‘The price point defines the sales model. It has to be simple, and you have to know how to make money with it.’ — industry pricing consultant
Pricing 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. Pricing 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.
The most important thing in developing any marketing strategy, including pricing strategy, is to understand as much as possible about current and potential customers. The more you know about their motivations, sensitivities, needs, and their own customers, the more likely you will be to maximize both the effectiveness of your product as well as your own revenue stream.
The purpose of this article is to explore the interrelation between product and pricing.
Before delving into details, here are some common pricing strategies. Note that combinations of these 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.
- Costs 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 wide-spread in large companies. A site license saves customers the trouble of managing licenses when the number of users fluctuates.
The pricing model sets the framework in which the final product price is calculated. Think of the pricing model as an equation. To get to the price (‘Y’) the value for ‘X’ in the equation needs to be inserted. This ‘X’ is the Price Baseline. An example is the price of a user license for a software program. After entering the Price Baseline into the pricing model and relevant discounts such as for volume, the product’s price point is calculated.
Testing the Validity of the Pricing Model
The pricing model should always be tested against sales scenarios. The best fit should be within the target market. Most models will not be optimized for some segments. In some cases, it may cause money to be left on the table or deals to be lost due to too high of a price. 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. This exercise should be repeated at least twice a year. The assumptions used in the comparison should be validated and the model should be tested on the previous quarters’ sales.
Another test for the fit of the pricing model and price point within a market segment is that a comparison with the competitors’ pricing must be made. Take into account the pricing differential based upon positioning and functional differences. If the differences between your price and that of your competitors? cannot be justified, you will either have to change the model or the pricing factors in it.
The last test is the market. Make sure that your prospects and customers ‘get it.’ The pricing model should be simple to explain. If you need more than a couple of sentences to explain the pricing model, it is too complex.
The Vendor’s Side
This section covers vendor approaches to products and pricing. The vendor’s pricing approach may determine the appropriate product packaging or vice versa. Consider a ‘one size fits all’ approach versus a specialized product approach, the logic of adding ever-more features and the impact of product development approaches on the customer’s perception of value.
Divide and Conquer Approach to Productizing
The ‘Divide and Conquer’ approach refers to breaking a whole product into parts and selling these individual pieces separately.
For example, a PC software application originally cost $8,000 for full functionality. A consultant investigated the way people used the toolkit and determined that there were five standard implementations. The R&D department created compile flags that would only include the features necessary for each specific implementation. As a result, the company was able to split the product into five specialized offerings using the same code base and sell them for $8,000 each. The difference was that each version of the new products worked out of the box. People will certainly pay for that!
The tool was originally marketed with a ‘you can do it all with this toolkit’ approach, and afterwards, the approach was changed to a ‘we have done it for you’ approach with the five main uses of the toolkit. In other words, the ‘tool’ was reconfigured and made into five separate ‘solutions.’
In another twist to this approach, a network fault management company decided to charge for the rules that managed individual network element types and not only for the tool itself. The developers didn’t understand why this was done. Non-developers created the rules so, of course, they should be free. Their point of view was that the customer only wants to pay for things created by developers. Contrary to this pretentious view, it was ‘the rules’ that made the real code valuable.
Continuing along this logic with a more familiar application, Microsoft could take a look at Word and other MS Office products. Customers pay hundreds of dollars for an application and beyond the basic functionality, use very little of it. Microsoft might break off some of the more advanced functionality such as the Macro Creator and the Mail Merge tools, package them separately and charge for them. The cost to make these add-ons would be negligible. These tools are used by professionals and would justify a separate expenditure. With MS’s market share, they will be able to get away with not reducing the price for the remaining Word application while charging hundreds of dollars for each of the above add on packages.
Adding Features–Is it worth it?
Ask yourself this question before adding any new feature: ‘Is adding this feature worthwhile?’ One example where the answer was ‘no’, was at OneTouch. OneTouch offers a satellite based distance-learning product. Its users interact with the instructor via keypads and customers began asking for them to be wireless. Everyone saw the benefit of the increased ease of use but when customers were asked, they were only willing to pay 15% premium for wireless keypads. Making the keypads wireless would have cost much more. So OneTouch never offered a wireless keypad. Despite this requirement on many RFPs, OneTouch never lost a sale over this issue.
