Value-Based Pricing

Value-based pricing is a pricing strategy in which the product's price is based on perceived value delivered to the customer instead of the actual cost of the product or service. This type of pricing is most commonly used by niche industries and those that provide customer-oriented customized products.

Value-based pricing is a pricing strategy to target a niche market. The product has to be customer-oriented and customizable according to the customer's needs. Undoubtedly, the quality of the product and service associated with the product should be of high quality, but the product's price will also be very high. There will be a better understanding between customer and manufacturer. The profits for the manufacturer are also very high, but it is not easy to scale up the production as the target will be niche.

• Value-based pricing refers to the pricing strategy where the product's price fixes on the perceived value delivered to the customer rather than the product or service's actual cost. 
• The value-based pricing is used mainly by niche industries and those who offer customer-oriented customized products. 
• The value-based pricing is of two types: reasonable and value-added.
• The profit margin in the value-based pricing is high, but the number of products is less than the cost-based pricing with a lesser profit margin. Therefore, it is a pricing strategy to target the niche market.

The price of a product/service is fixed based on the estimated value of a product or the value to the customers but not exclusively from these criteria. For example, the same cuisine is priced differently in different restaurants. The typical restaurant will charge a nominal price, whereas the same dish is priced higher at a premium in a 5-star hotel. Even though the food is the same and irrelevant to the taste, the customer would be ready to pay that premium amount to get the attached benefits like enjoying the hotel ambiance. This is a perfect instance of value-based pricing strategy.

A painting may cost a lot more than just the cost of raw materials involved. Likewise, an art piece may be valued more than just the cost of the production. In other words, pricing a product shows how much the customers see its value. For example, designer apparel is priced at a premium compared to the same garment available on Amazon or Walmart by a local seller.

There value-based pricing strategy are two types. Each one is mentioned along with an explanation below:

#1 - Good Value Pricing

In this type of value-based pricing approach, the product is priced as per the quality of the product and service provided to the customers concerning the product. Therefore, the pricing depends mainly on the quality and service associated with the product.

#2 - Value-Added Pricing

In this type of pricing, the product/service is priced as per the value-added products for the customer to use. From the customer’s perspective, how much ever the value of a particular feature in the product is worth is studied, and accordingly, the price is decided for the whole creation.

• The products priced under this strategy are always customer focussed. Any improvements, changes, versions, and product variations are made only after consulting the customer and according to their needs.
• Companies manufacturing such products should have a niche market for products. In addition, such products should be associated with a service that differentiates them from the other players providing similar products.
• There should be a vital communication channel to collect effective customer feedback, as customer perception is the main driving force in deciding the price of the product/service.
• Firms willing to price products using such a strategy must spend a significant amount of time understanding their customers' needs. Only then will satisfied customers justify the price of the products.

1. The product in case of value-based pricing approach should be focused on a particular segment and not deviate from the main and only element. Customer perceived value is estimated in this step.
2. The price of the nearest competitor’s products in the same segment is taken to decide the range of fixed costs. Then, based on feedback from customers, the price range of the product is determined.
3. To see the product's value from a customer’s perspective and point out differentiated features in the product to be priced. To check how much the customer values the output.
4. Decide a price for this differentiated product feature and price the product collectively by adding a competitor’s price and extra feature price.

Let us understand the concept of value-based pricing approach with the help of some suitable examples.

Example #1

Consider a brand, ABC fashion designers who are into men’s fashion. Suppose they are launching new trousers and the pricing needs to be made as per value-based. Brand ABC, a premium fashion retailer, has to price the product appropriately to target the correct audience. It will consider another premium fashion retailer, brand XYZ, to compare similar trousers’ prices.

Suppose the brand XYZ has priced at $125, then brand ABC is a similar brand and launching a similar product, the price should also be around $125. Depending on the value addition happening in the new product to be established, ABC decided to launch the product at $130.

