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The 4 Hidden Fears of Value-based Pricing

By July 19, 2021August 20th, 2021Featured, Pricing, Pricing Strategy

I began my career at National Instruments, writing drivers for test and measurement hardware. During my time there, I was always interested in how the firm determined prices for the hardware business. Back then, the company used a simple cost-plus pricing approach, marking up the cost of devices on a fixed basis determined by the cost of goods sold (COGS). I thought this was a handy way to manage pricing at the time — It wasn’t until I studied pricing at Kellogg that I realized how misguided this approach was. By focusing on cost-based pricing instead of value-based pricing, National Instruments left significant profit on the table. 

Hopefully, this article helps you to avoid the same fate.  

Introduction to the Three C’s of SaaS Pricing

Let’s start with the basics. There are three pricing orientations— often known as the ‘Three Cs of Pricing’: 

  • Cost-based 
  • Customer Value-based (referred to from here simply as value-based)
  • Competitor-based 

Although the numbers vary slightly over time and industry, in practice, most companies (44%) use competitor-based pricing, while a somewhat smaller percentage (31%) use cost-based. Value-based adoption comes in last, with only 25% of companies citing this as their pricing orientation1. Over time, I’ve come to a critical realization that has informed my entire perspective on pricing: value-based pricing is the only orientation that makes sense for a SaaS business. It maximizes profit potential and better reflects the overall company goal: creating satisfied customers. Companies should consider internal costs, competitor pricing, and customer value when determining their pricing and packaging; however, a value-based orientation should be primary in your pricing process.

The prevalence of Pricing Orientations in Practice. Competitor-based pricing is 44%, cost-based pricing is 31%, and value-based pricing is 25%.
Adoption of Pricing Orientations, Source: Liozu, S. M.1

Still, there appears to be a world of confusion about value-based pricing. How does it truly work? Is it a strategy, a framework, or an orientation? What is getting in the way of broader adoption? 

What is Value-based Pricing?

One likely factor hindering adoption is a lack of coherent definition in practice. When talking to pricing professionals, there is very little agreement on what value-based pricing is. When surveyed (results shown in the chart below), many folks who do pricing work for a living cannot agree on whether value-based pricing is a strategy, methodology, framework, orientation, approach, or something else entirely! How is a non-professional supposed to wrap their mind around this concept?

Understanding of Value-Based Pricing. 39% view it as a pricing strategy, 22% a pricing methodology, 13% a pricing framework, 13% a pricing orientation, 9% a pricing approach, and 4% other.
Industry Definitions of Value-based Pricing, Source: Liozu, S. M.1

I prefer Cressman’s definition of value-based pricing as a pricing orientation. 

Value pricing then is a cultural orientation that focuses a seller’s business on designing and developing offerings with significant impact on the buyer’s business, then pricing to capture a portion of that impact. Specifically, value pricing can be defined as the practice of pricing to capture a portion of a seller’s economic impact on a target customer’s business.”

George Cressman, Handbook of Business-to-Business Marketing, Ch. 14: Value-based Pricing: A State of the Art Review

It’s not a strategy because a strategy (or at least a good one) should explicitly define what you won’t do just as much as it states what you will do. It’s not a framework, or a methodology, because I have yet to see a concrete, step-by-step approach to follow. But thinking about value-based pricing as an orientation helps me assign a relative priority to price process inputs: customer value, competitors, and costs. 

Filling In The SaaS Pricing Gaps 

You might be thinking that the Three C’s of Pricing is missing something. What about usage-based pricing, user/seat-based pricing, tiered pricing, flat-rate pricing, per-feature pricing, Freemium or advertising models, etc.? These aren’t included in the above because they aren’t pricing orientations but pricing models or pricing structures. These are decisions that you make around the appropriate pricing metrics that you ultimately choose to monetize.

But what about other pricing strategies, like price skimming, penetration pricing, or neutral pricing? These are pricing strategies, but these are specifically around setting price levels

Pricing models and pricing strategies are important, for sure, but including them with the Three C’s of Pricing causes massive confusion about each approach’s role in the pricing process. Some of the confusion has arisen because non-pricing professionals have generated poorly researched SEO clickbait. Indeed, you’ve probably seen these articles before with titles like “The Definitive Guide to SaaS Pricing” or “The Ultimate SaaS Pricing Model.” These authors know how to grab the right keywords, but they’ve failed to ground their pricing knowledge on well-researched principles. </conclude rant>.

