Every business that sells some type of product or service has a pricing method. Pricing methods are ways of calculating the price of goods and services by taking into account all the factors that can influence pricing strategy.
There are four popular pricing methods: cost-plus pricing, competitor-based pricing, demand-based pricing and value-based pricing. Of these four options, value-based pricing is the best option, for your business.
So, let’s get into what value-based pricing is, why it’s so great, and some stellar examples of it.
What is value-based pricing?
Value-based pricing could easily be called “customer-based pricing” because that’s essentially what it is. The more formal definition describes value-based pricing as basing a product or service’s price on how much the target consumers believe it’s worth. Instead of looking inwardly at your company or laterally toward competitors, value-based pricing gives you an outward look.
Why ProfitWell loves value-based pricing
We love value-based pricing here at ProfitWell, and for three good reasons. You can price higher than your competitors because you’re basing the pricing off of what customers say they’re willing to pay. If they’re willing to pay higher than what your competitor is charging, then that means more money in your pocket.
Value-based pricing also makes improving your product a continual process. Pricing is more than just a dollar sign on your website. It includes packaging and how you offer features. Knowing what your customers value at all times will make evolving your product and features an absolute must.
Finally, since your customers are determining product value, you need to communicate with them quite a bit. This constant communication builds great company/customer rapport. You’re building trust and this trust can lead to good things down the road, like higher retention and less churn.
Who is value-based pricing for?
Value-based pricing is the best option for every company that has the time and resources to execute it properly. It’s the most representative pricing possible. For SaaS, value-based pricing is truly the only viable option. However, different forms of businesses may use other pricing methods. For example, a gas station is more likely to implement a cost-plus pricing method, which is the most basic form of pricing (selling something for more than it costs to make).
The benefits of value-based pricing
I’ve spoken very highly of value-based pricing, so I think it’s time I break down specific benefits that come with this pricing method.
Higher price point right off the bat
If you have shown there is a high willingness to pay among your customers, you can start at a higher price point. Then, as you continually add value to your product and create additional features, you can adjust prices accordingly. If you were to implement a competitor-based pricing method, you’d be duplicating what your competition is doing. What if they didn’t conduct proper research and are lowballing their pricing? If you duplicate their prices, you could be missing out on revenue. You can make the most money by going off the source of your revenue: the customer. Additionally, as your company and product offerings evolve, you should be re-evaluating your pricing strategy every six months.
Proves real willingness to pay data
Collecting willingness-to-pay data requires some serious elbow grease, but it’s worth the work. Again, willingness to pay is the maximum amount a customer is willing to pay for your product or service. It varies based on a number of factors but is one of the best ways to conceptualize overall demand at any given time. The research behind a value-based pricing strategy provides real data that forces you into a profit generating price.
Knowing what your customers are willing to pay for your product or service is essential in building an effective and competitive pricing strategy. Without it, you’re just guessing.
Helps you develop higher quality products
Taking a consumer perspective will help you discover what solutions people want to find within your products and features. Through this perspective, you’ll generate new ideas on how to continue progressing your products. Progressing your products means finding new ways to improve what’s already been built and where you can add. Offering supplementary features will boost revenue and give customers a more dynamic experience with your service.
Increased focus on customer service
The customer takes center-stage with value-based pricing. Most customer data used for value-based pricing is collected through customer surveys and interviews. This attention given to the consumer will also likely strengthen the relationships with your current customers. You’ll be more attentive to their needs and they will appreciate your diligence in helping them. This builds rapport that will increase retention and threaten churn.
The downside of value-based pricing
Like everything in life, value-based pricing isn’t flawless. I’ll go through some reasons why value-based pricing might not be the best option for you right now.
It requires ample time and resources
To adopt a value-based pricing strategy means you need to be dedicated to it. Building the basis for quantifying your buyer personas is time consuming. Figuring out customer valuations is more difficult than it sounds, which is why so many companies opt for cost-plus and competitor-based pricing. Customer research is continual. So once you adopt one pricing strategy, you use the information to build and evolve upon it, meaning the work is never truly done. This type of grit is not for everyone.
