September 13, 2017
3 types of pricing strategy (and why you need value based pricing)

How do you decide the price of your product?

Some will say you should go with your gut. Others say that you should go with your gut, then double it. Either way, it seems most pricing advice out there is gastrointestinal-based rather than brain-based.

 
 
 
 
 
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This gets to the heart of the problem with pricing strategy - not enough thought goes into it, let alone enough data. Pricing is a process, with the ultimate goal of defining a strategy that will maximize your revenue. Picking numbers out of the air — or out of your gut — doesn’t count as a process or a strategy. 

To help you on this pricing as a process journey, let's walk through the three common strategies used to define their pricing process: cost-plus, competitor-based, and value-based. We'll then show you why value-based pricing is the pricing strategy you should be using in your recurring revenue business. 

Cost-Plus Pricing

A pricing method in which the selling price is set by evaluating all variable costs a company incurs and adding a markup percentage to establish the price.

Price Intelligently Dictionary

Cost-plus pricing strategy is what people automatically think of when they think of “pricing strategy.” 

This is the most basic form of pricing: selling something for more than it costs to make. You add up all of the costs of providing the service and then add a profit margin on top to represent the value you are giving your customers. In SaaS, the costs might be product development and design, the companies own SaaS providers, and the costs of the team. Then add a 5%, 10%, or healthy 20% margin on top for profit.

Calculating price from costs has two main benefits:

  1. It’s simple. As long as you know how much your costs are, it’s trivial to work out your price. No market research, no data analysis, no strategizing. Just some addition and percentages.

  2. You will cover your costs. As this is cost-plus pricing, you know that you will be adding a certain margin on top of your costs as pure profit.

Taking those advantages at face value, cost-plus pricing seems like a great idea and certainly a good starting point, with little overhead and definite profits.

Yet, cost-plus pricing is anything but a sure win. You won’t necessarily know all your costs, and therefore can’t know if you’re going to cover your costs. Your initial costs might include only hosting and some development, but as you grow you’ll have to factor in sales, marketing, and a number of other previously unknown costs. You can’t change your prices to account for every new hire, which means your profits will take a hit.

Also, costs fluctuate over time. If a SaaS provider is using value-based pricing and has changed their prices, you can’t constantly change the price of your product to maintain the same margin. That might work for a gas station, but it won’t work for a SaaS company. Again, profits take a hit.

This is what happens when you use cost-plus pricing:
image_7A9312DC-0F9B-4BCC-B1EE-E0D12B48DEBA.pngIn this example, the company calculates costs, and then adds a healthy 15% margin on top. This works well for a few months, until some unexpected costs crop up. Then the margin is cut to 5% and then 0%, where the company is only breaking even. Then all it takes is for one of their own SaaS suppliers to raise prices and they are losing money on every sale.

The Big Problem With Cost-Plus Pricing:

Customers don’t care about cost, they care about value.

You have no idea how much it costs for Starbucks to make your Frappuccino. You have no idea how much it costs for Honda to make your Accord. The price of these items is tied to the value they represent to you, not their internal cost. Sure, Starbucks and Honda are pricing their products over what it costs to make them, otherwise they’d be in trouble, but how much over is not determined by the cost of the coffee beans or the engine parts.

For SaaS in particular, the unit cost of delivering one account can be very low. It is the value that your customers will get out of using your product that really matters to them, not how much you paid your developers.

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Competitor-Based Pricing

A pricing method that utilizes competitor prices as a benchmark, rather than setting a price based on company costs or customer value.

Price Intelligently Dictionary

For a SaaS company starting out in a new industry, competitor-based pricing strategy will seem the logical way to go. Unsure of the initial value of your product, and not wanting to go too high or too low, it seems obvious that you should look at the other companies selling similar products to decide your own price point.

Again, calculating price from competitors has two main bonuses:

  1. Simplicity. By spending 30 minutes on competitors’ sites finding all their pricing information you can have a “pricing strategy.” It’s also unlikely to go wrong. By placing yourself in the middle of the pack, you’ll be anchoring yourself for any future customers and they won’t think your product is too cheap or too expensive.

