Value-Based Pricing

Value-Based Pricing Definition

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.

Explanation

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.

A painting may cost a lot more than just the cost of raw materialsRaw MaterialsRaw materials refer to unfinished substances or unrefined natural resources used to manufacture finished goods.read more 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.

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Types of Value-Based Pricing

There are two types. Each one is mentioned along with an explanation below:

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#1 – Good Value Pricing

In this type of pricing, 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.

Characteristics

• 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 strong 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.

How to Calculate Value-Based Pricing?

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.

Steps

1. The product 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.

Difference Between Value-Based and Cost-Based Pricing

• 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 pricingCost-based PricingCost-based pricing is a pricing strategy in which a certain percentage of the total cost is added to the cost of the product to determine its selling price. Simply put, it is a pricing method in which the selling price is decided by adding a profit percentage to the cost of making the product.read more, 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 Cost IncurredIncurred Cost refers to an expense that a Company needs to pay in exchange for the usage of a service, product, or asset. This might include direct, indirect, production, operating, & distribution charges incurred for business operations. read more.
• The profit marginProfit MarginProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. read more is higher in value-based, but the number of products is less than cost-based, with a lesser profit margin.

Advantages

• Increased profits for the manufacturer.
• Customer loyalty is higher in these types of pricing.
• Customization of products is possible.
• Better quality of product and service.
• Better understanding and rapport between customer and manufacturer.

Disadvantages

• Products are priced very high.
• A manufacturer can target only a niche market.
• Difficult to scale up the production due to a lack of market scope.
• The competitor can launch a similar product at a similar price range, and the manufacturer will have to sacrifice the market share.
• Labor costs Labor CostsCost of labor is the remuneration paid in the form of wages and salaries to the employees. The allowances are sub-divided broadly into two categories- direct labor involved in the manufacturing process and indirect labor pertaining to all other processes.read more are also very high, involving more skilled labor to produce and service.

Conclusion

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.

Frequently Asked Questions (FAQs)

Recommended Articles

This article is a guide to Value-Based Pricing. We discuss the value-based pricing definition, types, calculations, advantages, disadvantages, and examples. Also, you can learn more about it from the following articles: –

• Penetration Pricing
• Dynamic Pricing
• Hedonic Pricing
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