This begs the question, is it worth adding a unique feature if a single customer pays for it? A prospect recently asked that we develop an integration with a caching server product they use. After a short investigation, it was clear that none of our other customers needed this. In a nutshell, if a company builds a targeted product for a well-defined market, it can rarely, if ever, cost-justify a one-off project. Can you imagine Proctor and Gamble developing anything without a business case or building a product for a one-time purchase? In the software industry, we tend to ignore the lessons of other industries. Agreeing to these ‘one timers’ rarely gets the deal, if ever, despite even after agreeing to what is basically bad business.
Furthermore, the real cost of adding features is not easy to calculate. Most product focused software companies have difficulty estimating the real cost for developing, testing and supporting a feature over time. In many cases, they will underestimate the direct costs. To reach the real cost of adding a feature, vendors must consider the resources that are tied up for the project over time. This is probably the most painful aspect that makes most special feature developments destructive.
Perceived value is the additional value that the prospect attributes to your product regardless of its intrinsic value. Perceived value is subjective and heavily influenced by the company and product image, word of mouth etc. If given a choice between two similar products, customers are frequently willing to pay more for the one with greater perceived value. For example, when given a choice between Benedryl and a generic house brand, consumers will often pay substantially more for Benedryl even though the two products have the exact same active components. Customers will pay extra for the familiarity and confidence that the brand name instills in them.
Creating perceived value is an excellent defense against product commoditization. Successful brands are able to prevent price erosion and demand a price premium by creating and maintaining brand value. Tom Peters has said, ‘In an increasingly crowded marketplace, fools will compete on price. Winners will find a way to create lasting value in the customer’s mind.’
If your price point is above the price the customer sees as the value point, you will either have to enhance the value of the product (an important part of the sales process) or lower the price. When the product is priced above the perceived value, prospects will be reluctant to buy or will tend to haggle on price. OneTouch used to sell its keypads for $235. Customers would constantly bargain with them over their price. Once they lowered the price to $100, the bargaining stopped.
How a product is packaged and delivered can impact its perceived value. Assume your software application fits onto a diskette but it costs several hundred dollars or more. Sending it out on a diskette will be counterproductive. Also, allowing clients to download an application that costs thousands of dollars can have a negative impact on its perceived value.
During price negotiations, the most common pressure is to lower the price of the product. Lowering the price is a lose-lose proposition for the vendor. In addition to the direct loss of revenue, the existing customer base will eventually discover the pricing inequity. New prospects will get wind of the discount and expect it as well. Competitors might feel that they are in a price war and retaliate with discounts or in other ways–creating a cycle of price reductions.
One way to relieve the pressure for discounting is to offer the customer a discount in exchange for flexibility of features, terms and speed of implementation, level of support etc. This approach will work best with a modular product. The ability to be flexible with functionality and terms will allow you to negotiate discounts for appropriate customers and justify cost inequities to current customers.
Products with high switchover costs are always a boon to vendors. The higher the cost to change to another product, the more loyal the customer will be. High switchover costs can be achieved by using proprietary formats and hardware, by creating a product that requires a large investment such as training, or by requiring a large investment in equipment. High switchover costs will also allow vendors to be more flexible in the product price. The profits will be realized once the customer is locked into the new product. The flip side is that not all prospects are ignorant to such issues and the switchover costs can deter them from buying.
Computer Associates (CA) is an expert at taking advantage of high switchover costs. They have made an art form of buying companies with mature products and using them as cash cows. The customers of these companies are many times ‘Main Streeters’ and are reluctant to replace the applications that work for them. CA can then charge a premium for services and support.
‘Velcro’ for Reducing Price Sensitivity
One way to fight price sensitivity is to increase the switch over costs by creating more contact points between the customer and your service. Some call this the ‘Velcro’ approach. By decreasing price sensitivity, suppliers can increases the prices they charge customers. By improving customer intimacy, suppliers reduce price sensitivity and increase the amount they can charge customers.
For example, by offering their customers overdraft protection, banks increase the utility credit card holders see in staying with them. Another advantage is that credit card companies cannot offer the same type of insurance.
