The Definitive Guide to Product Pricing
Pricing is one of the most important decisions you will make for a product. Price your product too high, and it might not sell; too low, and you risk cheating yourself out of a profit. But there’s much more to it than that. Gone are the days of cost-plus pricing or calculating your product costs and adding a certain percentage. Today, there are myriad pricing strategies to choose from, including Pragmatic Institute’s favored—value-based pricing. Here’s everything you need to know about how to price a product.
What is pricing?The concept of pricing is simple: It’s the amount of money you ask your customers to pay for your product. That could be in the form of a single transaction, subscription model, pay-as-you-go or some other cadence. But make no mistake, pricing shouldn’t be decided lightly. It’s one of the most important decisions you’ll make about your product, and it can make or break your business.
Why is pricing important?
Pricing is quite possibly the most important decision you’ll make for your product. It has far-reaching effects beyond the cost of the product. Pricing is just as much a positioning statement as a definition of the cost to buy.
Price defines the entry threshold: who your buyers are and their sensitivities, which competitors you will encounter, who you will be negotiating with and what the customers’ expectations will be. Good pricing will remove the price issue from being an obstacle to a sale. Pricing is also used as a weapon to fight the competition as well as gray markets. Pricing is unique from other marketing decisions for several reasons:
- Price is the only marketing element that produces revenue. All other marketing decisions produce costs.
- Pricing is the most flexible marketing decision.
- Pricing reflects a product’s strengths and weaknesses. It implies value as well as positioning.
- Pricing has the most immediate impact on the bottom line. For example, in the high-tech industry, a 1% increase in price can lead to a 10% (or more) increase in profit. This is twice the effect that the same change in volume, fixed or variable costs have on profits.
Pricing is just as much a positioning statement as a definition of the cost to buy.
What is pricing strategy?
Pricing strategy is the method a company uses to assign prices to its products. There are numerous pricing strategies out there; the trick is finding the most appropriate one for your business and product. A lot of it has to do with an organization’s size, maturity and strategic approach. But in all cases, one of the first steps is to map out pricing methodologies and models. At Pragmatic Institute, we’re proponents of the value-based pricing strategy.
When should you consider pricing strategy?
Often, pricing conversations occur far too late in the product development process. If you want to create more profitable products and product portfolios, it’s important to incorporate pricing concepts from the outset. In fact, your pricing strategy should begin taking shape in the business plan: Which packaging, pricing and business models will be used to achieve the forecasted results and support corporate goals? Equally important is understanding the buyers’ problems we’re solving. Delivering a market-viable price point and approach requires insight and confirmation from the market.
Who owns pricing strategy?
Having a single owner of product pricing is aspirational at best. After all, setting price is just one part of the process; it’s not the finish line. Pricing is about setting a strategy based on understanding the market and your competitors and developing policies and processes to govern and monitor pricing. Product teams, executive teams and operational groups must all participate if your pricing strategy is to be successful.
That said, delivering a market-viable price point and approach requires insight and confirmation from the market. This is something often best provided by product team members. They can provide input through market validation and iterative interactions. However, that product team may not actually determine the price. Ultimately, it may be determined by a committee, by finance or even by sales.
Pricing is a team sport. It requires involving executives in strategy, product teams in business planning and opportunity analysis, development in problem solving and sales in engaging buyers. Although the product team should be centrally involved in mapping the first steps—and perhaps own one or more steps in the process—the continuum from strategy to execution creates a level of complexity that can only be managed from a team approach.
And remember, no matter who owns pricing, systems, processes and metrics are needed to monitor and gauge effectiveness. Your product’s perceived value can change based on where the market is in adoption, the influence of competitors and the dynamics of an evolving product. Monitoring helps you understand the value you deliver to the market, and everyone must own that.
Whichever route your company chooses, it’s imperative that you build a pricing strategy that your sales team will champion.
What are some examples of pricing strategies?
There are plenty of pricing strategies to choose from, and in some cases, you may decide a combination of pricing strategies is best. The strategy Pragmatic advocates for whenever possible is value-based pricing. Here, we outline eight pricing strategies to illustrate their uses and differences.
Value-based pricing is when you charge what the market is willing to pay for your product. It’s the ultimate win-win scenario, in which you get the revenue you require and the customer feels as though your product is worth what they are going to pay for it. This makes for a reciprocal long-term relationship, whereby both parties are satisfied. How can you be sure you’ll get the revenue you require? Because you’re going to consider price from the very beginning in your business plan.
Price segmentation is when you charge customers differently for the same or similar products based on their ability or willingness to pay. For example, software companies that price student products lower than nearly identical professional products are using price segmentation. They do so because they know when someone trains on their software, they’re more likely to use it in their career.
Dynamic pricing is similar in concept to price segmentation except that instead of charging different prices for different customers, your prices change over time with environmental factors or demand. Movie theaters have long used dynamic pricing by charging more for evening showtimes than matinees. Gas stations also use dynamic pricing—when oil prices go up, they raise gas prices, often the same day.
Portfolio pricing is when you consider your entire product portfolio when establishing prices. You may price some products lower than you otherwise would if they stood alone but are willing to take a hit because it makes the rest of your portfolio more attractive and the product seem more valuable to customers. This is the loss-leader concept. Fast-food dollar menus are an example of portfolio pricing at work. McDonald’s is happy to charge at or even less than their cost for a hamburger because they know most of their customers will also buy fries and a drink, too, and those products have great margins. Printers are another example. Companies might charge less for the hardware knowing they’re going to make up for it in the revenue they make in ink.
