Value-Based Price Setting isn’t always the answer!

One topic that seems to get a disproportionate amount of attention within pricing is Value-based pricing. When focusing on the more theoretical aspects of it, the attention might be warranted (as the concept does make sense). On a practical level however, I believe that value-based pricing drastically overstays its welcome. Why? For starters because the theory can prove more difficult in reality than indicate. Secondly, it makes it seem that setting prices based on value, is all that pricing is about. The latter might be my biggest grievance against it. ?Good pricing is about much more than value-based pricing (or competing price setting methods for that matter). An exaggerated focus on this topic does a disservice to the wider field of pricing.

So, what is value-based pricing? The core idea is that the price you charge for a product should reflect the customer’s perceived value of that same product. Other competing methods of price setting would be cost-plus where prices are based on what it costs to produce a product + a margin on top. Market-based pricing is another widespread and popular price setting methodology. Here, the price of a product is heavily influenced by what prices competition are charging. Within the theory of value-based pricing, both of these other price setting methods are seen as inferior. The promise made by value-based pricing is, that by using value as a determinant for pricing, you will make more money. Pricing is a value transaction and customers pay for the value they receive. At its heart, an intuitive idea which should resonate with most people. If only it was as easy in reality, as it is on paper.

As alluded to in the first paragraph there are two big issues with value-based pricing. The first issue arises when companies think that pricing is almost exclusively about value-based pricing. Pricing is really an intricate system and your ability to price well is dependent on a range of different variables. What it is really about is pricing efficiency and not your favorite method of calculating the right price (price setting). Not discounting the importance of price setting, but what matters the most is your pricing efficiency.

The second issue with value-based pricing is that it can be very complex, and sometimes even impossible to implement. The theory rarely deals with that aspect but for value-based pricing to make sense, it must be attainable. You need to question what increases your overall ability to price the most. It is never a given that value-based pricing is the answer to that question. First, you want to identify the different areas of your pricing system which can be improved or outright needs to be fixed. Next, determine whether they are feasible to pursue. You’ll likely end up with a few different pricing initiatives that you could focus on and out of those, value-based pricing might not be the one most deserving of your effort.

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The trouble with Value Based Pricing

A simpler way to put it is that different pricing initiatives come with different requirements. Whether you want to do value-based pricing or something completely else – there are dependencies. Across initiatives some requirements might be the same, but others likely won’t be. On top of that, complexity will also differ when comparing the feasibility of different initiatives. Essentially you want to identify the initiative with the highest increase in your pricing efficiency, but which take as little effort as possible.

One could argue whether this isn’t just the same as mapping resources required vs expected output? Partially yes. However, the issue is that when people are inexperienced within pricing, they risk underestimating the dependencies for a given initiative to succeed. Mapping out the complexity of the requirements needed can be a more tangible way of expressing the resource cost. ?Some initiatives will be too big of an undertaking but luckily there plenty of areas which helps build pricing efficiency. ?If one initiative is deemed too difficult - look elsewhere. There are always opportunities for better pricing.

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?An important mention about requirements is, that they can be dependent on other requirements. A hierarchy can exist between them. Perhaps the simplest way to think of this is using the metaphor of a rocket. A rocket ready to launch for space, will normally consist of multiple stages. Each stage being fitted with engines, propulsion systems and various components. The different stages are the requirements needed for the rocket to reach its final destination, (your pricing initiative). The different stages in a rocket also represent a hierarchy. You need to have the first stage in place to make any use of a second stage. Some destinations are more challenging to reach and calls for a more complex rocket. Same for pricing initiative. Value-based pricing can be among the more complex ones to reach. Other initiatives however might be easier and can be done with a simpler rocket. Compare getting a satellite into orbit or shooting for the moon. Both might hold value, but one is also way less resource consuming than the other.

