One of the main issues faced when releasing a new product or service is how much to charge. There are many different pricing strategies; however, few companies use a pricing strategy that is focused on the customer as opposed to the product or service. Value-based pricing is a pricing strategy which sets the price of the product or service on the perceived or estimated value to the customer rather than on the cost of the product, competitor prices, or historical prices.
Traditional pricing strategies do not incorporate market research to determine the optimal price for the product or service. With value-based pricing, research (typically in the form of a survey and multivariate statistical modeling) is conducted so the product or service is launched with minimal to no adverse effect on consumer perception due to incorrect pricing. Determining the optimal price for a product or service is critical to its success. Charge too much, and the product or service will not sell; charge too little, and your product or service is fixed in the market at a low level. Of the two, charging too little is by far the worst choice as raising a products’ price often proves to be extremely difficult.
Calculating the optimal price point is a science. According to a McKinsey & Company analysis of the typical S&P 1500 company, a price rise of 1%, if volumes remain stable, can lead to a profit increase of 8%. However, the opposite also stands true, a price of 1% less than the optimal price can lead to a loss of 8% of its potential profit. Changes in variable costs such as lower material cost and labor do not impact profit margins nearly as much as having correct pricing. While some companies believe that a lower price will lead to increased sales volumes, this rarely happens. In the same McKinsey & Company analysis, volumes have to rise by almost 19% to offset a 5% price cut.
So how do we determine the value of a product or service to consumers to determine the optimal price? There are several methodologies that may be employed on their own or in conjunction with others. One of the classic approaches is using the Van Westendorp method with a Revenue Forecast Extension. The method asks consumers a series of questions relating to their purchasing intent based on price. Next, a range of acceptable prices and an optimum price point based on an analysis of price and value ratings obtained from consumers is calculated. The Revenue Forecast Extension is then used to determine the optimal price taking purchase intent into account.
Another approach used is the Discrete Choice Model. Consumers are asked to choose between two or more hypothetical products or services at different price levels. The resulting model includes a simplified description of reality that provides a better understanding of how consumers make their choice. A well-constructed model allows for multiple scenarios within the model and can optimize price and brand position. With Discrete Choice, a company can project their potential market share among key competitors.
A newer methodology is Maximum Difference (Maxdiff). Maxdiff uses customer trade off rather than usual rating scales responses. Consumers identify the best and worst choice from a variety of groupings of three or more products or services at different prices. The order of questions is randomized and price levels are randomly assigned. A discrete choice model and a simulator are developed. Modification of price within the simulator allows the client to quickly identify what happens to demand as price increases or decreases.
The application of Monte Carlo Simulation to pricing takes in to account the customer’s price value perception, product, variable fixed costs, and market size. Several levels of price are tested for a given product. The resulting analysis shows the penetration of the product or service at each price point. Typically the model output is presented in an Excel spreadsheet. The key benefit of this approach is that it allows the client to run multiple “what if” scenarios by changing the parameters in the worksheet.
There are various methods to determine the optimal price for a product or service based on the perceived or estimated value to the customer. A value-based pricing strategy allows companies to launch new products and services with reduced risk and confidence that the success will not be hindered by sub-optimal pricing.
Xavier Alvarez is a Project Analyst at Q2 Insights, a market research consulting firm with offices in San Diego and New Orleans.