Value-based pricing is a buzz word that you hear a lot when working as a pricing professional. I find it to be a very important concept but have noticed that some people like to use it because it sounds "good" without clear understanding of what it is and how to derive the value. There are those that believe that by doing value-based pricing, you always get to charge more (but more than what?).
Value-based pricing doesn't mean you always get to charge more. Sometimes you have to charge less. But the critical question is "more than what" or "less than what"? The "what" is critical.
I define value-based pricing as setting a price to reflect the target customer segment's perceived value of the product. There are two important factors in the way I define value-based pricing: target customer segment and perceived value. It is a fact that different people value things differently. When you are pricing a product, you need to understand the value that your product brings to different customer segments.
I posted a picture of the Peloton for this blog post because I believe they are a good example of value-based pricing. The Peloton (https://www.onepeloton.com/shop/bike) is an exercise cycle (but is it really?) that costs $1445 USD. In addition to the exercise cycle, an extra $44/month for a subscription to online classes is required. The company also smartly provides a 0% financing for 39 months. So over a 39 month period, you are paying a total of $3,161 or $81.05 per month. So why is this 0% finance important? Keep reading below.
When I went on Facebook, and of course I was served a targeted ad for the Peloton, I see that many people complained that the Peloton was too expensive. Many people say that this product is more than 10X the price of other exercise cycles on the market. Visiting Amazon.com and searching for "Exercise Cycles", I see you can get pretty good ones for $200-$400. A very small fraction of the Peloton price as the Facebook users have noted. Without proper customer segmentation, one would then believe that the Peloton should be priced much lower.
The correct customer segment, however, is not the general public but rather spin cycle enthusiasts. SoulCycle for example, charges $660 for 20 classes ($33/class). For this customer segment, the Peloton seems to be quite a good deal. Remember the 0% financing that I had mentioned earlier? Over 39 months, the monthly price is $81 which equates to about 2.5 SoulCycle classes. By understanding their target segment, Peloton was able to derive a much higher price. Peloton's $81/month is a very good deal when compared to SoulCycle's $33/class.
The other important concept when working with value-based pricing is understanding the "next best alternative". This is important because the value that you deliver to the customer is judged relative to this next best alternative. Each customer segment has their own set of next best alternatives. For the person who just wants to ride an indoor bike to lose some weight, their next best alternative is the $200 exercise cycle that they can get on Amazon. For the spin enthusiast, the next best alternative are the specialized gyms such as SoulCycle.
Once you have your target customer segment and understand their next best alternative relative to your product, you then need to determine the dimensions that you are better or worse than the alternative. When you are better, you can charge more... when you are worse, you need to discount the price. This next best alternative is the "what" that I mentioned at the beginning my blog. Value-based pricing helps you to price more/less relative to the next best alternative for your target customer segment.
As a thought exercise, if your company created a new 9-volt battery that can run continuously for 3 years, how would you price it? What is the target customer segment? What are the next best alternatives? What can this battery do better than the next best alternative?
One approach is to estimate how much a standard 9-volt battery would cost and then figure out how long it lasts. Let's assume that a good battery is about $2 each and can last for 6 months. So the reference point would be $12 (6 batteries over 3 years X $2/each).
Another approach is to look at rechargeable 9-volt batteries. Assuming a good one is around $10 and allows you to recharge over 100 times, you would then think that your 3-year battery should be priced below $10 (since the rechargeable battery can be reused for longer than 3 years).
But what about using your 3-year battery for applications where the cost of changing the batteries is prohibitively high? What if you can put them in remote sensors and not have to replace them for 3 years? The cost of having someone go to the sensor and changing the batteries could be much higher than the cost of the batteries themselves. For this customer segment, the next best alternative is a much higher priced solution (e.g. paying for the labor to replace the batteries).