Which pricing method sets the price of the product and what the customer is willing to pay?

What Is Value-Based Pricing?

Value-based pricing is a strategy of setting prices primarily based on a consumer's perceived value of a product or service. Value pricing is customer-focused pricing, meaning companies base their pricing on how much the customer believes a product is worth.

Value-based pricing is different than "cost-plus" pricing, which factors the costs of production into the pricing calculation. Companies that offer unique or highly valuable features or services are better positioned to take advantage of the value pricing model than companies which chiefly sell commoditized items.

Key Takeaways

• Value-based pricing is a strategy of setting prices primarily based on a consumer's perceived value of the product or service in question.
• Value pricing is customer-focused pricing, meaning companies base their pricing on how much the customer believes a product is worth.
• Companies that offer unique or highly valuable products and features are better positioned to take advantage of the value pricing model than companies which chiefly sell commoditized items.

Understanding Value-Based Pricing

The value-based pricing principle mainly applies to markets where possessing an item enhances a customer's self-image or facilitates unparalleled life experiences. To that end, this perceived value reflects the worth of an item that consumers are willing to assign to it, and consequently directly affects the price the consumer ultimately pays.

Although pricing value is an inexact science, the price can be determined with marketing techniques. For example, luxury automakers solicit customer feedback, that effectively quantifies customers' perceived value of their experiences driving a particular car model. As a result, sellers can use the value-based pricing approach to establish a vehicle's price, going forward.

Characteristics Needed for Value-based Pricing

Any company engaged in value pricing must have a product or service that differentiates itself from the competition. The product must be customer-focused, meaning any improvements and added features should be based on the customer's wants and needs. Of course, the product or service must be of high quality if the company's executives are looking to have a value-added pricing strategy.

The company must also have open communication channels and strong relationships with its customers. In doing so, companies can obtain feedback from its customers regarding the features they're looking for as well as how much they're willing to pay.

For companies to develop a successful value-based pricing strategy, they must invest a significant amount of time with their customers to determine their wants.

Examples of Value-Based Markets

The fashion industry is one of the most heavily influenced by value-based pricing, where value price determination is standard practice. Typically, popular name-brand designers command higher prices based on consumers' perceptions of how the brand affects their image. Also, if a designer can persuade an A-list celebrity to wear his or her look to a red-carpet event, the perceived value of the associated brand can suddenly skyrocket. On the other hand, when a brand's image diminishes for any reason, the pricing strategy tends to re-conform to a cost-based pricing principle.

Other industries subject to value-based pricing models include name-brand pharmaceuticals, cosmetics, and personal care.

What Is Customer-Driven Pricing?

One important decision companies face is setting prices. The three major pricing strategies are cost-based pricing, competition-based pricing, and customer driver or customer value-based pricing. Customer-driven pricing is the practice of setting prices according to customers' perceived value of a company's goods or services.

The assumption basis for this model is that a customer is willing to pay a certain price when the value delivered exceeds that cost. Customer-driven pricing can work when a product or service is customizable as opposed to commoditized (e.g., corn) as there will be many options if there are many competitors offering similar products or services.

The pricing strategy can also be applied in different geographical markets, where supply and demand forces are biased toward the seller and the customer may be willing to pay more than a customer elsewhere. Customer-driven pricing is contrasted with competition based pricing - setting prices based on competitors' prices and strategies—and cost-based pricing, in which a company concentrates on reaching a margin target with little regard to analyzing customers' perceived value.

How Customer-Driven Pricing Works

To optimize pricing, companies need to consider how to best segment the market so that prices reflect the differences in value discerned by different types of consumers. To do this, companies must undertake a comprehensive understanding of how a customer values a product or service.

If it is a business, is this product or service integral to its operations, something that is absolutely necessary to keep the business running smoothly? Does it provide additional or differentiated benefits to an ordinary consumer? If so, the company may be able to set prices at premiums to increase aggregate sales.

If the company's offering is available to customers from several competitors in a given market and lacks meaningful differentiation, then customer-driven pricing is unlikely to succeed as a strategy to enhance revenues. Where competition may be thinner, even if its product or service does not distinguish itself, a company may be able to engage in customer-driven pricing because supply could be constrained relative to demand.

The customer-driven pricing strategy works well for products that appeal to consumers' emotional needs and in niche markets.

Customer-Driven Pricing in the Age of E-Commerce

In previous eras when information was not as free-flowing as today, companies had more latitude to vary its prices of goods and services among different customer groups. Product and service attributes, as well as prices, were not as transparent as they are today. This presents challenges to companies to set customer-driven prices because information advantages have been eroded.

It is still possible, though, for companies that stay current on the needs of long-standing customers to retain pricing power when they provide product or service value that exceeds the cost to the customers.

Key Takeaways

• Customer-driven pricing is a pricing strategy in which a company sets prices according to customers' perceived value of its products and services.
• To be effective, companies should consider how to best segment the market so that prices reflect those segments perceptions of value.

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