Given the widespread recognition that value-based pricing drives faster growth and higher returns, why do so few companies apply it?
There are two reasons, one most common in the start-up world, the other prevalent among established companies.
The most common product development sequence is as follows:
Begin with a product. Figure out the costs. Use the costs to set a price (cost-plus pricing). Hopefully, some customers will buy at that price. Maybe they will get value.
This approach can fail at two points.
- Build the wrong product
At early-stage companies, the most common problem is a failure to establish product-market fit. This is always a risk when doing a product before you have customers. It is why most institutional money wants to see a minimum viable product that has been tested in the market before writing a check. This is not enough to assure success, but it does improve the odds.
- Set the wrong price
Many early-stage companies set prices by copying the market leader or ‘throwing it at the wall to see what sticks.
These are both losing strategies.
Copying a market leader’s pricing generally means playing to their strengths on the ground they have defined. The only way to wedge one’s way in is to underprice. I have heard too many pitches from early-stage companies that claim their differentiation is a lower price. That is not differentiation. It only works if you are the low-cost provider, most early-stage companies are actually high-cost providers as they lack economies of scale and experience in the market.
Pricing by trying something to see if it works sounds edgy and agile, in tune with the move fast start-up ethos. Every once in a while, through superior instincts or good luck, it even works (at least for a while). When it does work, it becomes a frozen accident. A way of pricing that gets accepted by the market as the norm and coded into market expectations and business processes.
A price is a lot more than a number. It is a whole system connecting value delivered to value captured. The price at which a new product is introduced provides the anchor price that all other prices get compared to. It can be very difficult to shift this anchor price. Once people have created a category in their minds and know-how prices are set for that category, everything else gets referenced.
Setting a frame that highlights your competitive differentiation and connects price to value is critical for early-stage companies and is part of achieving product-market fit.
Cost-Based Pricing is a Downhill Slope
Established companies have customers and can usually learn from customers what products they will buy. This does not help them with disruptive innovation, of course. Continued bets on past success tend to follow a law of diminishing returns, but at least there are customers to inform product development.
Established companies are often driven by finance. They have trained their investors to expect a certain level of return. The easiest way to ensure a stable return over the short term is to just add margin to costs. In other words, with cost-plus pricing.
The problem with cost-based pricing is that your customers really don’t care what your costs are. How much something costs to produce has nothing to do with how much value it creates.
Incentives are misaligned. Cost-based pricing encourages companies to rely on market forces to keep costs down. They tend to underinvest in differentiation (the value drivers your product offers that the competitor does not) and unintentionally push themselves into commodity land where the market actually does set prices.
Start With Customers to Get to Product
There is a better way. Start by understanding the customer. Figure out how to deliver value. Set a price based on that value. Calculate acceptable costs. Design the product around the value and cost requirements.
Start With the Customer
Pricing is designed. The best practices for design, such as design thinking, are a powerful way to approach pricing. (See Pricing as a Design Problem.)
Design thinking is a proven approach to design and innovation. The design thinking group that Ibbaka manages on LinkedIn has more than 170,000 members. The process, formalized by Ideo and the Stanford University d.school works through cycles of Empathize, Define, Ideate, Prototype, Test. You begin with Empathize, and in this case, Empathize means understanding your customers, how they create value and how you can help them improve their own business model.
The real trick here is to go beyond your own customers to look at your customers’ customers. Ask, “How can I help my customers provide more value to their own customers?”
Set Price Based on Value
The two key concepts in value-based pricing are the value metrics and pricing metrics.
The value metric is the unit of consumption by which your customer gets value.
The pricing metric is the unit of consumption for which you charge.
You have value-based pricing when you can explain the connection between your value metric and your pricing metric.
The actual price you set will depend on a number of factors, the most important of which is your differentiated value. This is the value you provide that customers cannot get from your competitors.
Part of your value is commoditized; there are many ways for the customer to get that value, and the price they are willing to pay depends on the price of these alternatives.
Your ability to charge a premium depends on your differentiation. Be laser-focused on how to create differentiated value for a target set of customers (i.e., don’t try to boil the ocean).
Costs Still Matter
Some people think value-based pricing ignores costs. In business, you have to be concerned with costs. It is just that cost-plus pricing gets the relationship backward. Cost does not drive price. Price sets constraints on costs and not the other way around. You have to design your offer, so the costs are driven by value and price and not the other way around.
Sunk costs are not relevant to price. The time to be concerned with sunk costs is before they are committed to. Once they are in the past, you cannot do anything about them. Don’t let them skew your pricing decisions. This may be controversial. Finance (and investors) may tell you to cover your development costs. Well, yes. But the time to make that determination is before you commit to development. That is why ‘product’ comes last in the process. Once you have spent the money, it is not coming back. Don’t let it distort your go-forward pricing choices.
Value-based pricing is a Positive-Sum Game
Some people see pricing as a zero-sum game. What I win, my customer loses. Let’s change that. Value-based pricing is about making your pricing a positive-sum game. The way to do this is by starting with understanding the customer and using this to create value. The value determines price and shapes your product.