So Many Ways to Price

Guest post by Steven Forth Co-Founder at Ibbaka Performance

There is an old joke about standards.

“The nice thing about standards is that there are so many to choose from.”

Some days the same seems to be true of pricing models.

Some years ago, when I was pitching a SaaS pricing platform to a VC, he scoffed and said …

“Pricing is easy. Your customers tell you what you can price.”

At some level this is true. If your customers don’t agree with your pricing you won’t have customers. Of course the same could be said about just about any part of your business, from your positioning to your functionality. All of these things are designed to shape how customers buy and how they experience your offers. The same is true of pricing.

The difference is that with pricing, you have to get to an agreement, or you will not have a customer.

A number of different approaches to pricing have emerged over the years. The most common are ‘cost plus pricing’ and ‘market following pricing.’ Both of these fall short when it comes to pricing innovation, and a number of alternative approaches have emerged:

• Value-Based Pricing

• Dynamic Pricing

• Usage-Based Pricing

• Behavioral Pricing

• Outcomes-Based Pricing

Let’s start with the strengths and weaknesses of ‘cost plus pricing’ and ‘market following pricing.’

Cost-plus

This seems like the easiest approach. You take your costs, add your target margin and you have your price. What could be simpler?

Well, there are two challenges here. The first turns on costs. 

‘What are the costs?’

‘ Which costs should be included?’

These are not easy questions to answer, especially for a product or digital service. How do you include your R&D costs, your marketing costs, your customer success costs? Most companies struggle to track these costs, let alone use them to price.

A bigger question, should you include sunk costs. The best advice on this, from my mentor Tom Nagle, author of The Strategy and Tactics of Pricing (if you just read one book on pricing read this one), is No. Sunk costs are in the past. They should not impact price setting. The time to consider sunk costs is before you commit to them.

This means you should understand your price before you commit to development. Follow that way of thinking and the logic of cost-based pricing unravels.

Too often, we see a pattern like this …

Costs → Price → Customer → Value (Maybe)

A better approach is

Customer → Value → Price → Costs

Costs should not be the tale that wags the dog. Your customer does not care what your costs are.

There are a few cases in which cost plus pricing makes sense. The most common one is when the customer controls the costs and needs to carry the risk of cost changes. This is why cost plus pricing can make sense for military and certain government contracts. It is also why cost plus is common within professional services, though even there the trend is to some form of value-based pricing.

Market following

Most economic theory, at least until the emergence of behavioral economics, was concerned with market-based pricing. This is the beautiful world of perfect information, where price elasticity of supply and price elasticity of demand intersect to define a market clearing price.

Market pricing works well in the world of commodities. If there are multiple substitutes, all interchangeable (fungible in the language of economics), then market pricing is the only approach.

Is your offer a commodity? If you are a growth-stage company, probably not. You have worked hard to create meaningful differentiation. That differentiation drives your pricing.

(Willingness to pay (WTP) is often positioned as value-based pricing. It is not. Willingness to pay is a rebranding of market pricing.)

There are some interesting aspects to market pricing. The most useful is when a market input drives a price. Think about housing mortgages. The main thing that determines your mortgage is the prime rate that banks can borrow at. One could argue this is a form of cost plus pricing, but when the costs are determined by external market forces pricing works very differently than when the costs are internal and the behavior is much closer to conventional market pricing.

If your costs, or the value you provide, is determined by an external and easily monitored variable, then consider designing that into your pricing model.

Value-Based Pricing

Historically, the alternative to cost plus and market pricing has been value-based pricing.

This is a simple idea. Your offer creates value. You share part of that value with your customers and claim part of it for yourself in price.

The challenge with value-based pricing is two-fold.

First, it is not the absolute value that determines price. Part of the value you create can just as easily be gotten from a substitute. That part of the value is commoditized, and the pricing of the commoditized part of your value is determined by the market.

Second, it is not always easy to determine how much value you provide. This is why some people use a substitute, like Willingness to Pay (WTP) as a proxy for value. The problem is that WTP represents the market price and not the value.

Value has three aspects: economic, emotional, and community. All three matter in pricing.

We plan to go deeper into value-based pricing in future posts. For a primer on value-based pricing see Jessie Tai’s post What is value-based pricing?

(For geeks, I use the term aspect in the sense it is used in aspect oriented programming, a cross cutting concern that can be abstracted and made modular.)

New approaches to pricing

If you have your ear to the ground, you have probably heard of a number of alternative approaches to pricing. Let’s work through them.

Dynamic pricing

Pricing is set by algorithm and changes in response to variations in supply and demand and estimates of willingness to pay. Is generally implemented through some form of pricing or revenue optimization software. This works best when there are many, repeated, transactions. The classic example is how airlines use dynamic pricing for load balancing.

Behavior-based pricing

Most decisions are not perfectly rational. This has been well researched by people like Amos Tversky, Daniel Kahnemand, and Richard Thaler. Wikipedia has a good introductory article. The main findings of behavioral economics are things like framing and anchoring effects (a $10,000 bicycle is expensive, it is cheap for a car) and risk aversion (most people will pay more to avoid a risk than to get a benefit).

Behavioral-based pricing uses these insights to design pricing models. 

These are important things to consider. Framing determines what your price is compared to. Anchoring sets an expectation in the buyer's mind that will have a big impact on price acceptance. Behavioral economics is one way to put pricing in context. 

Usage-based pricing

One of the hot topics for 2021 is usage-based pricing. Thought leaders like Kyle Poyar have identified it as one of the most important things to consider when renewing your pricing model. Zuora has found that companies that include usage in their pricing models grow faster than their competitors (but note that they also found that companies relying solely on usage-based pricing grew slower).

With this approach, user engagement and price paid are brought together, which can create better alignment between vendor and customer. There are a number of ‘gotchas’ with usage-based pricing though. If you are considering this check out How to introduce usage-based pricing.

Outcomes-based pricing

The goal of value-based and usage-based pricing is to get to outcomes, where the price is based on the actual outcomes from using the solution. For most of us, this is still a ways off, but the companies that can execute on this will dominate their markets.

Most solutions have a risk discount built into their pricing. Buyers are not sure they will get the value promised so to improve their odds they discount the price. In some cases, we have found this risk discount to be as high as 97%.

In outcomes-based pricing, the performance risk is shifted to the seller. Understanding how to take on and manage this risk will put you on the path to outcomes-based pricing. The recent book The Ends Game: How Smart Companies Stop Selling Products and Start Delivering Value by Marco Bertini and Oded Koenigsberg will give you a good grounding in the concepts.

What pricing method to use?

Let’s pull all this together into a table. You can use this as a guide to which approach you should adopt.

In most cases, you will be blending two or more of these methods to design your pricing model and set prices. 

You may provide a market-based price for standard functionality and a usage-based pricing component for part of your solution where you have a unique value proposition that will drive engagement. How you combine these different approaches is one way you can find ways to use pricing to drive differentiation.

What would you like to talk about pricing? Ping me at steven@ibbaka.com with questions and ideas.