We’ve worked with all kinds of companies here at Price Intelligently, from software to retail and consumer to enterprise. Yet, throughout all of our conversations, one of the biggest themes we see is that at every company there’s always that one person who thinks discounting and promotions are the answers to all of their pricing problems. For some reason, the target customer just needs 10% off to finally pay up.
Fortunately, since there’s one of these individuals at every company we work with, I’ve got my response down pretty well:
“Blindly discounting is one of the worst things you can do, because you’re conditioning your customer into de-valuing your product, and you’re literally throwing money away by putting it back on the table from the initial and future sales with that customer”
Don’t believe us? Don’t worry. We’ve got data to back all this up. Let’s explore this concept a bit more by first looking at the fundamentals of a discount pricing strategy and why it doesn't properly translate to software. We'll then reveal hard evidence into the true impact of a discount price on your bottom line, before finally illuminating solutions to get you on the right track to boosting your value and defending premium pricing.
photo credit: Images_of_Money
What is a discount pricing strategy?
A discount pricing strategy temporarily decreases the price of a good or service for a specific amount of time. Companies usually do discounts for holidays, volume purchases, and cash payments.
Calculating the discount price is simple. All you need to do is:
- Look for the original price
- Figure out the discount percentage
- Calculate the savings
- Subtract the savings from the original price and you’ll get the sales price
Here is the same calculation in the form of a formula:
Discount price = original price - (original price * discount / 100)
Discounting: Attempting to translate a retail practice to software
As human beings, we've been trained by a century's worth of retail pricing to love discounts. The idea of scoring a deal makes us feel like we’re beating the system, and to a greater extent, makes us feel special. Yet, to understand the discount pricing strategy, we need realize that at its core, a price is your exchange rate on the value you’re creating through your product or service. With that number put down in pixels, you’re saying that whatever you’ve produced is worth $X, because that product or service helps the customer in a manner that fits that equates to their perceived value.
Different types of customers value that product or service at different price points, meaning different segments of customers will have a different exchange rate, or perceived value, of your offering. Take a look at the price elasticity graph below (a screenshot from our software). The profile of the graph shows us that different segments of target customers value the product differently. As such, stakeholders need to decide where on that graph their product resides to spur a sizable profit margin for their business.
Once you’ve decided where on this range you’re going to price, discounting then comes into play in an attempt to move more sensitive customers “up river.” Essentially, discounting works in a similar fashion to a free trial or even a freemium tier. You’re lowering the price point to the level of sensitivity of a new tranche of users. Thus, attempting to convince those users during that initial term that the product is worth the higher price, and when the next term comes up they should pay the regular price.
For instance, imagine that this chart is showing the price sensitivity for a particular SaaS tier for a brand new CRM. Management, taking into account different stakeholders in sales, marketing, finance, and the like decide to put a stake in the ground at point A. Of course, they aren’t capturing all of the market, but that’s fine because they believe for the current state of the business there are plenty of customer at that level. The next quarter comes up and sales aren’t going so well, so the team decides to slash prices 20% for inbound prospects to point B. Immediately, a bunch of users hop on board, helping the sales team meet quota.
A discount pricing strategy has sweeping implications
Everything is rainbows and sunshine now, right? Well, no, not at all actually. By discounting you’ve conditioned the customer to de-value your product. Discounting works in the retail space so well, because brands can limit supply (or at least make it look like supply is limited), and therefore create a sense of urgency in the eyes of the consumer. In the software space, supply is practically unlimited and non-physical, and we’re inundated with so many promotions and discounts every day that we know more are coming down the pipeline, even if you say, “for two days only.”
What’s even worse, is that when that next month or updated product comes, the customer is already using the product at a particular price. Very few companies have the first month user retention strategies in place to boost value to the original price point. Switching costs are so low (especially after only one month of use) that customers churn out, wasting you even more money from marketing, onboarding, and any extraneous costs associated with having that non-ideal customer distract you. You've put in anchor pricing that discounted your selling price and left your business with less profit. As David Skok illustrated, churn is kryptonite to startups, and if you’re growing sales through discounts, problems will only get worse, even if you are retaining a certain percentage of those customers.
Let’s talk turkey though, because everything has been philosophical up until this point. We’ve run hundreds of price sensitivity campaigns for software companies and one of the segments we always test is the effect of discounting on willingness to pay. Enough results have come in for us to assert that the numbers back up our above analysis. Even though it varies by product, industry, etc., customers receiving a discount on their first month or initial purchase value the product at least 12% lower than the product’s list price. Note that free trials and promotion still reduce perceived value of the main product, but not as much as if you offer discounts or a freemium offering (read more about how we’re opposed to freemium as a default strategy).
How to move beyond discounts
1. Create an entry-level tier
The main axis your revenue model should be based upon is a “value metric,” meaning as your customer uses your product more (bandwidth, installs, contacts, etc.) he should be charged more. As such, an entry-level tier allows you to still drive folks to your main product, but allows you to capture customers with a lower willingness to pay. Thus, giving you an opportunity to wine and dine them at a lower service level until they convert to a higher, more ideal tier.
Note: This doesn’t mean freemium, which is an acquisition strategy not a revenue model. You should check out our analysis of freemium here to learn more about proper implementation.
2. Add value instead of providing negative discounts
As we stated before, people LOVE to get deals and feel special, but that doesn’t mean you have to cut the price. Instead, add more units, more user seats, premium service, etc. A little surprisingly goes a long way, and you won’t succumb to the long term implications of discounting. Plus, we’ve already chatted about how psychologists have proven, human beings would rather receive 2 for 1 than 50% off.
3. Improve your marketing segmentation
Whether the price for your product or service is optimal for maximizing revenue is irrelevant to understanding the trigger features and value propositions of your customer. Way too many software companies run rough shot marketing practices that spew the same message to everyone. You need to get deeper and more specific, because even if you’re selling to a niche customer, value will be different amongst different size companies, geographies, incomes, etc.
Overall, we obviously don't expect you to retool your entire pricing strategy over night, especially if your customers are already conditioned into discounts. Keep in mind though, we want you to move toward a more sustainable, revenue maximizing strategy. The payoff is enormous and it's not difficult, but it does require some work. To learn more, check out our Pricing Strategy ebook, our Pricing Page Bootcamp (it’s free!), or learn more about our price optimization software and solutions. We're here to help!