Please note: This post is the fourth post in a four part series on the main pricing methodologies, highlighting the pros and cons of each. Check out the first post on cost plus pricing, second post on competitor based pricing, or third post on value based pricing.
We’re beginning every one of these posts with the same statement: “Pricing is the most important aspect of your business.” No other lever has a higher impact on improving profits. We elaborated on this assertion in a previous pricing strategy post, but realize that a 1% improvement in price optimization results in an average boost of 11.1% in profits. That’s no small change (pun intended).
Remember what we’ve been saying throughout our existence, pricing is a process that utilizes data to eliminate as much doubt as possible for key stakeholders to make a profit maximizing decision. There is no silver bullet, but with data you’ll have a nice barrel full of lead. The metaphor we’ve been using (some of you like it, some of you don’t) is a dartboard where you’re trying to hit a bullseye with the perfect price, but there’s all that extra space “distracting” your dart. Data and these methodologies eliminate that space, guiding your dart to the ideal price point.
So far, we’ve already learned about cost plus pricing, competitor based pricing, and value based pricing in depth. We learned that cost plus and competitive pricing can be useful, but they’re fairly weak overall, particularly in the SaaS or software space. We also learned that value based pricing, although it has its quirks provides valuable data to shrink the dartboard when done correctly. To recap for those of you who don’t want to read the other posts, let’s review each methodology and give you the top level findings to utilize immediately.
Cost plus pricing: The oldest and simplest (mostly) method of setting prices
Cost plus pricing is the simplest method of determining price, and embodies the basic idea behind doing business. You make something, sell it for more than you spent making it (because you’ve added value by providing the product), and buy something nice with the difference. In practice, a lot of companies calculate their cost of production, determine their desired profit margin by pulling a number out of thin air, slap the two numbers together and then stick it on a couple thousand widgets. It’s really that simple. This method involves very little market research, and also doesn't take into consideration consumer demands and competitor strategies.
Fortunately, cost-plus pricing is really simple, requires few resources and hedges against incomplete knowledge by covering the entirety of a product’s costs. Yet unfortunately, it’s horribly inefficient, because it creates a culture of isolationism and doesn’t take a single ounce of customer perspective to determine prices.
Overall though, cost plus pricing isn’t ideal for most businesses, unless you truly cannot spend some extra time on the most important aspect of your business, which sometimes happens when you’re bogged down by fulfilling orders or just getting off the ground. Regardless of ease, no software or SaaS company should use cost plus pricing, because the value you’re providing is traditionally much more than your costs of doing business.
Competitive based pricing: Essentially, ineffective plagiarism
Competitive based pricing is a lot like plagiarism - you decide not to do your homework, so you copy that of those who have already done some work (or that you’re assuming have done some work). Obviously the market doesn’t dole out suspensions for copying prices, but the processes of swiping an essay and competitor based pricing are pretty similar. Also called strategic pricing, this method involves looking at the prices set by other businesses in the same sector, and then adopting those numbers, plus or minus a few percent according to how your product looks that day. The dartboard gets smaller, because there’s more data here, allowing you to rely on your competitors to do the work for you (as long as you trust they actually know what’s going on in the market).
Competitive based pricing remains a simple, low risk way of quickly gauging prices, and in some cases it can be fairly accurate. Yet, it leads to enormously large missed opportunities, because companies employing the strategy end up not assessing their true value and get caught in a race to the bottom through industry group think.
To summarize though, certain businesses need to use competitor based pricing extensively, because consumers price compare with switching costs from buying a product at store X or store Y remaining exceptionally low. Yet, for most businesses, especially in the software or SaaS space, competitor data should not be the central tenet of your pricing strategy, because there are too many other variables to consider when you’re not comparing congruent products.
Value based pricing: It's all about the customer (and the benjamins)
A value based pricing strategy works to determine the true willingness to pay of a target customer for a particular product by utilizing customer data. Most common pricing strategies and methodologies forget about the customer, instead focusing on internal reasons and/or competitive metrics to justify prices. Yet, customers don’t care how much something cost you to make or your competitors, they care how much value they’re receiving at a particular price. By maintaining this customer focus, value based pricing provides real data, helps you develop higher quality products, and even improves customer loyalty. Simply put, you have the greatest amount of data to make an informed decision about your profit maximizing price. Thus, shrinking down the dartboard.
Of course, value based pricing isn’t perfect. The process requires time and resources, along with consistent dedication, not just a “set it and forget it” mentality, especially because the willingness to pay differs for different customer personas, regions, and even offers. A 100% accurate prediction is impossible, but we can get pretty darn close.
To summarize, almost everyone in the software and SaaS space will benefit from value based pricing. Even individuals in retail, media, etc. can benefit from the methodology. It takes dedication, but when done right, provides enormous benefits in terms of more profit, better and more competitive products, and customer oriented marketing and development.
Remember, pricing is a process
We repeat this notion, because it’s true, but also because we know how daunting approaching pricing can be for a business that doesn’t have someone fully dedicated to their pricing strategy. Pricing is a black box that can only be illuminated through a process. Take this knowledge, apply what’s useful, scrap what’s not, but just systematize your pricing to the point that you're capturing more cash from the table. If you don’t, then you’re losing an enormous amount of money, and that hurts no one, but you.