Another familiar example is AOL’s strategy. AOL distributes thousands of CDs with their software and 6 months of free service. Their correct assumption is that once a customer has an account with their own email, a buddy list and other features, the willingness of customers to switch Internet provides is significantly reduced. Low incremental costs by user registration automation and a great out-of-the-box experience are what make the Velcro approach possible.
Customer Lock In
Another version of Velcro Pricing can be seen in the printer market. By requiring unique cartridges, printer companies lock in their customers after the purchase of a printer. Due to this lock in, HP and Lexmark can afford to lower the prices of their printers. Their profits don’t come so much from the printers they sell but from the toner and ink cartridges. The printer companies can charge a premium for these cartridges. Once generic refills become available, smaller premiums are still possible because of the perceived value that these brand names offer. There is a tension between the desire for creating unique types of ink cartridges and distribution costs. While the printer manufacturers would like to see a unique cartridge for each printer, resellers would balk at the overhead of carrying so many cartridge types.
For the purpose of this article, standards will be divided into two groups: Proprietary and Open. Embracing, extending, or creating standards impacts pricing as well.
Owning a proprietary standard and a strong market share allows the vendor to raise prices when they own a significant share of the market. The proprietary standard increases switchover costs for the consumers. Familiar examples are Microsoft’s Office products. Most computer consumers use MS Word so the switchover costs to another word processor that is not fully compatible with Word would be too high. By constantly changing the standard, vendors with large market shares can pressure customers to upgrade once the people they exchange files with have upgraded themselves.
When a company creates and owns a standard, even if the standard is openly accessible, they place all other vendors at the disadvantage of playing catch up. This is not only a marketing advantage but a practical one as well. Microsoft’s ActiveX technology is very common on web sites. The Netscape and Opera web browsers have trouble keeping pace. If users want to utilize ActiveX components, they need to stick with the Internet Explorer. This approach works only if the standard becomes widely adopted. Microsoft tried this with its LRN (Learning Resource iNterchange) standard but failed to get industry buy-in and now seems to be abandoning it.
Open Standards refer to standards that are controlled by public bodies such as TCP/IP, HTML etc. In contrast, Open Standards such as TCP/IP, XML, and HTML have both an upside and a downside for vendors. By supporting an open standard, vendors decrease the customers? switchover costs. Newcomers to the market can take advantage of this. For example, switchover costs for customers to another networking card vendor are very low. By supporting the open TCP/IP standard, vendors can make their products interoperable with current equipment and thus more attractive to potential customers.
The Difficult Comparison Effect
The more difficult it is to compare between products, the less price will be an issue in the purchasing process. To make it more difficult for customers to compare products vendors can add features (good for differentiating), obfuscate the function of common features with creative naming, sell the product in a way that makes it hard for consumers to compare as well as create complex pricing models (see below).
Have you ever wondered about all those stores that announce that they will not be undersold? Large retailers with massive product sales can receive a unique model of a product from the vendor. No other retailer will have this EXACT model. This is very easy to do and in consumer electronics, the uniqueness is many times not much more than a different label or box.
One example of products that are hard to compare are mattresses. The comparison criteria are subjective and are based on customers’ subjective memories. Retailers can therefore rely on their consumers to have limited capacity to compare items between stores. By the time they go to another store, the previous mattresses they saw are only a vague memory.
Defending Against Disruptive Technologies 
Disruptive technologies allow vendors to create products with a new approach to solving current market needs. To capture a beachhead in the market, disruptive technologies tend to offer only part the functionality the incumbent offers better addressing the needs of a niche market and for a significantly lower price. A disruptive product poses two challenges to existing vendors. The first one answering the needs of niche markets becomes harder and harder as products grow with the maturing of the technology and the second is that incumbents find it impossible to compete with the price.
One way to better deal with disruptive technologies is to have an entry level offering that can be priced competitively so as to discourage competition and that is flexible enough to refocus it to address competitive threats. An entry-level product built specifically with flexibility in mind is the best option. Due to lack of resources, companies often create a scaled down version of the main product. Another advantage of having an entry level product is having an upgrade path for customers that are not willing to make a commitment out front or that are not big enough to purchase the full-featured product.
