how to set pricesMy initial blog on pricing strategy, ‘How To Set Prices To Seriously Increase Profit,’ was written to identify pricing as an under-utilized tool to drive your company’s bottom line. Since pricing is a complex issue for many organizations, I decided to write a series of posts regarding different types of pricing strategies, moving along a continuum from the simple to the more complex.

Here’s an interesting statistic from an Austrian research paper:

While there is recognition that market focused options are more effective in building longer-term profitability,  >80 per cent of companies continue to price their products or services primarily on the basis of costs or competitive prices.

For this very reason, this article (#3 in the series) will look at Customer Based Pricing.

What is Customer Based Pricing?

Man walks into a bar and asks how much a beer costs. Bartender says, “That depends. How thirsty are you? What kind of car do you drive? Where do you work?” … Welcome to Customer Based Pricing!

With Customer Based Pricing (sometimes referred to as Value Based Pricing), the seller makes decisions based on the estimated value of the product or service from the customer’s perspective. Since this will likely result in variable pricing by customer or customer segment, this approach should deliver the maximum amount a company can charge for its product or service.

But how do you determine how much the customer is willing to pay?

Well, let’s be honest, we’ll never know exactly what a given customer is willing to pay, but we can use experience and research to estimate what they are prepared to pay.

Experience – If you’ve been doing this for a while, you’ve gathered a lot of data about your market. In addition to tracking a variety of inputs, you’ve likely segmented the market by product, customer and competitor.

  • Putting yourself in the customer’s position, what would you pay?
  • Take a look at your previous offers, and your success rate or closing ratio. What does that reveal about where you should be?
  • Which competitor is the customer considering? Does that help determine where your pricing should be?
  • What else do you know about the customer? How will they use the product, how do they segment their business, is this a strategic purchase or merely a tactical buy? Is it a component of a commodity product they make, or a small element of a value added item they produce?

The more you are able to apply your experience, the greater your ability to understand your customer’s willingness to pay.

Research based – Perhaps this is a new category, or a new customer. Or perhaps you are ready to invest in developing further market knowledge. Depending on circumstances, some options might include:

  • Surveys with customer personnel designed to examine perceptions of value;
  • Statistical research and analysis to determine how people value different attributes of your product or service;
  • Simulation exercises in which customer price sensitivity, competitor reactions and other factors are considered.

As you move into Customer Based Pricing, companies must fully understand the customer, their motivations, and what they value. How will they benefit from the transaction?

Impact of this pricing strategy

This approach can deliver the highest possible volume/ margin combination since the company has the flexibility to charge varying prices to different customers.

However, there are weaknesses to this pricing strategy, both for today’s ‘deal’ and for tomorrow’s ‘relationship’. For example:

  • This approach can alienate those customers who pay more; it can be viewed as discriminatory. If your customer suspects price discrimination, he will become more aggressive to secure a lower price.
  • Customer Based Pricing can also be detrimental to longer-term value-added relationships. A buyer who understands that pricing will be set on perceived willingness to pay has no incentive to appear attracted to the sellers product or value proposal. In fact, the buyer may go to great lengths to appear disinterested. They may withhold important information, appear negative and comparison shop more aggressively. This kind of negotiation leads to a transactional approach versus the development of a long-term partnership.
  • Customer Based Pricing can also lead to internal conflict between sales people (especially commissioned sales people) and other groups within the selling organization. For example, in situations where there is aggressive negotiation, the salesperson may be inclined to offset the volume risk through price concessions. This is counter to the over-riding mandate of profit maximization on each sale.
  • Lastly, situations are fluid. While willingness to pay will differ between customers, it may also differ within the same customer in diverse situations…. timing, location, segment, brand, etc. The selling organization needs to be committed to Customer Based Pricing, including the principle of ongoing research.

Summary

Customer Based Pricing strives to match pricing to the customer’s willingness to pay. While this approach will theoretically maximize volume and profit, it’s important to develop and resource an ongoing process to gather, interpret and apply data.

As always, your comments are welcome.

PS – Following are links to the first two blogs in this series about types of pricing strategies: Cost Based Pricing and Competitor Based Pricing