Good practice before deciding upon a particular pricing initiative is to conduct a small feasibility analysis. The purpose is to help clarify whether the pricing initiative in question is desirable to pursue. For this assessment I will provide a loose framework/checklist. It won’t go into the minute details, but it can help establish a more critical mindset when evaluating initiatives and their requirements.

The focus of this framework is on the requirements needed for a given pricing initiative to succeed. Obviously, you would also want to look at expected impact (expressed in operational or financial KPI’s) but that exercise is not part of this framework. To keep it simple we are only looking at requirements.

Breaking it down there are three broad categories to consider. External Conditions; Structure and Design. Whereas the first one looks at the external requirements, the latter two are focused on internal requirements. ?Let’s start by looking at the external conditions.

External conditions

Not all pricing initiatives have external dependencies. There is a lot you can do without the external world forcing your hand. Want to redesign your pricing architecture. You can do that. Roll out a new report suite filled with pricing insights? You can do that too. Value-based pricing however, can prove difficult. Here external conditions will impact how easy or difficult this will be to achieve. Using value-based pricing as an example, especially three external conditions have to be met:

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a)????? You need to have a lot of transactions/data points

One way to quantify the relationship between value and price is through a large sample size of transactions. Enough transactional data and you can measure the demand for a product at different price levels. At its core, demand is an expression of value (how desirable is your product). As prices go up and down, demand will normally change. Plentiful transactions will give you a good outset for value-based pricing but also the means for testing new price points to further refine your understanding of value and price. If you don’t have a lot of transactions, another means for understanding value is by having large enough quantities of customer data tailored at understanding value and price. The common denominator is that you need to have enough data to make it statistically significant. Small sample sizes don’t work well.

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b)????? Trustworthy data on customers (e.g. conjoint analysis)

That data has to be trustworthy is self-evident so why even mention it? Because data on pricing is not always reliable indicator for understanding value. As mentioned above, price and how it ties into demand is a good indicator for value in most consumer industries. Unfortunately, the same cannot be said for B2B industries. Here, pricing data could stem from price negotiations. In this case the individual price points in your data might tell you more about negotiation power than the value of your product. Here, you need to treat your data carefully as it might not be reliable.

Acquiring trustworthy data on value and price can also be done by conducting surveys such as conjoint analysis. Done right, the conjoint analysis helps quantify the elements of your product that customers care about, expressed through a monetary value. Two things are especially important if using a conjoint analysis. That you (a) survey product elements that customer actually care for and (b) that you get a big enough sample size (rule of thumb would be 500 – 1,000 respondents). For instance, a company selling high speed internet connections might want to quantify the monetary value of download speed, upload speed, and uptime. All relevant product elements that customers care about. However, in some industries it is less clear what the most important elements are. Clarifying this might require a pre-study before conducting the conjoint analysis. However, just as before conjoint rarely works in a B2B customer setting. Most B2B customers will be careful about revealing the true price that they are willing to pay, so even if you become wiser on what element of your product or service they value, you might still struggle with linking this to a particular price point.

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c)?????? A high throughput time on data

Companies rarely operate in static markets, so data on value and how it connects with price will also have an expiration date. Take the hospitality industry where seasonality has a large impact on demand. The value of a hotel room in Southern France is obviously higher at summer season then in February. If this particular hotel want to understand the value of their product better, they want to break down their data into the different seasons they operate in (e.g. low-, shoulder-, and high season). This means that every defined time period needs to have enough critical data as they represent a different value to the customer. Seasonality is only example of how time impacts the relevance of your data. The perceived value of a product might also change if customer needs change over time. This could happen due to change in preferences or new competitors entering the market. Whatever the reason behind a change in perceived value, be mindful of your data’s expiration date. There won’t always be obvious circumstances alerting you that the value of your product is now perceived differently. A high throughput time ensures data stays relevant. This is particularly critical when value is at the heart of pricing.

