How to Shift From a Cost-Plus to a Value-Based Pricing Strategy

Tapping Into Consumer Perception

Before we explain how to shift to a Value-Based pricing strategy, we must first address why companies are using a Cost-Plus pricing strategy in the first place. A Cost-Plus pricing strategy is often viewed as the “straight forward” and “simple” approach to pricing because it is based on data that is readily available (via accounting data). Simply defined, Cost-Plus pricing is the cost of making the product + a mark-up (aka margin). Value-Based pricing is predicated on the perceived value to the customer rather than the cost of the product or historical prices. In a market where the product demand or value is not easily understood, a Cost-Plus approach gives companies an easy and reliable way to price their product and estimate profit.

Why switch to a Value-Based pricing strategy?

Cost-plus pricing is not the most effective long-term pricing strategy

Pricing that does not pay attention to consumer needs and perspective is not a reliable long-term strategy. What’s valuable to consumers is constantly changing. Pricing must be able to adapt to those changes in order to maximize return.

The risk of Cost-Plus pricing is too great

Pricing can make or break a product. If your price is wrong, you could be missing out on opportunities. Studies have shown that Cost-Plus pricing leads to sub-standard profitability. It’s like operating in the dark. I like to think of the example of selling a house. By asking the potential buyer a few questions you can begin to gauge their buying urgency and desires in a property. If you feel like your property is their dream home and they are in a hurry to buy, you can sell for a higher price. The money left on the table is often much greater than the time and money spent understanding the value of your product through the eyes of your customer.

Biggest Obstacles

A study among executives in Austria, Germany, China, and the US by Hinterhuber & Partners showed that the top 2 obstacles to implementing a Value-Based pricing strategy are Value Assessment and Value Communication. In other words, companies are struggling internally to identify the value of their product or service as well as how to communicate the value to customers.

Research Objective

What is the Selling Proposition that maximizes our customer’s willingness to pay?

Value Pricing

Building Value Generates Price Opportunities

The figure below shows the current structure of pricing under the Cost-Plus model (Cost+), the perceived value structure under the current price (Current Value), and the potential pricing opportunity (Optimized Value). Pricing opportunities are seized by better understanding the value of your service, product, or brand.

A good example of Value-Based pricing is the airline industry. Consumers have many value-options to weigh when booking their travel plans. For example, first class or coach, exit row seating, number of stops, seat spacing in the plane, etc. The price consumers pay also varies by how far in advance the flight is booked, whether they’re a member of the airline’s frequent flyer program, and other service benefits. The airline industry is pricing to a perceived value.

Alternative Methodologies

Econometric modeling

• Requires historical time-series
• Past not relevant when converting to new pricing paradigm

Direct Questioning Approaches (e.g. Surveys, Focus Groups)

• “Ask a rational person a rational question – get a rational answer”
• Who would WANT to pay more?

Indirect Questioning Approaches

• Develop “Value Bundle” scenarios and ask respondents to choose which one they prefer (e.g. Conjoint Analysis)

Which method would be best for switching to Value-Based?

The most recommended approach for understanding customers’ willingness to pay and the value of your product/service offerings is through Indirect Questioning Approaches like Conjoint Analysis.

Benefits of Conjoint Analysis

Price sensitivity related to value proposition

• Systematically changing elements of the concept can change their willingness to pay
  • Short-term Implications:
    • Informs pricing strategy
    • Guides marketing communications planning
  • Longer-term Implications:
    • Understand how to develop product and services which maximize long-term value

Additional Conjoint Benefits

• Simulations allow examination of demand impact under alternative product configuration/pricing scenarios
• Price sensitivity is rarely homogeneous – conjoint can identify market segments with different price elasticities
• Assists in the “sell-in” of pricing strategies to various classes of trade
• Inform development of selling strategy – how best to position products and services in the market
• With data to support the “sell-in”, manufacturers can minimize push-back and channel conflict

For further reading on Conjoint Analysis, check out our in-depth explanation.

Output

A key output in a study like this is the utility scores for each product/service attribute (with Price being one of the attributes). A utility score shows the relative value of each attribute (e.g. Price) and corresponding levels of each attribute (e.g. $13.50, $12.25, etc.). In the case of price, the figure below shows how impactful each price-point is for a particular type of carpet. It’s important to understand that utility values are a relative measure and that all of the utility values under a single attribute (e.g. Price) equate to zero. For example, in the figure below, the price point of $13.50/ Sq. ft. (utility score of 31.1) has more than double the positive impact than the price point of $12.25/Sq. Ft. (utility score of 14.1).

By running simulations of all the utility values you can begin to identify the product or service offering that maximizes your customers’ willingness to pay. You can also test the price sensitivity of each product/service bundling in order to find the price point that maximizes ROI.

Key Takeaways

• Reality: it’s an evolutionary process
  • Markets don’t accept radical price changes in one move
• Understanding how to increase the perceived value of key product benefits is critical to increasing customers’ willingness-to-pay
• Consumers are making Value-Based pricing decisions more often because they can compare prices online