Revolutionize Your Revenue: How to Use Customer Willingness-to-Pay for Value Based Pricing

Welcome to the third installment of our series, Tuning Your Pricing Strategy: A 5-Part Guide." This series provides you with a roadmap (image below) to evaluate key pricing strategies and examples to develop optimal pricing.

Most recently, in #2 we focused on an example of cost based pricing. If you’re just joining the series, you can reference the links at the end of this article to catch up on earlier content before diving into this article.

Lately, We've ALL Questioned Purchasing Decisions

You (and your customers evaluate):

• “Did I get what I expected?”

• “Did I just pay more for less?”

"Price is what you pay. Value is what you get." - Warren Buffet

To further illustrate these concepts, I’ll share a quick story:

While visiting a chain restaurant, my partner and I were dismayed to discover that the beloved side dish was not available. Furthermore, the business did not provide any explanation, yet we proceeded to order.

Months later, we returned to the same restaurant but a different location, and not only was the signature item still unavailable, it was still listed on the drive-in menu, providing a false sense of customer hope! We arrived home with our order and were unpleasantly surprised that both of our side dishes were half empty (image below).

Our "half" sides

Understanding the Importance of Value-Based Pricing

If you read the article on cost-based pricing, you may have identified products or services in your organization that aren't as profitable as they could be. But don't despair!

Although analyzing cost-based pricing is important, it's equally critical to evaluate pricing based on the customer's value. Here's why:

• A discrepancy often exists between customer's willingness to pay and cost plus some basic markup

• Conducting a value-based analysis will help your organization better articulate the value of your product/service to customers, making it easier to retain current customers and attract new ones

• This pricing strategy is often utilized in the technology industry and among high-end goods

Remember, understanding the value your product or service brings to the customer is key to pricing it effectively.

My Experiences with Value-Based Pricing Strategy

I've conducted hundreds of analyses to inform purchase decision making for companies, boards, and my personal life, utilizing my education and work experience in finance and strategy. Similar to cost-based pricing, we aim to quantify whenever possible (but on the other side of the transaction - in the mind of the buyer!) to estimate customer value (which is ultimately compared to purchase price). Value-based pricing, unlike cost-based pricing, relies heavily on quantitative and qualitative analysis, making it more complex. To me, this makes value-based pricing interesting!

Let's get started!

What is Value Based Pricing? What Does "WTP" Mean?

“Value based pricing” is a strategy that primarily relies on customers' perceived value of goods or services to determine what to charge customers. "Willingness to pay" (WTP) is a term to describe the maximum amount a customer is willing to pay for a good or service. A buyer's willingness to pay may vary significantly from customer to customer. Here are some of the factors that contribute to this variation:

a. Customer's perceived need for the product or service

b. Customer's perception of benefits that the product or service can offer, which you can evaluate by:

• Listing out every possible customer benefit. (You can always decide later it is not significant.)

• Quantifying customer benefits in $ where possible (i.e. cost or time savings, incremental sales/revenue/income).

• Categorizing/describing qualitative customer benefits (i.e. risk).

c. Customer's perception of product/service quality

d. Customer's actual ability to pay (i.e. income, cash on hand, access to credit)

Dynamic Pricing Strategies & Their Relation to Value-Based Pricing

Customer willingness to pay is not fixed over time and may change due to factors such as: the economy, competitor offerings, and brand reputation (i.e. word-of-mouth, news headlines). Consequently, value-based pricing may be closely related to dynamic pricing strategy.

Combining Value-Based Pricing & Cost Based Pricing

By combining the insights from our previous article on cost-based pricing with this article’s focus on value-based pricing, particularly customer's willingness to pay, we aim to address the following question (see visual below):

Obviously, an organization can talk to customers and conduct surveys and focus groups to help identify customer's willingness to pay for products/services. However, how do buyers (i.e. business leaders, smart consumers) determine their $ WTP from a logical point of view?

Demonstrating Value-Based Pricing through Customer Willingness to Pay (WTP): An Example

To illustrate value-based pricing and customer WTP, let's consider Darby's customer persona, as he navigates the process of considering a robot vacuum purchase. (Side note: a similar process can be applied to B2B purchase decisions.)

Current situation:

• Darby currently has a well-functioning vacuum, so he considers purchasing a robot vacuum as a "want" rather than a "need."

• Darby has a monthly cleaning service which spends 0.5hr vacuuming and charges $40/hour.

• On the alternating weeks, Darby drags himself out of bed on weekends to vacuum himself. (Darby's partner hates to vacuum so takes on other chores to balance things out.)

• If someone stops over unexpectedly between vacuuming, Darby often hides due to his anxiety. Unfortunately, it is usually his grandmother who is always trying to use a gift of Darby’s favorite Temptations treats as an excuse to stop over. If Darby ghosts on his grandmother, he ends up buying the treats himself for $5/bag/week (~$260 per year).

Potential benefits of purchase:

• By switching to the robot vacuum, Darby can reduce cleaning costs by 0.5/hr per visit x $40/hour x12 months per year, which equals $240 per year.

• In addition, Darby can also eliminate the need for "active vacuuming” that he does on weekends, when he’d rather sleep in or consider working an extra hour at his fun weekend gig which pays $30/hour.

• Furthermore, the robot can run often, thereby reducing Darby’s anxiety about unexpected guests popping over. So Darby would program it to run daily to make sure he doesn’t miss grandma’s weekly visit with his favorite treats.

Willingness to pay:

• Darby has done initial research and knows he can purchase a robot vacuum for $240 or less, so he would easily breakeven financially with reduced cleaning service costs within one year after purchase.

• Darby knows he could also get up to $260 in “grandma treats.”

• Darby could either schedule more work hours or sleep in since he would not need to perform vacuuming himself.

• Darby sees this purchase as an investment (remember, he already has a functioning vacuum) and loves cool technology. Therefore, he will explore higher end products to assess if they are worth the extra cost compared to their features.

Ability to pay:

• Darby has two-earners in his household and they manage their personal finances well with no major competing $ priorities currently.

Below is a recap of key factors related to Darby’s WTP:

What's Next: Exploring Our Final Pricing Strategy

Homework:

• Begin by working through a value-based pricing analysis for your organization's pricing models identified in #1 article in series. Start with the simpler pricing model if you have more than one.

• Compare the results of your value-based pricing analysis based on this article to your cost-based pricing analysis from #2 article in series.

• Consider how dynamic pricing may relate to both cost-based strategy and value-based pricing strategy for your organization.

• To avoid underestimating your customer's willingness to pay and thus understating your potential profitability, conduct research to ensure that you are considering all potential "values." Additionally, seek other perspectives on the values you have assigned to your customers to avoid inadvertently overstating customer willingness to pay.

• Looking ahead, in the next article in this series (#4), we'll delve into competitive pricing and explore how value-based pricing and competitive pricing strategies are interconnected, as both rely heavily on customer perception.

Subscribe so you don’t miss next article in series, which focuses on competitor based pricing

If you would like to get more help with pricing strategy, contact me.

Other suggested reading: Link to article 1 in this series Link to article 2 in this series