Case in point: In 1996, Cimatron, a CAD/CAM software vendor was selling $30,000 plus CAD/CAM software seats. That year, Solidworks announced a product based on a new design technology with a starting cost of $5,000. Initially, Cimatron scoffed at the new product. It only addressed one part of the market and at its price point it could not support professional services, a technician to install it, etc. It didn’t need them. However, Solidworks had clearly identified an unsolved problem in an underserved market segment. After losing a significant part of their market share, Cimatron eventually responded, with their own ‘light’ product. Their delay in identifying the market trend cost them dearly.
Unlike Cimatron, Mercury Interactive, a provider of enterprise testing and performance solutions, was able to take a threat from upstarts and turn it into a hands-down victory. In 1998, when selling into large accounts, they found that two new upstart competitors were already present in many of them. These competitors offered only web based testing but for a quarter of the price of Mercury’s testing suite. During that timeframe, Mercury recognized that the dynamics of web testing had changed, (e.g. downloadable, lower entry level, less technical users etc….) and developed a new product–Astra. The advantages Astra offered customers were: the security that comes with buying from a market leader, an upgrade path (all test scripts were compatible with their enterprise level application) and any customer that upgraded within a certain timeframe would get a refund for their purchase of Astra. With this strategy, they were able to not only stop their competitors but also increase their own market share.
A side note: While not Mercury’s largest source of revenue, Astra has become a significant part of their lead generation efforts.
Pricing and the Technology Adoption Life Cycle
Another way to look at pricing models is from the Technology Adoption Cycle. Where you are with your product in the cycle bears heavily on the approach to pricing you should take.
Early Stage Buyers
The early stage buyer is interested in the technology, often in the form of toolkits. They enjoy being on the ?cutting edge?. Since a lot of their motivation involves ego gratification and gaining some kind of competitive edge, this audience may not see a difficult implementation as a bad thing. This means someone else with less fortitude will not be able to follow his or her trail–at least not easily.
One mistake vendors make with Early Stage Buyers is assuming that a lower price will drive the business–it won’t. It will probably leave money on the table. Lower prices will lower margins, but not raise volume significantly with these buyers.
Main Street Buyers
Main Street Buyers purchase products. Vendors can take two approaches with Main Street Buyers. They can differentiate to keep prices at a maximum or inadvertently enter a price war with competitors. Main Street buyers expect service, reliability, integration with existing systems etc. They will not tolerate what Early Stage Buyers did. With proper planning, the product can spearhead the differentiating effort.
Late Stage Buyers
The Late Stage Buyer buys the #1 (read: safest) company or the cheapest product. These are people who want to know what ‘the thing’ will do for them, whether it really works, and what is involved in running it. This is much more a ‘mainstream’ set of issues. They are hesitant to buy unless they can speak with someone from their industry that uses the product successfully. When you have reached this point in the product cycle, you should be well into introducing the next generation of your product as well as cutting back on your product’s R&D expenses as prices go down.
‘Groucho Marx’ Pricing
Groucho Marx is quoted as saying ‘I do not care to belong to a club that accepts people like me as members.’ Groucho Marx pricing refers to the situation where the pricing can deter ideal customers and attract undesirable ones. The credit industry has this problem where its ideal customers (those that pay their bills), are the ones that need credit the least. This creates a situation where the consumers willing to pay for expensive credit are people that badly need it because they have a bad credit history and are high high-risk customers. This way, a high- end product might inadvertently attract ‘bad’ customers. Or as a paraphrase on Groucho Marx: the credit cards offering is inviting to those that they do not want to sell to in the first place. To avoid this problem, credit companies created a somewhat unique mechanism: They use credit histories to decide whom they want to sell their product to. The customer expresses a desire to buy but the credit card company decides if they want to sell. This model is rare outside the financial services industries.
