Establishing a SaaS pricing strategy can feel a little like throwing spaghetti at the wall and seeing what sticks. Are your customers willing to pay more? How much is too much? Are you leaving money on the table? Are you delivering differentiated value to your customers?
At the end of the day, your pricing strategy is fundamentally a marketing discipline. Failing to see that can lead Founders to make a few common mistakes when setting the price for their SaaS product. Here are a few we’ve seen, and why you should avoid them.
1. Cost-plus pricing
Cost-plus pricing takes a hard look at marginal cost and adds a healthy margin to meet strategic revenue goals. Pricing above your costs may seem like a logical approach, but this strategy results in prices that bear no relation to what customers are willing to pay.
The customer is not concerned with your cost of production. And in many cases they’re willing to pay more than a cost-plus price, which means that many Founders are leaving money on the table.
Considering costs and price separately frees you up to use price more creatively, such as through the use of loss leaders or discounted elements of a multi-product purchase. For example, many software companies make use of a “freemium” strategy where their introductory product is free. Raising the price by even $0.01 would significantly reduce the effectiveness of this strategy. Despite the fact that free users are technically unprofitable, they are a crucial component to lead generation.
2. Competition-based pricing
On the surface, a competition-based pricing strategy seems like a good approach. When you’re an early stage business, it’s easy to say “well my competitor charges X so I will charge X because they probably did the homework to figure out that price and I need to stay competitive, right?”
If this is your line of thinking, you’re not alone. Entrepreneurs gravitate toward competition-based pricing because they feel embattled. Surveys show that 57% of business owners believe themselves to be in a price war, and of those, 90% of them say the other party started it. This statistic reveals a mistaken perception that business competition is more cut-throat than it really is.
Taking cues from those you’re up against presents two problems: 1) you probably don’t know what’s special about your product, and 2) you’re giving up the chance to do things better.
The first problem – what makes you special? If the pricing strategy for your SaaS business is based solely on staying in line with your competitor, how is a customer supposed to differentiate your value proposition vs. your competition? Imagine this scenario – a customer asks “why does your product cost $99/month?” and you respond “Because the market charge’s $99/month.” If your pricing strategy is based solely on matching your competitor, you’ve just lost a chance to tell your customer the value your product brings over your competitor. This is a differentiation problem, not a pricing problem.
The second problem with a competition-based pricing strategy – all of your competitors could be approaching pricing wrong. You might have an opportunity to do it differently or better. Companies that pioneered pay-as-you-go subscription pricing for everyday products, such as Dollar Shave Club, ignored their competitors’ pricing models to catapult ahead in their categories. Their creativity in pricing structure was actually a part of their value proposition.
3. Economic value pricing
What if you could calculate how much something is worth to a customer? Should you base the price of your product on that amount? Probably not.
This approach, sometimes called economic value analysis, also has a couple problems. The first is that even if you can figure out the full value of your product, you have no logical way to extrapolate a price from that number.
Let’s say that you can quantify that your software will save a customer 200 hours of processing time annually, amounting to $120,000 in cost savings – the value to the customer. Okay, but what percentage of that value is the appropriate price? Should you ask for 20% of the amount you save the company? 10%? 30%? Your decision will be arbitrary.
The other problem is that price level is not the same as price structure. Charging 20% in the previous example, for instance, means you’ll ask the customer for $24,000 to secure its $120,000 in annual savings. The customer, however, only budgeted $10,000 per month to cover its annual cost for that function. They may not want or be able to front $24,000 — more than twice the monthly budget — even if they’d like to reduce their annual costs.
What’s the correct way to approach your pricing strategy?
The only true way to set prices is by basing price on the customer’s willingness to pay. Only willingness to pay captures “perceived value relative to alternatives”. Let’s break this down.
First, is “perceived”. Often a customer’s perception of the price is more subjective than objective. Is your product considered “premium”? How mission critical is it? Is price even important in their purchasing decision? The only way to answer these questions is to go straight to the source – your customers. Set up pricing interviews with your customers and listen to what they perceive to be true about your product.
Second is “value”. Most importantly, “value” is not a single number. What other metrics scale with customer value? Number of users? Advanced features? How do price and value relate to time (e.g. subscription) and volume (e.g. usage tiers)? This is the area of data analysis – everything from simple correlations to complex regressions.
Lastly is “relative to alternatives,” and here I do not only mean competition. “Alternatives” could be using a paper based method instead of software or investing in headcount. Here you need to understand if your value proposition is resonating with customers, and how well you are delivering on their expectations. The simplest way to gather this information is through a well designed pricing survey.
If there is a common thread here, it is that pricing is about understanding your customers, not your margins or competitors. It is about structure rather than dollars and cents. And it is about communicating your value, and asking for a fair price in return. You build your products with the customer in mind – it’s time to price them that way too.