Pricing 101: Understand the Power of Pricing & how to do it
A quick look at pricing strategies, models and tactics for the growth of your SaaS product
Hey there! Thanks for being a great audience. On my last issue, I encourage everyone to work on side projects. I received many requests for a deeper understanding of how to make money off them. Today I want to talk about strategies to price your product.
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Pricing is difficult. Period.
The question of how to price your product has been around ever since humans started trading. And, there’s no simple answer to that, be it physical goods or Software as a Service (SaaS).
SaaS is a model where the software is centrally hosted on the internet and delivered to customers on a subscription basis, and this is exactly what sets it apart from others. You need to put much more thought to come up with a price.
Marketing gurus will tell you that pricing is nothing but your ability to sell the product. Pricing is a dynamic process that needs to be constantly optimized and updated to generate higher revenue. The key is to adapt to the market and evolve constantly.
Despite pricing having the maximum effect on revenue, a lot of SaaS companies undervalue its importance and thus do not know how to price their product well, making them vulnerable in the longer run. Again, there’s no simple formula, but for the sake of simplicity, I can write
Pricing = Value + Psychology + Economics → Growth for the company
From the value your service adds to a customer to understand their mindset and what appeals to them to marketing the product to optimize your profits, everything plays a pivotal role.
Hence, I decided to come up with this three-part issue on ‘Pricing 101’. There are already a lot of articles/blogs/guides on the same, my aim will be to keep it concise and simple.
In the first part, I’ll focus on pricing strategies that are essential for the growth of your company. A pricing strategy is nothing but a method to determine the price at which you should sell your product. A right pricing strategy in place is crucial to SaaS success, if you charge your customers higher, they will shift to other similar services whereas charging lower can hurt your revenue.
Therefore, you need a thorough understanding of your product (value), market (economics), and customers (psychology) to select a suitable pricing strategy. Let’s take a look at the top 5 pricing strategies.
1. Cost Plus pricing
One of the basic pricing strategies that companies can use initially is Cost Plus pricing. The strategy includes adding a considerable profit margin to the costs incurred by the company in developing, marketing, etc. in providing a customer their service.
Due to its simplicity, it is generally a good strategy to start with for new companies/products when you don’t have an idea about how much your users would be willing to pay. The strategy also works when there are no competitors in the market to set a benchmark price, and all you know is how much you spent.
So, as long as you are calculating the costs correctly, this strategy will get you guaranteed returns. However, since this strategy is extremely less research-oriented (precisely what makes it simple) and doesn’t take into account the market and consumers (their price sensitivity as well as the perceived value of the product), it has been proven to be highly inefficient in the long run. Moreover, there are always additional costs that cannot be determined first hand and thus could lead to reduced profit margin.
2. Competitor based pricing
If you step into an arena that already has a few players, you can set your prices using your competitor’s prices as a benchmark instead of cost. Again, this is a starting pricing strategy if you do not have a true estimate of what value your product data or other market-related research.
It gives you an idea of how much you can charge your customers, for example, if you charge your users much more than your competitors, they are likely to be not drawn towards your product. On the other hand, if you charge them much lower, they might be suspicious of your product. So, keeping your price in a similar range could do the job for you. It’s more like utilizing someone else’s research or copying a friend’s assignment just before the deadline. You are basically setting your price based on someone else’s research, and while that makes your job easier, it is exactly where the drawback of this strategy lies.
Now, if you are coming up with a new product in the market, of course, it would be bringing something new, something that adds more value to your consumers than your competitors, right? So, you should definitely be able to charge more because you are providing more.
That’s why I had emphasized ‘much more and much lower’ in the previous paragraph, you should charge more but don’t venture far off the track unless you have some revolutionary feature in your product that definitely justifies your high charges.
A variant of penetration pricing is Captive Pricing, which has two components. A core product that can be sold at a cheaper rate and accessory products that cost more and add enhances the value of the core product. Printers and their ink is the most cited example for this strategy, you can read more about it here.
3. Penetration pricing
As the name suggests, this strategy helps your product penetrate in the market. How? By simply setting the initial price of the product to be quite low. A lower price offering in a short period can quickly attract a lot of potential consumers and help you gain an edge over your competitors.
