Know how to price your software product effectively – a definitive guide to pricing economics and improving your bottom line
If you are a budding entrepreneur, you must have struggled with pricing your product. It is vital for every startup to know their customer base, understand software pricing strategies and the importance of pricing software or SaaS products in a way that can help your business be successful in the long run.
You’ve created a groundbreaking product that is ready to disrupt the space it operates in. Your investors are happy with the end product, your target audience loves your marketing campaigns, and you’ve hit the market at the right time. But somehow, you cannot find the numbers you need to ensure profitability. If you cannot find faults with the product or your go-to-market strategy, have you thought of learning more about how to price a product effectively?
Most customers are inherently “price-sensitive”. Although this “sensitivity” to the price of a product may be at different levels, too high or even too low a price can put off potential customers.
A well-known example of a product losing steam because of its cost is Google Glass. A head-mounted device with smartphone capabilities was the first attempt of a major tech company to connect the typical customer to augmented reality. Although the product lost favour with customers due to multiple reasons, the price was an important factor.
As a customer, I love a deal when it comes my way. When I started as an entrepreneur, I was a one-man army for nearly everything tech and non-tech. I would create the newsletters by hand and even send out mailers to my target audience on my own. I shied away from purchasing subscriptions for SaaS tools such as Grammarly because they were too expensive for me at the time.
One day, I chanced upon a promotional email from Grammarly offering me 20% off on the current running price on my birthday. I quickly did some math and found that Grammarly would help me and my team write clearly and effectively.
I bought the subscription immediately—because Grammarly had gotten the price right for me with the discount. I was now paying an amount that offered me more value for money, making the purchase a no-brainer. I also understood the value of the discount offered for a limited time, making the purchase a no-brainer.
What is software pricing?
Software pricing is setting a final cost for your end product. You must balance this number to ensure that you see a steady flow of customers while ensuring profitability. It would be best if you considered the following factors before you decide how to price your software product:
- Cost of product development
- Cost of infrastructure
- Revenue goals
- Competitive product cost analysis
Businesses thrive if they are in profit, and getting your product pricing right ensures profitability. If the pricing of your software is not optimized, the fundamental economics of your business go off balance.
Please note these essential facts about software pricing
Pricing is not a one-time decision
A simple way to determine the price of a product is to add up all the costs involved in creating your product and bringing it to the market. Add your profit margin on top of this value, and you’re golden!
There is no “wrong” price for your product
If you are unsure about the right price for your product, you can use a price comparison engine such as Google Shopping, PriceGrabber, Shopzilla, and many others. A price comparison engine can help you see how your product stacks up with the competition regarding price and features. This can give you a good idea of where to begin.
Understanding the connection between pricing and human behaviour
Pricing is the most complex topic that you may face as an entrepreneur or a product manager. Experimenting with the pricing of your product can result in unprecedented growth and drive your company towards the path of profitability faster than you expected. However, getting the pricing of your product right is not easy.
Buying a product is a process of the heart and not the mind. This essentially means that you make purchase decisions for emotional reasons even when you’re thinking analytically.
How is the value of a product determined?
Did you know that software pricing is dependent on the concept of value? Highly-priced products are considered better than their lower-priced counterparts and seem to offer significantly more value. Additionally, inculcating a sense of scarcity—labelling products as a “limited edition” can expedite the time taken to purchase a product.
However, the value of a product is perceived individually. This makes software pricing complicated and a sweet spot challenging to find, but it is the best software pricing approach.
The importance of pricing for a SaaS product
The viability and growth indicators of a SaaS product lie in customer acquisition, customer retention and monetization. Not many companies believe that monetization has the maximum impact on a SaaS company’s bottom line.
This is because struggling SaaS companies want to maximize user count while ignoring their bottom line. A survey of over 500 SaaS companies by Price Intelligently found that monetization was the key to the growth of SaaS businesses and not customer retention or acquisition.
Their data showed that knowing how to set a price for a product appropriately was 2x as efficient as retention and 4x as efficient as acquisition in improving a SaaS company’s bottom line.
Pricing touches every part of your business
Considered to be at the intersection of marketing, sales and product development—pricing plays the most important role in the growth of a company. Yet, no single department takes ownership of the pricing of your product.
