Unrestricted price competition can be devastating. It forces a race to the bottom that destroys profit margins, erodes brand image, and can lead to reduced product and service quality as companies attempt to lower prices even further. To insulate yourself from this, your business needs to develop pricing power, the ability to charge more than your competitors without losing customers. Pricing power is so important that investor Warren Buffett called it the single most important element in evaluating a business. You can cultivate pricing power through a value-based pricing strategy, which bases the price of your product on what customers are willing to pay for it, not on the price that your competitors charge. In this article, we discuss what value-based pricing is, and how to adopt it at your company.
Customer Value-Based Pricing
To define a value-based pricing strategy, we should look at the other two common pricing strategies. In a cost-based strategy, the final cost is determined by the input costs, both fixed and variable, plus a markup. For example, if it costs you 10 dollars to get your product to market and you want a 50 percent markup, you would charge 15 dollars. In a competition-based strategy, you would look at the prices that your competitors charge for a similar product and price your own accordingly. If everyone else charges 10 dollars, you might decide to charge nine.
Value-based pricing, on the other hand, uses research to determine how much customers value your product, and then charges accordingly. Under this strategy, the price charged by your competitors is of much less importance. If your research indicates that customers value your product at 15 dollars then you charge 15, whether or not all of your competitors charge 10. A successful value-based pricing strategy insulates you from competition, preventing you from being dragged into price wars and allowing your prices to remain more stable.
Value-based pricing has one obvious pitfall. Unless you can convince potential customers that your product has unique value, they will buy from your cheaper competitors instead. If you want to charge more than your competitors, you have to give customers a justification for spending more. This requires clear product differentiation.
One obvious example of product differentiation is Apple. Their ability to set their products apart is why people divide smartphones into Apple and Android devices. Apple products are set apart from the competition with distinctive designs, extremely long battery life, generous repair policies, a unique operating system and a walled garden of apps that you can't get on any other device. Apple is able to make a convincing case that their products are different enough that there is no like-for-like competition, allowing them to set prices more independently of their rivals.
Without strong product differentiation, though, value-based pricing is doomed to fail, as it relies on being seen as different enough from your competitors that you can get away with charging a premium. Even for strongly differentiated brands, overreaching can be dangerous. Apple's first iPhone launched at a $599, a price that they quickly realised was too high. When they reduced the price less than three months after the launch, it caused a wave of bad press.
Making Value-Based Pricing Work
Value-based pricing relies on data about how your customers perceive your product's value. To set a value-based price, you first need to know which market segment you are targeting. If you are about to launch a new flagship smartphone, you need to focus on the market for flagship smartphones, not all cellphones.
Setting a value-based price doesn't have to involve working out the dollar value for everything your product does. There is a quicker, easier method. Once you know which segment you need to target, find the next-best alternative to your product. Work out what makes your product better than the competitor, and then use market research to determine how much a customer might be willing to pay for that difference. You should also be honest with yourself and determine what the competitor does better. Once you have a dollar value for the difference, add that to their price to find yours.
This is a rule of thumb, not a foolproof method. If your competitor has set an unsustainably low price, then basing your price on theirs will make yours too low as well. It also doesn't really take into account some extremely important aspects of your pricing strategy, like branding. Returning to the example of Apple, while there are things that make their products unique, their ability to charge a premium price is mostly dependent on an extremely strong brand identity and a loyal base of customers. Your price should ultimately be based on your product's own merits, not those of your competitors.
In the end, then, value-based pricing and a strong brand identity are some of the most effective ways that you can protect your products' prices and opt out of downward-spiralling price competition. If you can successfully adopt the strategy, you greatly increase your business' chances of success.
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