Pricing Strategy: How to Precisely Price Your Product
What Is the Best Way to Design a Pricing Strategy?
In the 1990s, Porsche was racing toward the financial cliff. Their annual sales was a third of what it had been in the 1980s.
The new CEO, Wendelin Wiedeking, was a young executive at 41 years old. He knew it was time to innovate with a new car or risk losing the business.
Rather than creating another high performing race car, Wiedeking’s team began to build an SUV for soccer moms and dads who longed to regain their lost youth. They would call it the Cayenne.
Due to their tight finances, Porsche could not afford to create a car with a bloated design. So the engineering team only added part if the customer was willing to pay for. If the customer was not interested in paying for a feature, it was removed.
A powerful engine and sports car handling were placed in the vehicle. But the famous six-speed manual transmission wasn’t on their customer dream list, so it was out. Large cup holders were a must, so Porsche put these in for the first time.
The result? The Cayenne became the highest generating profits per car in the whole automotive history. After ten years on the market, Porsche was selling around 100,000 Cayennes every year. As of 2012, these sales account for half of their annual profits.
Smart cofounders know the best way to design a product and pricing strategy is around the customer’s needs and values.
What Are the Most Successful Revenue Models?
How you charge trumps what you charge.
When I started Growth Ramp, I had a single mission: I wanted to help 1,000 entrepreneurs go from idea to scale.
The industry was (and still is) filled with scam artists promising financial freedom, quick cash, and rich living. To set myself apart, I decided to offer my services and get in the trenches with the co-founders.
There was only one problem.
When I asked potential customers their willingness to pay (WTP) for my service, the amount was bottom-of-the-barrel low. With the WTP range I got, I estimated I would need 20-40 clients a month just to make ends meet. No bueno.
Finally, I had a breakthrough. Using the customer discovery interview process, one interviewee told me to consider a commission revenue model. After running the numbers, this revenue model would require 2-4 clients a month.
What’s the most successful revenue model for your startup?
The revenue model that serves your customer, ideally based around the value. In other words, the more value your customers receive from your products, the more you can charge.
According to Wikipedia, there are 24 revenue models. Which one should you choose?
During customer validation interviews, you asked potential customers about their WTP for your product with four questions. Those four questions are:
- At what price would you consider the product to be so expensive that you would not consider buying it? (Too Expensive)
- At what price would you consider the product to be priced so low that you would feel the quality couldn’t be very good? (Too Cheap)
- At what price would you consider the product starting to get expensive, so that it is not out of the question, but you would have to give some thought to buying it? (Expensive, Will Buy)
- At what price would you consider the product to be a bargain, a great buy for the money? (Inexpensive, Will Buy)
When asking these questions, a customer may give you feedback about the best revenue model for them.
Most startups use one of these eight revenue models:
- Advertising. The advertising model is common among media businesses. This includes traditional media (TV, radio, print, magazines), digital media (online publications, blogs), and social media (Facebook, LinkedIn, Reddit, Twitter, Instagram) websites. You also see this model among businesses with network effects, such as Google, Amazon, Genius, and Taobao. Advertising is difficult to make a significant amount of money without a lot of users.
- Commission. The commission model happens when a business charges a certain percent for a sale, typically between two other parties. Upwork and eBay both use the commission model. Payment processors like Stripe, Paypal, and Square use a commission model between the merchant and customer. Affiliate marketing uses a commission model too.
- Donations/Donationware. With donationware, the startup gives fully operational software with unrestricted access. Then they ask users to donate a certain amount to pay for its usage. Famous examples of donationware include Wikipedia and Web Archive. Some businesses also use a for-profit method to make money too. Firefox receives 60% of revenue from donations and 40% from royalties according to their annual report.
- Dynamic Pricing. Dynamic pricing involves prices that use outside factors to change the price based on supply and demand. The factors may include weather, season, time of day, or an upcoming deadline. Airline tickets are a classic example of dynamic pricing. Uber and Lyft also use dynamic pricing based on the supply of drivers and demand from riders.
- Freemium Pricing. Freemium works by offering a product for free while charging a premium for advanced features, functionality, or for other related products and services. The goal of freemium is to attract a huge user base to the free version and convert a percent of the free users to become paying customers. Dropbox, Slack, social networks, and many smartphone apps use the freemium model. Keep in mind freemium by itself is a marketing strategy (also called engineering as marketing). You will need a second revenue model to have a successful business.
