It’s time to decide on a price for your product. Most business owners consider this a fairly mindless task. I mean, how hard can it be? You write down a number. People pay you that number. Simple enough.

Unfortunately, there’s a little more to it than just that.

Yes, the price of your product directly correlates with how much money your business makes. But too many businesses treat the price they will charge for their products as an afterthought. Those same businesses could easily maximize their profit potential with a basic understanding of how various pricing strategies can be implemented into pricing their own product. In fact, a 1% improvement in price can increase operating profit by 11.1%.

Let’s look at a few of those strategies that will help you in deciding what to charge your customers.

1. Cost-Based Pricing

Cost-Based Pricing is likely the most straightforward pricing method out there. Under cost pricing, a business will generally determine a required profit margin they wish to make on a product, and then use their costs of producing that product to set its price accordingly so the margin can be realized.

By far the simplest pricing scheme to calculate, it is also extremely stable in that your marginal income will always be the same for every unit sold. However, it completely ignores competitors and customer value (which we are about to discuss), and is not a very reliable strategy if a business is trying to fully maximize its profit-making potential.

2. Competitor-Based Pricing

Just like the name says, Competitor-Based Pricing uses the prices of your competitor’s products in determining what you should charge. A business using this method will first analyze the advantages and disadvantages of their own product in relation to their competitors. They then use that analysis to decide on an appropriate price according to how they believe their product stacks up with the competition.

Competitor-based pricing is the most frequently used pricing methodology, and it does yield some benefits. It’s easy to calculate, and is typically accurate assuming your competitor’s products are priced correctly. The only issue is, what if your competitors got their pricing wrong? What happens if your target customer thinks that your competitor’s products are priced fairly/unfairly? Not only that, but if you have created a truly innovative product in a new or emerging market, then there might not be any competition around for you to accurately base your price. And finally, most businesses tend to overestimate how much better their product is compared to the competition. So when you charge a premium on your “better” product, but the customer still prefers the product of the competition… then it is probably time to go back to the drawing board.

3. Value-Based Pricing

Finally, we have Value-Based Pricing. While it is the most analytically challenging and time-consuming pricing strategy, it can reap the largest rewards. The goal of value-based pricing is to essentially let your customers determine your product’s worth. Ok, they don’t exactly decide your price. If that were the case, it would be free because everyone likes free.

The real intent of a value-based method is to figure out what the customer’s perceived value of your product is, or effectively how willing they are to buy it. If you can determine how willing they are to buy it, then you can also find out the price they are willing to pay.

Check out Sequoia Capital’s Pricing Your Product for more on perceived value

Like I said, this can be quite challenging in the fact that all of your customers are different. What one perceives as a bargain, the other might think is a complete rip-off.

However, Hinterhuber & Partners study on value-based pricing highlights a few techniques, so you can perfect the value of your product in your customer’s eyes:

  • Expert Interviews. Gathering the consensus of experts in your industry on what your price point should be.
  • Focus Group Assessments. Potential customers in small groups are surveyed on the importance of new products.
  • Conjoint Analysis. Products with a variety of different attributes are presented to a focus group. The group then ranks the products in terms of value.
  • Value-in-Use Assessments. Allow the customers to use the new product and survey their satisfaction/dissatisfaction while they test the product.
  • Importance Ratings. Customers rank the importance of an existing product’s features which is then used for determining the new product value.

It is important to understand that a Value-Based Pricing strategy requires many hours, and lots of thorough research and examination. Although, when employed correctly, it has the potential to amplify profits significantly.

Why Your Business Should Use Value-Based Pricing: It All Comes Down to Customer ROI

Hopefully by now, we have clearly articulated why your business would be missing out by not taking advantage of Value-Based Pricing. In sum, a customer evaluates every purchase they make in terms of personal Return on Investment. Thus, if the customer does not see the value gained from your product as being greater than the price paid, then they simply won’t buy it. This is why Value-Based Pricing is so critical for the success of both your product and your customer. In understanding the customer’s perceived value for your product, you can ensure that they maximize their personal ROI.

However, it must be disclaimed that just because you have priced your product through a value-based system, does not necessarily mean your product is correctly priced. A customer’s perceptions and needs are constantly changing. Just like the customer, a value-based strategy is in need of constant reevaluation – but this happens to also be one of the true beauties of the method. In the process of continuously needing to keep up with your customer, you are able to also innovate your product to further satisfy their needs. You are essentially placing your product in your customer’s shoes, to let them drive both product price and advancement.

Nothing nearly as impactful could ever be accomplished while using Cost-Based or Competitor-Based pricing.