In 2012, the Wall Street Journal published an article claiming that Mac users were willing to pay $20-$30 more per night for a hotel than Windows users. The insight came from a huge, reliable data set published and shared by the travel site Orbitz.
This should surprise almost no one. I’ve paid close to $3k for multiple Mac machines and I can tell you that 1) it’s clearly worth it, and 2) I’m also the kind of person who tends to buy the most expensive thing when given the choice.
I’m cheap in many areas of my life though. I exclusively buy unsexy, used, and extremely safe cars, then drive them until the wheels fall off. That literally happened once – thankfully I was in a parking lot driving 3mph.
This study showed something that economists have been saying for over a hundred years, and everyone knows to be true: different people are willing to pay different amounts because different people have different preferences.
Leave it to academia to show up a century late and say what everyone else knows.
There’s a prevailing story out there that you should adopt a similar pricing strategy, usually called value-based pricing. But I’m here to tell you that value-based pricing is oversold, despite a credible cadre of zealots promoting it’s game-changing benefits for your profit margin.
I’m also here to tell you that they’re right, and that it’s a complicated story. I recently saw a private survey of firms that showed value pricing accounted for less than 1% of revenues. It reinforced my opinion of the concept: value pricing is useful to know, but it isn’t an option for most firms.
Let’s look at what value pricing is, how it works, and the core challenges that make it magnetically-attractive but incredibly-elusive to most.
What Is a Value-Based Pricing Strategy?
Value-based pricing is a strategy that relies on the differing preferences of groups and individuals. Simply put, you charge more to people who value things more.
The implications of this simple idea run deep in your revenue strategy. The obvious place to start is that larger companies and wealthier people will, on average, tend to pay more for the same thing.
If you’re selling brand strategy, the $1B company will surely be willing to pay more than the $1M company. It’s just worth more, even if the deliverables are identical. As a result, you charge different amounts for different clients based on their preferences.
How Value-Based Pricing Works
Unlike other pricing methods, value-based pricing requires the customer to explicitly or implicitly reveal their preferences.
Implicit preferences are preferences you can infer based on other observable characteristics. That’s what Orbitz figured out about Mac users. Similarly, you might assume a larger client is willing to pay more because of their scale.
Explicit preferences are revealed directly by your prospect. They tell you what they value. The challenge is that not all prospects will be able to quantify their preferences or the perceived value of achieving their goals, and therefore the value of your services.
Still, value-based pricing relies on three primary inputs:
- The change and results that your client wants to experience
- The amount of the change and results they’ll get
- The value, per unit, of that change
Once you have answers to those questions, you’re in a clear position to anchor your pricing to your clients’ desired outcomes. That’s not to say that the value of your service is equivalent to your clients’ desired outcomes. Of course it’s not. They still need to pay the bills and make a profit.
Blair Enns summarized the components of value-based pricing as the answers to four simple questions: 1) What do you want?; 2) What will we measure?; 3) What’s this worth to you?; and 4) What would you pay for this?
The point here is to anchor your client on the maximum value you can provide before talking about fees. Contrast that to the typical sales advice which urges you to artlessly ask your client what their budget is. Tradeoffs exist on both ends of the spectrum.
Value-Based Pricing Example
Using the inputs outlined above, we can take the example of a company looking for a better brand strategy on the road to IPO. Their goal would certainly be to stand out from the competition and offer a more differentiated choice to their customers, leading to increased market share and pricing power. You know, the things every business wants.
If we collect the three inputs needed for value pricing, we may hear answers like these:
- Goal and amount: increase market share by 10% and increase the average sale price by 5%
- Value of each unit: every 1% of market share is worth $20M, and every 1% of price increase is worth $500k
- Total: multiply it all out and the total value of achieving these goals is $200M per year
In this example, the explicit value of a project that achieves the client’s goals is $200M in annual revenue. This doesn’t consider the increased shareholder value created before the IPO, which would be considerable.
Now the big question: how to apply this information to your pricing?
Let’s start with first principles. None of this matters unless your client agrees with it.
Remember that value pricing is based on individual and group preferences. Whatever you think has little to no bearing on what your client will pay. Sure, you can try to persuade them, but it’s a poor approach as compared to your client reaching their own conclusions.
The concrete bottom-line number here will function as a price anchor more than anything. Once your client agrees that their goal is to capture another $200M in annual value, you have an upward anchor to use in your pricing discussions.
To my mind, that’s the most obvious utility of the value-based pricing exercise. But it’s also true that, for most people and most companies, value-based pricing flatly will not work.
Who This Isn’t For
It’s time to address trust and leverage. Value-based pricing has exactly zero chance of working if your client doesn’t believe you can deliver the results they want. It’s unlikely that you’d reach advanced talks with them if they didn’t trust you, but it’s a little more complicated than that.
Trust isn’t binary, it spans a spectrum. The more your client trusts you and your firm, the more likely they are to believe that you’ll deliver the promised results, and therefore your way-above-market-priced proposal will be worth it.
“Have you done this before, and to similar effect?” asked every client you’ve ever spoken to. They don’t want to take a risk on you, or at least they want to minimize their risk. Once you enter the realm of value pricing, this question will become more pressing. Which leads to the next point of leverage.
