Whether you’re a new product manager about to launch a product or service, an entrepreneur just getting your venture off the ground, or a business leader reevaluating your company's direction, it’s crucial to have the right pricing strategy to maximize profits.
A value-based pricing strategy offers a practical path forward for your company. Below is an in-depth examination of value-based pricing, including an overview of the value stick framework and the different components that make it so effective.
What Is a Value-Based Pricing Strategy?
Value-based pricing is a means of price-setting wherein a company primarily relies on its customers’ perceived value of the goods or services being sold—also known as customers’ willingness to pay—to determine the price it will charge. Because it revolves around customers’ priorities, it’s occasionally called customer-focused pricing.
Harvard Business School’s value stick framework offers a helpful way of visualizing the tenets of value-based pricing, as well as the ways firms can maximize profit margins while creating more value for their customers and suppliers.
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The Value Stick
The value stick is a visual representation of a value-based pricing strategy’s different components. At the top of the stick is the value that’s been captured by the end consumer, called the customer’s delight. In the middle of the stick is the value captured by the firm, called the firm’s margin. At the bottom of the stick is the value captured by the firm’s suppliers, called the supplier surplus.
The value stick comprises four components: willingness to pay, price, cost, and willingness to sell. Where on the stick each of these points falls determines how a sale’s value is split between a firm, its customers, and its suppliers.
Here’s a more in-depth look at each of these components.
1. Willingness to Pay
Willingness to pay (WTP) is the highest price a customer is willing to pay for your product or service. Customers are likely to make a purchase when companies charge any amount up to that threshold. Charging even a cent above that number heightens the risk that the customer will decide against purchasing.
The difference between the customer’s willingness to pay and the final price of the purchase is known as the customer’s delight. This is the level of goodwill, loyalty, and brand enthusiasm that the customer feels after making a purchase, which is typically tied to the value they’ve claimed from the transaction.
2. Price
Price refers to the final price a company charges when it sells a product or service. As such, price is the point on the value stick that a firm has the most control over. It can be set at any point between a firm’s cost of production and its customers’ willingness to pay.
When a firm sells a product or service, the value is split between the customer and the firm. As explained above, customers receive the difference between their willingness to pay and the actual price, while the company gets the difference between the price it charges and the costs associated with creating the product. This is referred to as the firm’s margin. Where the company chooses to set its price determines how value is shared with the consumer.
Naturally, companies aim to maximize profits from each sale. But they also strive to maximize customers’ delight to build brand loyalty and turn a single purchase into a repeat one. This creates a level of competition wherein a firm must find the optimal point on the value stick to achieve both goals.
3. Cost
Cost refers to how much money goes into producing a product or service, including all of its components. This includes physical costs, such as the various nuts, bolts, and widgets that make up an item, along with non-physical costs, such as utilities and rental space.
The lower a firm’s cost, the higher the value it can share with customers. This creates competition between a firm and its suppliers that work to drive the price up to maximize their value.
4. Willingness to Sell
Willingness to sell (WTS), also known as willingness to accept, is the lowest price a firm’s suppliers are willing to accept in exchange for the raw materials needed to create products. While many suppliers would like to sell goods for the highest amount possible to maximize profits, most are willing to reduce prices to a certain extent to make a sale. Their willingness to sell represents the lowest point they’re willing to drop before it no longer makes sense to pursue a sale.
The difference between the suppliers’ willingness to sell and the cost (what they charge the firm) is known as the supplier surplus—or the supplier delight—and it represents the value they’ve captured from a sale at the firm’s expense.
Using the Value Stick to Drive Value Creation
When the four points above are plotted along the value stick, they create three wedges: customer delight, firm margin, and supplier surplus.
Firms that embrace value-based pricing can manipulate these wedges in one of two ways. They can either adjust where the points of cost and price fall on the value stick, or they can work to increase the length of the stick (and the total value shared by all parties) by increasing customers’ willingness to pay and decreasing suppliers’ willingness to sell.
Here are four strategies companies can use to increase profit margin with the value stick framework:
1. Raise Prices
A firm can easily increase profit margins by raising prices without changing anything else. This allows them to capture a greater share of each transaction’s value at customers’ expense.
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2. Raise Customers’ Willingness to Pay
Firms can increase customers’ willingness to pay, in effect lengthening the value stick and increasing the total value that can be split. This enables them to raise prices while delivering enough value to keep customers excited and delighted about the purchase.
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3. Lower Costs
Firms can lower their costs by paying suppliers less, without changing anything else about the equation. This allows them to capture more value at the suppliers’ expense.
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4. Lower Suppliers’ Willingness to Sell
Firms can lower their suppliers’ willingness to sell, in effect lengthening the value stick and increasing the amount of shared value. This allows them to pay a lower cost while increasing the suppliers' surplus.
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Of the four strategies outlined above, numbers two and four allow firms the opportunity to increase the value wedges for all parties involved. This enables them to maximize profits without negatively impacting others. Strategies one and three, on the other hand, allow firms to maximize profits at the expense of customers and suppliers, growing their own value wedge while shrinking others'.
Choosing the Right Strategy for Your Business
The real benefit of leveraging value-based pricing for your business is that it forces you to truly understand the motivations of all parties involved in a transaction—your company, suppliers, and customers. This understanding of economics empowers you to make intelligent decisions around how you price your products or services and, compared to other strategies, often leads to more beneficial outcomes.
Are you interested in learning more about value-based pricing and other key frameworks? Explore our eight-week course Economics for Managers and other online strategy courses, and learn more about how to develop effective pricing strategies.
This article was updated on October 19, 2021. It was originally published on November 3, 2020.
