A Quick Guide To Value-Based Pricing

Pricing Strategy
A Quick Guide to Value-Based

Pricing
by Utpal M. Dholakia
August 09, 2016
In my 15-plus years of working with companies & teaching courses

on pricing strategies to MBA students, I have found value-based
pricing (also known as “value pricing”) to be the most commonly
discussed concept that’s also the most misunderstood one. It
creates more confusion among marketers, even many pricing
experts, than any other pricing concept. What is more, these
misconceptions often lead companies to shy away from using it,
instead settling for cost-based or other pricing methods that leave
money on the table.
What is Value-Based Pricing?
I like to use this definition: “Value-based pricing is the method of

setting a price by which a company calculates and tries to earn
the differentiated worth of its product for a particular customer
segment when compared to its competitor.”
To understand how value-based pricing works, let’s take the

example of Brand A that is about to launch a new LED television.
It wants to figure out the price for its new 65-inch LED TV, the
biggest screen size in the marketplace at the time. The company’s
closest competitor, Brand B, recently introduced a 60-inch TV for
$799. Both TVs have other features that are similar — both have
built-in WiFi, the same level of definition, same number of HDMI
inputs, same refresh rate, and so on.
Now let’s apply value-based pricing by considering each part of

the definition carefully:
1) Focus on a single segment. The first thing to know about

value-based pricing is that it always references one specific
segment. (For B2B products, it can be a single customer). Brand
A’s focus is only on big-screen TV buyers, not all TV buyers.
Marketers can’t use value-based pricing unless they have a
specific segment. If they have multiple segments, they must
determine a suitable value-based price for each one.
2) Compare with next best alternative. This pricing method
only works when the target segment has a specific competitor’s
product they can buy instead. Value-based pricers always ask the
question: “What would this segment buy if my product wasn’t
available?” This “next best alternative” for the target is the
essential point of comparison for calculating the value-based
price. For products that are truly new, without peers, the value-
based pricing methodology won’t work well.
3) Understand differentiated worth. The next task is to figure

out which product features are unique, that is, differentiated,
from the competitor’s offering. In our case, the only differentiated
feature of Brand A is its larger screen size.
4) Place a dollar amount on the differentiation. The last, and

arguably the most difficult, step in calculating value-based price
is to estimate the dollar value of the differentiated features. For
us, this boils down to: “How much will big-screen TV shoppers
pay for an extra 5 inches of screen size?” and then add that
amount (let’s say it is $150) to $799, Brand B’s price. The value-
based price of Brand A’s TV is $949. To accomplish this step,
marketers typically use research methods like conjoint analysis or
qualitative customer interviewing.
One final point about value-based pricing is this. Just because the
differentiated worth is $150 doesn’t mean the company will get it
all. In many situations (buying or renting a house for example),
there will be a negotiation process, and the marketer may have to
share the differentiated worth with the customer.
Dispelling Key Misconceptions About Value-Based Pricing

:
Value-based pricing is used in virtually every industry, to price
everything from TVs and drugs, to oil rigs and airplanes. Despite
its popularity, marketers have significant misconceptions about
the approach. Here are three of the most common ones.
Misconception 1: Value-based pricing requires the company

to evaluate consumers’ willingness-to-pay for each and every
product feature. Some marketers wrongly believe that when a
company uses value-based pricing, it has to assess how much the
customer values every single product feature, assign a dollar
amount to each one, and then add them all up to calculate the
product’s final price. Even the simplest products have dozens of
features. Imagine the difficulty of pulling this off for an oil rig or
even a TV. This misconception turns many marketers off at the
outset.
In reality, feature common with the next best alternative is

captured by its price. In our TV example, the fact that both TVs
have 3 HDMI inputs, built-in Wifi, and 4K Ultra HD is included in
Brand B’s $799. We do not have to calculate each feature’s value
separately. The only thing Brand A has to do is find the feature
differences and assess customers’ valuation of these
differentiated features. This is a lot easier to do.
Misconception 2: Even if competitors are not smart with

pricing, using value-based pricing will lead to success. This is
likely the most dangerous misperception about value-based
pricing because it can create false, high expectations. Many
marketers think that value-based pricing is a panacea. If they use
it, they will make lots of money under any circumstances. Not
true! The success of value-based pricing depends on how smartly
competitors have priced their products. If they have set untenably
low prices, value-based pricing can’t save you.
:
Just imagine what would happen if Brand B foolishly chose to sell
its TV at $399 instead of $799. Brand A would still be only able to
charge the $150 extra for its larger screen size, not any more. It
would end up with a low price, and perhaps even lose money
because of Brand B. Competitors have to practice “intelligent
pricing” if value-based pricing is to work successfully.
Misconception 3: The brand’s value is part of the value-based

pricing calculation. With value-based pricing, the marketer’s
goal is to put a dollar amount on its differentiated features. The
method’s focus is on features that add value to the customer and
that can be converted into dollars and cents. Features such as
“longer-lasting by X%,” “faster by Y hours,” “less likely to break
down by Z%,” all work nicely because they can be easily
converted into money.
But it’s much harder to deal with a brand’s value this way. This is
why brand value is left out of the equation with value-based
pricing. And it is one reason why the method is more popular in
B2B settings that give less weight to the brand value.
Value-based pricing is an effective method to price products. On

the one hand, it’s a lot easier in practice than it appears to be in
theory. The marketer needs to identify and assess its products’
differentiated features only (except the brand’s value), not every
feature. And when competitors have priced their products
foolishly, value-based pricing won’t help. With a stronger grasp of
how this method works, marketers will be able to make smarter
pricing decisions, and employ value-based pricing to increase
profits.
:
Utpal M. Dholakia is the George R. Brown
Professor of Marketing at Rice University’s
Jesse H. Jones Graduate School of Business and
author of How to Price Effectively: A Guide for
Managers and Entrepreneurs.
Recommended For You
When Cost-Plus Pricing Is a Good Idea
The Good-Better-Best Approach to Pricing
Upgrade Your Pricing Strategy to Match Consumer Behavior
If You're Going to Raise Prices, Tell Customers Why

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Pricing Strategy

A Quick Guide to Value-Based

August 09, 2016

In my 15-plus years of working with companies & teaching courses

What is Value-Based Pricing?

I like to use this definition: “Value-based pricing is the method of

To understand how value-based pricing works, let’s take the

Now let’s apply value-based pricing by considering each part of

1) Focus on a single segment. The first thing to know about

3) Understand differentiated worth. The next task is to figure

4) Place a dollar amount on the differentiation. The last, and

Dispelling Key Misconceptions About Value-Based Pricing

Misconception 1: Value-based pricing requires the company

In reality, feature common with the next best alternative is

Misconception 2: Even if competitors are not smart with

Misconception 3: The brand’s value is part of the value-based

Value-based pricing is an effective method to price products. On

Recommended For You

When Cost-Plus Pricing Is a Good Idea

The Good-Better-Best Approach to Pricing

Upgrade Your Pricing Strategy to Match Consumer Behavior

If You're Going to Raise Prices, Tell Customers Why

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