David C. Baker outlined seven points of leverage, but I’d like to emphasize two here: positioning and pipeline.
Your positioning has to do with who you serve, what you do for them, and how you’re different from other options on the market. Ideally, your positioning strategy is so strong that you’re seen as a category of one, though it’s quite difficult to achieve, let alone sustain. The stronger your positioning, the more leverage you possess because of your ability to credibly create dramatic improvements for your clients.
You need a large pipeline to have value pricing swagger. If you have more opportunities than you can handle, you’re more confident throughout your sales process because each deal and each client you encounter have less importance to your business. You’re free of desperation, and confident that more opportunity will always be available. This confidence translates directly to the prices you charge.
Your sales process will be slower and you’ll need top-notch marketing. This is no small point. Value-based pricing will require you to implement value-based selling, and for you and your team to learn new skills. You’ll also need exceptional marketing to reinforce your positioning and build your pipeline.
If you’re not committed to these activities, value pricing isn’t for you.
A Note About Fairness
Capuchin monkeys love grapes. They’ll eat cucumbers too, but they prefer grapes if given the choice between the two.
In a 2003 study capuchin monkeys were given tokens they could trade for food. They found that a monkey in isolation is happy to trade a token for either grapes or cucumbers. But if a monkey trades a token and receives a cucumber after witnessing another monkey receiving a grape, it gets hella mad. Like, mad enough to throw the cucumber it just received.
Now think back to the Mac v. Windows story, and the willingness of different users to pay. One detail I left out is that Orbitz didn’t charge more for the same room, they simply observed that Mac users would choose more expensive rooms. This makes sense, since most Mac users also have higher incomes.
Imagine if you found out that you were paying more for the same thing because of your revealed preferences. It’s totally irrational, because you were happy with your purchase before knowing that someone else paid less. In the case of the monkeys, they’re happy with grapes or cucumbers in isolation – it’s only when they’re aware of their disadvantage that they get pissed off.
Value-based pricing has this cosmic, innate question of fairness baked into it, for both you and your clients.
I’ve spoken to dozens of people over the years who are unwilling to entertain value-based pricing because of how they would feel if they found out they were paying a variable rate. Of course, this tends only to apply if you’re the one overpaying, but the point stands: your own sense of fairness is an obstacle on your path to value-based pricing.
Likewise, your clients won’t like it very much if they find out they’re paying a lot more than other clients. This speaks once again to the importance of having a strong position. If you or your firm are seen as a commodity with perfect market substitutes, who in their right mind would pay you any kind of premium?
Key Challenges of Value-Based Pricing
By now you’re starting to get a sense of why I believe value-based pricing is a useful idea but an unwieldy tool for most.
It’s useful in that it forces you to think more about how your clients perceive and experience value. You’ll begin to understand and pinpoint the sources of value that your clients experience. You’ll also need a deep understanding of how your clients perceive you relative to competitors and other alternatives. That’s a good mindset to have.
But value pricing is unwieldy, or even ineffectual, insofar as most providers will never meet the prerequisites to succeed at it. I’ve written about revenue strategies and delivered training for many years, and I’m still surprised by how inadequately firms prioritize sales and marketing competence. And while value-based pricing has the sex appeal of a SPAC in 2021, it’s a black belt tactic promoted to relative novices. It goes way beyond sales fundamentals into advanced territory.
It’s possible that you or your firm can apply it, but you’ll have to overcome the key challenges I’ve laid out throughout this article.
Namely, value-based pricing requires five key factors you’ll need to meet before you should attempt it:
- Have a strong market position and differentiation strategy
- Maintain a strong reputation that generates trust and credibility
- Practice to ensure you can guide a value conversation with a client
- Sustain a healthy, abundant pipeline of opportunity
- Work large enough deals to justify a totally custom sales process and pricing strategy
Alternative Pricing Models
In case I talked you out of value-based pricing – my goal for most readers – I want to present the primary pricing alternatives. You’re likely already doing one or more of these.
Here they are, in order of how commonly they’re used:
- Cost-based pricing (or cost-plus pricing): determine your costs to deliver, then add a profit margin on top and call it a day
- Competition- or market-based pricing: setting your price based on market norms, typically plus or minus 20%
- Performance pricing (or revenue sharing or commission): pricing determined in part or entirely on the results of your engagement
- Demand-based pricing (or surge pricing): variable pricing based on changes in demand; you’ve experienced this with Uber and other ride-sharing apps
Last is the issue of how your fee is assessed. This is another area where I have a strong opinion: bill using fixed fees in most cases. There are clear advantages to hourly billing in some cases, but if your value proposition is based on your expertise, use fixed-fee billing instead of hourly billing.
Wherever you land on the question of value-based pricing, I recommend you maintain a healthy degree of skepticism. You’ll also need some self-awareness about your skill level and reputation with prospects.
I also recommend that you absolutely internalize the fact that different people and organizations have different preferences. Understanding this will help you recognize patterns amongst different types of clients while leaving room for new information that can help you deliver more individualized value.
And there’s a final point to make: the prerequisites to value-based pricing are good for your business whether or not you ever attempt value-based pricing.