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Value Based Pricing

Value Based Pricing

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Pricing is the tool that can either create or destroy the demand for any product. The pricing decision is one of the most critical decisions that a firm can make in the launch of a product.In modern pricing context pricing can be considered as the monitory equivalent of the value. A product’s worth depends on how it stacks up against competing products. If it is a better-than average product, it is worth more than average. Such products could be sold for a premium price. On the other hand, customers will often tolerate reduced performance if they can get the product at an economy price. Customer value measurement and accounting is a structured approach for comparing a product or service against the competition to understand its comparative strengths and weaknesses, assess its worth, and provide a rational basis for setting its price.

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From a marketing perspective, the goal of pricing strategy is to assign a price that is the monetary equivalent of the value the customer perceives in the product while meeting profit and return on investment goals. This white paper posits the literature review that corroborates traditional cost-based approaches to product pricing as being short-term, tactical in nature, and place the interests of the seller over the interests of the buyer.

Paper on Value-Based Marketing & Pricing by Bradley T. Gale and Donald J. Swire indicates that pricing approaches based on customers’ perceptions of value are strategic and long-term in nature since they are focused on capturing unique value from each market segment through the pricing mechanism. Firms need to invest to create “pricing capital” to ensure the long-term benefits of value-based pricing. Firms that invest in a strategic pricing center can make better product decisions throughout the development process by understanding how customers value product alternatives and arrive at prices that they are willing to pay.

Traditional methods of pricing:

As per the paper on Value-Based Pricing For New Software Products Strategy Insights for Developer by Robert Harmon, David Raffo and  Stuart Faulk  few of the traditional methods of pricing entail cost based pricing approach containing Flat Pricing, Tiered Pricing, User based Pricing, and Usage based Pricing.

This section tries to elucidate the aspects of traditional methods of pricing and compare and contrast it with the value based pricing. Cost-based pricing is historically the most popular method since it relies on more readily available information from the cost-accounting system. This data is generated as a matter of course to produce operating results, budgets, and financial statements. It is imbued with an aura of authenticity. Financial, marketing, and product managers are schooled to price the software product to yield a desired return on fully allocated costs.

As per ROI Guide: Economic Value Added by J. Berry the fundamental problems with cost-driven pricing derive from the assumptions that must be made about product costs. First, unit costs are volume dependent. Fixed cost per unit is an allocated number that varies with projected volume. The allocation procedures, be they direct labor hours, or some other surrogate metric, are not very precise. Therefore, product costs are imprecise at best and a continually moving target at worst. In addition, cost-based pricing is bedeviled by a circular logic—price is based on unit-volume assumptions, but price will determine sales volume. The inability of firms to successfully model the impact of price on volume and of volume on price calls cost-based pricing into question. The circular nature of cost-based pricing can lead to overpricing in weak markets and under-pricing in strong markets. Earned value (EV) is a related cost-based concept that is used for tracking a project’s adherence to the original project budget. EV analysis focuses on explaining the cost variances between the amounts budgeted for the work and the equivalent dollar volume of work accomplished during a specified time period. The cost variances are identifiable to specific project tasks, which can then be evaluated for corrective action. Practitioners of the activity based costing (ABC) approach to determining product costs recognize that traditional cost information is not useful for firms who need to base strategic resource allocation decisions on accurate product costs. ABC methods can improve the overhead allocation process for assigning costs such as logistics, marketing, sales, production, finance, and general administration to individual products or product lines. Traditional methods of overhead allocation use direct labor hours that tend to over burden less-complex products and high-volume products. Conversely, they under allocate overhead cost to complex to low-volume products. The resulting cost distortion can produce misleading profit estimates and lead to poor decisions. A firm’s cost behavior and relative cost position in an industry are derived from the value-producing activities of the firm. Each value activity has its own cost structure.

After identifying the relevant value chain, operating costs and asset costs are assigned to the product-related activities that they support. By analyzing the “cost drivers” of its value producing activities the firm can better assign costs to products and understand its true cost position.

A literature review of common approaches to product pricing is as follows.

