What is Value-Based Pricing?
Jessie Tai is a Consultant at Ibbaka. See her Skill Profile on Ibbaka Talent.
Why Use Value-based pricing?
Pricing can be extremely complex. For many people it is a nuanced art but also a strange science. There are many different pricing models and strategies to choose from. It's hard to know where to even start. If your product has differentiated offers (you provide more value than the alternatives or you provide value in different ways for specific customers) and you want the most flexible model that can support different pricing strategies, then value-based pricing is for you. Pricing models might seem complicated, but here we break down the structure to show the basics of value-based pricing.
(We at Ibbaka are indebted to the foundational work done by Tom Nagle on value-based pricing and would like to thank him for all he has contributed.)
Let’s Start with Value
Before we get into the pricing, we must first understand value. I’ve always found it fascinating to see the spectrum of what people value and the patterns that can be uncovered. Value might seem like an abstract concept to some, but we can make it easy to understand with a framework for value drivers. Value drivers are how a customer gets value. By categorizing value drivers we can then measure them and use them to inform segmentation. But before we go there, let's have a look at the categories of value drivers: Emotional, Community and Economic. Each category is unique, powerful and an important lens by which to segment your market and an input into your pricing model.
This is a general overview of the value drivers, but you can read more into the implications and impacts here:
* In some industries value drivers that impact the balance sheet are also important, in subscription businesses it can be important to organize economic value drivers in terms of unit economics such as the Lifetime Value of a Customer.
What We Actually Care About - Differentiated Value
Another important part of value is differentiated value. To understand your pricing power in value-based pricing you need to look at differentiated value. A key aspect of value is that it is always relative to the alternative. If you are offering a product, the customers will always have alternatives. This comparison with other options introduces the importance of differentiated value. This is the value a potential customer wants and can’t get from another source easily. Furthermore, look at this explanation of economic value drivers and Economic Value Estimation, here you can see how pricing power comes from differentiated value.
As we move into segmentation, note that we need to understand how much differentiated value can be captured in each segment. Being able to maximize the differentiated value will be significant when we design the pricing model.
Why Market Segmentation is Critical in Value-Based Pricing
Market segmentation is really the foundation for value-based pricing. When collecting data keep in mind the importance of segmentation. During your market research, you need to make sure you are capturing the range of value drivers outlined.
Consider: What do your customers want? What are your customer’s biggest challenges? What does success mean to them?
With the collected data, we can create more meaningful segments. More specifically, capturing information on value drivers is more powerful than relying on demographics. Value drivers connect better to purchasing patterns and personas.
Another misunderstanding some people may have is the idea of segmenting by willingness to pay (WTP). Of course, when you think about pricing, it’s almost automatic to think about willingness to pay. The issue here is that many people try to replace value with willingness to pay. This is a common misconception; instead, start with value and proper segmentation in order to build up the framing for willingness to pay. Willingness to pay is something that you shape through pricing, not something that is given. That is why we need to properly frame the pricing model. But before we get into the pricing model, let’s review the metrics.
How We Connect Value to Price - Value Metrics and Pricing Metrics
Without these units of measure, there is nothing to capture or price. A value metric is how the user gets value while the pricing metric is how you charge your customers. Linking these two metrics is key.
The elemental structure of the value graph
By expanding this diagram we can see how the metrics feed into the larger structure below. Now we can see why there is such an emphasis on value drivers. Everything in value-based pricing is linked back to the drivers, and properly assigning value metrics and pricing metrics is a crucial step in pricing.
The expanded value graph
Bringing Everything Together in the Pricing Model
If we have completed all the foundational work, discovering and validating value drivers, using them to build a value-based market segmentation and then defining the metrics, we can begin the final step of designing the pricing model. In general terms, a pricing model is the design of pricing metrics, fencing and packaging. This process is really the pinnacle of combining the art and science of pricing. The goal here is to design packages/tiers for segments where you can maximize on the differentiated value to increase willingness to pay and then to capture your fair share of the value you create.
Here are key five questions you need to consider when designing your pricing model:
What segment is the package designed for?
What functions create value for that segment? (Packaging should help highlight segment differentiation.)
What are the value metrics associated with the functions?
What are the interactions between the different packages and tiers?
What pricing metric will track the value metric(s)?
We expand more on this process here.
Lastly, we turn to setting the actual price. This is where the science comes into play and usually scares most people away. The technicality of pricing can indeed be intricate, but experts at Ibbaka have spent years breaking down this process. If you are interested in value-based pricing and want to see what Ibbaka can do for you, schedule a review with us today.
