Should You Use Value-Based Pricing for Your Service Business?
by Claudette Albers-Reid on August 8, 2022
The value-based pricing model is gaining popularity across multiple industries, including professional services like software developers, consulting agencies, etc. For PSOs, the overarching idea is that the price for services reflects more than just the time, materials, and profit margin included in the equation. Instead, value-based pricing attempts to hone in on the actual dollar value of your services, considering relatable factors like competitor pricing and how much customers are willing to pay.
Keep reading to discover more about value-based pricing for service businesses and see if this model could potentially benefit your organization.
What exactly is value-based pricing?
Value-based pricing is a method by which a company prices goods and services based on their customers’ perceived value of said goods and services. In other words, instead of calculating time and expense plus inserting a markup, companies use value-based pricing to determine how much their customers are actually willing to pay. And then they make sure they charge at or below that price.
For service businesses, this means that what you charge for deliverables will reflect the value of those deliverables to your clients, not necessarily the costs incurred to produce them.
How to do it
While calculating the value of your services using the value-based pricing model, you must examine these aspects to determine the price:
- Determine your customer segment. To use the value-based pricing model, you have to focus on a singular customer segment. For example, if a digital marketing firm is trying to price out their social media services, they will focus solely on customers that buy that service (i.e. not customers that want SEO or an all-in-one package).
- What is your strongest competitor charging? In the example of the marketing firm, the company would then figure out what similar companies are charging for the service. What is the price of this next-best alternative to your service? This is the focus of the comparison.
- What is the differentiated worth of your service compared to the next-best alternative? Now, you flush out what makes your service unique compared to the competition. What do you offer that the next-best thing does not? In the marketing firm example, perhaps they offer full-blown production services for social videos that the competition does not. This is what would make their offering different.
- What is the dollar amount that this differentiation is worth? This part can be tricky, and it’s what makes the value-based pricing model different. Now, you need to assign a monetary value to the services/features/perks that make you stand out from your closest competitor. The question is this– how much are customers willing to pay for the differentiation? In the example of the marketing firm whose differentiation is their video production capabilities, you’d try to figure out how much that’s worth to the customer. Marketing firms themselves perform various analyses to try to figure out this step, but companies who know their customers well may be able to arrive at it on their own.
Value-based pricing example
Want to know the basics of using value-based pricing? Let’s stick with the example we already used to explain the different aspects of the value-based pricing model.
EX: A digital marketing firm is pricing out their individual service offerings, starting with their social media marketing services.1. Determine the customer segment.
The customer segment here is companies that need social media marketing services.
2. What is the competition charging?
Let’s say this firm is familiar with another marketing group whose social media marketing services fit the definition of the next-best alternative. This competitor charges clients $2,000 per month for social media marketing.3. What makes your services different from the competition?
As above, let’s say the differentiation is video production services, which the competitor does not offer.4. What is the value of the differentiation?
Professional video production can really up the social media game of certain businesses, particularly in e-commerce. You could argue that these capabilities provide an extra value of $1000 per month. But remember, you have to factor in your customers’ willingness to pay, which can get tricky. Let’s say in this example that the marketing firm believes in around $1000 of additional value, but perhaps settles on $750 because they know from experience and/or market research that customers aren’t willing to pay more than that.
Company service: Social media marketing
‘Next-best alternative’ pricing: $2k per month
Differentiator(s): Professional video production
Value of differentiation: $750
Value-based price: $2,750 per month
The value stick: Visual tool to understand value-based pricing
Getting more granular with value-based pricing requires a bit more forethought than the above example. Enter the value stick.
The value stick shows you how value-based pricing works with 4 main sections:
- Willingness to pay
- Willingness to sell
You can see that these 4 parts coincide with customer delight at the top of the stick, the firm margin in the middle, and supplier surplus. This explains who and what is capturing the value in each section.
Willingness to pay
Willingness to pay is just what it sounds like– what is the maximum customers are willing to pay for your services? WTP is the highest threshold you could charge without turning potential customers off. Calculating WTP often requires surveys and other market research. The area between the top of the value stick– WTP– and the final price is what’s called customer delight. This is the pricing area you want to be in, where customers aren’t charged above their WTP and maintain a certain amount of goodwill toward the brand and the service rendered.
The price level on the value stick indicates what you charge for your service and must be located between the WTP line and the cost line. When the price is higher, the firm margin automatically goes up. However, when the price goes up, Customer Delight goes down. Finding the sweet spot between the two levels can be difficult, but doing so is the whole point of the value-based pricing model. Getting it right in this area is the goal.
This is all the fixed and variable costs that go into the service(s) you provide that you’re trying to price out. Time and expense, materials, etc. are all factored in. When you lower the cost, Firm Margin and Customer Delight increase.
Willingness to sell
Willingness to sell describes the lowest price possible suppliers are willing to accept in exchange for ‘raw materials’ used to create the product/service. For service businesses, willingness to sell can apply to price points for raw materials and also hourly rates for consultants, creatives, etc. The inverse of willingness to pay, willingness to sell is the lowest amount suppliers will accept before they will decide to drop the sale. And finally, this section between the willingness to sell and cost is called the Supplier Surplus, which represents the value suppliers capture from a sale. For service businesses, this will be the monetary gains earned by team members who work on projects and any suppliers that provide physical materials.
Value-Based Pricing: Pros & Cons
While value-based pricing can potentially help service businesses increase their project profit margins, it’s not a cure-all. Depending on what services your company offers and what your competitors are doing, value-based pricing could help or hurt your bottom line because its determinants– like perceived value– can fluctuate greatly. Here’s an overview of the pros and cons of using the model to calculate the price of your services:
- Effective and popular with B2B companies
- Good for PSO’s with services that are highly differentiated in an outstanding way
- Perceived value can always increase
- Markups can go sky-high when perceived value goes up
- It’s dependent on what your competitors are doing; if your competition hasn’t been smart about setting their prices, your project profitability is at stake
- Not good for startups where competitors are scattered or hard to find
- May not work for many B2C companies, as brand’s overall value is not factored in
- Can be unstable as perceived value changes
Does value-based pricing make sense for your service business?
Value-based pricing is common in the fashion industry, whereas it makes practically no sense for companies who sell commodities. As far as service businesses go, the model can be lucrative, provided a service is offered or a feature/technology is leveraged that differentiates the service itself from the closest-following competition.
Value-based pricing is a highly customer-centric endeavor that will require you to have intimate knowledge of what your customers want and what they need. This means you’ll need to devote a big chunk of time to getting into your customers’ heads, whether it be through surveys, market research, interviews, etc.
For service businesses that have a special technology, service offering, or perk that makes them stand out from the crowd, value-based pricing can potentially help increase profit margins. Just remember that some legwork is required to determine willingness to pay on behalf of the customers. If you already have intimate knowledge of your customer base and their needs, the value-based pricing model may be worth its weight in gold for your PSO.