  2. It might be close. If you’re in a competitive market, pricing for the companies involved should be close to what the market can reasonably sustain.

But the biggest downside of competitor-based pricing should be obvious. You don’t have your pricing strategy, you have their pricing strategy. Your company exists to offer customers something different to what is already on the market. You are offering more value and a better product, otherwise you shouldn’t be building it.

That is why you have to find your own space within the industry, both for your product and your pricing. If you don't, your profits will end up like this:
image_EA9F93B3-7253-4712-B484-C1D47B573A7C.pngFlatlined. OK, this looks a lot better than the cost-based pricing, with a profit throughout the year. But it is also static, with no chance of adding value by raising prices without pricing yourself above your competitors.

The moral of the competitor-based story is look, but don’t touch. You want to know where your competitors are pricing their products so that you’re in the same ballpark, but they should not be guiding your decisions.

The Big Problem With Competitor-Based Pricing:

Customers don’t care about your competitors, they care about their value.

As before, this is missing the point for your customers. Instead of focusing on what you can give them and how you can put together the right features and plan for them at the right price, you are offering them something that they could literally get elsewhere.

If a potential customer is on your site, it is because they are interested in what you have to offer. If it’s just a regurgitation of what they have already seen elsewhere, then they will just use the original instead.

Value-Based Pricing

Basing a product or service's price on how much the target consumers believes it is worth.

Price Intelligently Dictionary

This could easily be called “Customer-Based Pricing” because that is effectively what it is. Instead of looking inwardly at your own company, or laterally towards your competitors, with value-based pricing strategy you look outward. You look for pricing information from the people who are going to make a decision depending on your price: your customers.

Three great reasons to base your pricing on customer value:

  1. Willingness to pay. This is the main reason you have to go out and ask your potential customers the value they see in your product. You need to know what customers will actually pay for your product. Competitor-based pricing does this in a roundabout way. If they are willing to pay $100 for your competitor, then they must be willing to pay $100 for your product as well. But this misses the fundamental point that your product should be different to your competitors. It should offer more value, and therefore priced differently.

  2. Build the best product. Pricing also isn’t just about the number on the page. It is about how you package and offer your selection of products and features, and to whom. This approach to pricing will help you understand what your customers truly want, and what features should be developed over time. Once you have developed your minimal viable product, your features and product updates should be driven by consumer demand.

  3. You get to know your customers. By placing a premium on the opinions of your customers, you are focusing on the people who will be making the buying decisions. They are the ones that will eventually be deciding whether your pricing and packaging is correct. If not, they won’t be buying.

The downside: all this takes time, and is the basis for quantifying your buyer personas. You have to be dedicated to finding out about your customers and your product to perform value-based pricing effectively. It’s also not going to be 100% reliable. With price sensitivity measurements and feature analysis you are only going to get approximations of the right pricing, packaging, and positioning for your product.

But this is still much closer to the truth than using just costs or competitors to set your price. It’s also based on your product and your value, so it gives a much more truthful representation of where your pricing should be set.

When you start using value-based pricing, amazing things can happen with your profit:
image_A990772A-AAE7-471B-882A-348779C63797.pngWith value based pricing, two things are different. Firstly, you can start at a higher price point if you have shown that there is a willingness to pay among your customers. Secondly, you can raise prices as you add more value to your product and find out more about your customers. This example has an aggressive pricing strategy, with two raises within a year. But this is entirely possible in SaaS. You should definitely be re-evaluating your pricing strategy every 6 months, and if there is room to raise prices you should.

Your customers care about value - and nothing else

Each of these pricing strategies has its place in business. If you’re running a gas station, you’re probably cost-plus pricing. If you are in the ultra-competitive retail space, pricing in line with competitors will be close to the price the market can sustain.

But in SaaS, the only viable option is value-based. Your SaaS company exists to offer value to your customers. By finding out how much they are willing to pay for your product and what features they want to see you develop, then you will be able to not only give customers what they want, but you’ll also be able to attract and retain these customers better. All while making more profit.

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SaaS Economist
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