Value-Based Pricing

Determining the price for a product the market hasn’t seen can be tricky. Set the price too low and the profit is not maximized. Set it too high and no one will buy the product and all invested marketing will be for nothing. A good way to find the right pricepoint is value-based pricing.

The too-high price hereby is even worse than too low because it takes significantly more effort to persuade a potential customer after adjusting the price to try the product again.

Using a Too Low Price as Advantage

“Why’s a too low price better?” you may ask and “am I not losing money with a too low price?”

Yes, you do. And I’d recommend changing this situation as soon as possible. But until then, use it to your advantage.

If a customer is using the product, it is easier to forward additional cost, for example of development, by increasing the perceived value with extensions via in-app purchases. In this case, the product is a channel to the most important person out there, your customer. There is not even a real marketing campaign required to reach an existing customer.

An active customer gives you valuable insights into usage patterns. These patterns can be utilized to further improve the product and discover additional marketable features.

Most importantly, a customer using your product already pays with data. This data enables you to extend your offering with more advanced features (machine learning for example).

If you read the previous paragraphs carefully, you might get to the conclusion that the more functionality you release in one block the bigger the risk of failing to meet the customers’ expectations. In addition, it is more likely to miss the right price. You are right.

This leads to two important constraints:

  • Release small increments
  • Know the customer values before pricing

There are at least two ways of pricing. Cost-based and value-based pricing, which I’d like to explain separately below.

Cost-Based Pricing

Using cost as a basis for pricing is a way to price a product or service by analyzing its cost structure and then applying a markup. Calculating cost includes amongst others development, operations, marketing, project management, sales, maintenance, infrastructure and overhead. The method works very well in environments with traditional project planning and component-oriented products.

During the price calculation, an estimated guess of the total customer base is used to spread the one time cost, for example development, across all customers. Coming up with the right amount of users can often be tricky.

In digital environments where a product is created once and sold to millions of users however, the cost of creating the product is typically low compared to the customer base. Customer acquisition cost (CAC) however get even more important.

Whether your price is covering the cost to provide the service should still be calculated when you do value-based pricing.

What is Customer Value?

Customer value is satisfaction, experienced by taking a given action relative to the cost of that action. Typically this action is taken to fulfill specific goals.

The action is usually the purchase, a sign-up or something similar. Cost refers to any type of payment/transfer in order to receive a benefit. This can, for example, be money, but also data, time or knowledge.

Knowing your customers’ goals and to address them in marketing with an appropriate ratio between satisfaction to cost increases your chance for a win-win.

Customer Goals

The primary goal of (almost) every company is:

To make money

Especially in large enterprises, this is often not clear throughout the organization due to the specialization of individuals/departments. Breaking down the goals into sub-goals such as to improve quality, reduce downtime, increase throughput, improve OEE, etc. replaces the main goal of the overall company (make money) during day-to-day operations.

While all of these sub-goals might make sense locally, it is often preventing to fully achieve the primary goal on an enterprise level.

The sum of local optima is not the global optima

As an example, you might want to think about corporate incentive systems that are typically set up around profit & loss. Two peers are for example indirectly incentivized to prevent collaboration, even though it would increase the profits for the company as a whole. Instead of collaborating, peers try to maximize individual profit (local optima).

The knowledge about the goals, corporate culture, strategies and internal politics of a customer helps to determine the appropriate price. Every pitch, flyer, link, poster, and whitepaper must address these goals.

Please note that value is perceived and therefore differs from customer to customer. Customers sharing the same values can be grouped into customer segments.

Because value-based pricing can be applied to whole segments and focuses on the customer (value), compared to on yourself (cost), the concept gets very powerful.

Product Pricing basing on Customer Value

An optimal deal always creates a win win

Determine which goal the customer is trying to achieve. For example, the goal is to minimize the time a maintenance manager of a plant needs to spend checking the oil level of a machine at a remote location.

The primary objective is to save costs (Pain). Depending on the customer’s operation, faster response times might offer additional, previously untapped opportunities (Gain). If the remote reading was digital, the maintenance manager could do something else during this time.

It’s important to note that there should be something else to do for him though. If there is nothing else to do, the employee would not be required. There might still be a way to sell, but definitely not to the maintenance manager.

It is better, to create inclusive products, which require training, not to replace people. Besides providing a more human solution, this creates a positive image of the company as well as the product and helps sales. If you can provide the training, you even earn double.

Best is if a product creates multiple wins not just win win

For the example above this means there are many winners, the customer (less cost, faster response time, safer operation), the maintenance manager (higher qualification, less repetition), society (less unemployment, less pollution, fewer cars on the road), government (sales tax, qualified workforce) and you (profit, access to data).

Example Calculation for Value-Based Pricing

The goal above was to minimize the time a maintenance manager of a plant needs to spend checking the oil level of a machine at a remote location.

By determining the average distance for one trip (100km) and the number of times to drive the tour (10 times per month) the total distance for the activity per month is 1000km.

The pickup truck to drive the distance has a consumption of 15l/100km. This means the total amount of fuel per month is 150l. Assuming gasoline and one liter is 1.22 Euros, all trips per month cost 183 Euros.

Depending on the customer segment, the willingness to share needs to be determined for example in customer interviews. Let’s assume a willingness to share the savings of 183 Euros is 30%. This means the customer is likely to accept a subscription price of 55 Euros per month.

To ensure profitability, the determined price still needs to be compared with the occurring cost to provide the service.

Conclusion

For digital products with many customers, value-based pricing allows to price according to the perceived customer value. This leads to increased profit and customer satisfaction.

You can find my favorite book regarding product development here.

Please let me know what you think, either by sharing or leaving a comment below.

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