Pricing

You built a product. Now its time to make some money. You want a healthy margin, but you don’t want to over charge and ruin the business long term. How to price properly?

One way to do it is to build your pricing thermometer. The price thermometer is the following:

+ +
+ +
+ + True Value
+ +
+ +
+ + Perceived Value
+ +        |
+ +      buyer incentive
+ +        |
+ + Price
+ +        |
+ +      seller incentive
+ +        |
+ + Cost
+ +
+ +

True value is the value that your product generates. If you are selling an accounting software that allows a company to save $1.000 in tax, then your true value is $1.000. This value is, frequently, hard to determine. Many segments of the market have different uses for a product, which unlocks various different True Values for each of them.

Perceived value is the value that the customer understands. It takes into account the marketing you do, but also the competitors and replacements available. Let’s say that your accounting software has 3 packages: HR, Procurement and Sales. Let’s say the software will save a customer $500 in HR, $490 in Procurement, and only $10 in Sales taxes. Because the software is quite complex, you don’t advertise the Sales taxes savings prominently, and you don’t know if a regular customer will be able to use more than 50% of the Procurement features. Therefore the perceived value is actually only $500+50%*$490 = $745. Finally, if there is a direct competitor selling a similar software for $695, then obviously this will be the perceived value of your product as well. If their software is not exactly similar, you should compare each individual feature and its value.

Cost of Product. This is the cost of goods or services sold.

Now, you should place price in between cost and the perceived value. The higher the price, the more margin you will make. Your incentive to sell equals Price minus Cost. The lower the price, the more benefit a user will extract. The customers incentive to buy equals Perceived Value minus Price.

Seller Incentive = Price - Cost
Buyer Incentive = Perceived value - Price

If Price = Cost, you make no money at all. If Price = Perceived Value, the customer is getting no benefit: he is paying as much for the product as he’ll benefit from it.

Generically, the higher the margin between perceived value and cost, the most likely an industry is likely to develop.

Seller Incentive + Buyer Incentive = Perceived Value - Cost

More. This notion of pricing using the thermometer is quite static. It’s very important when you want to build a strong brand and product, and a long term relationship with the client. In a dynamic market, it takes time to educate your customers on how to extract the true value of your product or service. Profit is what truly matters, but if you want to maximise the revenue you get at each moment, you may need to do a bit of tinkering in Pricing.

A quite simple and quick way to determine optimal price in a multi-customer setting is to start up and slowly go down. So, you start with a price near the maximum perceived value, say 100, and you get to sell 20 units. Then you drop to 90 and maybe you get 25 customers. You keep going down, and calculating Revenue = Price x Quantity.. At some point you reach a maximum, and that’s your optimal price to maximize revenue. You can do the same with margin of course, what you need to maximize instead is Margin = Quantity x (Price - Cost). Note that in digital software and many online services the marginal cost of serving another customer is zero, therefore maximising Revenue is similar to maximising margin.