Pricing is hard.
Pricing for a startup is even harder.
Most people I’ve talked to come up with their pricing by guessing and throwing darts based on cost-plus or competitor research.
But that is typically the worst way to maximize revenue and you’ll often leave yourself in a reactionary position and leaving money on the table. This is especially true when you’re trying to sell products that are commodities or close to becoming a commodity.
So how do you set your pricing strategy?
Start with Cost-Plus and Competitor Research
I know I just said that basing your pricing strategy on cost-plus and competitor research was bad. But that doesn’t mean you should ignore it either.
Understanding your COGS and what margins you need to be profitable are very important for any sustainable business. This also helps set a price floor – the lowest you can price your product before you become unprofitable.
Similarly, you can’t ignore the conventions of your industry and what your competitors are doing in order to maximize opportunities and minimize threats. This will also help you understand a price ceiling.
By looking at what competitors charge, you’ll know what a realistic markup could be. For example, Papa John’s would be hard pressed to charge $50 for a large pepperoni pizza when Pizza Hut is only charging $20.
However, the main thing to remember is to not let this basic research be the only factors that dictate your pricing strategy.
Factor value into your pricing strategy
If you don’t factor in the value of your product or service when setting your price, no one’s going to do it for you.
After understanding your price floor by looking at cost-plus pricing, and knowing your potential price ceiling by looking at competitors, it’s time to factor in the value your product has to your customers.
The reason value based pricing is so effective is because it puts your customer first. The value they perceive dictates how much they would be willing to pay, and is key to maximizing revenue.
This is especially true in for companies operating in services or commodity industries.
One recent example of a fast growing company who stood out by emphasizing value is the Honest Company.
Many products catering to parents of infants can be considered commodities such as diapers and baby wipes.
Yet, due to great usage of founder Jessica Alba’s celebrity, positioning of safe and organic messaging, the Honest Company can charge a premium over other similar products and get it.
It’s no coincidence that establishing such a strong brand and value in the minds of consumers helps mitigate any pricing wars and was a big part of their billion dollar valuation.
The team at Price Intelligently writes more about Value Based Pricing and even gives a great guide on how to implement it.
Vary prices based on value not features
The other upside of value based pricing is that it helps give you a roadmap on how to price your tiers and product models.
Not surprisingly there’s a bunch of great posts on Price Intelligently that goes into great detail about using value metrics to price your SaaS tiers and how good product versioning can increase revenue.
But the key takeaway is that you need to base your tiers and pricing around value metrics.
For example, Dropbox smartly increases prices based on the amount of storage someone needs. It just makes sense since storage space is the key value users get from Dropbox.
But what if Dropbox suddenly changed its pricing around the number of files uploaded? Would that make as much sense and be as easy to communicate the value to users?
How discounts can ruin a solid pricing strategy
So you’ve done all the legwork and have come up with a great initial pricing strategy based on value. You roll it out and…all of a sudden you don’t hit your numbers. So what do you do?
Create a special offer to boost sales!
The tried and true discounting is a viable option for every business – as long as it’s done smartly.
But being reactionary and only focusing on the short term, can actually handicap your pricing strategy in the long term.
Price Intelligently’s data showed them that for a SaaS company, discounting can lower LTV by 30% due to longer payback periods, increased churn, and attracting more price sensitive buyers.
For more transactional businesses like retail and e-commerce, discounting and promotional pricing is status quo. However, the stakes become even higher as applying the wrong discounts applied to products can hurt revenue in the long term.
Kurt Salmon shares an example of a publicly traded retailer who deeply discounted prices store wide to drive sales during Black Friday 2011. This left them poorly positioned in stock and margins for the rest of the fall that eventually led to unfavorable January sales and a significant drop in stock price.
To make discounts work for you, it’s important to line it up with your overall strategy.
For retailers this practice happens all the time with “loss leaders” being the carrot to bring customers to the store where they purchase other items to make the overall sale profitable.
For SaaS, discounts should be segmented and applied away from core products. As an example, waiving or discounting a one time set up fee provides a value to customers, but doesn’t reduce pricing from the core product.
Wrapping it up
In the end, pricing is difficult because it’s based on more than just COGS, but also on perceptions of your customers, positioning against competitors and isn’t always rational.
But by keeping in mind the big picture and understanding how customers get value from your product and services, a good pricing strategy will be key for driving sustainable growth for your business.