Check our newest report - State of German SaaS Pricing 2023

Pricing 101. Why pricing strategy is important and why you need to have one?

by
in
Maciej Wilczyński
Managing Partner, Founder Valueships
March 17, 2019
pricing
strategy

Having a pricing strategy is something than just telling your customers how much your product or service is worth. Your market position, revenue, customer acquisition, and satisfaction - everything depends on the price of your products.  Warren Buffet even once said that when he’s evaluating a business, the company’s pricing strategy is what matters to him the most. So why do so many brands spend so little time working on that? 

We’ll try to answer this question in this article. The following post will also tell you:

  1. What is the impact of price on overall profitability?
  2. Why do you need a pricing strategy?
  3. What are four pricing strategies you need to know?

Profitability and magical power of 1%

In the same interview, Wizard of Omaha (Warren Buffet’s nickname) also said

“If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business.”

In this simple sentence, he didn’t mention just the pricing, but included a strong statement on competitive advantage, brand, company products, and most important: profitability.

When I’m writing this post, the economy is growing, VCs keep pumping start-up heart and despite a few obstacles, everything goes pretty well. But we live in a world where making a profit doesn’t follow growth. The machine keeps spinning, but one day the market says, “check”. Companies that enjoy healthy profit margins may prevail, while others will go belly up. 

If you want to prepare for that, I suggest reading “Beat the Crisis” from Herman Simon, he is a pricing guru you need to know.

Why profitability is so important?

One of the essential reasons for a company's existence is “to make money”. Of course, you can say that it’s all about making great products, a mission and making the world a better place, but in the end, investors and founders want to get their cash back. And even if they don’t, you probably need it to run further product development, get more customers and pay the office rent. Profitability is critical here.

We all know that equation for economic profit is:

Profit = Revenue [Unit Volume x Price of product] – Costs [Variable Costs + Fixed Costs]

The simplest question is: which of these variables have the highest impact on profitability? Please guess.

Impact of price on profitability

I’ve been exploring this area for a while and research results done by top consulting companies provide consistent information: if you want to improve your profitability, you should improve your price.

A study from Yankee Group (available in this book) proves that 90% of investments in pricing meet or exceed the expected return on investment (ROI). They even mentioned it in another way:

“For any dollar invested in performance improvement, the greatest return comes when it’s invested in pricing.” 

Of course, initial results come from calculating your costs properly, identifying waste, and leaning them in a systematic way (there will be separate series on that).

However, if you’re looking for substantial improvements, try working with the price. 

Friendly reminder: I’m not mentioning you should go and randomly play around with it as you wish. It needs to be properly researched, data-driven, and well-thought as you can screw up your profitability. It’s a strong weapon, and you need to use it carefully.

Do you need more practical insights?

Learn more about pricing

Why pricing is critical? Story of Porsche Cayenne

From an economic standpoint, price is an instrument of rent creation. It pretty much divides the value between the final customer and the company. To put it simpler: “You give me cash, I give you value.”

In fact, if you don’t understand the value your products or services provide, you simply don’t follow your customers and what makes them tick and what makes them buy the stuff you make. 


Product value is exactly the thing that makes your clients leave money with you and when they stop seeing it, they will leave


Simple as that, yet easily forgotten. Let me give you an example about one of the most successful cars in the history of the automotive industry. You can read more about it in this book.

The story of Porsche Cayenne

You have probably heard of Porsche and its SUV Cayenne model, but you may not know why it’s so special. In the 1990s, Porsche was facing a pretty hard situation. Pressure from top competitors, new ways of manufacturing (Japanese cars) and increased production costs were enough to drive the company to the brink of financial distress. They needed something bold, risky and new to change the odds.

Porsche knew they were known for tremendous horsepower and luxurious fast car production. Making a family-like SUV seemed revolutionary and a little bit off from the previous strategy. Understanding the circumstances, the company decided to build their new product around the price instead of starting from design and then trying to sell it with a premium mark-up. Producer wanted to check how much the customer is willing-to-pay for the product and then decide to move forward with the project.

Before they produced the first model of a car, Porsche surveyed hundreds of potential customers from the new segment. Found out that their new target group consist of people who always wanted to have a Porsche, but didn’t like the edgy feel of buying “middle age crisis” car. Pretty much BMW X-series or Lexus buyers. Getting them would not only boost profits but may also hurt competitors. We’re talking about a serious market entry here.

The company realized there is a potential for investment and thus started the design process. They literally researched every feature and checked whether it was on the wish list.

  • Racer gear is not on the list? Out. 
  • Manual transmission not wanted? Out. 
  • Cup holders are needed? Definitely!
  • Strong performance combined with design? Bring it on!

Instead of listening to engineers only, they were focused on voice of customer. It was highly innovative and totally different than what others did.

Cost-based pricing vs value-based pricing

Not only did Porsche their customer development work, but also learned what is the actual value of the features and how much they can charge for it. Then they produced one of the most customizable cars in history with different pricing schemes for different sets of clients.

Customers loved it, making Cayenne the most profitable car model in automotive history. Its sales make over half of the company’s total profit, exceeding the the 911 or Carrera series. Also, it allowed the company to increase its cash reserves and pay debts. 

What you can learn from this story?

Porsche story is a highly MBA-level strategic case study, but provides important lesson into what pricing, especially it’s value-based version is.

If done right, it allows to use pricing capabilities to ensure profitability and gain significant competitive advantage. Side product is a tremendous amount of customer insights you generate as simply you need to know your clients better. It reduces risk of wrong decision and allows to predict market outcomes more precisely.

