.

We’re beginning every one of these posts with the same statement: “Pricing is the most important aspect of your business.” No other lever has a higher impact on improving profits. We elaborated on this assertion in a previous pricing strategy post, but realize that a 1% improvement in price optimization results in an average boost of 11.1% in profits. That’s no small change.

Value based pricing is the pinnacle of pricing if you can figure out how to get there (more on this below). Remember what we said last time, pricing is a process that utilizes data to eliminate as much doubt as possible for key stakeholders to make a profit maximizing decision. The metaphor we’ve been using (some of you like it, some of you don’t) is a dartboard where you’re trying to hit a bullseye with the perfect price, but there’s all that extra space “distracting” your dart. Data and these methodologies eliminate that space, guiding your dart to the ideal price point.

We’ve already learned that cost plus pricing and competitor based pricing can be useful, but they’re fairly weak overall, especially in the SaaS or software space. Fortunately, value based pricing, when done correctly, provides valuable data to shrink that dartboard down tremendously. Yet, like all methodologies, it has some quirks.

To understand value based pricing, let's take a look at what value based pricing entails, uncover the methodology's pros and cons, before exploring who should and shouldn't utilize value based pricing.

Value based pricing: It's all about the customer (and the benjamins)

To consumers, price is a numerical evaluation of how much they value what you are selling. For example, if I needed a new winter hat, I could get one from the local GoodWill store for a dollar or I could go to Macy’s and buy one for $25. If I only cared about covering my head, Goodwill would win, but since I care about my fashion sense, Macy’s wins. My willingngess to pay is contingent upon the value I place into the product I want and need, which depends on hundreds of different aspects of my psyche and situation. Essentially, value based pricing cuts through the red tape of this scenario to determine the true willingness to pay of a target customer for a particular product.

Unfortunately, the most common pricing strategies and methodologies forget about the customer. Instead, people in charge of pricing justify price points based on internal reasons or simply adopting existing market prices. Newsflash: customers don’t care how much something cost you to make or your competitors, they care how much value they’re receiving at a particular price.

Value based pricing requires a lot of research, which is right up there with working overtime while your friends are at the bar (or just bring the work to the bar).  However, unlike cost plus and competitor based pricing, it is impossible to fabricate a number that correctly reflects how consumers feel. Plus, unlike pricing done by market norms, this method focuses on isolating qualities that distinguish the product in question from the 85 look a-likes on the market.

Value based pricing models and software utilize customer data, as well as breakdowns of the relative value of different features within your offering. You’ll also need to conduct an analysis of competing goods, because once you have the data, you’ll want to know the other options consumers have open to them. In the end though, you have the greatest amount of data to make an informed decision about your profit maximizing price (unless you’re in a market based pricing situation, which will talk more about tomorrow). Thus, shrinking down the dartboard.

Pros of value based pricing

1. It provides real willingness to pay data.

Most companies shy away from diving into pricing, because they’re afraid of the process and end up rushing to solve other problems facing the business, because they at least know how to test different landing pages. Yet, even though there’s work involved, value based pricing provides real data that forces you into a profit generating price within your pricing strategy.

Simply put, if done correctly, value based pricing helps you generate the most profit.

2. It helps you develop higher quality products.

Value based pricing not only determines a more accurate price for the end product, but the process will also benefit your business. The heavy emphasis on research is like sweating on a treadmill; not only do you burn off those appletinis (don’t think our CEO, Patrick, doesn’t drink them), but you are also healthier.

Exploring your competition will help you understand the advantages of your product, which is where marketing should focus on, and its disadvantages, the parts that should be altered. Taking on a consumer perspective will also help you discover what clients are really looking for in your solution. Products and features will be driven by consumer demand, which raises perceived value, thereby resulting in a higher price.

3. It allows you to provide phenomenal customer service.

Much of the customer data in value based pricing is collected through customer surveys or interviews. The responses we’ve seen to simply bringing customers into the discussion of value have been extraordinarily positive and appreciated.

This attention to consumer opinions and wants will result in more personable and considerate services. This can be the difference between one time customers and loyal clients who develop a bond with the company and always come back, because they trust you’re providing the value you continue to claim you are in your price.

Cons of value based pricing

1. It takes time and resources.

The method can be simplified and quickened, but it’s not necessarily as quick as Googling your competitors or calculating your costs and pulling a margin number out of thin air. You can also be a bit intimidated by the method, because pricing isn’t something they teach us Businesses 101.

For this reason, many businesses shy away from the most important aspect of their business (Fun fact: In business school they tell you how important pricing is to profit, but they never tell you how to optimize pricing.). Businesses also think only extremely large and wealthy businesses can afford to do things this way. However, there are in fact ways to find perceived value without breaking the bank.

2. It’s a science, just not an exact science.

The secret is out: Unless you’re dealing with a very saturated product where market based pricing works, there is no silver bullet for pricing. Thus, value based pricing is more of a process that requires consistent dedication, not just a “set it and forget it” mentality.

Think about it, willingness to pay differs between different customer personas, regions, and even offer. A 100% accurate prediction is impossible, but we can get pretty darn close.

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In a nutshell

Value based pricing should be a part of almost everyone’s pricing strategy, but you shouldn’t shy away from other methodologies.

To summarize, almost everyone in the software and SaaS space will benefit from value based pricing. Even individuals outside of this space (retail, media, etc.) would benefit from the methodology, because even with staunch competition you can determine the value of profit maximizing, differentiated features for your product. Think about toilet paper. I totally pay more for quilted sheets.

Remember though, value based pricing takes dedication. Yet, when done right, provides enormous benefits in terms of more profit, better and more competitive products, and customer oriented marketing and development.

To learn more, check out our Pricing Strategy ebook, or speak to one our experts.

Related reading

5 SaaS billing trends to boost your revenue 
Pricing and Customer Acquisition Cost (CAC) in SaaS
Pricing Strategy Guide: Unlock Growth with These 3 Strategies