- Pay As You Go/Alternative Metric Pricing/Fee for Service. Many companies have succeeded charging based on usage. With pay as you go, you can charge either upfront (typically using a credit system) or from the last month’s usage. Phone companies and utility companies are famous examples. Some software as a service (SaaS) startups are successful using pay-as-you-go pricing, such as AWS, Google Cloud, MailChimp, and Heroku. Pro tip: I do not recommend charging per user for most startups. Most customers don’t receive more value from your product with every user they add. As a result, you hamstring your product usage and word-of-mouth.
- Production/Retail/E-Commerce Model. The production model is the tried-and-true method. A business creates a product and sells it to customers who pay for it. Zappos, Amazon, and Walmart fit into this category.
- Subscription Model (Licensing or E-commerce). Pioneered by book publishers and periodicals in the 17th century, the subscription model charges a recurring price at a set time. Meal delivery and kit services like Blue Apron, HelloFresh, and Sun Basket use this model. Most SaaS startups use this model as well, licensing their software for a flat monthly or annual fee.
There are also dozens of hybrid models you can use too.
Costco charges a subscription fee to be a member and for their products. LinkedIn has an advertising platform and a SaaS (licensing) model. OpenTable charges restaurants a monthly fee and a transaction (commission) fee for every reservation.
But the most successful startups begin by picking ONE revenue model and making it work.
5 Questions for Choosing the Right Revenue Model
Before choosing a revenue model, you should talk to your customers. The goal is to find out which model will work best for them and your business.
Talking to your customers about each model isn’t a good use of time. Instead, you and your co-founders should ask five questions when deciding on your revenue model:
1. How likely are your customers to accept the revenue model?
In 1999, Coca Cola began testing a vending machine that would raise prices based on warmer weather. As temperatures increased, so would sales… right? Unfortunately for them, Coke customers didn’t like this model at all.
Your customers almost always prefer a certain revenue model. But just because everyone in your industry uses a subscription model doesn’t mean you need to as well.
As I mentioned before, some customers will tell you their preferred revenue model when you have the WTP talk.
You can also specifically test different revenue models by giving different options.
One way to do this is by using the same price for a set period of time. For example, would you rather pay $1,200 a year or 10% of $12,000? If they are indifferent, then either revenue model will work.
The downside is you may have to account for hyperbolic discounting. Hyperbolic discounting is the tendency for people to have a stronger preference for more immediate payoffs compared to later payoffs.
As a result, most people will prefer paying $100 a month for 12 months compared to $1,200 for a yearly subscription. Not paying upfront improves their cash flow.
2. How will future developments impact the revenue model?
Every business should look for trends in their industry before picking a revenue model. For example, the subscription model is common in the food industry. But would the model work for footwear? Maybe, maybe not.
Brick-and-mortar business owners are more comfortable advertising online. Would it make sense to use an advertising model? Or perhaps they prefer to pay a flat fee rather than a price-per-lead?
By looking at trends and evaluating their risks and opportunities will allow you to guage which revenue model is best for you and your customers.
3. What stage is your company in, and does your revenue model fit that stage?
Advertising is rarely a sustainable model with only 1,000 visitors a month.
And trying to make two monetization models work at the beginning is difficult. This is why we recommend early-stage startups should focus on ONE revenue model, with ONE price strategy, and ONE price point.
As your startup grows you can consider other price strategies, revenue models, and price points.
4. What are your competitors doing?
Copying the competition isn’t always the right answer. In fact, setting yourself apart is key to a good positioning strategy. That’s how Netflix put Blockbuster out of business.
However if you are different in a way that doesn’t serve your customers, no one will buy from you.
Looking at the competition will help you know where you want to set yourself apart, and where to keep the same.
5. How difficult is the revenue model to put into action?
It’s simple: if you can’t get your revenue model to work, you can’t charge accordingly. You may also find the number of support tools you need isn’t worth the added time or financial cost.
You do not need to have the existing system you need in place. But you should consider the cost of making the necessary switch.
For more on these questions and picking your revenue model, I recommend reading chapter 7 of Monetizing Innovation.
