A study by the consulting firm McKinsey showed that a 1% increase in price translates into an 11% increase in profits. On the other hand, increasing volume by the same amount resulted in only a 3.3% increase. So, knowing this, when your business and your shareholders request a profit increase, should your best strategy not be to take a hard look at your pricing strategy?
Given that 1% in realized prices can lead to such profit increases, managing the right price point and then rolling it out successfully is naturally important. However, many businesses lack a structured way to think about and implementing pricing. Decisions tend to be based on a ‘what we can get away with’ approach or be cost-led or competitor-led; which may all work up to a point but, leads to a position of pricing not incorporating value and differentiation.
Introduction to Value-Based Pricing
Very precisely, value-based is a technique for setting the price of your product or service based on the economic value it offers to customers, allowing companies to capture the maximum amount that a prospect (be it a consumer in the B2C word vs. a customer in the B2C arena) is willing to pay in order to significantly improve company profits.
Product managers, especially in B2B settings, often adopt a cost-plus pricing technique that can seriously impact both revenue and profitability. The cost-plus approach is inefficient because prices may be set too high or too low, as the rationale for what we charge is purely based on the cost of the product. If prices are set too high, then obviously you will lose the business to competition, as, without any perceived differences, why would they pay more?
Understanding Your Value
To put some more insights behind how value-pricing has arisen, it is important to first understand the term True Economic Value (TEV). TEV represents what a customer will pay for a product or service that delivers value in excess of its closest competitor. In essence, TEV can be calculated by analysing the cost of the best alternative to what you offer, plus, the value of performance differential. As an example, let's say you are launching a new Bluetooth headset with two hours of extra battery life than the closest competitor's product, which is priced at €80. If the consumer values the extra battery life at €5, then the TEV would be €80+€5=€85. This simple equation offers a starting point for calculating value to customers.
Cost & Value of the ‘Best Alternative’
But first, how do you get to the cost of the best alternative? The answer is simple - ask your customer what they would buy as an alternative to your product, and then determine the price of that alternative. This helps to understand where you are with your attributes (what you think is important with your product), versus, what your potential customers think. Once the cost of the next best alternative is established, it is then paramount we work on the value of our ‘performance differential’ - features of your product that are better than the next best option and estimate how much you think these differences are worth to your customers. So, knowing costs, and, knowing the differences is a shore-way to help you implement a value-based pricing approach.
Article by Gavin Eccles, Programme Director of Value Based Pricing