What is Value Based Pricing?

Value based pricing is the practice of setting the price of a product or service at its perceived value to the customer. This approach tends to result in very high prices and correspondingly high profits for those companies that can persuade their customers to agree to it. It does not take into account the cost of the product or service, nor existing market prices. Value based pricing is usually applied to very specialized services. For example, an attorney experienced in defense against criminal charges can charge a high price to his or her clients, since the value to them of not being incarcerated is presumably quite high. Similarly, an attorney skilled in initial public offerings can use value pricing, since clients might not otherwise raise millions of dollars without their services. Other areas where value based pricing may be an option include product design, bankruptcy work outs, cost reduction analysis, lawsuit defense, and pharmaceuticals engineering. Value based pricing is also more applicable to situations where customer approval is made at the executive level, rather than by the procurement department. The purchasing staff is more skilled in evaluating supplier prices, and so would be less likely to allow such pricing.

The Value Based Pricing Calculation

ABC Legal has built up an investment banking service that assists its clients with preferred stock placements. The internal cost for ABC to provide this service is usually about 1,000 hours of staff time at a cost of $100 per hour, or $100,000 in total. The typical stock placement is for $10 million, for which ABC charges 5%; this works out to an average fee of $500,000. There is no relationship between the fee charged and the cost incurred by ABC. Thus, ABC earns $400,000 on $100,000 of internal costs. The company's clients do not complain, because they have obtained an average of $10 million each.

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Advantages of Value Based Pricing

The following are advantages to using the value based pricing method:

Increases profits. Value based pricing results in the highest possible price that you can charge, and so maximizes profits.
Increased customer loyalty. Despite the high prices charged, you can achieve extremely high customer loyalty for repeat business and referrals, but only if the service or product provided justifies the high price. This advantage tends to also derive from the nature of the sales relationship, which needs to be both close and trusting before value based pricing can even be contemplated.

Disadvantages of Value Based Pricing

The following are disadvantages of using the value based pricing method:

Only applies to niche markets. The high prices to be expected under this method will only be acceptable to a small number of customers. It may even alienate some prospective customers.
Not scalable. This method tends to work best for smaller organizations that are highly specialized. It is difficult to apply it in larger businesses where employee skill levels may not be so high.
Increased competition. Any company that persistently engages in value based pricing is leaving a great deal of room for competitors to offer lower prices and take away their market share. This will likely work for the company’s price-sensitive customers, resulting in a higher degree of customer turnover among this group.
Increased labor costs. Assuming that a service is being provided, you are likely offering such a high-end skill set that the employees needed to provide the service will be quite expensive. There is also a risk that they may leave to start competing firms.

Evaluation of Value Based Pricing

This method is exceptionally profitable in those niche areas where a company can offer premium services that are highly valued by their customers. Many attorneys and investment bankers have engaged in value based pricing for decades, so it is clearly a viable method. However, it is not applicable in most businesses, where normal competitive pressures make it impossible to use value based pricing. When a company’s products are completely commoditized, value based pricing is not a viable strategy.