Meet Dave, a mid-market tech CEO. He is smart, savvy, and universally respected by his employees and industry peers. He’s invested wisely in sales and marketing optimization over the years, and consequently his team makes the number more often than not. Overall, the board is happy with his solid leadership.
When it comes to pricing, Dave uses a cost-plus strategy. He’s heard of value-based pricing, but he hasn’t explored it because he’s skeptical about what it could deliver. After all, he already bakes an aggressive 50 percent margin into his prices and he’s still growing share.
Why rock the boat when things are going so well? Here’s why: Dave’s decision against adopting a value-based pricing strategy means that every year he is letting millions of dollars slip through his fingers.
Cost-plus is the most frequently used pricing methodology across industries. Understandably so. It’s straightforward and defensible, and helps control profitability. But it has a fundamental flaw. Customers don’t buy based on how much a product costs to produce. They buy based on what they are willing to pay for it. If the price is equal to or lower than their willingness to pay, customers will consider buying the product. If it is higher they will not. It’s that simple.
Boosting the Bottom Line
Pricing based on the customer’s willingness to pay is known as value-based pricing. Adopting this approach is the gateway to unlocking revenues and profits you have already earned but are missing out on.
Willingness to pay for a product is strongly linked to the value a customer expects to receive, so it can be highly variable across a customer base. A large company may value an e-commerce platform more than a small company. And a professional services firm that uses an analytics package to sell projects and generate revenue may value the software more than a company that uses it for internal analysis.
This means that if you are not pricing to value, then at least one of the following is true:
- You are missing out on potential customers that you could be serving profitably.
- You are undercharging at least some of your customers who would happily pay more for your product.
Exploring How Value-Based Pricing Works
Your products or services create value for your customers. Their willingness to pay reflects the amount of value they perceive. It’s crucial to analyze each customer segment’s willingness to pay. Otherwise, your list price will typically fall below your customers’ willingness to pay. Moreover, if you discount, your realized price will be even lower. As a result, the actual value you capture will be a fraction of the value you create. As a resource, download our 10th annual workbook, How to Make Your Number in 2017. Review the Pricing phase in the corporate strategy section on pages 94 – 99 of the workbook.
For example, imagine we are a vendor selling product X into the market. Product X costs $1,000 every time we sell it into an account. We have three different potential customers for this product, and each has a different willingness to pay. Account A is willing to pay $1,500; Account B, $2,000; and Account C, $3,000.
Using Dave’s 50 percent margin strategy, we should price product X at $2,000. If we do that, Account A will not buy since its willingness to pay threshold is $500 lower than the selling price. However, Accounts B and C will buy product X and we will realize $1,000 in profit from each. is gives us a total profit of $2,000.
But what if we used value-based pricing instead? If we can find a mechanism to do so, we can set a different price for each of the three accounts based on their willingness to pay. That means we can now sell to Account A at $1,500. This doesn’t reach Dave’s 50 percent profit margin target, but still nets $500 of profit. More importantly, it means we’ve increased our market share—we are now selling to all three accounts.
Also, we can increase Account C’s price to $3,000, meaning we net $2,000 of profit from that deal. We still sell to Account B at $2,000 as before. Now our total profit is $500 + $1,000 + $2,000 = $3,500, significantly more than we realized when pricing was based on cost.
You may point out that this is an unrealistic, oversimplified example. So let’s look at a very conservative and realistic one. Imagine you operate a $100 million business with a 40 percent gross profit margin. If you believe 20 percent of your customers would be willing to pay 10 percent higher prices, that would result in an extra $2 million of revenue. This revenue would drop straight to the bottom line, raising gross profits by 5 percent.
Dispelling B2B Myths
Let’s dispel some common myths. Value-based pricing does work in B2B businesses. In fact, value-based pricing may work better in B2B than B2C because of the long B2B sales cycles and available resources to drive home the value-based message.
Make no mistake, it does work in competitive industries. Competition may shift the price-to-value relationship, but it does not destroy that relationship. Value-based pricing even works when the industry dictates that pricing must be fully transparent. If some customers happen to see that others are getting a lower price, they can still be persuaded that this is fair.
There is only one case where value-based pricing is not appropriate: when customers do not perceive any product or service differentiation among competitors. In that instance price is indeed the only negotiation lever. But the situation occurs far less frequently than some would have you believe.
Making the Switch
Three success levers govern the move to a value-based pricing system. First, achieve an analytical understanding of your customers. Next, establish a price differentiation mechanism. And finally, drive the value-based culture.
1. Achieve an Analytical Understanding of Your Customers
The foundation for value-based pricing is a detailed understanding of your customer segments. Start by determining needs, seeing how well your product or service meets these needs, and figuring out what customers are willing to pay. To price with confidence, you must know your customer, not just make assumptions.
Gaining this detailed information gives you a leg up over your competitors. Your sales reps know what customers are willing to pay, so they will be less inclined to discount. Your marketing and product teams know what resonates with your customers, so they can reinforce key messages and make product improvements that will drive up willingness to pay. Most importantly, this knowledge gives you insights to create a mechanism for pricing differently across segments.
2. Establish a Price Differentiation Mechanism
Now it’s time to decide the best way to price differentiate. If there is a good reason for price differentiation, it’s vital to select the right technique to achieve it. For example, you can adopt a metric that ties price to a scaling factor; target a product version to each segment; or structure discounting to change net prices without a ecting list prices.
3. Drive the Value-Based Culture
It is easier for sales reps to win deals on price than on value, so the CEO must reinforce a value-based culture. Everyone in the organization must understand how the company’s products or services deliver value to the segments. And they must be committed to maintaining price points.
This means being willing to walk away from a deal when necessary. If high willingness-to-pay customers are allowed to pay low prices, the whole system collapses. The CEO’s public dedication to the cause is a proven driver of success in value-based pricing initiatives.
Value-based pricing can be a true competitive advantage for B2B CEOs with the vision and focus to invest in it. You’ve already created the value. Why not capture more of it? Consider a visit to The Studio, SBI’s multimillion dollar, one-of-a-kind, state-of-the-art executive briefing center. A visit to The Studio increases the probability of making your number because the sessions are built on the proven strength and stability of SBI, the industry leader in B2B sales and marketing.