The idea is to compensate for these low prices in a long time, once the company gets a large user base. The early adopters of your products will develop a sense of loyalty towards your product and thus can promote sales through word of mouth, turning the whole thing into a more profitable channel.
Moreover, these low prices can eliminate the entry of competitors and establish the company’s monopoly over a segment. This type of strategy is suitable for mass markets where demand is elastic (i.e. price changes significantly affect the product demand). As people become used to your product and enjoy the service, they would stay even if you increase your prices slightly.
However, the drawback with this strategy is that it sets a low price expectation/conception for the users even in the long run and a price increase would mean that they would switch to the then cheaper alternatives. This preconception issue can be tackled by setting the initial price as the one to be used in the longer run but offer discounts on that in the initial stage.
For instance, when the delivery app Swiggy started its Super plan that included free delivery, no surge charges and other promotional offers, the plan was set at ₹49 per month with ₹149 per month struck out in the background to highlight the discount they were offering. After a few months, they set it to ₹149 per month, and though a lot of users were reluctant to pay roughly three times of what they were initially, they knew that it would eventually increase to this price after some time.
4. Price Skimming
Contrary to penetration pricing, this strategy implies starting with a high price for the product and gradually lowering it over a short period. It is best suited for a new type of product with high demand that is basically inelastic in nature (i.e. prices don’t significantly affect the demands), and when there aren’t enough competitors.
The initial high price serves as a sign of quality and luxury, converting the products into something that early adopters can boast off. At the same time, it helps in generating a larger return of investment (RoI) while the demand is high. This is precisely the reason why it helps with new products because you’ll be able to charge a lot more because there’s practically no rival out there, and thus help you in recovering the cost incurred.
As the early adopter market saturates and the demand decreases, the company lowers the product price to attract more price-conscious customers, leading to market segmentation. The lowering of the price is important because as the product matures, unlike price penetration, it will attract more competitors that can develop upon your idea and offer it at a lower price.
Riding down the demand curve helps you in appealing to different segments of the markets based on price sensitivity and gaining that consumer surplus to increase revenue. This is how the strategy gets its name, it ‘skims’ off the top of each customer segment.
However, it is important to note that drastically reducing the price in a very short period of time after the launch can upset your early adopters who paid a huge sum and the company can face backlash. Therefore, the price drop should be consistent and driven by market research so that you aren’t too late in reducing the price (i.e. by the time competitors have entered the market).
The best example of this strategy would be Apple products that are highly priced at the time of launch. Multitudes of people rush to the stores to get their hands on the latest tech. After a few months, the prices are reduced, attracting a price-sensitive segment to purchase their products.
5. Value-based pricing
Saving the best for the last. Value-based pricing strategy is in stark contrast to the cost-plus strategy. While cost-plus keeps the company’s costs and profits at the center, value-based pricing keeps customers/users at the center, and that’s what should really matter.
The pricing is based on how much your users are willing to pay for your product depending on how they perceive the value of your product. You see, your customers don’t care how much you spent in making the product, they only care about how your product will make their life simpler.
Once you understand what your customers actually want, you can set your price packages accordingly, even higher than your competitors if you determine that you are adding more value to their lives. This helps in building trust with your consumer base as well as maximizing profit from the start.
Remember, pricing is a dynamic process. Value-based strategy helps the company evolve as you always working towards adding more value for your users to meet their needs and thus reevaluate prices (and, hence revenue) accordingly. If your prices don’t work, you can always modify your product and improve its quality to better suit the market instead of lowering the price. To put it simply:
Value-Based Pricing = Growth
Determining the value that you provide is not so straightforward as other strategies, it requires extensive research, a lot of time, and dedication. You need to collect and analyze real-time data from the market carefully to understand the perception, price sensitivity, and willingness of your customers, which varies from person to person, region to region, etc.
Building a relationship with your customers directly helps in understanding their needs better and at the same time, the customers feel that their values/opinions matter, and thus develop loyalty towards your brand.
