A key challenge that an entrepreneur, especially in the case of new and innovative products, often faces is “how do I price my product or service?” I faced this situation at two early stage companies that I worked for and at one startup where I was the cofounder.
Conventional pricing theory, which Robert Phillips explains very well in his book Pricing and Revenue Optimization, says that there are three (3) methods for setting prices:
- Cost-based: add a markup to the cost of production.
- Market-based: charge the price where supply equals demand – the final price is arrived at after the customer compares competitors’ prices
- Value-based: relate price to the benefit gained by the customer – negotiate a price that is proportional to the value that the customer gains by using the product
While one can make a case for each method of pricing, my experience has proven the following related points regarding new product pricing:
– a customer will pay a price that is similar to what it pays for something that it (i.e., the customer) perceives as a substitute
– a customer will pay what it feels is the market price that in turn is constrained by a budget. For example, back in 1999 when I worked for one of the early software-as-a-service (SAAS) companies, one of our prospective customers had a $10K per month budget for application software – the price that we eventually negotiated did not exceed the $10K per month budgetary limit.
In my 20+ years in the enterprise applications business I have noticed that, while vendors like to rave about “value-based” pricing, customers end up negotiating a market-based price. I do feel that the value-message is the right one – it’s just that customers often, and rightly, feel that it is impossible to link value to specific products. Therefore, the market-based pricing method is what actually works in the real world.
Pricing is a hot topic in several industries. Most of us are aware of yield-management in the airline industry where different classes of customers (e.g., leisure travellers that book early versus businesspeople that buy at the last minute) pay different prices. In the software industry several companies, especially those with SAAS offerings, offer “freemium” products – you can use a free version upto a certain number of users etc. In the world of web 2.0, social media and online gaming, there are challenges such as what to charge for virtual goods, how to monetize offerings (e.g., Twitter) etc.
There is a lot of debate about pricing in the world of enterprise software as well as consumer software. Recently Techcrunch published a great writeup on free pricing in enterprise software. Bill Gurley from Benchmark Capital has a nice writeup on pricing-related opinions of several notables including Malcolm Gladwell (author of Outliers, Blink (my favorite book) and Tipping Point). My perspective is that nothing of value is ever free. In the enterprise software industry, newer technologies such as cloud computing and web 2.0 collaboration are enabling vendors to provide freemium offerings – the vendor benefits by lowering the cost of pre-sales (instead of viewing demonstrations, why not try the software for free!) as well as by getting faster product feedback (therefore lowering the cost of product management/development etc.). In my own experience as an entrepreneur I started using free versions of software until I had to upgrade because of increased users – I paid because I saw value.
Pricing is a complex topic with nuances such as price differentiation, dynamic pricing (i.e., the price changes with supply and demand) and monetization strategies (e.g, Twitter). Despite the complexities, I have seen that conventional economic principles of supply and demand still influence prices. My simple rule of pricing is to set a price that is close to that of similar products and then run it by your customer – the customer will most probably compare your price to those offered by the competition, and eventually pay what the customer feels is the right price – which is essentially the market-based price!
What do you think?