In a recent class, we discussed how startups should approach pricing. When you think about how important pricing is to customer acquisition, market perception of value, and venture profitability, it is surprising that founders commonly consider pricing strategies quite late in business model development. Yet, pricing is an integral part of the overall marketing strategy. Although non-price factors have become more prominent in buying behavior in recent decades, the price remains one of the most critical elements in determining a company’s market share and profitability. In addition, it can lead to favorable early customer acquisition rates and brand recognition for startups.
Once the founders conduct the marketing analysis and competition review, they should begin to develop the pricing and sales plan. Pricing is the key to controlling costs and showing a profit. In addition, the price of a product or service conveys an image and affects demand. Therefore, preparing the pricing and sales strategy is one of the most challenging tasks regarding the product or service.
Several other factors can influence the entrepreneur’s ability to effectively price the product or service: notably, the number of competitors, seasonal or cyclical changes in supply and demand, production and distribution costs, customer services, and markups.
For this post, I will focus on a startup’s decision to price new products, ones they are or have developed as part of their new venture. Many of these steps will apply to price changes to new versions of a product or changes based on market conditions, and I will note some of these relationships throughout this post.
Establishing Marketing Objectives
An effective marketing plan relies on clearly understanding the startup’s objectives. However, as I will discuss later, these objectives should only be part of your pricing strategy. For a startup, the three main goals are:
1. Revenue Oriented: The aim is to maximize income over expenditures. Pricing is a powerful profit lever. Studies have shown that increasing the price of an existing product by 1% can increase profits by 8.7%
2. Customer Acquisition Oriented: The aim is to attract customers, even at a loss, like grand opening sales. For example, a theater may give away seats for an opening night performance to create an image of excitement and popularity. Furthermore, if advertising is a significant revenue draw, giving substantial discounts might pay off in higher advertising rates for the increased exposure.
3. Operations Oriented: Typically, capacity-constrained startups seek to match supply and demand to ensure optimal use of their productive capacity at any given time. When demand is low, organizations may offer special discounts. Conversely, when demand exceeds capacity, these firms try to increase profits and ration demand by raising prices (“peak season” prices).
Depending on the startup stage, the importance of any one of these outcomes may change. Additionally, you will find that often these objectives conflict with each other, thus making them unsuitable as decision drivers. Most times emphasizing one of these goals is at the expense of the other. For example, founders can increase customer acquisition by lowering prices and profit margins. Or one can improve profit margins by being more selective, focusing on customers’ will to pay more.
No matter the business or industry, you should build a pricing strategy with a structured process that considers all factors, including costs, value to the customer, competitive pricing, and the overall company’s values and business strategy. Let’s look at each of these and, in turn, how they interact.
Pricing Strategies
Pricing strategies differ depending on the nature of the business, whether it is retail, manufacturing, or service oriented. However, the general methods below may be applied to any business. They also demonstrate the basic steps in adopting a pricing system and how that system should relate to the desired pricing goals. The entrepreneur can formulate the most appropriate pricing strategy with this general method.
While many see the following approaches as independent strategies, I suggest all these strategies should play a part in the final pricing decisions. You may weigh each of them differently depending on your overall goals and business strategy, but don’t discount the importance of taking them all into account. Let’s start with the most common approach – cost-based pricing.
Cost Pricing
For many startups, pricing based on costs is the go-to strategy. Cost-based pricing is a common strategy across many industries. Many industries apply standard markup percentages that most companies use in their business. This situation is commonly found in the retail and service industries, where business price specific products and services under standard markup percentages. In some sectors, a cost-plus approach is applied where total costs are considered to price the product. For example, in many consulting services, a project will be priced in this manner.
Costs play an important role in pricing strategy. At the most basic level, the economic relationships between the pricing decision and the costs set the lower boundaries of what you can charge customers. There are two major categories of expenses, variable and fixed. These two categories create a range of cost boundaries that founders consider during the pricing decision process.
The Role of Variable Costs. The pricing of many new products starts with the costs inherent in producing them in the first place. As I will discuss shortly, incremental or variable costs are the most relevant cost factors in pricing decisions. However, one may consider longer-term costs not directly tied to a sales transaction contributing to final pricing decisions. A founder’s understanding of costs changes as sales volume increases. As variable costs stabilize, you will have a clearer picture of how the current pricing strategy drives the sales unit’s contribution toward profit. With this understanding, you can look at how to apply pricing changes to increase customer or profit growth. With unit economics well in hand, founders will have more flexibility to use pricing strategies toward their business goals.
In looking at costs, founders determine the variable costs associated directly with product production and sale. These costs vary and are directly related to specific product activities. These direct costs are separate from a startup’s other product development costs. Many founders consider the costs of early product development and testing relevant for pricing. In most cases, adding these development costs would inflate pricing beyond customers’ willingness to pay.
