Value-Based Pricing

Definition: Value-based pricing is a method of pricing products in which companies first try to determine how much the products are worth to their customers. The goal is to avoid setting prices that are either too high for customers or lower than they would be willing to pay if they knew what kind of benefits they could get by using a product. Data mining software can play an important role in the process by helping users segment their customers and define the value they receive.

Most products are still priced according to what they cost to produce. But some manufacturers and IT vendors employ an alternative approach, using information technology to help estimate how much value a product would provide to the buyer, then basing its price on that value.

For example, one pharmaceutical maker priced a new antiulcer drug, but not by adding up the costs of developing and manufacturing the medication and tacking on the amount of profit it wanted to make, says George Cressman, a product pricing consultant at Strategic Pricing Group Inc. in Marlboro, Mass.

Instead, the company used value-based pricing techniques to justify a higher price than it might otherwise have been able to get from medical insurers. Its weapon: studies that showed the new drug could help patients avoid expensive surgery, which in turn would lower costs for the insurance companies.

The goal is to avoid setting prices above the ceiling of what someone will pay -- and also to make sure you don't give away the store by charging too little.

The problem with traditional cost-based pricing approaches "is you don't know what value your product offers to customers," Cressman says. "You can end up leaving money on the table and not getting paid what your product is worth."

Pricing Strategies

Strategic Pricing Group is a consulting firm that helps corporations design and implement value-based pricing strategies. Its clients include companies in mainstream manufacturing markets such as chemicals, pharmaceuticals and metals.

Another client, a chemical company, based the price of its pipe-sealing gaskets on the cleanup costs and potential liabilities that buyers could avoid because of the products' ability to prevent chemical leaks and spills, Cressman says. He declined to identify either company.

Some software vendors, such as i2 Technologies Inc. in Dallas and Aspect Development Inc. in Mountain View, Calif., use value-based pricing. Their software license fees depend on the amount of internal savings that individual customers expect to get by using the applications -- a figure the two sides try to determine during a presales consultation.

To assess a product's value for one of its clients, Strategic Pricing Group starts by conducting in-depth interviews with a set of the manufacturer's customers that are similar to one another -- sometimes eight to 10 companies, sometimes "significantly more" than that, Cressman says.

Each interview can last as long as two hours. Shorter surveys of customers are usually too superficial to produce the detailed information needed to "show them what impact (a product) will have on their business and what it's worth to them," he adds.

But on the whole, value-based pricing is still pretty rare. A recent survey suggests that only about 10% of companies use the approach, and even that "might be a generous assessment," Cressman says. "There are very few companies that are doing this right now."

Part of the reason is that value-based pricing can be difficult to sell to customers, who may be wary that they'll end up paying nosebleed prices rather than amounts based on what it cost the manufacturer to make their products. "People have an emotional problem with the idea of having the price be almost incessantly variable," says Jim Shepherd, an analyst at AMR Research Inc. in Boston. "A lot of (buyers) just have a gut feeling that they're getting screwed."

Value-based pricing sounds like a smoke-and-mirrors way to sell a product "for however much you can get for it," adds Joshua Greenbaum, an analyst at Enterprise Applications Consulting in Berkeley, Calif. "To me, the emperor has at best a G-string on."

Figuring out the value of a product also isn't a simple matter. "You really have to start with an understanding of your customer, and that takes a lot of work," Cressman says. "Adding up your costs and putting a (profit) margin on top of that looks much easier and more precise."

Technology's Role

While value-based pricing depends heavily on manual work, technology also has a big role to play.

Manufacturers that want to adopt value-based pricing approaches without trying to set individual prices for every buyer have to segment their customers into groups of companies with similar needs or patterns of behavior. Such a task calls out for data mining software with the ability to comb through databases and discover trends and characteristics that customers might share.

Activity-based costing software, which helps users gauge the cost of individual business activities such as making a product or processing orders, can also be a useful tool. "You don't want to let the costs drive your pricing, but you do need to know whether you're making money," Cressman says.

Airlines and hotels are the businesses that come up first in any discussion of value-based pricing, but Cressman and Shepherd say that's something of a misperception of the concept. For example, the dizzying array of ticket prices charged for the same flight are determined by sophisticated yield-management techniques meant to fill as many seats as possible while maximizing the revenue that the flight produces.

That certainly can increase a flight's value to the airline, but Shepherd says it isn't really a case of value-based pricing from the customer's perspective. The justification for the high prices that last-minute travelers have to pay is "based more on their desperation" than on any real sense of how much taking the flight will actually be worth to them in financial terms, he says.

Resource Links

Descriptions and explanations of value-based pricing:

  • www.time¿.com/lexicon/glossary/assetsmetrics/valuebasedpricing.htm -- Value-based pricing explained, with links to related terms, from a guide to setting up online marketplaces developed by Perot Systems Corp. in Dallas
  • -- A primer on the factors that need to be taken into account when pricing products, from Web-based magazine Guerrilla Marketing Online
  • -- An in-depth article on pricing fundamentals and comparisons of cost- and value-based pricing strategies, by the Online Women's Business Center
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