A Software Pricing Primer

Early on in many sales discussions, someone inevitably asks: "How much?" The natural tendency at that point (especially among sales people) is to give an answer like: "$14,239 plus tax...".

The correct answer is, "It depends." Mostly, it depends on your product, your business strategy, your target customers, and your people. That is, it depends on a lot of things -- many of which are in your company's control.

Pricing is not just about the number – the price level – it is about what is behind the number. The price level is but one aspect of capital P Pricing. Here are some aspects of Pricing that can affect price level:

•   Product delivery
•   Installation speed 
•   Training and support availability
•   Skill levels of support people
•   Payment terms and timing

If you want to obtain the highest price possible from a customer, you must understand in detail what your customer considers valuable. Then it is up to marketing and sales to make the case for this value in every customer encounter. And then it is easier for a sales person to say "it depends."

To give you some perspective as you read this article, there are four sections to this primer:

1.  Keep Pricing in Perspective – Anyone can change the amount they charge for a product. But price is not the only lever you can use to improve financial performance and accelerate cashflow.

2.  Many Products; Few Pricing Strategies – There are only a handful of pricing strategies. To be successful you should choose one that is consistent with your overall business strategy and then use that one strategy to respond to competition.

3.  Non-Price Dimensions of Pricing – Changing price is one way to increase value delivered to customers. The other way is to change the value without changing the price. Consider those changes before changing price levels.

4.  Warning: Wrong Prices Can Cause Death Spiral – Viewing price as just a number can lead to business stagnation or death. Pricing is a strategic activity. To treat it as a tactic is a mistake with serious consequences.

Keep Pricing in Perspective

Price levels are easy to cut; they are hard to raise. But price is often the first thing that companies look to change when they want to enhance their revenues or share of market.

This is a narrow, company-centric view of pricing – narrow because it is not using the different dimensions of Pricing. A better way to view pricing is to …

•   Align Pricing with customers and what they value in your product
•   Accelerate and increase cashflow

In Fig. 1, the relationship among the various elements a business can control to affect cashflow is illustrated. As important as price may be, notice that price is only one of the elements.

Figure 1: Fishbone chart showing the relationship between several business elements and cash flow.
             Price is one of the many tools available for increasing cash flow.

For example, if your costs have gone up and you are thinking about raising prices, look at what you can do to cut costs directly and indirectly. An example of indirect cost cutting is having marketing do things that will lower the cost of sales. Many marketing professionals know a series of low cost tactics that can shorten the sales cycle thereby lowering the cost of the sale.

Instead of lowering prices to remain competitive, try to increase the value you deliver by increasing quality or improving a customer's perception of your product value. Maybe repackaging can add enough value to maintain your position in the marketplace. If you do need to lower prices, take away features to decrease the value of your offering. Marketing has a role here as does development.

The Fishbone Chart above can be used to suggest a number of pricing tactics. Take the items we mentioned at the beginning of this article.

•   Product delivery
  
  •   Premium prices for weekend delivery
  •   Expediting charges for next day delivery
  •   Discount for two week delivery
•   Installation speed
  •   No extra charge for scheduled installation during business hours
  •   Premium pricing for 24-hour turnaround time
•   Training and support availability
  •   Premium prices for on-site training including a "train the trainer" course
  •   Standard prices for attending scheduled public training courses
•   Skill levels of support people
  •   Different rates for senior technical consultants
  •   Premium rates for 24-hour, seven-day service provided by engineers
•   Payment terms and timing
  •   Financing available
  •   Discount for prompt payment

After reading this list, you probably have a better appreciation why questions about price should often be answered by "It depends". And this answer may be the right one instead of an immediate price reduction.

Many Products – Few Pricing Strategies

Pricing strategies fall into one of several categories:

What the Market Will Bear / Price Leader

Companies that are "first with the most" may be able to do this until a competitor catches up -- or catches on. This is also known as a "skim" strategy (as in "skimming the cream off the top"). Companies with a commanding lead in their product category like Oracle in databases and Dell in servers can command premium prices. (When they don't, it is sometimes because discounting is out of control or they are putting pressure on competitiors who are price followers.)

Meet the Competition / Price Follower

Meeting the competition is a common promotional ploy but is only a long term strategy for the lowest-cost producer. More typically companies offering products that are directly comparable to each other may be forced to play this game. If they are facing a dominant and well known competitor, they often have to price a little below the prices set by the leader..

Good Value

Every product has a performance/price ratio. Good value  means working on both the numerator and denominator in the ratio. Vendors using this strategy may also offer a choice of features at different prices (e.g. good, better, best) to counter the competition. Cutting price alone to raise the value ratio is not a good idea since lower revenues may follow.

