Pricing a product or service is a delicate art; there are many options to choose from, and the optimal one is never set in stone. In this tutorial, we run down some of the popular methods and how you can select the most appropriate strategy for your business.
Define Your Type of Business
Before choosing the pricing strategy, you first must define what type of business you’re pricing for. It is very different to sell to companies (business to business, or B2B) than it is to sell to final consumers (business to consumer, or B2C). Depending on which type of client a company has, different implications have to be thought out before choosing the pricing strategy.
Although for many readers, the difference between both types of companies is clear, it is worth defining them:
B2B: A company with a business-to-business model is a company that sells to other businesses. The ticket size per transaction is usually large, but the sales cycle is also generally longer than selling directly to consumers, depending on the size of the companies involved. Furthermore, a sales process within the B2B sector can usually involve several bidders that compete with each other (request for proposal). Finally, a B2B transaction tends to have recurrent customers that buy frequently from the seller, which helps with cash flow. Some could argue that B2B is a more quantifiable business model to price towards, as business owners are largely drawn to products that either help them sell more or spend less.
B2C: A company with a business-to-consumer model is a company that sells directly to the individual consumer. The ticket size per transaction is usually smaller than B2B sales, but the purchaser usually decides to make the transaction immediately. The stickiness of a B2C customer is frequently lower than that of a B2B client.
Recently, there have been a few additions to this simple classification, such as business-to-business-to-consumer (B2B2C) or direct-to-consumer (D2C). For pricing implications, most of these additions can be grouped into B2B or B2C.
Types of Pricing Strategies
Once you have defined what type of clients your business caters to, you can review the different pricing options available and the implications that they might have on your growth. It is important to note that this is just an overview of each pricing strategy, and the application of different pricing strategies will have other effects depending on the business.
SaaS Pricing: SaaS means software as a service, which is a software distribution model in which another company hosts an application or product for the customer, and the customer can access it through an internet connection. SaaS pricing is usually periodic, where the customer pays for the right to use the software for a specific period. Unlike traditional software models, where a lump license is bought outright for one version of a product, SaaS business models charge customers into perpetuity for new iterations of the service.
Freemium Pricing: Freemium pricing means offering your customers some product features for free, with the expectation that they get hooked on the service and eventually demand more features that will be charged. Spotify is a great example of freemium pricing: At first, you sign up for free streaming, accepting ads every once in a while. After a few months of this, you get tired of hearing the same ad again and again, and you finally pay the monthly fee. Dropbox is another notorious example: You use the limited free space for your family photos, but once you reach the limit, you are hooked and decide to pay for the premium version.
Tiered or Goldilocks Pricing: Tiered or Goldilocks pricing offers several pricing options to the customer, usually going from basic all the way to enterprise. Businesses structure them in ways such that a customer eventually increases their knowledge and use of the service, hits a roadblock in their current service plan, and then upgrades. For example, once again, look at Dropbox, which, as you can see, offers three different business plans for customers depending on customer needs.
When considering the Goldilocks pricing option, it is important to know what objectives you have for your company. Two different goals can be pursued:
Nudging the customer to choose a specific option, which is usually the middle price between the extremes. This strategy is also called the anchoring effect. In the Dropbox example, it seems the company is pushing customers to buy the Advanced model, which has unlimited space versus “only” 2TB.
This Ted Talk from MIT professor Dan Ariely provides one of the best examples available (starting at 12:25), where he speaks about a specific case. In this real-life example, The Economist provided its readers with three subscription options: an online subscription for $59, a print-only subscription for $125, and finally, a third option of print plus online, also for $125.
Ariely showed his MIT students all three options to see what options they would choose, and the results can be seen in the following table:
As the table shows, 84% of students chose the print and online option. After this first survey, Ariely removed the “print only” option and gave a separate group of MIT students the same study with the two remaining options. These were the results:
The difference in results is clear: Only 32% of students chose the print and online option. If these were real results for The Economist, offering all three chances with the “print only” anchor would have increased revenue by 42.8%. Clearly, anchoring through Goldilocks pricing can be a highly effective strategy for getting the maximum value from your products and services.
One-time Licensing Fee: In a one-time licensing fee, the customer buys the software or product one time, and the customer owns it without any more payments. One clear disadvantage is that this pricing strategy does not make the customer sticky, as the transaction is made only once. Another disadvantage is that there are no immediate incentives for software updates and maintenance. From a cash flow perspective, this pricing model also results in irregular periods of high cash inflow around times such as a new release, new budget years, or even Christmas.
This option was popular before the rise of the internet (remember buying Microsoft Encarta every year?) and the resulting ability to upgrade and maintain software online.
Per User/Seat Pricing: Per user/seat pricing means pricing in conjunction with how many users per customer will use the product. This option is also called per-license pricing.
Enterprise Pricing: Enterprise pricing is ad-hoc pricing that a company prepares for a large client that cannot fit into a standard option plan. Usually, enterprise contracts are closed for at least a year, as the amount of development and setup work is significant for both parties.
Cost-based Pricing: Cost-based pricing first analyzes what the actual product costs are, and then, based on that cost level, the business increases the pricing by a certain percentage. For example, a physical store retailer can decide that it will sell all items at a 100% markup. Therefore, if it buys a product wholesale for $10, it will sell the product at $20. This option is very common among retail companies.