Flat pricing:

Users pay a fixed price for unlimited use of the product. This approach enables customers to more easily predict what they will pay for the use of the product. The fixed price is usually restricted to a particular user and/or machine. Many consumer  offerings are priced in this manner. Some level of online support is typically built in for a set period of time. The primary drawback to this method is the lack of flexibility in customizing a price for each customer based on the value the customer requires. Some customers will have to pay more than they would like and may be motivated to seek better deals. Others will enjoy a subsidy since they would be willing to pay more for the higher value they perceive. A fixed-price strategy can be segmented to embrace discounts for large purchasers, government, and members of preferred buying organizations. Flat pricing simplifies the vendor’s pricing model since the price is set to return a dependable but fixed rate of return. Prices are based on a financial return model, not on customer value. Prices are increased when costs increase.

Tiered-pricing:

Tiered-pricing attempts to package product benefits according to user requirements and their willingness to pay. This approach to pricing is an attempt to link product costs to perceived customer value. Tiered-pricing is viewed more favorably when the customer can easily see the increase in value received and the pricing scheme offers desirable choices.

User-based pricing:

This is another cost-based pricing method that tends to benefit the vendor more than the user by maximizing license fee revenues in terms of technology services. The charge is based on the number of users that utilize a collection of service features over a given period of time.

Per-user pricing:

Prices to the individual user who typically can use the product on an unlimited basic for the term of the license. The price is set on assumptions about product costs and customer use. This approach typically offers one price for a specified number of users.

High water mark pricing:

 Charges are based on the maximum number of concurrent users over a given time period.

Per client pricing:

 Similar to per user pricing, except that the license is assigned to the designated number of users.

Usage-based pricing:

Customers pay only for what they actually use on a transaction basis. This model is also known as “pay-as-you-go pricing” or network-based pricing model. It is often associated with technology services.

Value based pricing:

On having the glimpse of traditional methods of pricing now we can move to understanding the underlying concepts of Value based Pricing.

According to The Wall Street Journal, 2002-Value based pricing involves setting of a product or service’s price, based on the benefits it provides to consumers. By contrast, cost-plus pricing is based on the amount of money it takes to produce the product. Companies that offer unique or highly valuable features or services are better positioned to take advantage of value-based pricing, than companies whose products are services are relatively indistinguishable from those of their competitors. Customer value is the overall benefit derived from the product, as the customer perceives it, at the price the customer is willing to pay. At the core of perceived value pricing is the requirement that companies must first understand how the customer perceives value. Perceived value can be defined in terms of the tradeoff between perceived benefits received and the perceived price for acquiring the product or service that delivers those benefits.

Different methods of value based pricing that are discussed in here are as follows penetration, skimming, and hybrid pricing strategies.

Penetration pricing strategies:

Penetration strategies target market segments where buyers have a high degree of price sensitivity . Price-sensitive buyers typically have low reservation prices. Delivering benefits that are perceived as industry standard at a price that is sufficiently low to generate increases in sales volume creates customer value.

Certain subcomponents of penetration pricing include the following:

Low-price leader (low reservation price/competitive pricing):

Low-price leaders target buyers with low reservation prices. This strategy targets the mass-market buyers with reasonable features at a low price. The competitive pricing objective recognizes that the market has reached maturity.

Experience-curve pricing (low reservation price/competitive pricing):

 This competitive strategy targets buyers with low reservation prices. The initial price is set below cost in order to build volume and move more rapidly down the cost curve toward profitability. The low price is intended to ramp volume quickly and to keep out competition.

Bundling (low reservation price/product-line pricing):

This strategy features several applications that are packaged together and priced as a single product. It targets buyers with low reservation prices. It is a product-line strategy since it maximizes sales of complementary products within the product line. There may be differing preferences for each individual product, but overall demand is increased if the value is perceived to be greater for the bundled package.

Skim-Pricing Strategies:

Skim strategies target buyers that are relatively insensitive to price. All have high search costs. Some will engage in search behavior and perceive a high degree of value in the features, advantages, and benefits of the product. For example, innovators are often willing to pay more since they perceive opportunity in their ability to exploit the unique value of a new product. Others are unwilling to search and see the high price as a cue indicating high quality.