Defining the Three C’s of SaaS Pricing

With that confusion out of the way, let’s break down the Three C’s in a bit more detail, so we can better understand their pros, cons, and use cases: 

Cost-based Pricing

Cost-based pricing has multiple names, including cost-plus pricing, mark-up pricing, or target-return pricing. The formula for this type of pricing is very straightforward: simply add up all the costs required to make, sell, and support a product, and then add the desired margin on top of that. 

Pros: 

  • It is a simple pricing method that is relatively clear-cut
  • The data needed to establish the pricing is easy to find within the firm
  • It can help set a “price floor,” below which pricing is unprofitable 

Cons: 

  • Your customers don’t care about your costs. They only care about their problems. 
  • There is no consideration of the customer’s willingness to pay or their perceived value of the product. 
  • The incremental costs of a SaaS product are minuscule (one of the beauties of a SaaS business), which doesn’t help when trying to determine pricing from costs. 
  • It can lead to circular reasoning in businesses where costs change incrementally based upon volume — a shift in costs impacts the volume sold, which changes costs, which affects the volume.
  • Thrashing may occur when costs change unexpectedly.
  • It doesn’t take competition into account when devising pricing. 

Remember, pricing is a function of marketing. As Lincoln Murphy of Sixteen Ventures reminds us, your pricing strategy is incorrect if you think it’s a function of finance, accounting, operations, or sales. If you’re coming up with a price resulting from a spreadsheet, you’re doing it wrong. A spreadsheet should not dictate your price. 

Competitor-based Pricing

Competitor-based pricing involves setting prices at a discount or premium compared to your competitors, based on where you think you fit into the market landscape. 

Pros: 

  • Like cost-based pricing, this is a simple concept to understand and execute. 
  • While data is not as readily available as in cost-based pricing, this data can be straightforward to collect in markets with transparent pricing.
  • It can be a good step at helping to determine baseline pricing, which can help define and price the differential value your product provides.
  • It can be reasonably accurate in saturated, commoditized markets.
  • Managers often perceive this method as low risk.

Cons: 

  • Assumes that your competitors have done their homework and know what they are doing with their pricing.
  • Implies that your target customer is evaluating the same competitive set, and these competitors are selling directly comparable products.
  • Suggests that your target customer is evaluating value from your competitors by the same parameters across the board. 
  • It does not consider customer willingness to pay or the value a product provides to the customer.
  • Grants competitors control over pricing, losing control of a valuable profit lever.
  • In markets with opaque pricing, it can be challenging to know if your underlying competitive pricing data is accurate.
  • Can result in market “herding” behavior as competitors blindly follow one another

Value-based Pricing

Unlike the two pricing orientations mentioned above, value-based pricing is not simple. It requires extensive research on the target customer: understanding their perceived competitive alternatives, extrapolating and articulating the differentiating value of your solution, and then gauging your customer’s willingness to pay. It is the most complex of the pricing orientations, but it is also the most grounded in reality — and the most likely to optimize profit margins while leaving you in control of your pricing. 

Pros: 

  • It’s customer-focused, aligning the company’s profitability directly with the customer’s value. 
  • It leaves the company in control of its pricing rather than being dictated by internal or external forces.
  • Most research supports this orientation as a superior way to price products.

Cons: 

  • Requires an internal organizational reorientation of pricing philosophy
  • Demands deep understanding of the market and customer segments via research, which is more costly in terms of both time and money 
  • It relies on managerial judgment as market research data rarely provides the exact “right price.”

The Three C’s of Pricing are not mutually exclusive. Of course, you need to understand your costs and competition. If you don’t consider your expenses, you run the risk of being unprofitable. If you don’t understand your competition, you’ll disconnect yourself from the reality that your customers occupy. This argument is really about the order of operations vs. exclusivity. Your focus should primarily be on the value your product provides to your customers, and then consider costs and competition as secondary factors to influence your pricing further. 

Leading the Value-based Pricing Pack 

Maybe your next question is, “If value-based pricing is so good, why isn’t everyone doing it?” And that’s a great question. Typically, the reasons that pricing managers avoid value-based pricing boils down to four distinctive biases: 1) a lack of confidence, 2) a herding mentality, 3) risk aversion, and 4) information overload. 