Direct or variable costs help set the lower floor of your pricing. At this lower range, you can charge the customer a price that generates some profit margin. You may be unable to sustain your business long-term with this lower price boundary. However, you may apply these lower prices for special promotions and conditions under certain circumstances. Variable costs establish the necessary pricing to meet short-term business goals. However, you must consider your fixed costs to set a price that covers the average cost to run the business.
The Role of Fixed Costs. You create a longer-term pricing boundary by considering your fixed costs in the analysis. Companies incur fixed costs regardless of product activity. Therefore, most fixed costs cannot directly influence pricing strategies. But these fixed costs still need to be covered by overall sales.
In some cases, specific recurring costs may be relevant if they vary with product activity. These recurring costs are referred to as semi-variable costs. For this reason, founders must differentiate these cost types as part of their analysis. Ultimately, combining variable and fixed costs establishes the more extended-term pricing boundary. Therefore, founders need to understand the dynamics of both categories to apply costs to future pricing decisions.
While cost-based pricing is relatively easy to understand and explain, it does not allow the customer’s perception of value to play a role in the decision process. As a result, startups that apply cost base pricing strategies to exclude customer value may hinder optimal financial performance and long-term growth.
Customer Value Pricing
Startups should not base pricing simply on cost plus a modest profit. Instead, base your prices on the product or service’s value to the customer. If the customer does not think the price is reasonable, the entrepreneur should consider a price change and a new image for the product or service. The entrepreneur must explain why his prices differ from those of the competitors. For instance, does the new business perform a function faster or more efficiently? A lower price may make sense. Or is the latest product created with higher quality or better materials? A higher cost can communicate this idea.
Often misunderstood, one calculates value-based pricing by the total amount of money the customer is willing to spend for the benefits enabled by your product. The challenge for founders is confusing the difference between benefits, features, and the overall value the customer places on both factors. Most products contain many features that may provide value to the target customer. You can quantify customer value by mapping features to benefits and benefits to the customer’s willingness to pay.
As you start to consider your approach to pricing, you need to break out the product into features and benefits to the customer. Typically, any product or service comprises several features. These features, individually or in combination, enable specific customer benefits. The customer is purchasing your product to receive these benefits, and their features are associated with particular outcomes.
Benefits are commonly divided into two categories, functional and emotional benefits. Functional benefits come from product attributes or features associated with its core reason for existence. For example, a functional benefit of most note-taking apps is to provide a repository of your ideas and be able to find them when needed. On the other side, emotional benefits are those intangible outcomes that produce an emotional response. For example, the fact that you know that your ideas are captured and available when needed alleviates anxiety about forgetting something important.
Understanding the role features and benefits play in the customer’s mind allows founders to define the product’s value. The product’s value combines functional and emotional benefits from the portfolio of features. The key to determining customer value is understanding the importance of these benefits and features and their willingness to pay.
There are several ways to quantify your customer’s value on specific benefits and features. One method I suggest to founders is integrating pricing information as part of the prioritizations of benefits and features during the early product design (MVP) process. Conducting a pricing information survey simultaneously as you plan your feature development can align well with a lean product approach. Once you prioritize the functional and emotional benefits that the customer values, you can connect these to specific features. Once you have a complete list of product features across both benefit categories, you can ask a sample of your target customers to quantify each benefit – feature in terms of how much they are willing to pay for each specific benefit. As a final step, you can calculate the aggregate economic value of all benefits. This calculation provides you with a credible data point for your pricing decision. Every additional product benefit and associated feature that the customer values lead to a potential increase in pricing.
Market Reference Pricing
The customer rarely makes purchase decisions in isolation. They compare your price against products they see as comparable to your offering. As I discussed in the product positioning post, you don’t always know which products your target customers compare to your offer. Customers discover many comparisons during the sales process, from competitive pricing to your product’s historical pricing to the costs of indirect solutions. Sometimes, customers may have a certain amount of money they are willing to spend for a specific benefit, sometimes expressed as a “share of wallet.” For example, one may have a particular amount of money they are willing to spend on entertainment. Your offering may be competing for a share of this amount. Founders discover this information during early customer engagement and early product testing.
Understanding existing market prices help to establish a range of what customers view as reasonable payments for a product. To determine these ranges, you want to research the pricing of comparable products in the market. As noted above, you want to know who your customers reference products and then determine the existing price ranges. These ranges provide a valuable data point for your pricing decisions. In many cases, your startup can take advantage of the higher end of the spectrum, thus optimizing revenues and margins.
When you engage target customers about pricing, you first want to ensure you are talking about the same product category. Then, ask the customer how much they typically spend. Let them tell you at the end of the range to consider the low, middle, or high-end prices. Next, probe why they may shift to various price ranges based on specific benefits. What does a product offer to motivate the customer to spend the higher range? As part of your customer discovery, you can ask what range of prices they consider reasonable and willing to pay. The goal is to learn the range of reasonable prices your customer is willing to pay for various benefits within a product category.
