Why value based pricing?

Warren Buffet famously stated

“Price is what you pay. Value is what you get.”

Value based buying approach is when customers make purchasing decisions based on a balanced consideration of price and other non price attributes in alignment with their priority needs. The price that firms charge should align with the value that they provide to their customers.

The unique value that a firm should aim to create for its customers is the ‘positive difference’ it provides relative to the next best alternative as perceived by its target customers.

Value based pricing assumes that firms are operating in markets where there are sufficient customers that are willing to pay for the value that they create, which enables such firms to both survive and thrive. If that assumption is incorrect, then perhaps such firms may have created services or products that are not aligned to their target customers’ needs and perhaps new market opportunities should be explored.

Value based pricing incentivises firms to focus on continuous achievement of price relative to the value created for customers. Value based pricing enables firms to fix prices to the customers rather than just to the product/service. A profitable value based price is the reward for serving customers well.

Competing by price

Effective competition is in the best interests of consumers but firms are unlikely to be sustainable in the long term if they adopt pricing strategies based on continuous discounting of prices unless they have a dominant market position, which enables them to leverage a significant volume of business. However, in most industry sectors, only a few firms can occupy such market positions and other firms need to adopt pricing strategies that foster differentiation and sustainability.

Competing through low prices particularly for small businesses is not sustainable because the barrier to entry is low and other businesses can easily give away their services through low prices.

It is recognised that external pressures such as recession and changes in consumer buying behaviour that result in reduction of sales can trigger a response through price reduction in order to stimulate demand but such price-cutting could end up being a self-inflicted wound.

Firms also need to remember that low prices can make a credibility statement, which may be relevant if strong consumer confidence is a key driver of consumer engagement particularly if the impact of service failure is very adverse.

The danger of competing primarily on lower prices is that it is much easier for other firms to imitate this pricing approach, which forces firms in such markets to bow to further pressure to make price cuts to remain competitive.

Michael Raynor and Mumtaz Ahmed[1] in their book The Three Rules: How Exceptional Companies Think make the following point that echoes the constraints about competition by lower prices:

 “Competing against a company on the basis of having lower prices while enjoying better profitability through higher prices is a logical impossibility.”

It is reasonable to assume that saturated markets with overcapacity may not be appropriate to implement value based pricing. However, such an assumption is likely to be valid only if the majority of existing providers are delivering the value that the customers require which may not always be case.

Markets with overcapacity may produce a lot of noise and more difficult for firms to stand out which is why lower prices is commonly used as a signal. In some markets, it could be argued that overcapacity is more a reflection of the low barriers to entry and firms offering services with little or no differentiation. Seth Godin the influential marketing author and blogger makes the following compelling point:

“Maybe the reason it seems that price is all your customers care about is that you haven’t given them anything else to care about.”

Another challenge with competing by inappropriately low prices is that it tends to breed customer dissatisfaction because such firms struggle to deliver consistently their promises in accordance with customer expectations.

It seems illogical to continue to absorb increasing costs to serve a firm’s target customers and deliver a better service without corresponding price increases. The more likely situation is compromise on some aspects in the service delivery process.