Product pricing must not work in a silo—it must be a joint effort with inputs from key departments, including marketing, sales, management and product.
Here’s how each of these departments impacts pricing:
- Product developers build features for a product based on their deep understanding of what their users want. This is necessary for the packing of your end product or offer.
- Marketing teams understand buyer personas and target groups. They understand the messaging that will resonate best with each user group and know how to communicate pricing.
- Sales teams know the common queries of customers and the objections they may have. Involving sales with pricing helps develop better pitches and generate more accurate sales forecasts that can directly impact revenue.
- From the CEO to the company’s executives, your management must coordinate pricing by getting inputs from all the other departments to arrive at an appropriate and viable SaaS pricing decision.
Pricing is vital for your unit economics
Every business strives to enhance and improve its customer lifetime value and decrease its customer acquisition costs. This is the only way to achieve growth as a business.
As your cost to acquire new customers reduces with an efficient pricing strategy, you generate more lifetime value from each customer acquisition, leading to a better bottom line.
If you are constantly thinking about “how much should I charge for my product”, it is essential to understand a little about unit economics.
- CAC or customer acquisition cost is the total cost of sales and marketing divided by the number of customers acquired. This is the cost of your marketing and sales efforts to get a new customer on board.
- LTV or lifetime value is the average revenue per user (APRU) divided by your churn rate. This means that your LTV will be what you will earn from each customer as long as they use your offering.
It is essential for any company, including SaaS companies, to have an LTV/CAC ratio of >1. Note that your LTV must be substantially higher than your CAC for long-term growth, which is the fundamental tenet of your cost-plus pricing strategy.
Understanding software pricing strategies
What pricing strategy should you use, and how often should you validate it?
Most companies do not put enough thought into pricing their products. They also do not understand that pricing is a continuous process to attain maximum value per sale.
The three common strategies used by businesses to define their product pricing include:
Competitor based pricing
This strategy is equally simple—it uses competitor pricing as a benchmark to set product prices. The problem with this strategy is that you have your competitor’s pricing strategy and not your own.
You are in the market to give your customers something better, which is the primary reason why they will shift their business to you. Additionally, the only way to earn more is to raise prices and become the “expensive alternative”.
In short, competitor analysis should guide you as a company and not influence your pricing decisions.
This is the most straightforward pricing mechanism. You calculate the cost of providing your service, add a profit margin, and done!
The benefits of this strategy include its simplicity (which is only relevant if you know what your costs are) and the fact that it will cover your costs. It is a good starting point and has little overhead—plus you know your profit percentage.
However, there is a problem—for SaaS products, you won’t necessarily know all your costs upfront, and these known costs too might fluctuate over time. So, if your expenses increase by 20%, your 15% margin might not do you much good.
Value-based pricing is essentially customer-driven pricing. This means instead of looking “in” (towards customers or competitors), you look for pricing inputs from the decision-makers—your customers.
The only downside of value-based pricing is that it takes time to get it right. By understanding your customer’s willingness to pay, you can start at a higher price point and raise prices as you add more value.
In SaaS, this makes complete sense—as you incrementally add value to your product, you can quickly re-evaluate pricing strategies every six months and raise prices if you can.
As a SaaS company, you exist to offer value to your customers. If you can figure out what your customers want to pay for your product and what they want as a future feature set, you will be able to easily retain these customers while enhancing your product—while increasing your profit!
Why is it important to know your customers?
Knowing who your customers are will help you create valid, quantified user personas. Quantified buyer personas are the foundation of a company’s pricing strategy and can play a significant role in long-term viability.
Quantitative buyer personas reflect the target market and break it down by the point of contact and define its features (buyer). This means defining the needs and budget of the contact point.
The importance of data
Intelligent, actionable data-driven buyer personas have replaced traditional adjective-driven personas.
Using actual, data-driven characteristics that matter will give you more value than just using adjectives derived from anecdotes and gut impressions. For data-driven customer insights, you must know how to:
- Identify your highest-value customers so you can position yourself well
- Know the valued features of your product that various subsets of your customers ask for
- What are these customer types willing to pay?
- Is the unit economics of these customers profitable for your company?
