10+1 Pricing strategies for products (Blog 1/3)
Product Managers and entrepreneurs often struggle with pricing their products. In this blog, I will try to unravel the existing pricing models that are available for PMs and entrepreneurs to seek inspiration from.
Pricing is a deep subject therefore this is a 3-part blog series.
- Blog 1- 10+1 Pricing strategies for products
- Blog 2- 7 Pricing Mistakes Entrepreneurs Make
- Blog 3- How to find the best price for your products or services?
The way you price your product speaks volumes of how your product is perceived in the market. It could be product quality, economic value, the competition that you are serving, & human emotions etc.
Pricing is more psychology than math or science.
So let us understand this a little deeper.
Prefer Watching instead of Reading?
Covered all the important and unimportant concepts of pricing in this 1-hour workshop. If you have some time, then you can watch this video.
6 components of pricing
Before we deep-dive into pricing strategies, we need to understand the 6 core components of pricing.
Cost is the total cost of goods sold and includes everything from sales, marketing, production, shipping and handling etc.
2. Reservation Price
Reservation price is the maximum price the customer is willing to pay you for your product or services.
You always put the price of your product above your cost and below the reservation price. Well, mostly unless you are on a mission to incur losses and wind up your business.
4. Customer Value
The customer value is the gap between Price and Reservation Price or in other words the value that customer perceives after using your product.
5. Business value
Business value is the gap between the cost and the price or in other words the value that you get from each product sold.
Now, as an entrepreneur your purpose is to maximize the business value while ensuring the customer value stays intact.
6. Unit of pricing
This is the per unit for which you wish to price your products. It could be per user, per transaction, per hour or something entirely different depending on your product.
You will see flavors of all these components in the next 11 models.
#1 COST PLUS PRICING
Imagine, you want to sell a t-shirt. Now how do you price this t-shirt? You include the COGS of the t-shirt and put some markup on each t-shirt that would accrue to your profits.
For example, the COGS for this t-shirt include:
- Material — $10
- Labor — $5
- Shipping and Handling — $7
TOTAL COGS = $22
If I wish a markup of 35% ~ $7.8 my selling price of the t-shirt becomes $30.
This technique is often used in retail, time and material based projects by consulting firms etc.
A big advantage of cost based pricing is that this pricing is simple & explainable. However, this method is oblivious to competition and market trends. You dictate your price based on your cost. What if there is another competition who can make the same t-shirt for $15?
#2 COMPETITION BASED PRICING
You would have seen these ads suggesting price matching guarantee etc. Now, here clearly the pricing is influenced by the competition.
Let’s say you are selling headphones. Your competition in the same segments sells headphones for $350. And you enter the same segment of market. Where would you like to put your price tag?
The answer is anywhere. It depends on your business strategy, marketing, and business plan.
EQUAL TO $350: If you are just entering a crowded market with minimum scope of differentiation then you might as well match the price to ensure you don’t lose the customer. E.g., the Target advertisement above.
LESS THAN $350: If you are operating in a market where customers are more price sensitive, and you want to differentiate on price then you place it at less than competition price. e.g., Walmart and DMart operate in this segment.
MORE THAN $350: If you wish to differentiate on quality, then you can place your product at a price higher than the competition price. e.g., Starbucks coffee may be placed here.
But the important aspect is that there is an entire machinery of product, marketing, branding, sales etc. that needs to support the price of the product.
#3 Value based pricing
Do you have an apple phone, or do you know of someone who owns one? Why do you think that they own one? What is the value you get out of owning an apple phone? Is it joy, status, fashion, ease of use or security?
All of the above are values that a user gets on top of a product. Now, imagine if you could put a dollar amount to each customer value. What would be an Apple iPhone’s worth?
This is value based pricing where you have a hypothesis on the customer value and you place your product pricing accordingly.
You can understand the relationship between value based pricing and Maslow’s hierarchy in the video linked at the top.
#4 Price Skimming
Continuing with the Apple iPhone example, you would know how Apple charges a premium for an initial product release and then reduces the price for the same model subsequently as time progresses.
Check the iPhone 8 price year on year. It was released at $699 and then reduced to $599, followed by $449.
Now what is Apple doing here? This is often referred to as price skimming.
To begin with, Apple can afford to price the product at a premium and reduce the prices subsequently since its products are highly differentiated.
Also, if you look at the reservation price of an iPhone 8, you will understand that the reservation price was very high when the product was released since it had novelty value. Therefore, there were many EARLY ADOPTERS who were willing to pay extra to own that product.
