If only software vendors could do pricing like a college does. Let me explain by reminiscing about, well, college.
In my college economics class I was introduced to the term “price discrimination.”
Sounded at first like something only a villain would engage in. Even after learning that it just means selling the same product for different prices to different people, it didn’t sound great.
But I came to realize it’s what every business aspires to do.
“Price discrimination? Never heard of it, but I like the sound of it…”
We all know products and services are worth more to some people than others.
- A bottle of water is worth more to a dehydrated person in the desert than to someone next to a bubbling spring.
- A plane ticket is worth more to someone urgently trying to get somewhere at the last minute than to someone planning a trip months ahead of time.
- Collaboration software is worth more to a group of co-workers trying to get a lucrative project done than to a bunch of buddies who could just as easily text each other.
Getting paid more for the extra benefit some buyers get gives the seller the means to invest more in the business, innovate, expand, etc.
And so yes, price discrimination is actually fair, reasonable and ethical.
Not a villainous plot at all. It makes sense to charge people different prices for the same thing.
But it’s really hard to pull off. Except if you’re a college.
Imagine if every business could do what a college does:
- First, they make you apply for the right to be their customer, and use your application to assess how much you want what they’re selling.
- Then they make you tell them every private detail about your financial situation and ability to pay.
- They even co-opt the U.S. federal government to help them find out what they want.
And only then do they tell you how much they’re going to charge you (effectively, factoring in financial and merit aid, etc.). Plus they give you a deadline to buy and make it clear there are many other eager buyers on a waiting list you should you decline.
If only we could all do that!
“You’re jealous, aren’t you. We also get summers off.”
But, of course, we can’t. There are very few markets where buyers will put up with this kind of scrutiny.
It certainly isn’t going to happen for any software business.
Instead, we have to find other ways to charge different buyers different prices for the same thing.
Enter value-based pricing.
This one I had to wait until business school to learn about. But I think everyone reading this article probably already knows what I’m referring to.
Value-based pricing is when you set the price for a product based on the value the customer will derive from it. The practice stands in contrast to cost-plus pricing, which is when you simply add a mark-up to the production cost of a good.
Doesn’t sound much different than price discrimination, does it? But there is a subtle difference, in practice.
To do value-based pricing you need to identify a value metric to use as a basis for pricing, instead of just declaring who pays how much. The right value metric gives you a pretense for charging each customer a different amount.
With the right value metric, as the metric increases, the customer’s value increases, and so does the amount they pay you.
So, even though buyers may all get an “entitlement” (to use a term pricing nerds love) to the same set of features, functions, etc., they’re paying vastly different amounts for it.
“Can we go back to pricing entitlements?”
With a value metric you can charge people different amounts without getting the federal government involved.
Problem solved? Not quite.
There are enough value metrics out there to choose from to make your head spin.
You might use metrics that track what the customer does with the software, such charging for each:
- Data volume unit
- Computing power unit
The idea is the more of these things the customer does or uses, the more value they’re getting, and the more you should get paid.
These kinds of pricing metrics are getting a lot of attention lately as the topic of “consumption-based” or “usage-based” pricing is getting hot.
I’d argue this exciting, new approach to pricing isn’t actually that new. What is new is the idea of not making buyers commit in advance to a certain level of consumption or usage, and instead having them pay for however much or little they actually use over time — made possible by SaaS delivery models.
But let’s set that aside for now, as it doesn’t change the fact that these consumption and usage metrics are only proxies for value.
They’re only proxies because just because someone is using a certain amount of something doesn’t mean they’re getting value from it — like Michael Scott and his multiple magic sets.
Imagine the pricing strategies that would come from this brain trust.
So, you might instead use metrics that align with actual results achieved, such as charging for:
- Online views garnered
- Clicks achieved
- People in a target audience reached
- Revenue generated.
But other than revenue, even these are arguably proxies. And charging based on revenue is tough to pull off.
At least you have lots of choices. Lots and lots and lots of choices…
Everyone says choosing the right value metric is the hard part. It isn’t.
