How do companies determine the ideal price of their new products? Setting prices based on manufacturing costs or competitors’ offers isn’t effective – profit potential can only be fully tapped through value-based pricing, where price is tied to the added value delivered to the customer.
“The single most important decision in evaluating a business is pricing power.” This is the insight of investment guru Warren Buffett. Unfortunately, companies rarely incorporate this principle into their day-to-day business. Not adopting innovative pricing strategies can have a significant financial impact on companies, since traditional models, such as cost-plus pricing and competition-oriented pricing, don’t capture how much customers are really willing to pay for a product. The risk of prices being set too high or too low is enormous, so profits can fall as a result.
Achieving optimal prices and customer satisfaction through value-based pricing
What can companies do to improve? The answer is to follow a value-based pricing approach. Unlike other price-setting approaches, production costs and competitors’ prices aren’t the sole factors used to calculate price. Instead, customers pay for the value their new product offers them. To achieve this, companies need to assign a price to every product feature or characteristic. The more valuable features a product has, the higher its price needs to be.
Not only does value-based pricing fully tap customers' willingness to pay, it also improves the manufacturer’s reputation and its trustworthiness in the eyes of its customers, since prices set using this method are perceived to be very logical and transparent.
Three types of valuable product features
Identifying and quantifying value-adding features is the greatest challenge for value-based pricing. Through decades of project experience, we have been able to identify three types of features that determine the value of a product:
- Hygiene factors, which must be present for customers to even consider buying the product
- Preference drivers, which determine whether a customer will buy a particular product over another
- Value drivers, which compel customers to pay a higher price for a product
Hygiene factors are the features that a product must have in order to be considered by customers at all. If a product lacks these features, it will be ruled out by the customer. For example, a hygiene factor for a shoe could be its size. If the shoe isn’t available in the right size, the customer won’t buy it, no matter the price. Preference drivers determine which product each customer will buy based on their own tastes, such as the color of the shoe. The third category of features, value drivers, is what companies should pay particular attention to. In the shoe example, a value driver would be a material that is perceived as being of high quality, so it is something customers are willing to pay more for.
Infographic 1: Breakdown of product features for a shoe
Identify value drivers using market research
How can companies determine which of their products’ features are value drivers? A number of market research methods are available, including the trade-off and MaxDiff methods, which enable companies to differentiate value drivers from hygiene factors and preference drivers. In the trade-off method, potential customers are shown two products that differ in only one feature. Then they have to indicate whether there is a price difference between the two variants and which one they think is more expensive. The product feature that the majority of participants consider expensive is a value driver. If opinions vary too much, the feature is a preference driver. The MaxDiff method provides even more insight. Market research participants receive lists of product features that they must evaluate according to the relevance for their purchase decision.
Quantify willingness to pay
Once companies have identified their products’ value drivers, they need to determine their customers’ willingness to pay. There are many direct and indirect questioning techniques they can use. Indirect questions can be asked using conjoint analysis. Test customers are prompted to rate products that differ in price as well as in their individual features and asked to indicate which ones they would buy. Consequently, a statistical analysis can be performed to calculate the benefit of every product feature individually and the markup or discount applied to each one.
Companies can use the Van Westendorp or Gabor-Granger methods to carry out direct price inquiries. The Van Westendorp technique involves customers rating the prices they consider too expensive, expensive, inexpensive, or too inexpensive for a specific product. For the Gabor-Granger method, study participants are randomly assigned product-price combinations and are asked to indicate how likely they are to buy each combination. However, companies should be aware that these types of direct surveys often underestimate customers’ willingness to pay and don’t take the competitive situation into account. For this reason, it is advisable to only use direct questioning techniques as a supplement to indirect ones.
Once companies have identified their products’ value drivers and their monetary value, they must translate these findings into specific prices. To do so, they need to apply the markups or discounts determined using the conjoint analysis to a base price. This reference price applies to an entire product category and should be in the low or medium price segment of the market.
Infographic 2: Example of the cost price and markups for jeans
Competitive advantages for product development
Value-based pricing not only helps companies optimize the prices of their products. Insights into which features make a product valuable also support companies in developing new products, as they can be specifically tailored to the needs and desires of their customers. In addition, manufacturers in the B2B sector can use added value to justify higher prices when selling to companies further down the supply chain.
This article was originally published in German in HSGfocus. To view the original article please click here