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Value-based Pricing & the Four Dimensions of Value Cheat Sheet (DRAFT) by [deleted]

This is a draft cheat sheet. It is a work in progress and is not finished yet.

Introd­uction

For many companies, the tradit­ional way to set prices has been some form of cost-plus pricing. In other words, they calculate their costs, slap on a margin, and there they have a price. However, this pricing scheme has come under increasing pressure as of late, and explor­ation is underway into other pricing schemes.

The most prized goal at the moment is often value-­based pricing: determ­ining the value the customer is able to create with the service and adjusting the price accord­ingly.

Price discri­min­ation

One of the key concepts in pricing is price discri­min­ation. It means that identical or largely similar goods are priced differ­ently by the same provider depending on the customers’ willin­gness to pay (WTP). Providers typically love to be able to employ some form of price discri­min­ation, because it enables them to improve their profits: if you can sell with high price to people who really want the product and at a lower price (still covering your costs) to people who do not want the product quite as much, you can maximize profits.

Three Types of Price Discri­min­ation:

First-­degree price discri­min­ation (perso­nalized pricing): The firm can price its products to perfectly match each customer’s willin­gness to pay. Project business is the most classic example of where this is possible, although it is becoming increa­singly common to do this on consumer markets over the internet as well – Amazon began experi­menting with this in the early 2000s, showing different prices for different people for the same products, but the big consumer backlash forced it to stop that practice back then. However, the practice has gained more prevalence as of late.
Second­-degree price discri­min­ation (menu pricing): The firm offers different deals, e.g. combin­ations of price and qualit­y/q­uan­tity, and the customers self-s­elect the deal they want. Examples of this include non-linear pricing (volume discou­nts), versioning (econo­my/­bus­iness class flights; student versions of software), and bundling (PS4 with The Last of Us; Word and Excel in MS Office bundle).
Third-­degree price discri­min­ation (group pricing): The firm is unable to determine individual willin­gness to pay, but it can determine rough estimates for different groups. The groups can be identi­fies, for example, based on work status (student discou­nts), location (soft drink at a superm­arket or at an airport), region, country, or time (travel in peak season or off-peak season).
 

Value-­based Pricing & Four Dimensions of Value

Using Value-­Based Pricing Effect­ively

In order to use value-­based pricing effect­ively, it is vital that the company is able to use some form of price discri­min­ation, preferably the first-­degree variant. However, it is important to note that just because a company uses some form of price discri­min­ation, it does not necess­arily do this on value basis.

Value-­based pricing

Value-­based pricing is based on recogn­izing the value of the service, and sharing the gains created in its use by all involved parties. Tradit­ion­ally, a value-­based price is formed from four building blocks:
Reference price. The market price of the altern­ative service the customer could buy.
Net revenue gain. The net revenue gain for the customer compared to the competing service. This has to be realistic and take into account possible revenue losses as well.
Net cost reduction. The net cost reduction for the customer compared to the competing service. This has to be realistic and take into account possible cost increases as well.
Emotional contri­bution. The most difficult piece to quantify, this refers to things such as reduced risk, better trust, and user prefer­ence.
Together, these form the maximum value-­based price. Of course, if the price eats up all of the added value, then the customer does not have a particular interest in buying this service over any other. Therefore, there is a negoti­ation corridor with which the price is set somewhere between the reference price and the maximum value-­based price.

Starting with Value-­based Pricing

Understand your customer: Without unders­tanding the customer, you cannot differ­ent­iate.
Know your differ­ent­iation: You also need to understand the compet­ition, in order to know where you can differ­ent­iate.
Quantify the differ­ent­iation: Without quanti­fic­ation, you cannot come up with a value-­based price.
Commun­icate your differ­ent­iated value: If you don’t tell the customer how you are different, the customer will never know, and selling value becomes imposs­ible.