a note from Luminas Founder & CEO, D. Keith Pigues
Value-based pricing sounds really intriguing, and potentially valuable, but where should you start? In his Harvard Business School Online article, “A Beginner’s Guide to Value-Based Strategy,” Tim Stobierski provides the basics and building blocks to get in the game and begin capturing your fair of the value created for your customers.
For those of us with many years of experience in the field, it is always helpful to reflect on the basics from time-to-time.
Whether you’re a new product manager about to launch a product or service, an entrepreneur just getting your venture off the ground, or a business leader reevaluating your company’s direction, it’s crucial to have the right pricing strategy to maximize profits.
A value-based pricing strategy offers a practical path forward for your company. Below is an in-depth examination of value-based pricing, including an overview of the value stick framework and the different components that make it so effective.
What is a Value-Based Pricing Strategy?
Value-based pricing is a means of price-setting wherein a company primarily relies on its customers’ perceived value of the goods or services being sold—also known as customers’ willingness to pay—to determine the price it will charge. Because it revolves around customers’ priorities, it’s occasionally called customer-focused pricing.
Harvard Business School’s value stick framework offers a helpful way of visualizing the tenets of value-based pricing, as well as the ways firms can maximize profit margins while creating more value for their customers and suppliers.
The Value Stick
The value stick is a visual representation of a value-based pricing strategy’s different components. At the top of the stick is the value that’s been captured by the end consumer, called the customer’s delight. In the middle of the stick is the value captured by the firm, called the firm’s margin. At the bottom of the stick is the value captured by the firm’s suppliers, called the supplier surplus.
The value stick comprises four components: willingness to pay, price, cost, and willingness to sell. Where on the stick each of these points falls determines how a sale’s value is split between a firm, its customers, and its suppliers.
Here’s a more in-depth look at each of these components.
1. Willingness to Pay
Willingness to pay (WTP) is the highest price a customer is willing to pay for your product or service. Customers are likely to make a purchase when companies charge any amount up to that threshold. Charging even a cent above that number heightens the risk that the customer will decide against purchasing.
The difference between the customer’s willingness to pay and the final price of the purchase is known as the customer’s delight. This is the level of goodwill, loyalty, and brand enthusiasm that the customer feels after making a purchase, which is typically tied to the value they’ve claimed from the transaction.
Price refers to the final price a company charges when it sells a product or service. As such, price is the point on the value stick that a firm has the most control over. It can be set at any point between a firm’s cost of production and its customers’ willingness to pay.
When a firm sells a product or service, the value is split between the customer and the firm. As explained above, customers receive the difference between their willingness to pay and the actual price, while the company gets the difference between the price it charges and the costs associated with creating the product. This is referred to as the firm’s margin. Where the company chooses to set its price determines how value is shared with the consumer.
Naturally, companies aim to maximize profits from each sale. But they also strive to maximize customers’ delight to build brand loyalty and turn a single purchase into a repeat one. This creates a level of competition wherein a firm must find the optimal point on the value stick to achieve both goals.
Cost refers to how much money goes into producing a product or service, including all of its components. This includes physical costs, such as the various nuts, bolts, and widgets that make up an item, along with non-physical costs, such as utilities and rental space.
The lower a firm’s cost, the higher the value it can share with customers. This creates competition between a firm and its suppliers that work to drive the price up to maximize their value.
4. Willingness to Sell
Willingness to sell (WTS), also known as willingness to accept, is the lowest price a firm’s suppliers are willing to accept in exchange for the raw materials needed to create products. While many suppliers would like to sell goods for the highest amount possible to maximize profits, most are willing to reduce prices to a certain extent to make a sale. Their willingness to sell represents the lowest point they’re willing to drop before it no longer makes sense to pursue a sale.
The difference between the suppliers’ willingness to sell and the cost (what they charge the firm) is known as the supplier surplus—or the supplier delight—and it represents the value they’ve captured from a sale at the firm’s expense.
Using the Value Stick to Drive Value Creation
When the four points above are plotted along the value stick, they create three wedges: customer delight, firm margin, and supplier surplus.
Firms that embrace value-based pricing can manipulate these wedges in one of two ways. They can either adjust where the points of cost and price fall on the value stick, or they can work to increase the length of the stick (and the total value shared by all parties) by increasing customers’ willingness to pay and decreasing suppliers’ willingness to sell.
Here are four strategies companies can use to increase profit margin with the value stick framework:
1. Raise Prices
A firm can easily increase profit margins by raising prices without changing anything else. This allows them to capture a greater share of each transaction’s value at customers’ expense.