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Although simplified, the above should help illustrate how external conditions can be pivotal for whether a pricing initiative is even possible. The focus above was specifically on value-based pricing as this is one of the more complex ones. However you shouldn’t need, a fixed list of items to check for across all types of pricing initiatives as most initiatives have few to no external conditions. As long as you stay aware of the external context, you should be able to identify potential requirements and whether you meet them or not. One category of initiatives which do have external conditions would be anything which drastically disrupt the status quo in the market. Major price hikes would be one. Another would be launching radically new pricing models (e.g. a subscription model in a market used to transactional pricing). Such initiatives might provoke strong reactions from competition as well as customers. In this case there certainly are external conditions you would want to consider. One being expected reaction from customers and competition.

Despite rarely having any ability to change external conditions short term, you might be able to influence them long term. For instance, external conditions not being met for doing value-based pricing right now, might be met in the future. Your market might have started out small but now grown and you might suddenly have a swath of transactional data.? Perhaps you are operating within B2B where trustworthy data was hard to come by. But as time has passed it might be that your data sources have expanded and perceived customer value and pricing is less of an enigma. Richer data allows you to approximate the value-price relationship more accurately. External conditions are not static so it can make sense to revisit them every now and then.

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Internal requirements

External conditions matter, but the biggest challenge to any pricing initiative is solving the internal requirements. You could say that the external conditions are more passive in nature whereas the internal ones require active effort. You have little sway over your external circumstances, but the internal requirements are fully within your control.

Internal requirements are all about defining the internal dependencies of a pricing initiative in a systematic way. Identifying the crucial pieces that your pricing initiative can’t work without. Maybe you want to improve the speed of your company’s quotation process. If so, one requirement is to streamline how prices are built. Internal requirements are about having the right components being clearly defined but flexible. Going back to our metaphor. Our rocket consists of various stages, and you want to make sure that the components on each stage are clearly defined and fit together so that your rocket works.

Example: A company realizes that their margins are getting thinner due to weak discount management. The company wants to improve transparency in this area and design a process and governance around how discounts are managed to avoid unnecessary revenue leakages. Internal requirements to succeed with this would be for the company to clearly streamline and structure any data around discounts. Another requirement would be to ensure that this data would both be stored and easily exposed for the creation of new reports and insights (Transparency). There would be a handful more requirements, but the point stays the same. If the company’s data on discounts are a hodgepodge of text fields, duplicates and data hidden in local spreadsheets, they can’t really do anything about their initiative before fixing this. This is what requirements are about. Identify what you have to fix to get your pricing initiative off the ground.

This is a simplified example, but often internal requirements revolve around creating the right structure for the most critical pieces and putting them into a system. For pricing purposes, I like to divide these requirements into two types. Structure and Design. In the example above, structure would be about how the data for (e.g.) discounts should look (naming convention, required data fields, where should it be stored, etc). Design is how to put it together in a system. This can cover reports (transparency on discount)as well as a general process around who should asses and make decisions on how and to who discounts are applied.

It should be mentioned that any solution you design will also impact your thought on what structure is necessary. You could say that you design the structure. On the other hand, the structure which is already there might also impact the way you want to design your systems and solutions. In other words, the two are interdependent. However, for sake of clarity I will still address them separately.

Structure

My preferred way to think about structure is to break it down into the manageable pieces which impact your pricing as a whole. Structural components. In the example from before, the way that discounts are defined and configured matters. Ultimately you need to be able to translate this into somethings which works in a digital setting and system. Discounts as whole would be a structural component but inside that component you will have different sub-elements making up discounts (maybe there are time-based discounts, volume discounts, location-based, etc. Additionally, it would also be common for rules and hierarchies to be part of this structural component. Perhaps some discounts rule out other discounts? You get the meaning. Other example of structural components within pricing could be Contracts, Customers, Price, Products, Inventory, etc. Part of a component being clearly defined is that it is fenced off from other components. You can’t have sub-elements of pricing both in your Pricing Component and in your Product component. It creates unnecessary complexity when trying to build the structure and design to deliver on a pricing initiative.