The hard part is choosing how many value metrics to use.
As appealing as the idea of a value metric is, any single value metric is really a blunt tool for capturing value with pricing. Even though prices go up as the value metric goes up, the price doesn’t go up exactly proportional with the metric.
Sometimes a buyer is getting value in a way not captured by the value metrics, so there’s a little wiggle room in between the value they get and the price they pay.
And in that wiggle room lies a terrible temptation to try to add more value metrics to a pricing scheme to better capture value. Pricing teams with lots of value metrics to choose from can be like a kid in a candy store.
Here’s an example:
A consulting client of mine wanted to create pricing for a new product. Their customers were companies that sold products through retailers. My client’s software would help users make better decisions about their products that would drive incremental retail sales.
To establish value-based pricing, my client wanted prices to increase as the customer used the software to drive sales..
There were many value metrics they could choose from. But no single one of these value metrics perfectly tracked the benefit a customer would experience with the software.
This is what I mean:
- Their pricing might have used product SKUs as a value metric — the more SKUs being analyzed, the more of an impact on retail sales, and so the higher the price would be. But then every time the customer used the software with a new retailer, they’d benefit greatly (by driving more sales through that retailer), while my client wouldn’t get paid any more because the number of SKUs wouldn’t have gone up.
- So, they could also include the number of retailers as a value metric. But not all retailers are made equal. Some might be a major channel, with lots of sales activity. Others might have a smaller impact.
- So they could add incremental revenue as a value metric. That’s always tricky, though, because it begs the question of how much of the revenue came from the software versus other factors. And even if they did, some revenue might be earned by using the software a lot, while other revenue might take less work.
- So maybe they should also add some measure of the volume of data going back and forth between the customer and the retailer, or the number of ecommerce website pages products were presented on, as measures of software usage — especially since these factors also drove up my client’s SaaS delivery costs.
And this was only the beginning of the thought process.
Before long, we had a list of value metrics so long it made their pricing scheme feel like an airplane cockpit, in terms of the complexity of all the dials and knobs they could turn.
“Just give me a sec, I’ll get your pricing ready.”
If they had used all these value drivers, or even more, it could have become a theoretically near-perfect pricing scheme. My client could have dialed in a price for every buyer that almost exactly captured the value they would realize by using the product.
There was only one problem.
Buyers hate pricing complexity.
Even if they understand and appreciate why a product might have complex pricing, customers hate it. It makes them work too hard to understand how much they’re going to pay. It makes it hard to predict costs. It makes them feel nickel-and-dimed (<<US slang, click for definition!).
Worse yet, it slows their buying process and makes them second-guess their inclination to buy.
I truly believe a software vendor can use simplified pricing as a competitive differentiator, and I’ve seen it happen often.
The simpler pricing is, the more likely customers are to buy, even in a complex, expensive deal.
And since pricing is a part of messaging — a topic that deserves a whole article unto itself — the simpler your pricing, the clearer the message, and since pricing is a message about value, it’s a critical topic.
So, vendors basically have to strike a balance in their pricing between including enough value drivers to not leave too much money on the table, and not making the pricing too complex.
“Not too complex/not too much money on the table. Focus. Breathe.
Not too complex/not too much money on the table…”
And that’s a hard balance to strike.
It’s hard because when you strike the right balance, it feels wrong to everyone.
Some people are going to want to try to extract every last bit of money from a customer, based on exactly how much benefit they’re getting from the product. They’re going to want to use as many value metrics as possible.
These people are often:
- The executives responsible for growth, who are looking for ways to squeeze a little more revenue out of every customer.
- The product people, especially those with an engineering background, who are comfortable with complexity and are, understandably, in love with everything the product does — and feel the company should get paid for every little thing that’s been built.
- The finance types, who may have a more theoretical view of pricing, akin to my college economics professor, and who cringe at the thought of realized value going unpaid for.
On the flip side are the people who want pricing to be as simple as possible, to eliminate friction and make it easy for prospects and customers to say “yes” and buy and consume the product.
