Value Based Pricing means charging what your customers are willing to pay (WTP).
The other day I was describing this to a successful, self-employed businesswoman and she kept asking, “How do I know what my customers are willing to pay?”.
I mentioned how she should put herself in her customers’ shoes, compare her offering to the competition. She said, “I don’t always know who else my customer is considering, and I certainly don’t know what he thinks about our offers.”
I told her she could use win/loss data to narrow down the possibilities. “I don’t have that many data points. Will this be significant?”
I described how she could use conjoint analysis to determine what types of customers are willing to pay for which features. “But that doesn’t tell me about the customer I’m talking to right now.”
I suggested she learn from her customers during the sales cycle. “Sure, but they aren’t going to tell me the most they are willing to pay, even if they know it.”
Finally, I conceded with an Aha! of my own. We will never know how much a specific customer is willing to pay in a specific situation. We can’t read his mind and he’s not going to volunteer that information. If we can’t know his true willingness to pay, what good is value based pricing?
Think of value based pricing as an attitude. We know we won’t always be right, but we are doing our best to estimate what our customers are willing to pay and charging as close to that as possible.
We can use experience (and statistics if possible) to guide our estimating methods. For example, if we continually lose, then we are estimating too high and need to lower our pricing. If we always win, we are pricing too low and need to estimate higher.
When you go to buy a car from a dealership, the salesman is looking you over, trying to determine how price sensitive you are. In other words, he is estimating your willingness to pay. He’s looking at the car you arrived in. He studies your clothes and your jewellery. Once you give him your address he will look up the value of your house. He can never know exactly what you will pay, but he can make estimates based on observable criteria.
This is what Value Based Pricing really is, estimating willingness to pay. If you know which competitor your customer is considering, that can help you know how much to charge. If you know which market segment your customer is in, you will price more appropriately. The more you know about this customer and this situation, the better.
This lack of precision is probably one reason companies like and use cost plus pricing. They know their costs (at least they think they do). If you always charge two times your cost, then there is no uncertainty. In fact, no thought is needed.
However, if you want to be more profitable, if you want to capture more of the value you create, then adopt value based pricing. Value based pricing enables more powerful pricing strategies, like price segmentation and product portfolio pricing. It has the power to focus the entire company on creating more value. Value Based Pricing may not be precise, but it is powerful.
Adopt the attitude.
Mark Stiving is a pricing strategist, runs Pragmatic Pricing, and is the author of Impact Pricing: Your Blueprint for Driving Profits.