Example #2

Another example of a software company, Value Tech, providing an exclusive software service to client Romez using value-based pricing is explained in the attached excel. The calculation to arrive at a price is also offered in the same.

The actual cost to the company is $5,25,000, whereas the total billed amount is $6,00,000. Thus, there is no relation between incurred and actual price.

Some important advantages of the concept value-based pricing models are as given below.

• Increased profits for the manufacturer - This is due to the fact that the prices are mostly above the average market prices of the products, resulting in higher profits.
• Customer loyalty is higher in these types of pricing - Since these kinds of products are usually customized and is designed to meet some specific needs of the market, customers do not like to change brands or companies because they may not get the type and quality of the product that they are getting from the present source.
• Customization of products is possible - It is possible for manufacturers to make or design the products in such a way so that those features may not be available in the market from any other producer. This makes the products unique and special, creating a particular niche for themselves with its own set of customer base.
• Better quality of product and service - It is necessary for manufacturers to make the best quality products because otherwise they will not be able to maintain their uniqueness and speciality in the market.
• Better understanding and rapport between customer and manufacturer - It is evident that if a good is different from others, it will have its customer base, resulting in a good and close relationship between the manufacturer and consumersdue to the fact that there is less competition.

Here are some noteworthy disadvantages of the concept of value-based pricing models. Let us study them in detail.

• Products are priced very high - In such pricing strategies, the prices are typically very high due to their speciality and unique features. There is very less competition resulting in encouragement to manufacturers to continue with high prices.
• A manufacturer can target only a niche market - As it can be derive from the above point, special products will have very less range of consumers who would want to use them and be ready to pay very high prices for the same. This leads to creation of a niche who have both affordability and demand for such products.
• Difficult to scale up the production due to a lack of market scope- Since the customer base is very low, the demand remains limited within a particular boundary and is very difficult for manufacturers to take advantage of high prices and scale up production in future. Continuous innovation and research is required to expand and grow.
• Competition in long term- The competitor can launch a similar product at a similar price range, and the manufacturer will have to sacrifice the market share.
• Labor Cost increase – The Labor costs are also very high, involving more skilled labor to produce and service. Since the products are customized and come with new and special features, they require different skills and competency to make them, Thus, this increases the labor cost, the cost of production and brings down the profitability.

Thus, the above are some advantages and disadvantages of the concept.

Both the above are pricing techniques commonly used by manufacturers in various industries to expands their customer base, earn revenue and increase profits in order to sustain in the business. However, there are some differences between them, as given below:

• In value-based pricing, the price decided is irrelevant to the cost incurred. In contrast, the price is determined mainly based on the cost incurred for production and other tangible overheads.
• Value-based pricing is done using intangible parameters as perceived by the customer. Whereas in cost-based pricing, the cost incurred is real.
• Cost-based pricing is always less expensive.  In comparison, value-based pricing is priced at a premium depending on the product's value.
• Value-based pricing has a bigger range of prices for products. At the same time, cost-based pricing does not have a price range depending on the product range, and cost incurred.
• The profit margin is higher in value-based, but the number of products is less than cost-based, with a lesser profit margin.
• In case of the former, it is important that the company is able to communicate the actual value of the product or service in terms of its speciality or uniqueness so that customers are convinced to pay a high price. This is not required in case of the latter since prices are based on cost incurred and at par with similar products in the market.
• The manufacturer should have a very good understanding of the customer needs, taste and preference, which will act as parameters to design the features of the products during value-based pricing. But such research is not required so thoroughly during cost-based pricing.

The above difference point out when and how companies use the two pricing methods. It is important to understand the difference in details so that the concepts can be used in the right context to cater to the market.

This article is a guide to Value-Based Pricing and its definition. We explain it with examples, vs cost-based pricing, advantages, disadvantages & types. Also, you can learn more about it from the following articles: -

• Penetration Pricing
• Dynamic Pricing
• Hedonic Pricing
• Best Pricing Books