Value-based Pricing Benefits and Techniques

Value-based pricing is widely regarded as the ideal monetization strategy for differentiated or unique products. In this article we’ll investigate the benefits and methodologies of value-based pricing. The alternatives to value-based pricing are cost-plus pricing and competitive pricing. With cost-plus, a markup is added to product cost to achieve a desired gross margin.  In the competitive approach, competitor pricing is used as a baseline. The third well-established approach, value-based pricing, uses customer value to determine optimal pricing.

Value-Based Pricing Defined

Value-based pricing sets price levels for your product offering based on the calculated value to a customer segment. A customer segment can be a single customer for a big-ticket enterprise product, or a group of customers with similar characteristics. Calculated value involves modeling the various components of product value.

Benefits of Value-Based Pricing

Value-based pricing has direct financial benefits, but it also helps align company strategy in many different ways.  Here is a summary of the key benefits of value-based pricing:

• Increases revenue and profit with optimized pricing that exceeds the potential of cost-plus pricing and competitive pricing

  
  

• Supports tiered pricing by differentiating customer segments based on what they value most

  
  

• Improves sales effectiveness with quantified feature differentiation 

  
  

• Informs product development by highlighting the most significant product benefits and biggest weaknesses

  
  

• Enables customer success to build positive relationships with customers by understanding product and service advantages    

  
  

• Helps marketing create messages that resonate with customers and prospects

Value-Based Pricing Techniques

A popular value-based pricing technique is Economic Value Estimation (EVE), which quantifies the differentiated economic value of a product relative to a reference alternative. EVE was introduced and detailed by Tom Nagle in his landmark book, “The Strategy and Tactics of Pricing”.  A key characteristic of EVE is that it is always relative to the next-best alternative. The next-best alternative is the top-choice substitute available for your product. The EVE approach calculates the financial value of both positive and negative differentiators of your product relative to the next-best alternative. The sum of negative and positive values is the net differentiation value. This value is split between the company and the customer. The value captured by the seller is the price premium charged above the next-best alternative price. The value retained by the customer is their share of the net differentiation value. This is the incremental value the customer receives from purchasing your product over the reference product. The split of net differentiation value between customer and company can be chosen to optimize profit.

In some cases a next-best alternative is not available, and thus the EVE methodology cannot be used appropriately. This can be true when creating a new product category, or developing a radically different product for an existing market. Another scenario where EVE won’t work is if competitors are not pricing rationally.  

An approach that can be used for these scenarios where EVE is ineffective is overall economic value.  Overall economic value uses similar techniques as EVE, but the difference is that the total value of the product is calculated, rather than the marginal value versus a reference product.  In this approach, the total economic value is the sum of quantified customer benefits minus the sum of quantified customer costs.  Quantified customer benefits include time savings, cost savings, revenue gains, and reduced risk. Quantified customer costs consist of implementation expenses, switching costs, support services, training, and other associated expenditures.  The value captured through pricing should be a percentage of overall economic value. The remaining value is the economic value to the customer.  As with EVE, the division of total value between the company and the customer can be optimized to maximize profit.

Calculating Economic Value

Calculating economic value for both EVE and total economic value utilizes similar principals and techniques.  At a high level, the objective is to quantify monetary benefits and costs.

Modeling revenue for economic value is similar to revenue modeling used in ROI analysis.  A side benefit of calculating economic value is that it can be easily leveraged to build an ROI model useful in the sales process. If we were to be very precise in economic terms, revenue modeling should include all of the new revenue streams that result from a product, and the timing of each revenue stream. Then, using the most rigorous approach, the NPV (net present value) should be calculated including an assumption of interest rate.  But Nobel Prize–level economic methodologies are often unnecessary—you can simply total the expected revenue gains on a one-time or annual basis. Lastly, common categories of revenue generation for calculating economic value include not only new or increased revenue streams, but also positive revenue drivers such as improved conversion rates, enhanced pricing power, greater upsell or cross-sell success, and shortened sales cycles.

Cost modeling for economic value follows a similar logic, but focuses on quantifying the savings or cost avoidance enabled by the product. These may include reductions in labor, lower infrastructure or operating costs, decreased error rates, or the elimination of redundant software or processes. As with revenue, the most precise approach involves mapping each cost impact over time and discounting future savings to present value. However, in practice, it’s often sufficient to estimate annual or one-time savings in broad categories. What matters most is identifying the cost levers that resonate with your buyer—ideally those tied directly to budget line items they control or care about.