The only downside to this strategy is that it takes a lot of time and resources, but aptly so. It is guaranteed to benefit your product and company in the long run in almost all areas, be it RoI, marketing, or development. However, it is important to note that you can only determine the approximate value over the sample space of your research, and arriving at an exact number is still something that you’ll set yourself (in the approximate range).
An easy rule to arrive at a value-based price is to follow the 10x rule, which states that the value you provide should be ten times its price. For example, after your research you find that using your software solution will save a company ₹100,000 per month, then your price should be set at ₹10,000 per month.
Once you nail your pricing strategy, you need to adopt a pricing model to charge your customers and make the most out of your product and service. Pricing models will be the focus of the second part.
Models basically refer to your pricing package, let’s take a look at the 5 popular models (names are self-explanatory!) that companies use and you can decide what suits your company best.
1. Usage Based
Basically, you pay more if you use more and vice-versa. Our internet and cell phone plans are prime examples of this model. It’s suitable for web-infrastructure services where they charge according to the bandwidth, or the number of API requests, etc. A great example of this would be AWS.
Since the model’s upfront costs are low and the plan is simple, it can be quite appealing to consumers, who can pay a small amount and get the product’s experience. Later on, if they like the services, they’ll utilize it further and pay a higher amount.
However, the reason why not many SaaS companies go for this model is that it does not directly relate to the value that you are adding to your consumers or as to why you stand out. It’s serving them a cost-based advantage, when another company steps-in with a cheaper plan, they’ll switch. Moreover, usage can vary considerably from person to person, time to time, so it makes the math complicated.
2. User Based
Another simple plan is to charge on the basis of users. An extremely popular model is per-user based pricing, where you charge customers a fixer rate per month per user account.
The model is again linear, you charge a user ₹100 per month, so for 100 users, you’ll generate revenue of ₹10,000. And, the simplicity of knowing what your bills will look like makes it attractive to customers.
However, this model too has no correlation with value, and for consumers looking to grow, more users would mean higher bills, which would lead them to cut seats wherever possible, or maybe switch to a cheaper alternative.
You could come up with a usage count-based model where a single user is charged ₹100, but 10 users are charged ₹800, and so on. This model could be appealing to large enterprises, but in the long run, the rate dependence on seats will still be a problem for their growth.
A better way to tackle the above problem is to use a per-active user system, where an enterprise can have all its employees sign up for your SaaS, but they will be charged only for those who are using it.
The model also has another drawback since customers can share their account and login details with others instead of paying more, an issue that streaming services like Netflix and Prime face.
SaaS companies’ favorite pricing model, you make multiple packages clubbing different features and price them accordingly. For example, you would have seen common two-tiered pricing: Basic and Pro.
This allows you to customize your product’s experience for a different type of users, a basic user wouldn’t be using all of your product’s features and thus charging him a lower amount for the minimal set of features is reasonable whereas your product’s advanced pictures will be used more by a professional and thus you get to charge more.
The reason why it’s recommended is that it’s based on the value your product adds to the user, allowing your company to grow: convert its ‘Basic’ users to ‘Pro’, and generate higher revenue. On average, you would have seen three-tiered pricing models, which is usually quite common with SaaS companies.
Adding too many packages can confuse your buyers and hurt your chances of conversion, it’s important to not over complicate your pricing model in the long run and your model will turn out to be highly profitable in the long run. I’ll talk more about these tiers and how to make the most out of them in the last part.
4. Per feature
Here, instead of users, you price your price on the basis of the features you provide. It’s similar to the tiered pricing model because you are using features as your value metric, but instead of clubbing them in different packages, you just have a base package on which you can add additional features by paying an extra sum for each of them. For example, satellite TV subscribers have the option to pay for additional channels.
This model ensures that the new features of the product don’t get unused as you will have users that interact fully with your product, helping you understand it better and come up with innovative solutions.
As is the case with value-based strategy, it requires a lot of data and research to get the pricing tier right and to determine how much you can charge for a particular feature. Further, if your competitors offer your additional features at a cheaper price, your churn rate will increase.
5. Flat rate pricing
Contrary to the tiered model, flat rate pricing is easily the simplest model, you charge a single rate for the entire product (i.e. all its features) irrespective of the number of users. This single rate can be billed monthly or annually, making it quite easy for consumers to adopt.