Certain subcomponents of skim pricing include the following:

Price signaling (high search costs/segment differential pricing):

This strategy is often used for segment differential pricing of new products where time is a

primary factor in the decision process. Innovators with high search costs and a high degree of trust in the brand do not want invest heavily to evaluate product alternatives. Information about price is more easily acquired than that about quality or performance. The high price signals the benefits these buyers desire. Buyers in this situation demand a high level of service and rapid response for their continued loyalty.

Reference pricing (high search costs/competitive pricing):

 This competitive pricing strategy is a variant of price signaling. Buyers have high search costs and higher perceived risk than the innovators. They need a reference point to calibrate the value in the price-quality relationship. Use of a reference price strategy can benchmark the higher price of an competitor. Comparison with the higher-priced product highlights the value of the moderate priced product and vice versa.

Image/prestige pricing (high search costs/product-line pricing):

This product line strategy targets customers with high search costs who are attracted to brands that have achieved a reputation for high quality and exclusivity. The buyer’s self image is emotionally linked to the brand’s image. Buyers have expectations for exclusiveness and high levels of support and service.

Hybrid Pricing Strategies:

Hybrid strategies combine elements of skimming and penetration strategies. Combinations of high search costs, low reservation prices, and/or special transaction costs may characterize potential buyers. Special transaction costs might include the complex and expensive evaluation process.

Certain subcomponents of hybrid pricing include the following

Complementary pricing:

Complementary pricing is a product-line strategy that exploits the special transaction costs of products that are used jointly but sold separately. The base product (low reservation price/product-line pricing) is sold at a low price that minimizes resistance to purchase. Higher profits are then made on the complementary consumable products or services due to the special transaction costs.

Premium pricing. Marketers address different groups of customers by using a

product-line strategy that addresses the higher search costs of some groups and

the lower reservation prices of others. This practice is also known as “price lining.” The strategy is implemented by pricing versions of the product to address entry level, mid-level, and high-end premium-buying customers.

Random discounting (high search costs/segment differential pricing:

A random discounting strategy maintains a high skimming price but offers discounts on a random basis as an incentive to new buyers to try the product. The price break serves to draw attention to the product.

Periodic discounting (low reservation price/segment differential pricing):

Periodic discounting strategy creates customer value for sequential classes of buyers with increasingly low reservation prices. The initial strategy focuses on skimming the inelastic demand of the innovator then reducing prices on a predictable basis as the market matures in order to attract more price sensitive customer groups.

Second-market discounting (differential pricing special transaction costs):

For second market discounting, marketers introduce an existing product to a new market where buyers are more price-sensitive than the primary market and have identifiable special transaction costs.

Techniques of value based pricing:

As per the “Matching Appropriate Pricing Strategy with Markets and Objectives” by C. R. Duke techniques of devising value based pricing entail the following: 1) Customer value analysis 2) Customer value drivers.

Customer Value Analysis:

Customer value analysis/ accounting is a comprehensive system of analysis that integrates whatever data is available from

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  • Importance-performance analysis based on market perception studies.
  • Price data from competitive intelligence
  • Engineering Economics studies.
  • Conjoint Analyses that are tightly couple to market perception studies.

Different aspects of customer value analysis include the following:

Conjoint analysis or trade-off analysis:

This technique enables firms to compute the consumers’ utility functions for individual variables and to understand how they are combined, traded off, and otherwise valued. Conjoint analysis is useful for pricing since the feature tradeoffs at different levels of price can be mapped.

Economic Value to the Customer (EVC): Alternately called “value-in-use” or “exchange value”, EVC is the maximum amount a customer would be willing to pay for the product, assuming s/he is fully informed about the product and competitive offerings. It is analogous to the reservation price. EVC answers the question, “What’s it worth to you?” EVC measures the life-cycle economic costs and benefits to the user of one product when compared with a reference product. Economic Value Added (EVA). Broadly stated, EVA measures a company’s net operating profit after taxes. It focuses the organization on earning a target rate of return over and above the cost of capital.