If these biases exist against adopting value-based pricing, what can you do to remove them? How can you help your company warm up to this pricing orientation? Let’s break down the biases and their solutions below. 

Value-based Pricing Bias 1: Lacking Confidence 

Pricing managers often get cold feet while setting pricing, fearing a lack of ability to affect prices in their markets2. As a result, they will opt for pricing that currently exists in the marketplace or back into a number that’s easy to justify based on predetermined financial goals above their pay grade. 

There’s a simple and easy way to help your pricing manager gain confidence. Create a decision-making process with a pricing committee, and appoint a final decision-maker as the leader — preferably the CMO, CPO, or Product Marketing leader (in a more established company). When a complex process like this has a precise definition, it can de-risk the decisions from a personal perspective, equipping decision-makers to lead without fear and challenge their organizations to be different. 

Value-based Pricing Bias 2: Safety in Herding

Social proof leads to “herding.” We, humans, are social creatures. One of the benefits of herding is that we can save time and energy by observing what others are doing around us. But the downside is that sometimes, we assume that others are already executing the best options. We doubt our ability to lead. “If there were something better to be done, someone else would already be doing it.” 

While staying with the herd makes us comfortable, it’s essential to understand that a reactive strategy is rarely a dominant strategy. Following the competitive herd will not result in outsized market returns for your firm. It may also be helpful to have one of your executives play the role of devil’s advocate in pricing-related discussions. This person can help surface unconscious assumptions that are holding the team in place. 

Value-based Pricing Bias 3: Risk-Averse Behavior 

Taking a leadership position on pricing could be perceived as risky — both for the company’s market performance and for an individual manager’s career — primarily if they are held accountable for what ends up being a poor pricing decision. Value-based pricing is inherently more ambiguous than a competitor or cost-based pricing, and most managers are averse to ambiguity because, in their minds, ambiguity = risk. If a manager lacks familiarity with the tools needed to help them assess and communicate the value of their product, their natural aversion will increase. This lack of skills can cause pricing managers to deem value-based pricing a form of economic “voodoo.” Also, managers may be concerned about the fairness of their pricing and contend that we should base it on costs. Or, they could fear the legality of pricing differentiation. It all boils down to risk — something that we try to avoid. 

Train your staff with the tools of the value-based pricing trade, such as customer segmentation techniques, direct and indirect pricing research methodologies, and the Jobs-to-be-Done framework.  This skill set will allow them to collect data that makes this territory much less ambiguous. Also, realize that cost and competitor-based strategies are no more fair to your customer than a value-based pricing strategy. We shouldn’t hold customers hostage to the flawed strategies of the competition, nor should we keep them captive to our cost structure. Neither of these things is relevant to them or their needs. 

Value-based Pricing Bias 4: Too Much Information

Often, managers incorrectly assume that value-based pricing requires understanding a customer’s willingness to pay for each feature. This assumption will lead them to stop pursuing a value-based approach prematurely, as they feel the level of information they need is impossible to gather. 

Pricing managers indeed have more responsibility to gather customer value and willingness-to-pay data in a value-based pricing orientation (don’t wait until the last minute to collect this — it’s critical!). And once they have that data, they’re also responsible for communicating that value back to the market. This is no small task. However, it’s better to invest the time and money upfront into market research so that you can make data-informed decisions about this critical aspect of your business. Help your pricing manager understand the necessity of this step, and empower them to take it confidently. 

In Conclusion

Differentiation is your greatest strength when it comes to your product and your pricing. You believe that your product is the industry leader, and your pricing should reflect that. Building ordinary, uniform products is not what your business does. You are a challenger, an innovator, a problem solver. A differentiated product deserves a differentiated price — something that only value-based pricing can provide. Do not shy away from the challenge. 

1Liozu, S. M. (2017). State of value-based-pricing survey: Perceptions, challenges, and impact. Journal of Revenue and Pricing Management, 16(1), 18–29. doi:10.1057/s41272-016-0059-8 
2Mario Kienzler (2018), Value-based pricing and cognitive biases: An overview for business markets, Industrial Marketing Management, Volume 68, Pages 86-94, ISSN 0019-8501, https://doi.org/10.1016/j.indmarman.2017.09.028