Price skimming. Popular with technology device companies including, Apple, price skimming is when you initially charge a high price for a product and then lower it over time. With this strategy, you’re charging early adopters more for the privilege of having a product before anyone else. Then you capture more of the market when you lower your price.
Cost-plus pricing is the old-school (and largely outdated) method of determining your product’s price, in which you calculate the cost to make your product and then mark it up a certain percentage or margin.
Penetration pricing is the “torrent of nickels” concept. It involves pricing products very low, usually not far above cost, to attract many buyers. The idea is that while you don’t make much on any individual sale, you will make a lot if you can capture a large portion of the market. Think Amazon and Walmart here.
Competitive pricing is when you base your prices off the prices of your competition and match or undercut them. Of course, you’ll want to research the competitive landscape and consider your competition’s prices, but basing your prices entirely off of another company’s prices is almost always a bad idea. First of all, how do you know your competitors priced their products well? And the competitive pricing model often leads to pricing wars, which are bad for everyone involved.
The strategy Pragmatic advocates for whenever possible is value-based pricing.
How do you determine value-based pricing?
The central question you need to answer when using the value-based pricing strategy is “What are my customers willing to pay?” And answering that question requires legwork and market research in the form of understanding market problems and through win-loss analysis.
The key to value-based pricing is surveying your market and asking them what they’re willing to pay for a product. While everyone’s surveys and questions will look different depending on their market, product, whether it’s a new product or a features release, etc., there are some best practices to consider. For instance, don’t simply ask customers what they want to pay for a product. They will low-ball you. You’ll need to do a bit more digging and extrapolating. Instead, try asking such questions as:
- What do you think your neighbor might be willing to pay for this product?
- What would you consider to be a low price for this product?
- What would be a fair price?
- How much would be too much to pay for this product?
For a step-by-step lesson on how to price a product using value-based pricing, register for Pragmatic Institute’s Price class today.
What are pricing models?
Pricing models are the specific ways customers pay for your products. Whereas pricing strategies are company-focused—they’re the methods you’ll use to determine how much to charge customers for a product—pricing models are customer-focused. They outline exactly how your customers will pay you. Traditionally, sales happen in a single “per unit” transaction, where customers give a company money and then receive a product. But today, there are lots of different pricing models, particularly when it comes to software and other technology-based products. Here are some common ones. Note that combinations of these pricing models are possible.
- Per unit. Also known as the “per seat” model in software. This is the way most people buy their material objects: home, car, software licenses, etc.
- Concurrent users. Cost is determined by the number of users that can access the service, application, etc. at the same time. The concurrent user model is common with server-based applications such as databases.
- Per usage. In the per usage model, the cost is proportional to the extent of usage. The most common example is long-distance calls and home utilities such as electricity and gas. Depending on the product, an initializing or installation fee might be tied in.
- Per unit of infrastructure. The product, such as a database, is licensed per the number of CPUs on the machine that runs the application.
- Revenue share. The customer pays a percentage of the additional revenue achieved when utilizing the product. The revenue-share model works best when the vendor manages the collection of the revenue.
- Cost savings. The customer pays a percentage of the savings achieved when utilizing the product. This can cause customer antagonism because the need to open books and share financial information will be seen as an intrusion.
- Site license. The customer pays a flat fee. Site licenses are used mostly when usage is widespread in large companies. A site license saves customers the trouble of managing licenses when the number of users fluctuates
Pricing mistakes to avoid?
Pricing your product seems simple enough, but there are plenty of opportunities to make mistakes. Here are some to avoid:
- Waiting until launch to determine pricing. Pricing should be part of your product business plan and considered from the very beginning. After all, if you don’t know if and how much your market is willing to pay for a product, how can you tell if the product will be viable?
- Overly complicated pricing. Confused minds don’t make purchases. When you start adding too many options or make pricing too complex and confusing, your customers will have a hard time making a decision and will shut down. Use the simplest pricing models possible for your products.
- Failing to test your pricing strategy. It’s necessary to test your pricing strategy against sales scenarios. One way to test the fit is to list various sales scenarios and compare the effect on revenue caused by changes of the pricing model and the price points that feed into it. You should also compare your pricing to your competitors. If differences cannot be justified, you’ll need to rethink your pricing.
What to consider when pricing for international markets
Pricing for international markets is one of the more challenging parts of product planning and development. There are several things you need to understand, the most important being: Different countries will have different willingness to pay for your product, and that’s if they’re willing to pay for it at all. Just as you will do research and conduct surveys before setting a price strategy in the U.S., you’ll need to do the same in any country or region you wish to sell in.
Some factors that will affect a market’s willingness to pay include:
- Level of competition or alternatives available in that country
- Differing tastes and preferences
- Varying government regulations
- Currency fluctuations
For more on what to consider when pricing for international markets, tune in to our podcast with Mark Stiving.
Learn more about how to price a product
Pricing is one of the most important decisions you’ll make for your product. To learn more about pricing, including step-by-step instructions on how to price a product using value-based pricing, register for Pragmatic Institute’s Price class today.