Once your structural components are clear and logical it will be easy to integrate them with other components. As an example, a customer purchase is linked to at least four structural components (keeping it simple). There is a customer, a product, a price, and invoicing/payment for the transaction. Although this should be quite basic, it is not uncommon that companies lack proper structure in their components. No matter what pricing initiative you are focusing on, you need the most important structural elements (tied to that initiative) to be streamlined. You don’t want to fix everything but pick the ones most crucial for what you are trying to achieve. Pricing might be a commercial discipline but one could argue that the success of it might be more tied to operational excellence.

Design

Design operates on several levels. On the macro level you design the blueprint for your pricing initiative. Your system. In the example from before this was the process for discount management and the right way of displaying discount data. Design could also be a faster quotation process for tenders; a model for value-based pricing, etc. A good way to design your blueprint is often by mapping out how your company works today. That gives you a baseline that you can start improving on and tweak. This ensures a manageable design process but also buy in from stakeholders as you a proposed solution start from a place that they can recognize. Trying to design something with have no semblance to any way your company is working today risk alienating people and you lose buy in. As you start putting the design together you will already have identified crucial structural components as part of that process. However, putting the structural components together in your designed system also requires for you to take a look at the micro level. The sub-elements and rules needed for each component. Design operates on both a macro and micro level.

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In the example with discount management, we discussed how sub-elements, rules and hierarchy need to be in place for it to work. This is design on the micro level. A design on a micro level for a structural component for discount could be something like this:

A company might have no categories for their discounts. Duplicates exist (like promotions and one-off discounts). Cleaning this up and labeling it clearly goes a long way for building transparency. A crucial part of the foundation for proper discount management.

The example of discounts on a micro level clearly shows how structure and design are two sides to the same coin.? It is only for clarity that we keep them separate. In my own experience, design on a macro level seem to get most of the attention when people discuss new initiatives. With this comes the risk of glancing over the structural part. For this reason alone there is an argument for emphasizing structure separately. Without proper structure any pricing initiative you pursue will fail.

Closing Remarks

Better pricing is about pricing efficiency and shouldn’t be limited to value-based pricing. Broadening one’s view on pricing opens up a host of different pricing initiatives which could all have a positive impact. Yet, as some pricing initiatives are more complex than others, assessing feasibility become paramount. What are the requirements? What gives the best return on invested effort? For some companies it will be feasible to switch to value-based price setting. For others it definitely won’t. If the below were two initiatives that your company were contemplating (and both had an equally positive impact on your pricing efficiency) the choice should be self-evident.

By now I’ve probably exceeded my quota for using the same metaphor so if I were to boil it down just remember this: pricing is an intrinsic system. Acknowledging that price setting (such as Value Based Pricing, Cost Plus or Market Based Pricing) is only one part of the equation will make your future pricing journey more fruitful. Focus on making your pricing system run optimally. To do that you need to identify opportunities (pricing initiatives) but also understand their requirements and assess feasibility based on that. A lightning-fast ability to put new prices into the market using a mediocre price setting methodology is sometimes more powerful than the opposite. Simply because it brings an overall higher pricing efficiency.

It should be mentioned a last time that Value Based Pricing not wrong. It just not always feasible. It is easy to get it wrong, so make sure that you can meet all the requirements if this is what you really want to do. Shifting the narrative in talks and literature on pricing from ‘what the optimal price setting is’ to ‘how companies improve their pricing efficiency’ would be a welcomed change in my eyes.

If agreeing that pricing efficiency should get more focus another question starts to loom. How do you build pricing efficiency? If each initiative can take different shapes and sizes (it’s not just price setting anymore) what does it take to design, build and implement it? After all, you can’t build a rocket and hope to reach the stars through wishful thinking. Well, coincidentally that will be the topic of my next article. How to become grow your pricing efficiency.

Until next time; stay safe and price well.