What Should Be My Pricing Strategy?
Ben Franklin once said, “Failing to plan is planning to fail.”
Many entrepreneurs look at their competitors to find similar products to their own. They then pick a price that makes sense to them, perhaps blindly making guesses based on where their product is at right now.
Yes, you should analyze your competition to know how to position your pricing strategy. But picking your price based on your competitors is another step in creating a me-too startup.
When you don’t have a system in place, it’s too easy to change direction with no true rhyme or reason. Let me give you an example by asking you five questions:
- What will generate more sales? Ending the price of your product in a “0,” “97,” “98,” or “99”?
- What is the best goal for your product? Revenue, market share, total profit, profit margin, customer lifetime value, average revenue per unit, or something else? And should that goal change during its life cycle?
- How will you react to the competition’s behavior? How might your competitors react to your product, and why? If you match a competitor’s price, how will it impact revenue and profit? What types of promotions will you never resort to doing?
- Should you price low for market share, or high for premium branding? Based on your WTP conversations with customers, what exactly is low and high pricing?
- What should be the central strategy for our product? And will the central strategy change if you offer different pricing tiers?
According to Wikipedia, there are at least 29 pricing strategies. Thankfully, there are only three core pricing strategies that matter most: market penetration, maximization, and skimming.
Market Penetration is a pricing strategy where you intentionally price your product lower to gain market share faster.
In some markets, this land-and-expand strategy is more critical to success. This strategy is common in network effect startups, and niches where customers have high loyalty to the first brand they choose.
When was the last time you switched your auto or homeowners insurance? Now compare that to the last time you switched (or wanted to switch) from Bank of America, BlueHost/HostGator/any other EIG web host, or Comcast. Customer loyalty expectations are different for each industry.
This price point is typically between too cheap (green) and expensive, will buy (yellow).
I recommend this core strategy for early-stage startups before they hit product-market fit. Price then becomes one less barrier to acquire new customers.
Maximization is a pricing strategy where your goal is to get more profit or revenue in the short term.
Here, gaining a huge market share rapidly is not worth the expense of lower revenue or profit.
I recommend this core strategy for early-stage startups after they hit product-market fit. Once you hit product-market fit, word of mouth will make up for the small loss of sales. The added revenue will allow you to invest more into your customer acquisition, which is wiser to scale up post-product-market fit.
This price point is typically between expensive, will buy (red) and inexpensive, will buy (blue).
Skimming is the process of segmenting and targeting customers who have a higher WTP.
Later on, you systematically offer similar, lower-priced products to customers with a lower WTP.
Skimming is an excellent strategy if you have a significant number of customers who have a high WTP than other customer segments.
Peter Thiel said that Elon Musk used this strategy with Tesla (Lecture 5: Business Strategy and Monopoly Theory). As each new car came out, there was a high price, before settling at a lower MSRP.
You most often see skimming in luxury niches. This includes the fashion, automobile, video game, smartphone, movie, and music industries.
I recommend this core strategy for early-stage startups if they have a wealthy network, or they have a large and relevant email list.
What Pricing Tactics Is Best to Use for a New Product?
“Strategy without tactics is the slowest route to victory. Tactics without strategy is the noise before defeat.” Sun Tzu, Art of War.
After you have chosen your pricing strategy, it’s time to consider what tactics you will use to maximize your results. Wikipedia lists 29 pricing tactics.
Until you have an established customer base, your goal should be to focus on one thing: how will I get enough customers to reach product-market fit?
During the Growth Ramp Gap Analysis™, we walk our clients through a list of pricing questions to help them flesh out their pricing strategy.
I’ll walk you through each question below.
1. Pricing (Monetization) Model
What revenue model(s) will you use?
If this is your first product, I recommend 95% of clients choose ONE revenue model, ONE product, and ONE pricing tier.
If you plan on testing other revenue models in the future, you can mention that in question three.
Will your revenue model be the same across all customer segments?
For example, will you price differently for enterprise customers? What about senior citizens, students, or non-profits?
If you plan to target only one customer segment, you can write down your future plans here.
Will the revenue model change over the life cycle of the product?
Will you experiment with a subscription model after you hit product-market fit? Or perhaps test hosting a conference after your website gets 100,000 visitors a month?
Whatever your future plans are, record those here.