In short, quantified buyer personas depict value. Here, value means knowing which customers are the most valuable to your company and how you become invaluable to your customers.
With data research and defining these characteristics for your customers, you can understand who they are, what they want from your product, and how much they are willing to pay for it.
So, a data-driven pricing process would follow these four steps:
- Define the problems that are inhibiting company growth
- Use buyer persona data to find the source of these problems
- Find the best possible solution for these causes
- Take the results from your experimentation and assimilate them into your pricing
Problems Faced While Pricing a Software
Here are some common pricing problems faced by software companies and the metrics you must analyze to price your software product effectively:
- Poor unit economics and price sensitivity
Price sensitivity is the degree to which the price of a product affects the purchasing behaviour of your customers. You must collate price sensitivity data according to each buyer persona. An excellent way to collect this data is through a price sensitivity study.
- Poor user retention
The cause for this can be either pricing or packaging. You must run relative preference studies to gather price sensitivity data close to core features and value propositions.
- Low acquisition volumes
The lack of a value proposition is the likely cause of low acquisition volumes. Knowing your customer’s relative preference for value propositions and brand promise through customer interviews is an excellent way to get this data.
- Low conversion rates
Your existing pricing strategy is possibly the root cause of low conversion rates. To know more, run price sensitivity studies segregated by buyer personas.
Why is it important to localize your product pricing?
Pricing localization does not mean just changing currencies. Similarly, one pricing strategy does not suit your entire customer base. Localized pricing takes into account local customer preferences, price sensitivity indices, buyer personas and market saturation.
Using this strategy to price your product effectively across geographies will help your customers find price points that suit their preferences and needs and satisfy their value concept.
Is discounting a bad thing? (A Bonus Tip)
Who doesn’t love a sale? I know I do! However, what works in retail will not necessarily work in software—especially SaaS. Aggressive discounting might raise your customer volume, but at the same time, it will also lead to higher churn rates. Discount customers are less likely to renew their subscriptions when prices go back to normal.
Customers acquired through aggressive discounting also have a higher price sensitivity and are less likely to renew their subscriptions. These customers offer a lower lifetime value compared to those who are more likely to continue.
In the world of SaaS, discounting undervalues a product. You will eventually end up spending a more extended amount of time recovering your CAC. Here’s an example to understand cost-plus pricing strategy that will put things into perspective:
Consider a 20% discount on a product that has a CAC of $6000. At a monthly recurring revenue of $400, it will take 15 months to recover your CAC. You can recover this amount in less than 12 months with a minimal discount by keeping the price at $500.
This also means that customers willing to pay a higher amount will be less sensitive to a value and cost increase of 5-10% over the next year or so, bringing up your bottom line substantially.
In short, be discreet about your discounts and do not broadcast your discount to everyone by offering your product at a lower price across the board.
This makes the ones paying full price for the product undervalued. Only target your discounts and a product cost-based pricing strategy towards those segments that need a push to close the deal.
Vary your offers and keep them for a limited timeframe so that your customers do not expect it and wait for the discounts before renewing or purchasing.
Remember: do not make discounts a habit. Instead, focus on the value proposition of your product to convince your customers that it is worth it at the full price.
Pricing by startup stages
Every startup must think about pricing their products well from the outset. Understand that the pricing strategy and processes will differ depending on your startup’s stage of growth. Here’s how to price your app:
- Pricing for early-stage startups: If you are still searching for that perfect product-market fit, focus on product pricing localization and build trust with your customer in your target markets.
- Pricing for growth-stage startups: Focus on monetization and set pricing points based on market saturation and your customer’s willingness to pay. Maximize returns by optimizing your LTV/CAC ratio. Re-evaluate your pricing every six months and pivot if needed.
- Pricing for growth-stage startups: Expand to new markets and find new users internationally. Localize your prices to become the best fit for your target group.
Pricing and product development go hand in hand. They are both iterative, consistent and dynamic. So, a data-driven approach will tell you how to determine product pricing and reap the rewards of a scientific pricing strategy for years to come!
As a business, you must understand the strategy that suits your kind of business and use the best possible metrics to come to a sweet spot that is beneficial for both you and your customers.
Schedule a 15-minute call with me here if you are unaware of the best way to price your products or need help in understanding market economics and product pricing.