It’s not exact
Value-based pricing isn’t a hard number; it’s an approximation. It’s not 100% reliable because price sensitivity measurements and feature analysis only give you approximations of the right pricing, packaging, and positioning for your product.
2 top pricing strategies compared with value-based pricing
Let's walk through the two other common strategies used to define their pricing process: cost-plus and competitor-based. We'll then show you the problems with these two strategies and how they don’t hold up when compared to value-based pricing.
A pricing method in which the selling price is set by evaluating all variable costs a company incurs and adding a markup percentage to establish the price.
Cost-plus pricing strategy is what people automatically think of when they think of “pricing strategy.”
This is the most basic form of pricing: selling something for more than it costs to make. You add up all of the costs of providing the service and then add a profit margin on top to represent the value you are giving your customers. In SaaS, the costs might be product development and design, the companies own SaaS providers, and the costs of the team. Then add a 5%, 10%, or healthy 20% margin on top for profit.
Calculating price from costs has two main benefits:
- It’s simple. As long as you know how much your costs are, it’s trivial to work out your price. No market research, no data analysis, no strategizing. Just some addition and percentages.
- You will cover your costs. As this is cost-plus pricing, you know that you will be adding a certain margin on top of your costs as pure profit.
Taking those advantages at face value, cost-plus pricing seems like a great idea and certainly a good starting point, with little overhead and definite profits.
Yet, cost-plus pricing is anything but a sure win. You won’t necessarily know all your costs, and therefore can’t know if you’re going to cover your costs. Your initial costs might include only hosting and some development, but as you grow you’ll have to factor in sales, marketing, and a number of other previously unknown costs. You can’t change your prices to account for every new hire, which means your profits will take a hit.
Also, costs fluctuate over time. If a SaaS provider is using value-based pricing and has changed their prices, you can’t constantly change the price of your product to maintain the same margin. That might work for a gas station, but it won’t work for a SaaS company. Again, profits take a hit.
This is what happens when you use cost-plus pricing:
In this example, the company calculates costs, and then adds a healthy 15% margin on top. This works well for a few months, until some unexpected costs crop up. Then the margin is cut to 5% and then 0%, where the company is only breaking even. Then all it takes is for one of their own SaaS suppliers to raise prices and they are losing money on every sale.
The Big Problem With Cost-Plus Pricing:
Customers don’t care about cost, they care about value.
You have no idea how much it costs for Starbucks to make your Frappuccino. You have no idea how much it costs for Honda to make your Accord. The price of these items is tied to the value they represent to you, not their internal cost. Sure, Starbucks and Honda are pricing their products over what it costs to make them, otherwise they’d be in trouble, but how much over is not determined by the cost of the product (coffee beans or the engine parts).
For SaaS in particular, the unit cost of delivering one account can be very low. It is the value that your customers will get out of using your product that really matters to them, not how much you paid your developers.
A pricing method that utilizes competitor prices as a benchmark, rather than setting a price based on company costs or customer value.
For a SaaS company starting out in a new industry, competitor-based pricing strategy will seem the logical way to go. Unsure of the initial value of your product, and not wanting to go too high or too low, it seems obvious that you should look at the other companies selling similar products to decide your own price point.
Again, calculating price from competitors has two main bonuses:
- Simplicity. By spending 30 minutes on competitors’ sites finding all their pricing information you can have a “pricing strategy.” It’s also unlikely to go wrong. By placing yourself in the middle of the pack, you’ll be anchoring yourself for any future customers and they won’t think your product is too cheap or too expensive.
- It might be close. If you’re in a competitive market, pricing for the companies involved should be close to what the market can reasonably sustain.
But the biggest downside of competitor-based pricing should be obvious. You don’t have your pricing strategy, you have their pricing strategy. Your company exists to offer customers something different to what is already on the market. You are offering more value and a better product, otherwise you shouldn’t be building it.
That is why you have to find your own space within the industry, both for your product and your pricing. If you don't, your profits will end up like this:
Flatlined. OK, this looks a lot better than the cost-based pricing, with a profit throughout the year. But it is also static, with no chance of adding value by raising prices without pricing yourself above your competitors.