With our revenue and costs fully modeled, we can then subtract costs from revenue to calculate either the marginal economic benefit using the EVE methodology, or total economic value for the overall economic value technique. Then considering pricing power and profitability optimization principals, a percentage of our newly modeled economic value can be captured with price.

Using Market Research to Inform Value-Based Pricing

Market research plays a crucial role in identifying, quantifying, and validating the economic benefits a product provides. Below are the key market research techniques that can be used to support a value-based pricing process:

• Customer Interviews and Surveys: Provide insight into how customers perceive value, what economic benefits they expect, and where they experience incremental costs. This helps identify key value drivers and quantify their impact

  
  

• Competitive Analysis: Understand competitor pricing, value propositions, and performance metrics. The data helps quantify a reference or "next-best alternative" to compare against your offering.  It also establishes a basis for clearly articulating and measuring differentiation relative to competitors

• Usage Data: Enables the validation of benefits with actual customer data. It may also provide insight into additional benefits not included in the initial value-based pricing exercise.  Further, customer usage data can help quantify the magnitude of financial gains resulting from product usage

• Willingness-to-Pay (WTP) Studies: Estimate how much customers would pay for specific features or benefits.  The three standard methodologies that can be used to quantify WTP by customer segment are Conjoint analysis, Gabor-Granger, and the Van Westendorp Price Sensitivity Meter.  For a deeper look at these techniques, see this article

• Industry Reports: Leverage published benchmarks, revenue drivers, economic benefits and cost data. Industry reports often compare competitors according to various relevant metrics. This data can be used to support economic assumptions and business modeling. Credible industry reports are published by Gartner, IDC, Forrester, and the Bureau of Labor Statistics

Setting Price Levels

After calculating customer value using overall economic value or EVE, the next step is to set price levels. The portion of customer value monetized through pricing is the company’s take of this value. The remaining economic value is garnered by the customer.  The customer’s economic value is the net dollar benefit received by the customer. The higher this is, the more attractive your product offering. This is also the value that would be used as the net economic benefit in customer ROI calculations.

Discounting is another consideration in setting price levels. The appropriate price level for financial calculations is average net price.  The equation that defines this is: Average Net Price = List Price * (1- Average Discount).  If your product will sell at list price, then list price is equal to net price and you don’t need to worry about discounting.  If you plan to discount, a calculation of average discount by segment is necessary to appropriately set list prices.  Estimating average discount usually involves setting a discounting policy for sales. Average net price is your profit optimizing price.  Solving the equation above, List Price = Average Net Price / (1 - Average Discount).

Below are the key factors that influence how much economic value a company can capture with pricing. The combined effect of these factors determines overall pricing power:

• Perceived Differentiation: The clearer and more compelling the advantage over alternatives, the greater the value you can monetize

  
  

• Customer Willingness to Pay: Strong alignment with customer priorities increases the share of value customers are willing to exchange for price

  
  

• Competitive Landscape: Limited strong alternatives or high switching costs allow for higher value capture

  
  

• Cost of Alternatives: A higher baseline cost (from the next-best option) creates more room to retain value through pricing

  
  

• Negotiating Power: Strong brand, market position, and sales leverage increase pricing strength

  
  

• Customer Perception of Risk: Lower risk (e.g., proven outcomes, trust, support) boosts the customer perceived value

  
  

• Sales & Marketing Effectiveness: The ability to communicate and justify value clearly (especially with ROI storytelling) directly impacts company percentage of value

Conclusion

Value-based pricing is not the right tool for every situation, but if your product is unique or highly differentiated, it is likely the ideal pricing approach for your company. If your product has a next-best alternative with rational pricing, the Economic Value Estimation (EVE) method can be used to quantify the incremental value of differentiated features—whether superior or inferior—relative to the competing offering. For products without a well-defined alternative, an overall economic value approach can be used effectively. In both approaches, the economic value created is shared with the customer based on a number of factors that affect pricing power. Lastly, final price levels are set considering expected discounting by segment with the objective of maximizing profit.