Price Sensitivity Measurement (PSM): PSM models are useful for estimating market demand and for calculating the proportion of buyers that would buy the product within a specific price range. PSM determines the limits of buyer resistance over a range of prices that relate to the product’s value perceptions. These value perceptions are market segment specific and based on the buyer’s perceptions of product value, buying intentions, and spending capabilities. Typical outputs from the model are the upper and lower bounds for the acceptable price range and the optimal pricing point. PSM is very useful for pricing alternate software configurations in the early stages of development and throughout the development cycle.

Customer Value Drivers:

In order to create the foundation for setting prices, it is necessary that product developers and managers understand what the customer’s value drivers are and how important each is in the purchase decision. Customer value drivers are emotional links that summarize customer beliefs about the product and firm, create positive attitudes and feelings, provide the basis for differentiation, and provide the reason to buy. Value drivers are the expression of the customer’s evaluations of the product, the perceived credibility of the vendor, and the confidence the customer has in the brand. The customers’ value drivers need to be reflected in the design requirements of the products if the value is to be subsequently captured by the pricing mechanism on the product’s launch. Some of the primitive and essential customer value drivers are the following:

1. Economic value.

Economic-value drivers are based on the buyer’s perceptions about the cost of acquiring, owning, installing, using, and disposing of a product or service. The concept encompasses costs savings and ROI impact deriving from the purchase of the product.

2. Performance value:

Performance value is based on the buyer’s perceptions of the utility to be derived from the functional features, advantages, and benefits associated with a product or a service.

3. Supplier Value:

The buyer’s perceptions about credibility of the vendor and trust in the business relationship links directly to brand acceptance. It is relatively easy for competitors to match economic and performance value by changes in price and product design. A strong brand provides a greater barrier to competition since it takes much longer to change perceptions about a company. Strong brands support skimming strategies across a broad range of pricing objectives.

4. Buyer Motivations:

The buyer’s psychological motivations and goals for a particular purchase are central to the decision process. Cost-based pricing does not consider these higher-level motivations. Psychological motives arise from the buyer’s need for recognition, esteem, and belonging. Additional motivations may involve novelty seeking and knowledge acquisition. Buyer motivations are often subjective and emotional.

5. The Buying Situation:

Purchase behavior always occurs within a situational context. The situation may act as a constraint or to facilitate a given purchase or it may have no effect at all.

Key situational variables are:

a. Task definition. The task situation addresses the question: “What objective or tasks are the products used for?” Knowledge of the specific task will help to define the software use situation and product requirements.

b. Resource capability. This variable focuses on the physical and intellectual resources of the buyer including budgets, infrastructure, and technical skills.

c. Time horizon. Time is an important influence on price perceptions. Buyers with short decision time horizons tend to be fewer prices sensitive. Key questions to be addressed are: “How long until the buyer is ready to make a decision? How long does the buyer anticipate using the product?”

d. Social influences. What is the composition and role dynamics of the buying center team that will influence the purchase the product?

e. Experience:

Highly experienced buyers tend to have stronger product-related

attitudes, which influence subsequent evaluations of product and price. Developers and marketers need to answer the question: “How experienced is the buyer with similar product?”

f. Availability. Availability refers to the ease of finding purchase related information about the product or company.

Summary:

This white paper presented a literature review of contemporary cost-based pricing models. This literature review decipher that  as current markets have become more competitive and buyers are faced with more choices, cost based pricing models that ignore customer-value requirements can no longer ensure a favorable rate of return to the vendor. A taxonomic analysis of customer value drivers indicates that cost-based models appeal to price-performance value drivers with promises of improved ROI for the customer while ignoring other potentially more important value drivers that are more intangible in nature. The primary contribution of this literature review is the detailed discussion of value-based pricing strategies as they relate to the current context. The article develops a prescriptive pricing taxonomy that depicts the relationships between customer characteristics, company objectives, and pricing strategy. It suggests that deep knowledge of the customer can result in more appropriate approaches to pricing strategy.

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