**Steven Forth** is a Managing Partner at Ibbaka. See his Skill Profile on Ibbaka Talent.

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Value based pricing gets a lot of press. It is widely accepted as the most effective way to price (though that is changing as some companies move towards outcome-based pricing). Like any popular process, design thinking comes to mind, there are many ways to implement value-based pricing and a lot of confusion as to what it really is. There is also a lot of misunderstanding as to what value-based pricing really is and how to succeed with it.

In part this is the result of software and consulting companies piling onto a trend. Value-based pricing was developed by Tom Nagle in the various editions of The Strategy and Tactics of Pricing, the single most important book ever published on pricing.

At essence it is pretty simple. Price should reflect the value actually provided to a customer. The closer the price actually tracks that value the closer one is to executing on value-based pricing.

What is value? In the classic approach developed by Tom Nagle, the Economic Value Estimation (EVE) approach is used to understand the economic impact of a solution on the business of a customer. relative to their next best competitive alternative. There are two key points here:

Value is for a specific customer or group of similar customers (a market segment)
Value is relative to the alternative

Ibbaka also considers emotional and community value in understanding how to segment the market and how customers will respond to price, but economic value is central to pricing.

Of course the value is not the price. The price model and price setting are connected to the value model, but the actual price will also depend on pricing power, pricing strategy and the current market conditions.

This sounds pretty simple, so why all the confusion?

One reason is that certain consultants and pricing software companies have conflated value-based pricing with pricing based on willingness to pay (WTP). This is a fundamental error. Value does not equal willingness to pay. Value is higher than willingness to pay, and the Value to Customer (V2C) must be larger than the Lifetime Value of a Customer (LTV). Willingness to pay is not even a good way to approximate value. It is not an input, it is an outcome. The value cycle of create, communicate, deliver, document, capture provides many opportunities to shape WTP. It is the job of pricing experts to do this and ensure that pricing is fair, consistent and transparent.

An example of the WTP fallacy at work can be seen in a recent LinkedIn Post by Robert Ribciuc: When Value-Based Pricing Means … Nothing by Robert Ribciuc

He claims that

“Its core tenet is that pricing should be driven by customers’ perceived value for the benefits of any good or service ("value"), and customers’ willingness to pay (“WTP”) for said perceived value.”

In other words, he conflates WTP and value. Note the prominent use of the term ‘perceived’ here. Good value-based pricing is based on conversations between buyer and seller, and other concerned parties, that leads to an agreement on what value is and how it will be delivered. For those with sales backgrounds, this is a kind of solution selling. Value claims are validated with customers.

Ribciuc goes on to ask nine questions, in bold below with my comments.

Is VBP applicable if …?

1. It is unclear who the buyer is (multiple parties are involved in the decision and/or payment)?

Yes. This is where value-based pricing shines. Part of the work of value-based pricing is to understand which value drivers impact which people in the stakeholder group. There are well tested approaches to doing this.

2. The “buyer” is under duress, facing death, illness, or debilitating loss?

I believe the implication here is that under such circumstances willingness to pay will be high. This may be true. But value-based pricing is not based on WTP. There are ethical considerations at play here. At Ibbaka we believe that pricing should be fair, consistent and transparent. A seller that takes advantage of a buyer under duress is being neither fair nor consistent.

3. The seller has a monopoly or some other competition-limiting or rent-seeking mechanism?

In other words, the seller has a great deal of pricing power and can claim a higher percentage of the differentiation value (see our work on the Value Ratio). The buyer will still not buy if the seller tries to claim too much of the differentiation value. In most cases buyers reject anything over 50% (they are willing to share the differentiation value 50/50) though in extreme cases the seller may be able to push this to 70% or even 90%.

4. The buyer pays with someone else’s money / there is no budget constraint?

Again, this is confusing willingness to pay with value. It is an example of how being careless with these two terms leads to confusion.

5. Buyer pays with “restricted funds”, that can’t be redirected to other purposes, or even expire right away if buyer doesn’t make this purchase?

Another willingness to pay argument. Yes, this can impact WTP. The buyer will still not pay more than the economic value (or is foolish to do so, or perhaps is acting to preserve budget allocations for the next fiscal year).

6. The buyer doesn’t have the capacity to evaluate the value claims / benefits of purchase, and relies on a third party to do so? (either buyer’s evaluative capacity is too low/impaired, or claims require highly specialized expertise to evaluate)

This is commonly the case, especially for innovative offers. Here it is the seller’s responsibility to educate the buyer, provide evidence (there is much we can all learn from evidence-based medicine and Health Economics and Outcomes Research). It is perfectly legitimate to collaborate with third parties on building evidence of value.

7. The third party can evaluate the claims, but has no visibility to price and/or has substantial conflicts of interest?

Why would the third party have no visibility into price? Because the seller has decided not to have consistent and transparent pricing. Conflicts of interest are an ethical risk that must be managed. This does not undercut the value of value based pricing.

8. The value claims are “enhanced” by (dramatic) omission of risks or disconfirming evidence?

This is saying the seller is dishonest. Good value-based pricing takes into account both positive and negative value drivers. Transparency on this builds trust and value-based pricing is based on trust. See Trust is the key to value-based pricing.

9. Buyers’ sole education about value claims comes through TV commercials built with marketing budgets that can buy small countries?

Would this be the seller’s fault or the buyer abdicating their responsibility? Both I suppose. I wonder how often this actually happens outside certain shady parts of the healthcare industry.

Value-based pricing will remain the foundation of pricing for many years to come. It provides the tools to understand and communicate value and then to monitor and document how value is being delivered.

Pricing mechanisms may change. Usage-based pricing is based on connecting the value model to the pricing model and then basing some part of the price on a variable that is used in both.

How to introduce usage-based pricing

A value model will change your business

Down the road, value-based pricing and usage-based pricing will come together in outcomes-based pricing. This is the true goal of pricing, for buyers and sellers, to base price on the value actually provided.

Let's talk about how we can help you build a value model.