Despite being uncomplicated and easy to sell, it is difficult to extract the value of your product from this model. There would be features that may go completely unused by some users and others will be using a lot more features while paying the same price. This may over time feel unsatisfactory to the former, who need less than what they pay for.
Therefore, it’s better to go for a tiered pricing model customized as per your users' needs which has been found to be profitable in the long run.
Making the most of your pricing
Coming on to the last part of this issue, I’ll be dealing with the third parameter in the pricing equation I wrote in the intro: psychology (when it comes to purchasing products). Here are some tested psychological tactics that you can employ to make the most out of your pricing model:
1. Keep your packages simple
The idea is not to make your pricing model complicated nor too basic. The maximum number of objects that a human can hold in working memory is 7±2, therefore it is a good idea to limit your packages to 3 or at max 4. In a study, it has been found that the average number of packages that SaaS companies offer is 3.5.
Having a lot of tiers with different pricing points can lead to analysis paralysis (read this interesting paper) where the increased number of choices makes it difficult to make a decision. On the other hand, a consumer can quickly determine which package is best suited if he/she has just been offered 3-4 packages.
Also, make sure that you name them. Basic, Pro, ProPlus are quite common categories, quirky names can be attractive but do not keep names that are difficult to register.
2. Charm pricing works
You must have wondered why almost all appliances and clothes are priced with digits ending in ‘99’. There’s something called the Left digit effect which basically says that when we read a number from left to right, the leftmost digit is retained better and we latch on to it, subconsciously rounding off the value to that number.
That’s why a product charged ₹499 looks better than ₹500 despite the difference being just a rupee. Our brain thinks that it is purchasing a product worth ₹400 and saving 100 bucks. Studies have shown that this always leads to more sales, and most SaaS companies enjoy this psychological pricing tactic.
3. Center gets the limelight
Things in the center get more attention. When given three choices, the audience is more likely to go with the package in the middle as they believe it is the most popular and balanced package.
By keeping a package that you have designed to be widely used between two extremes, you increase the chances for its adoption. Even though the package in the middle will be perceived as popular, many companies make it stand out by highlighting it in a different color and adding labels like ‘popular’ and ‘recommended’ to it. This makes it easier for the audience to arrive at a decision.
4. High to Low vs Low to High
Usually, packages are arranged from the cheapest on left to the most expensive on right because of our ability to latch on to things on the left. Offering the lowest price on the left sets up a reference point in the buyer’s mind as he/she moves towards the right.
Therefore, in low to high, you don’t potentially scare away your customers by offering higher-priced packages and raising that reference bar. However, going high to low can actually improve your chances due to the same reason.
When you see the highest-priced package on the left, the cheaper ones on the right feel more reasonable in comparison and the buyers would go for them. This is an example of price anchoring, by shifting the price reference point in the mind of the buyers to a higher value, you motivate them to go for the medium package.
One more psychological tactic that can be used on a similar line is to use decoy pricing. You add a redundant package that basically is priced the same as the package you want to sell the most. For example, the redundant package contains a set of features whereas your profitable package contains the same set plus a few more features. This drivers buyer into going for it because they are getting more for the same price.
5. Go Freemium vs offer a Free Trial
When it comes to purchasing, ‘free’ has perhaps the most impact on our minds. We love discounts and getting something extra without paying for it. In the freemium model, companies offer the basic package free of cost.
This model will allow your company to grow more early adopters in a short period of time, however, in the long run, the increased number of free users can negatively affect your revenue and costs of operation.
Offering a free trial for a limited period of time is a way out that many SaaS companies use. ‘Start free trial’ is the most common CTA (call to action) This goes with the psychology associated with free products and also allows buyers to reduce the risks with their purchase.
Adhering to these models and strategies can indeed make pricing simpler and help you understand what is best suited for you. The key takeaway is to give more attention to pricing. Spend more time in knowing your users and their needs, always use value as a metric for your models, and more importantly, keep it simple.
If there’s anything I can do to help, please feel free to reach out over Twitter- I’m at aayushjaiswal07. Share your thoughts in the comments. 😊🙏