The moral of the competitor-based story is look, but don’t touch. You want to know where your competitors are pricing their products so that you’re in the same ballpark, but they should not be guiding your decisions.
The Big Problem With Competitor-Based Pricing:
Customers don’t care about your competitors, they care about their value.
As before, this is missing the point for your customers. Instead of focusing on what you can give them and how you can put together the right features and plan for them at the right price, you are offering them something that they could literally get elsewhere.
If a potential customer is on your site, it is because they are interested in what you have to offer. If it’s just a regurgitation of what they have already seen elsewhere, then they will just use the original instead.
Examples of value-based pricing
We’ve gone in-depth about what pricing based on value truly means. Let me show you some companies who have nailed a value-based pricing strategy.
Drift, a conversational marketing and sales technology software, has done a kick-ass job with value-based pricing.
First and foremost, its pricing page is easy to navigate. You select whether you are looking for a plan built for individuals, teams, or enterprise. So, the pricing plan is also pre-tailored to your specific needs. Let’s say you’re an individual. Drift has a free option that’s said to be ideal for sites who want basic chat capability. If that’s not enough, you can pay $50/mo to proactively start conversations with prospects. There is a range of tiers for teams and for enterprise.
With this diverse range of options, Drift obviously understands people find different value in their product, therefore the different pricing. It’s not a one-size-fits-all pricing model. Not everybody has the same bandwidth as a large team and Drift’s pricing clearly recognizes that.
Zenefits, a cloud-based software for managing human resources offers three base plans that are front and center on its pricing page, with gradual increase in prices as more features are added. There’s also a clear layout for all the add-ons Zenefits offers. For example, you can choose to add payroll management to your plan, for a clearly stated price of $6/mo per employee. If these prices don’t suit you, you can contact a sales rep.
This pricing plan is not only easy to navigate, it’s super personalized. The base plans are reasonably priced, but there are many add-ons. It’s clear that Zenefits has done its customer research and values what customers have been asking for.
Data needed for value based pricing
You probably get the drift by now, but you need to collect a lot of data for value-based pricing. Here’s exactly what you need to do:
1. Identify and analyze buyer personas
Buyer personas are a fictionalized representation of your ideal customer. Your product will most likely fit the needs of many different types of customers, which means you should create multiple buyer personas. You can define your buyer personas by thinking about their personal background, role in the company, daily challenges, expectations from leadership, etc. Once you have defined buyer personas, talk about them as if they are real people in meetings.
2. Survey and talk to your customer base
Value-based pricing is from qualitative and quantitative data. Collect customer data by surveying customers on how much they would pay and which features and benefits they value most in your product. Buyer personas come into play here because your surveys need to target a specific audience. Sending out surveys to a random sample of people won’t result in quality data. One thing to keep in mind, since people are taking time out of their day to answer the survey, keep it short and simple.
3. Analyze data to build tiers and bundle packages
Once you have all this data, put it to good use. Analyze the patterns, features, benefits, and price points your different buyer personas value in your product. Create tiers and pricing packages based off of these patterns.
4. Test and review
Pricing is a process. You need to test out this data and strategy before it’s totally implemented. If it doesn’t work, then go back to the drawing board. Not getting it perfect the first time is normal, but just proves how hard this process can be.
Does ProfitWell recommend value-based pricing?
We 100% recommend value-based pricing. Like I mentioned above, value-based pricing gives an outward look of your company. You put yourself in the customer's shoes, which gives you a unique perspective of both your customer and your company.
Value-based pricing gives customers trust in your product and brand. Your pricing matches what they’re willing to pay for the value you provide. You can offer packages and price points that precisely meet their needs because you understand what they truly want. You can price higher than competitors because you conducted the research that proves how much customers are truly willing to pay. You can also re-evaluate prices as you add value to your product and learn more about your customers and their evolving needs.
Price Intelligently helps you figure it out. We hook you up with a pricing audit so you can map out your pricing strategy to better understand how you should differentiate and price your features and plans, how to localize pricing, and how to create persona and market mapping.