Price management: Why commodity pricing keeps CROs up at night
Nightmare time, CRO style. Learn about industry trends and pricing strategies to reduce margin compression risks.
Setting the right price for products and services is always tricky, due to fast-changing market dynamics, customer preferences, and competition. Value-based pricing is one way businesses tackle the challenge.
It’s an effective method where businesses can recognize the opportunity to capture the value they generate for customers. Yet, misconceptions about value-based pricing often lead companies to shy away from using it, instead settling for cost-based or other pricing methods that leave money on the table.
Let’s delve into value-based pricing and how organizations can approach it to effectively optimize their pricing strategies to unlock greater profits.
What is value-based pricing?
Value-based pricing is the organizational strategy of adjusting prices based on the consumer’s perceived value of a product or service. In other words, what is the customer willing to pay?
This customer-centric approach contrasts with cost-plus pricing, where companies set prices based on the cost to produce a product or service then add a markup.
Value-based pricing helps manufacturers calculate and deliver pricing guidance that ensures that value is maximized without leaving money on the table. It also improves win rates by clearly understanding the options customers have in the market and quantifying how solutions differentiate from the competition in terms of value to the customer.
To illustrate the concept, consider the CASA C-101 and LEARJET 35 aircraft, both with the same engine. Despite having the same core component, each aircraft fulfills a different mission—air fighting training and executive transport, respectively. This raises the question: How would each aircraft operator value the same engine?
Value-based pricing allows organizations to account for such nuances and understand the unique value propositions and market dynamics associated with their products.
3 core pillars of value-based pricing and their benefits
Value-based pricing is a strategic approach to navigate the complexities of modern markets.
Three core concepts drive value-based pricing, with great benefits:
1. Value is customer specific. From a business perspective, value is going to be anything that will sustain operation or prevent it from going under. For example, it might refer to reaching new customers, accessing new markets, or reducing operation costs to increase margin.
Products and services have no intrinsic value; they offer features that address challenges or provide benefits to an organization and the realization of those benefits generates value.
This has a very important implication, which is that a product or service that provides a benefit to a customer in one market might be of little value to another customer in a different market. Not recognizing this aspect of value-based pricing can lead to an offering’s demise if all we’re focusing on is on the value that we associate to our product.
2. Value is relative to the next best alternative. If your product is the same as the competition, then why would customers buy your product and not the alternative? Beyond being able to charge more, a competitive advantage means customers will measure the available offerings on the same terms, and those terms are not price but value.
Here’s the kicker: one of the most common alternatives customers have is to simply do nothing. Think about how many times you’ve thought “Nah, I don’t really need it I already have X.” When you fail to recognize “do nothing” as the next best alternative, then it’s quite likely any customers you have today won’t return for more or you’ll lose them when someone else does recognize it.
3. Know thy market. The concept of market segmentation means more than just categorizing customers in different buckets. It means understanding how the value of a product is perceived across different types or customers and producing versions of the product or service that correlate to each market in a different way.
But there’s a more important aspect of this pillar. If you can’t offer a version of your product for a given segment in a way that’s differentiated from the competition and which represents a profitable opportunity for your company, then you shouldn’t enter that market.
Not for the faint of heart
While value-based pricing holds immense potential, it’s not without challenges. This approach is best suited for go-to-market strategies that require a customer-focused approach and constant feedback. Value-based pricing is labor-intensive, and isn’t a set-it-and-forget-it kind of strategy.
Understanding the value proposition in a given market segment is no small feat. There are methodologies that businesses can use to uncover the value drivers that differentiate products or services. Each one of these can take months to execute for a single product.
In discrete manufacturing, additional challenges crop up, such as:
- Portfolio size and variability
- Prevalence of pricing to close gaps
- Difficulty in understanding competition in the B2B space
- Siloed systems and processes
- Managing a long tail of products that contribute a small percentage to the business
The solution lies in using data to understand trends in customer behavior, sales activity, market changes, and other business details correlating to the value and the ability of a company to command power for their products.
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The role of proxy data in price management
To address these challenges for effective value-based pricing, organizations can take an approach that streamlines price management processes and increases capacity by leveraging available data.
Proxy-based pricing is defined as the use of data highly correlated to the perceived preference and usage of a product or service in the market.
This offers significant benefits, including:
- Fast iterations deliver faster outcomes, and enable quick adjustments to pricing strategies
- Test and validate hypotheses at scale; adapt pricing strategies to evolving market conditions
- Create capacity by empowering teams to tackle bigger problems. Automation improves the quality and speed of decision-making
- Identify new sources of value and understand the driving forces behind business success
The effectiveness of proxy-based pricing hinges on the ability to identify relevant proxies. Organizations need to look beyond conventional sources and consider:
- Market indices
- Supply chain data
- Sales data
- Industry metrics
- Seasonality patterns
- Customer churn data
- Customer feedback
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Deeper insights drive resilience
In order to use proxy-based pricing successfully, businesses need to consider a couple things.
- Identify a proxy metric: Use metrics that correlate to the value of a given product, such as usage. For example, in the case of aircraft engines, it’s possible to measure and track flight hours and use trends of that metric to determine preference in the market for a given product.
- Simplicity and scalability: A benefit of proxy-based pricing is ease of measurement and understanding, since value-based pricing can take significant resources to yield a result. What’s needed is a repeatable and scalable process. Having readily-available metrics in the mix helps achieve that goal.
There are some challenges to consider as well – most importantly, finding a good metric that highly correlates to value and the fact that over time this metric could hold less power to predict pricing power.
Value-based pricing is a smart strategy for managing complex, always-changing markets. By leveraging proxies, businesses can gain a deeper understanding of their products’ value and pricing power, ensuring they remain agile and responsive in a business landscape that never stands still.