These are often:
- Salespeople, who generally want the most friction-free path to a deal closing, even if a little money is left on the table (because a closed, imperfect deal is better than a perfect deal that was lost).
- Customer success teams, who are usually the ones who have to deal first-hand with customers frustrated by over-complicated pricing, especially when it means they have to pay extra for something they feel should be included with that the already bought
- Marketing people — especially product marketers! — who like everything to be clear and simple, including pricing
This makes the pricing process often feel more like a tug-of-war than a tightrope balancing act.
This group most resembles…Sales? Marketing? Product? You tell me (but don’t tell them).
And which side wins depends on all the usual corporate factors — power, influence, timing, political maneuvering, etc.
But it’s better if no one “wins.”
Finding the right balance between all these pricing factors means no one feels like they’ve won. Instead it’s a compromise, which leaves everyone feeling a little dissatisfied and thinking that the pricing feels slightly wrong.
The “leave nothing on the table” people will feel you could get just a little…bit…more…out of every deal.
The “make it easy” people will feel the pricing is a little…too…complicated…and that buyers will hate it.
At that point you pretty much know it’s right.
So how do you find that sweet spot, where pricing feels slightly wrong to everyone and so is probably exactly right?
Here are some tips.
- Consider all your options: explore all possible value metrics and don’t rule any out at first. Don’t be limited to value metrics that have precedent in your market or target industries — think creatively to come up with new ideas.
- Design ideal pricing, then pare back: go crazy to begin with and design pricing that would perfectly capture customer value, no matter how many value metrics you use and how complicated it gets. Consider this the starting point, and then start to pare back the complexity to strike the right balance.
- Have a sounding board: line up a few people to give you reactions to your pricing scheme as you develop it, preferably some combination of the two groups mentioned earlier (those inclined towards more complexity vs. simplicity), or even real customers if possible.
Not THIS sounding board.
- Run scenarios: identify several customers that represent very different profiles. As you pare back complexity, see how the new pricing would impact these profiles. Watch out for situations such as where you know a customer would pay $100k per year, but your new pricing has them only paying $25k.
- Assess the interplay between revenue per deal and wins: don’t forget that simplifying pricing can increase win rate. As you run your scenarios, don’t just consider how much money you’re capturing or leaving on the table in each deal, but also how many new deals you’ll win with different pricing schemes. The same is true for charging for new features or new modules, in terms of adoption across your customer base.
- Capture more than you leave on the table: as you pare back, a good rule of thumb is to make sure you’re capturing more value than you’re leaving on the table. Running scenarios can help with this, too. For each customer profile, see how much value you’re capturing versus missing out on.
- Watch out for cloud costs: make sure you don’t inadvertently remove a value metric in the interest of simplicity that actually protects your margin. For example, if two customers would pay the same price, but the SaaS costs for one’s usage is much greater (due to more computing power, data storage, network bandwidth, etc.), you’ve probably cut the wrong value metric.
- Test, if possible: as with all things in marketing, it’s best to test pricing as much as possible before rolling it out formally, to see what the market’s reaction is. For enterprise deals where you don’t make pricing public, try new pricing schemes in a few deals. If you do publish pricing, test pricing on early adopters or in your customer base before publishing it.
- Have a pricing committee: the question of “who decides pricing” is murky at many companies. As bureaucratic as it sounds, it’s best to set up a formal pricing committee as soon as possible. Marketing should the process, but have cross-functional representation on the committee and have the committee approve all pricing decisions. This usually yields the right balance between all pricing considerations.
Imagine if colleges priced like software companies.
I’ve got kids in high school and college in the near future, so I can’t help but go back to the opening point of this article and imagine what it would be like if colleges priced more like us in the software industry.
Competitive bidding, volume discounts (less for the second kid!), room for negotiation, special treatment if you do a case study, sweetheart deals at the end of the quarter, and maybe even free swag!
Sounds pretty good to me. But it’s never gonna happen.
Sometimes a parent can only dream.