However, the most important part is: your price have a chance to capture full value as the product is neither too expensive, nor to cheap. In economics, we call it optimal. You want to create a new version of product and conquer the world with it. Before you do so, please start from homework.

Do you need more practical insights?
Do you need more practical insights?
Learn more about pricing

Big 4 of pricing strategies

We can identify four main pricing strategies. They’re ordered from easiest-to-implement, but least impactful to hardest and most game changing:

  1. Cost-based pricing
  2. Competitor-based pricing
  3. Context-based pricing
  4. Value-based pricing

‍From my experience, companies start from the first two strategies and move up the value creation line as their strategy's sophistication increase.

Cost-based pricing

It’s the simplest one. It takes costs into consideration, adds a “healthy” surplus like 15-20% and prices it accordingly. It’s one of the most basic strategies, and it’s super easy to implement. Also, if you have a stable margin goal, you always make money with every transaction.

What is the disadvantage, then? First of all, it doesn’t capture full value. For instance, SaaS products have a very low-cost base due to cloud-computing and marginal cost of adding new users approaches zero. So in this case, the company would have to charge only a few bucks for every new user, which doesn’t make sense at all.

Another problem is that you may not take all costs under consideration and they tend to grow with time. Initially, it’s only hosting, but later we have upkeep, customer service, and we also need to increase our office space. It may be hard to adjust prices so fast, and generally, customers don’t like it.

Competitor-based pricing

I personally hate it, yet it’s leveraged by the majority of start-up companies I see. We create new product, have some cool functionalities and have no idea how to price them. 15 minutes of Google search and we know – it should be around $150 for the seat as our competitor has $200. We won’t scare customers as it’s comparable and close enough. It’s also not risky at all - the market conditions are like that, so we follow.

And that is the problem. It is not your strategy but your competitors. By following and not using your own guidance, you pretty much give a potential competitive advantage away. To go with a military reference: “Observe, but don’t engage with the enemy.” It’s always good to know what the market conditions look like, but ultimately we want to change them and become leaders. If we simply follow, how do we differentiate from others?

Context-based pricing

That one is actually tricky and very often doesn’t belong to the top four. I like to include it as it’s the natural step between benchmarking/costs and a value-based approach. In this strategy, we already use customer insights and their voice to better understand their needs and divide them into groups properly (it’s also called segment-based). Thanks to that, we can target the right offering to the predefined groups and context.

In B2B, it’s giving discounts, charging for new functionalities, cross/up-selling, etc. Sales reps need to have clear pricing guidance and knowledge to put the right quote on the client's need. In B2C, it would be pricing the product differently for discount stores, supermarkets and hotels, so it’s important to have the right distribution mode.

Such a pricing scheme captures more value, but can be risky as we may accidentally erode our margins, e.g. through loose discounts policy. It’s also critical to create clear, but also strict internal procedures. You may want to communicate the pricing policy in CRM or implement it directly.

Value-based pricing

Crème de la crème of pricing strategies. As shown on Porsche example, it captures maximum value and it’s the most impactful among all strategies. Overall, it comes to the topic of “willingness-to-pay – how much value do I bring to the table, so my customers want to pay for it?

Ultimately, it answers a simple question – what is the value of my offer? It allows for better product creation as we develop only what is wanted and mentioned specifically. We also, similarly to Porsche, produce massive levels of insights about our customers. It’s valuable knowledge you can use for other activities, e.g. brand positioning or viral campaigns.

On the other hand, it’s easier said than done. Value-based pricing requires a few more advanced skills that allow you to properly calculate WTP and tackle the right pricing. Rome was not built in a day and so won’t your pricing capabilities.

Some things (like the Price Sensitivity Meter survey) you can run relatively easily, but others require a more sophisticated toolkit and methodology (e.g., Conjoint Analysis).

We also covered a few other pricing models in our other article, “A deep dive into different pricing strategies”, so you might also want to read this one. 

How to start thinking of pricing?

Even considering above, you can simply start asking: “so how much would you pay for it?”. It should be enough. Also, you’re not alone as we will cover the topics here, or you can always shoot me an e-mail here: maciejwilczynski24@gmail.com

There are few books, you can use the ones from the links provided in a content, but I will also create a separate post with that and link it here. Personally, I think that pricing is one of the hardest parts of business and companies need to prepare for it. Doing it right may skyrocket your business, but there is always a risk of screwing things up. I strongly recommend to do the research and increase your knowledge on that.

Conclusion

Pricing is an extremely important, but also highly interesting subject, which combines economics, management, finances, psychology, statistics and technology. It’s a challenge to grasp the knowledge, yet value generated is extremely high. Once you learn how to use the pricing strategy to its full potential, you are on the best way to bring more customers to your business - and grow your revenue as a result.

Do you need more than this? We have another option!

Subscribe to our newsletter and grab more pricing insights.

I want to know more!
Maciej Wilczyński
Managing Partner, Founder Valueships

Expert in B2B pricing, monetization and value-based selling strategies. Over the past year, he has completed over 40 consulting projects in Europe. Prior to founding Valueships, he worked at McKinsey & Company, mainly in the TelCo, software, and banking industries. He completed his doctorate in pricing in SaaS start-ups at the University of Economics in Wrocław, where he also lectures.

Schedlue a free consultation
Maciej Wilczyński
Managing Partner, Founder Valueships

Expert in B2B pricing, monetization and value-based selling strategies. Over the past year, he has completed over 40 consulting projects in Europe. Prior to founding Valueships, he worked at McKinsey & Company, mainly in the TelCo, software, and banking industries. He completed his doctorate in pricing in SaaS start-ups at the University of Economics in Wrocław, where he also lectures.