As time passes, the novelty reduces, therefore the value associated with “joy” and “status” reduces and the product price reduces.
#5 Introductory Price
This is a classic pricing strategy where you see organizations setting low introductory prices in order to penetrate the market. The intent is to win customers from existing competition. You may see this price war where the product offering is highly undifferentiated. E.g., Telecom providers in India.
While this can be an effective strategy for winning customers in the short term, but one needs to build the value statement beyond just pricing. If you are an early entrepreneur or a product manager not loaded with tons of cash, then try to avoid predatory pricing techniques.
If you are loaded with cash and wish to enter predatory pricing, then I suggest you can buy me a coffee instead to avoid burning your cash flows.
#6 Penetration Pricing
A different avatar of introductory pricing is when you extend discounts, sales, buy one get one free offer to customers over the existence of your sales and product offering. This may be done with the intent of:
- Inventory clearance
- Seasonal penetration
- New product launch
- Customer growth etc.
It is a common strategy employed by retailers to boost sales. While I don’t see enterprises getting into seasonality based discounts, it may be a good plot to enroll big enterprises for your services and products.
#7 Volume Pricing
Volume pricing is a pricing structure that SaaS applications follow. It results in discounts for large quantity purchases. The more that is purchased at one time, the larger the discount.
Most enterprise products offer volume discounting since the intent is to pass the value back to the customers since a single large customer may be buying enough from you to save you on your marketing, sales, legal cost etc.
The only problem with volume based pricing is that the revenue reduces as volumes increase. You burn holes in your cash flow. If you are confident about your product and the value it has to offer, then you do not offer a discount.
# 8 Tiered Pricing
Probably one of the most popular pricing structures is the tiered pricing model. Simply understood, it is a model in which you have tiers or layers of pricing that may change based on a particular variable. For example, imagine if I sell a code repo at $0 for a team of less than 5 individuals. I may charge $40 for a team of size 10. And $210 for a team of size 100+.
I will add tremendous value as I change my pricing tiers so that each segment feels that the price set is below their reservation price.
Price tiering gives options to users to pay more if they find more value with your services.
In tiered pricing, the reservation price changes with each tier or segment because the expectation is that the value changes with each tier. In the above example of GitHub pricing, you can see how each tier may cater to a different tier or different segment of customer and also provide additional value with each changing tier.
There is a subtle difference between tiered pricing and volume based pricing. While volume based pricing changes price based on customer growth, each tier in a tiered based pricing approach may cater to a different customer all together.
#9 Loss based model
Loss based model or the razor blade model is mostly used when complementary products are sold together. For example, a razor and blade or a gaming console and games.
In such cases one product may be sold at a loss since the losses are made up by sales of the complementary product. For example, XBOX maybe sold at a loss since the money can be made up on games.
Another aspect that you may observe is the high affinity between the complementary products. i.e., Games and Consoles have high affinity. Razor and blades have high affinity. There is a lock-in i.e. a blade from one company will not work with another company’s razor. Similarly, you cannot play a Sony game on an XBOX console.
On the contrary, you may not apply this for every complementary product. For example, bread and butter are complementary but you will not sell butter at a discount in the hope to make up for, by selling bread. For the simple reason that there is not high affinity between the two. I can use bread with jam and I can use butter with pancakes.
The loss based model has tremendous stickiness since the complementary products make a moat around the products and locks the customer in for a long time. Imagine, if you buy an XBOX controller, you will buy XBOX games for at least a few years.
#10 Bundle pricing
Price bundling has been used for a long time. It is the concept of bundling products that have a higher likelihood of being purchased together. Here the intent is that bunding products reduces the cost of marketing, distribution, and sales effort therefore you pass on this efficiency back to the customer in the form of a discount. Bundling can often boost your revenue.
#10 Anchor pricing
Anchor pricing is all about setting a frame of reference for pricing. When I say that an iPhone is for $699 then it elicits no response in your brain. However, if I say that the same iPhone was for $999 10 days back then you start thinking of the happiness of catching the deal while it lasts.
This is generally used for discounting.
Hybrid is not a product strategy, but it is a hybrid of the above 10. You may wish to use tiered, anchor, and value-based pricing together to price your products.
GitHub pricing may be a good example of Hybrid pricing.
Now that we have understood the various pricing models, there are still 2 questions that need to be answered:
- What mistakes do entrepreneurs and PMs make while pricing products?
- How do we find the most optimum price to generate maximum value?
I hope you found this blog helpful. Do write to me and share how did you price your products? You can always leave a clap or two if you find this helpful.