Before anything can be sold in the marketplace, you need to formulate a price for that product or service. For nearly the entire history of capitalism, decision-makers have chosen one of two pricing strategies, often without knowing what pricing strategy they are actually using. These two pricing processes are the cost-based approach, where a price is formulated from its overall cost of production (plus a markup), and the competitor based approach, where a price is created based on what other market participants are charging (or maybe a little less than they are charging if you’re a new competitor).
Business owners, product managers, and marketing executives tasked with determining product or service prices have an increasing number of options where pricing methods and strategies are concerned. Additionally, competitive product pricing relies on countless internal and external factors. To ease the difficulty associated with determining a pricing strategy, we decided to focus this article on a pricing method that our CPA and accounting firm has adopted; a pricing strategy that more and more professional services companies have found meets their revenue goals while also increasing customer satisfaction.
Value-Based Pricing Explained
In order to explain value-based pricing, it’s first necessary to think about what we mean when we say value. Value is defined by the importance, worth, or usefulness of something. Therefore, the value can mean different things to different people, and it can be based on perception, an economic enhancement, or (what we most commonly associate with value) an exchange of some sort. Value-based pricing is the tactic of basing prices on customers’ objectively measured value of your product or service. When compared with other types of pricing strategies, value-based pricing holds the most promise, yet requires the most amount of research into customer buying decisions and willingness to pay.
Value-Based Pricing Strategy
When exploring the value-based pricing strategy, the first question is often, “How can my business make more money? Where do I start?” Before jumping blindly into this new form of pricing, there are several points of the strategy that should be observed. These include:
- Value-based pricing focuses on individual transactions and is based on the mix of net revenue gain to be obtained by the customer, and the total net cost reduction that the customer will experience.
- Transactions under value-based pricing focus on highlighting the key differentiators of your solution and, more importantly, measure this differentiation.
- As we focus on service or product differentiation, it becomes crucial to deliver an optimal solution to a customer’s problem.
- Value-based pricing strategy takes excellent care to concentrate on customers who care deeply about value and focuses on educating them on the real-world value of your offering.
- Focuses on making the customer aware of the value that they have been enjoying and has come to expect.
Value-Based Pricing vs. Cost-Based Pricing
There are many different types of pricing strategies that are in use today, some more obscure than others. A few of the more commonly used pricing methods include competition-based pricing, economy pricing, market penetration pricing, and pricing at a premium. While these each have their appropriate place and market, perhaps the most universally used pricing model is the cost-based approach. Cost-based pricing is the “default” pricing strategy because of its simplicity. To determine prices based on cost-based pricing, one simply adds up the total fixed cost of a unit, adds a markup, and then you have your rate. Easy enough. In addition to the ease of calculation, some other advantages of cost-based pricing include transparency in how price is achieved, minimal information requirements to set the price, easily updated as costs change, and simplified accounting system data availability.
Unfortunately, cost-based pricing has a lopsided number of disadvantages that lead it to be an inferior pricing strategy. For starters, cost-based approaches ignore customer needs when compared to value-based pricing. Furthermore, cost-based pricing can compound previous pricing errors, can distort profitability calculations, and does not take noneconomic factors into account.
While companies that utilize cost-based pricing may attract customers in a highly competitive market where customers are seeking the cheapest products and services, value-based pricing attracts customers who are highly concerned with the quality on what they spend their money. From a revenue generation perspective, value-based pricing allows companies to earn higher profits per unit.
Benefits of Value-Based Pricing
Perhaps the most significant advantage of value-based pricing is the transferring of risk from the client or customer to the company offering the service.
Thinking about that statement is a cause of a pretty important revelation: most service-oriented businesses actively (and often unknowingly) sell risk to their customers. Ponder this example: when you typically hire an accountant or attorney, you agree to pay X amount per hour. You may get an idea of how many hours that professional will charge you, but you cannot be sure because of unforeseen situations. Even if you get a quote, it’s just that: an estimation. The risk for the customer derives from the uncertainty of the final bill, and in the business world uncertainty equals risk. Now, take the value-based pricing strategy. Because value-based pricing allows companies to calculate their costs and timelines better, customers can better know how much they will pay and how long the services are going to take.
Because you’re assuming the risk of the customer, your services will become much easier to sell.
CPA Business Advisors
Overall, value-based pricing isn’t merely about higher prices or better profits; it’s about improving and growing your business by promoting the value in your product or service. Value-based pricing is perhaps the best pricing strategy we’ve implemented to show our customers that we are willing to accept some of the risk involved and put some “skin in the game.” Again, value-based pricing does involve more work in the form of exploring buyer personas and re-evaluating pricing strategy often. However, it’s important to mention that adopting value-based pricing not only helps improve the business but also enhances the company’s ability to communicate what makes them different from every other company in your space.
At Lawhorn CPA Group, we are passionate about offering more and more value to our clients. One way we achieve this is to continually pursue improvements in the business, whether it be earning more revenue through streamlining efficiency or improving customer retention. Value-based pricing can help with both, so contact us today for more information and to find out how we can help your company make the transition to value-based pricing.
Make sure to subscribe to our blog and connect with us on social media to get future value-based pricing advice and news articles such as how to implement value-based pricing, common mistakes made while implementing value-based pricing, and value-based selling.