Positioning Decisions
These three pricing methods must be grounded in the startup’s product positioning strategy. The product position must communicate to the customer why your offer benefits them and how it differs from other solutions in the market. Your positioning statement provides the guidelines and constraints for the rest of your marketing mix – pricing, promotion, and placement.
The research conducted during each of these pricing approaches supports positioning strategies. First, soliciting customer input into the economic value they place on each product benefit and feature allows you to validate what is most important to the customer and how much they are willing to pay. Identifying the product’s main benefits and features is a significant component of your positioning statement. Secondly, as you understand the alternative products in the market, you can compare your product’s benefits to the competition. This comparison helps to identify the main differences between your product and those competing solutions. Finally, your positioning statement should communicate to your customer what is unique about your product relative to competing offers.
As part of your competitive analysis, you want to dive deeply into each competing product’s benefits and features. First, you must identify benefits and features that your product shares (or must share) with a competing solution. A must “shared feature” is critical to core functioning, and every solution must provide it to customers. For example, it would be hard to imagine a smartphone without a camera in today’s environment. The other part of this analysis determines where your product is superior to competing options. Superiority can arise from various sources, from specific features to particular core competencies that your startup possesses. On the opposite end of this analysis, you should identify any area where your product is inferior to other options in the marketplace. Understanding what your product lacks compared to others will help you assess which customers will not be interested in your product. As noted earlier, various customer segments value different benefits and features. As a founder, you want to know the preferences of different customer segments to optimize your promotional activities.
The effectiveness of your positioning depends on the degree that your target customer values the specific benefits and features and the differences between your product and comparable offers. Determining your product position helps you to answer the following questions: Which customer segments should you target?; What are the product’s strengths and weaknesses relative to our competitors?; What is unique about our product offerings?; and How should we use the three pricing approaches – Cost, Value, and Market References – to create an optimal pricing strategy?
Startup Business Values
A critical success factor for any new enterprise is defining what is essential to the founders, what values determine who they are and how they want to be perceived in the marketplace. Communicating these values is an integral part of your brand identity and starts to develop when you engage early customers. Your pricing strategies can reflect and reinforce many potential values, including transparency, fairness, flexibility, and quality. Once founders determine their core values, every decision should be viewed through the lens of these beliefs. For example, if you want your company to stand for transparency, then every aspect of your business model should be viewed through transparency. From a pricing perspective, are you open to your customers about how you make money, set prices, and determine costs?
Early Pricing Execution
One of the secrets of effective pricing strategies is that there can be a gap between your stated prices and what you receive from customers. Rarely do I find founders who account for various reasons that the final purchase price differs from the initially intended prices in their financial estimates. These pricing gaps occur for several reasons, from new customer incentives to special discounts and limited-time offers to free samples. For example, in B2B services, you may see quantity incentives to cash discounts for prompt invoice payment, advertising allowances for free customization, and extra warranties to free storage or delivery. These incentives create a gap between the stated price and the final payment amount.
In a startup context, many factors can lead to pricing gaps. Therefore, you must establish plans to manage customer incentives and discounts and account for them in your financials. For startups, early customers provide a unique opportunity to learn the role pricing will play in your marketing strategy.
You want to allow for flexibility with early customers who are willing to collaborate with you to test and improve your products. These customers also have the potential to become early advocates for your startup, facilitating increases in customer acquisition. There are several ways to provide special pricing for these customers without devaluing your product in the marketplace. First, consider early user discounts in exchange for feedback and referrals. In most cases, it is a better strategy to price higher and offer discounts to early customers. Starting at a low price will make it challenging to raise prices later. Customers who pay a lower price initially will be difficult to convinced them to pay a higher price in the future.
The entrepreneur can also consider price bundling as an option. Often, companies will “bundle” a core service with a supplementary one—for example, concessions at a theater and an admission ticket sold under one price. This approach works well for motivating customers to try different products or services in addition to those they already buy from the company.
A word on freemium pricing models. Freemium, an amalgam of free and premium, is often applied to software products and services. With a cloud-based model, service costs are usually small and variable. While marketing costs can be pretty high, offering a free service to attract users with a premium tier to monetize them has become quite popular. Users adopt the free version for its value and become familiar with the product. Then, the customer can upgrade to the premium tier based on knowledge gained from the very free usage patterns that attracted them!
The freemium model works best when the service cost is relatively low, there is a clear distinction between the free and paid versions, and when there is a natural incentive to upgrade. Additional value can be derived from allowing users to earn more by promoting the product for the business. However, you should plan to transition customers from a free to a paid service. Measuring the transition from free to premium is critical for this pricing model.
Summary
Positioning and pricing are essential elements of a new venture’s marketing mix. A founder’s understanding of the customer and the marketplace evolve and influences early product pricing. Considering all three pricing approaches ensures that early revenues and profit margins are optimized.
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