2. Price Differentiation
Will you differentiate your price? If so, what are the differentiating factors (by distribution channel? industry vertical? region?)
Will you charge the same price in Canada, Europe, Australia, and the United States?
How about for the holidays? Will you charge a different price for Christmas, Easter, or Halloween?
What about different prices by distribution channels? Will you charge the same for your new bottled coffee espresso in hotels, stores, vending machines, and online?
How about when you first launch your product? Will you price it higher? When will you lower the price? By how much?
Typically, I recommend very little differentiation when you first launch a new product. But again, these questions are worth revisiting as you grow your business.
Will you maintain a maximum spread for your range of prices?
If you differentiate your price, will all prices be within a certain range, such as 200% of the average price? Why do you feel this would better serve your customers and your brand?
3. Price Floors
Will you have a price floor below which you will never price?
If you’ve had the willingness to pay (WTP) talk with your customers, I recommend never pricing below the price range they gave you.
It’s also worth considering what is the minimum if you choose to discount your product.
Will you have a floor below which you will never discount? (such as a 50% maximum discount)?
I’m not a fan of discounting products.
It’s like drugs for business owners: you begin to condition your customers to expect a discount. And it’s harder to return your profit to “normal.” But not every entrepreneur is like me.
Will you discount your products? If so, when will you do so? For your affiliates? For holidays?
Starting off, I again recommend keeping it simple. Your goal should be to get to product-market fit faster.
4. Price Endings
Price endings are a common part of pricing psychology, which I will talk about in more detail in the next section of this article.
How would you "end" all of your prices?
Will you end with a 0? 98? 99? 97? What about a random digit?
Why will you end your product prices as you have?
Will this change when you discount your product? How about when it’s on clearance?
What will the numbers on the price tags look like?
Will you show the cents, or will you round every number to the nearest dollar?
Will you use superscript for the cents in your price?
Will you strike out the old price on your pricing page when you discount it?
5. Price Increases
Will you increase the price over time?
If so, how much and at what frequency?
Will this change on an annual basis? When you introduce another product?
Again, until you reach product-market fit, I’d recommend keeping to a single price that does not change.
However, you should consider how you will approach the topic of increasing prices as you grow.
What Is Pricing Psychology? Are There "Magic Numbers" in Pricing Psychology That Result in More Sales?
Pricing psychology is a pleasurable way to push up profits.
But like other pricing tactics, without a clear strategy, it will get you nowhere. This is why you must first start by mapping out your pricing strategy.
In 1991, consumer psychologist Robert Schindler examined the psychology behind pricing endings.
Schindler and his team suggested the following meanings to price endings:
- The item has a low price: 5, 8, 9, 95, 99
- The item is of poor quality: 9, 99
- The seller offers good value: 9, 99
- The seller sells cheap, poor-quality items: 9, 99
- The price has been reduced from its original higher value: 3, 7, 99
- The seller is trying to manipulate the shopper: 9, 99
- The item’s price hasn’t been raised recently: 5, 8, 9
- This price is a discounted or sale price: 3, 7
- The price is not fixed, it is negotiable: 0
- The item’s price is high: 0
- The item is of high quality: 0
- The seller is upscale (sophisticated, classy, prestigious): 0
- The seller is likely to sell unique products: 2, 3, 4, 6, 7, 8
- The seller has given thought to establish its prices: 2, 3, 4, 6, 7, 8
- The seller has a playful approach to business: 2, 3, 4, 6, 7, 8
As a smart entrepreneur, you know that applying this information requires context.
For example, look at stores like Walmart and WinCo. They end their prices in (seemingly) random digits to give the appearance their price is well thought out and the lowest possible.
Are their products unique? Not really. Do they have a playful brand? Again, not really.
If McDonald’s changed its $1 menu to $1.00, would you think their burgers were high priced and high quality? I would not.
Therefore the pricing tactics you choose must fit in the context of your overall strategy.
There are dozens of psychological pricing tactics you can use. I’m aware of over 40 tactics. While pricing psychology can be fun, if it doesn’t make you more money then you are just playing business.
I've Finished My Pricing Strategy. What Should I Do Next?
After you have finished your pricing strategy, you should create a customer persona. This information will give you the foundation to accurately analyze your competitors and positions your startup.