Market Penetration

This strategy is the opposite of a skim strategy. In this case a vendor offers unheard-of-value at a price point. This strategy expands a market by opening new, price sensitive segments. Think software-as-a-service and the low prices and small bundles at low prices. If a competitor's price is so low another entrant cannot make money, this is also called pre-emptive pricing, a tactic frequently used by dominant competitors.

Cost Based

Vendors price their products based on the variable cost of goods. They may use "rules of thumb" like "$10 over cost" or 3X manufacturing cost. This strategy does not consider the value to the customer. Vendors of mature products or products that have become commodities may follow this strategy but only one vendor — the low cost producer — will win. Software companies that try this strategy underprice their products (even more than normal).

When you understand what different pricing strategies look like, your response to competition can be targeted yet consistent with your own pricing strategy.

For example, what should you do if a competitor offers low prices that are part of their Market Penetration pricing strategy? If your response was to lower prices then you would be pursuing a Meet the Competition pricing strategy. But if want to pursue a Good Value pricing strategy, a more appropriate response might be to create a lower priced product that has fewer features while maintaining a reasonable performance-to-price ratio.

It is important to understand what different pricing strategies are available so you can select a starting point that fits with your company's business strategy. If you understand these strategies, you can gain a deeper understanding of your application segment or a particular competitor.

Non-Price Dimensions of Pricing

How strange it is that many companies –— especially technology companies — still think that price is the major factor in the decision to purchase a product or license software. In most purchasing surveys price (levels) comes out in the third or fourth position. Price is the determining factor when all things are equal. Therefore, your objective should be to make sure things are not equal.

If you want to win, don't play the game on a level playing field. Tilt it in your favor. (Even better: Change the game.)

Here are a few ways to change the game:

1.  Credit terms - Offer different credit limits for follow-on orders. Offer trade-in or upgrade credits for staying with your products (or switching from a competitor's)

2.  Discount - Dollar- or unit-volume discounts are standard. Make sure these are "pay-as-you-go" with credits applied when higher discount levels are earned. Don’t give up discount dollars for promises of future business.

3.  Time - Give discounts for speedy payments. Use seasonal discounts to offset lulls in the business. Don't forget about using time-limited offers and pre-publication pricing.

4.  Customer type/status - Volume discounts separate the high volume customers from others. You can also differentiate by customer longevity, frequency of purchase (frequent buyer programs), or region. Be careful your offer doesn’t allow customers to pick which price they pay.

5.  Service - Services are often a no charge add-on. In effect this is the same as giving a discount equal to the amount of the services. Tailor the amount, duration, or type of service to the type of customer and the service is delivered.

6.  Payment form - Nothing says you have to take all cash and all at one time. Spread payments are useful to smooth out a customer's cashflow. If you are a small company, you might even consider bartering your products for something you need or you can convert into cash.

These are but a few examples of how one can lower prices without cutting the price directly. As a rule however, make sure the customer understands the value you are adding or subtracting so they will pay properly for your modified offering. If you are adding value to “sweeten the deal, make sure the value the customer perceives is worth considerably more than the cost of delivering the extra value.

Warning: Wrong Prices Can Cause Death Spiral

Often the biggest problem a company faces is new product pricing. This is especially important when it comes to products in a new product category.

Setting the right price point and developing the right packaging of features for that price point is part art and part science. There is still a lot of the gut feel pricing going on: It is unavoidable.

The wrong price can lead to a downward spiral. This death spiral illustrated in Fig. 2 can lead to a long and painful set of experiences.

Figure 2: Setting the wrong price can cause a company to enter a "death spiral". If the price is too high, the sales effort will be too costly. If the price is too low, the margins will be too low. Either way, company growth suffers.

Be very careful when setting prices because, if you choose the "wrong" price, you can get in trouble. If prices are too high, the cost of sales may rise and the timeframe for sales will stretch out. If you set prices too low, you may not have enough contribution to fund the development of differentiating features or the promotion of those differences.

Strategy and Pricing Must Work Together

Pricing is a strategic tool that can be used as a competitive weapon but is best applied as part of an overall business strategy. Pricing must contribute to a company's strategy to be successful. In order to do so there needs to be a company strategy or vision.

Companies that can articulate why they are in business and how they want to compete provide the strategic backdrop for successful Pricing. When such a backdrop exists, it is much easier to create and capture customer value. You can also select the right business elements in the Fishbone Chart to achieve strategic objectives,

Call it a corporate strategy statement, a vision, mission statement, or whatever. These statements are very useful for tying together all of your sales and marketing activities (at least) of which Pricing is one important element.