Variable Pricing Models
Some of the best-known examples of variable pricing models are eBay, Priceline, the airlines and the stock market. In these markets, the price is set dynamically with little restriction. The nature of the markets limits the type of products that can be sold on them.
eBay is the case exemplar of the ideal marketplace. Geography is not an issue prices are set by supply and demand. Consumers know what they are looking for and there is no need for anything beyond a spec sheet. eBay might be one of the cheapest selling channels but this type of marketplace is only good for products that are sold As-Is with easily defined features. Products that require complex service contracts, professional services or presale work are not good candidates for this eBay.
Priceline is similar in the bidding aspect but is fundamentally different in another. It adds an uncertainty in the purchase such as the date for the airline tickets or the exact hotel as a trade off for lower prices. This uncertainty can be seen as a flaw in the offered product. In exchange for this ‘flaw’ and the ability to sell last minute vacancies, vendors are willing to reduce prices.
The new pricing model does not fit all products such as perishables. Imagine for example a bakery that offers slightly stale bread from yesterday at a discount. Most people would not be interested in such an offer.
Airlines have made variable pricing into an art. By segmenting their market, they have created a complex, confusing model. They sell a basically identical product at different prices all depending on when you buy and who they think you are. The first parameter is the time of purchase. The price of ticket is significantly lower if you purchase it at least two weeks ahead of time. Airlines assume that anyone buying a ticket at the last moment or that is not staying over the weekend is a businessman and therefore, they can change more. The reasoning here is that the cost will be covered by the employer so the customer is not as price sensitive as those who are paying out of their own pocket. The second parameter is the Saturday night stay-over. Airlines assume that business people want to return home for the weekend and will charge more for itineraries that do not include the next Sunday. This confusing approach also infuriates the airlines’ customers, particularly the business traveler.
The Prospect’s Side
Comparing Apples to Oranges
The customer needs to be able to compare apples to apples especially when they need to sell the solution internally. If your offering has a unique pricing model, any internal effort to justify buying your solution will be all that more difficult because the prospect will find it hard to compare your offering to that of others.
This issue was brought up when a large online content site convened advertising buyers in an attempt to find ways to increase sales. The buyers complained that the online industry’s terminology, pricing and, ROI models were not standardized and that this was causing a great deal of problems. Creating an industry standard would probably have benefited all the players in the online advertising market.
When this discussion took place in early 2001, the market was mature enough from a technology perspective.
Prospects abhor a proposal that is not capped. If a service costs $10,000 to set up plus 50 cents per minute, prospects will be concerned about what the final cost will be for them. No one wants to exceed their budget so prospects will appreciate a cap to the variable costs. If you have control over the variable costs, you will gain from capping them as long as you can guarantee that no damage will be done to your company if they exceed usage. Imagine the first-time cell phone customer who receives a $200 usage bill instead of the expected $45 one.
To look at another aspect of open ended pricing let’s assume your company resells a product such as conference calls together with value added services that you add on. You purchase the conference calls at a per-minute cost that varies by the location of the caller. You have no control over the actual cost of the call. If the prospect asks for capped price, you should think very carefully about this. The costs that you do not control may come back to bite you?
Pricing Models During a Price War
Earlier in the article, the relationship between the functionality of the product and the pricing model was discussed. Proper product planning and positioning can help prevent a price war by allowing the vendor to charge a premium. However, if the products are similar and as the market matures, price becomes a bigger factor in the buying decision. Pricing wars start once the differentiation within the market space has eroded. Unless the vendors can extract themselves from the price war by better positioning, the vendor that is able to offer lower prices over time will win the price war.
In essence, a price war is not fought with pricing models. If a battlefield analogy is to be used, the pricing model is the transportation device. It is the tool the vendor used to arrive at a price point for the product. The showdown of a price war is focused around the price point, not how the vendor arrived at it. If the vendor chooses to lower prices to fight a price war, the pricing model must be calibrated at a lower price point or discarded all together and the product features must be adjusted as well.
For example, current ERP systems require endless adjustment and configuration. In theory, should the ERP vendors enter a price war, the vendor whose product has the lowest incremental costs during the sales cycle and the installation and configuration is in a better position to survive.
The Pricing Model as a Differentiator?
While the price of a product might be a differentiating factor, the pricing model in itself is not. For a pricing model to offer a vendor an advantage in the market place it must be backed up by a unique product, technology or business model. This is because d