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Juan MC Larrosa
You’re Pricing It Wrong: Software Pricing Demystified
Pricing your own product is always a tricky proposition, and the more critical the price is to your product’s success, the more difficult it is to set. It’s easy to look at another product and say how much you would be willing to pay for it, but how can you know how much people would be willing to pay for yours?
There are no absolute truths or perfect formulas for finding the best price, assuming that the “best price” even exists. Instead, take a structured approach to finding a good starting point, and improve it through feedback and testing. But first, you need to understand what the best price actually is.
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Riding the Demand Curve
When we price a product, our goal (assuming we’re running a business) is to maximize revenue. We want
sales × price = highest possible value.
Economic theory suggests that as we raise the price, the number of sales will drop. Each intersection of price and number of sales can be plotted on a graph, creating what is called a demand curve.
The sweet point is where the intersection forms the largest rectangle. This rectangle represents the calculation of
sales × price, and the biggest rectangle represents the biggest revenue.
This makes sense… until you consider that your clients are people, and people do not often make rational purchasing decisions. In his excellent eBook Don’t Just Roll the Dice, Neil Davidson says (emphasis is mine):
Once you’ve determined what your product is, you need to consider its value to your customers. In the case of the Time Tracker 3000, let’s say that it will save a particular customer, Willhelm, three hours of work and that Willhelm prices his time at $50 an hour. That means that Willhelm should buy the Time Tracker 3000 at any price under $150, assuming he has nothing better to spend his money on.Of course, this assumes that Willhelm is the rational, decision-making machine that economists love. In fact, Willhelm is a flesh-and-blood, irrational human being who doesn’t price his time and calculate costs and benefits. He has a perceived value of the Time Tracker 3000,which may or may not be linked to its objective value.
Neil goes into much more detail than I can in this article, but to recap quickly: perceived value can be different than objective value, and it can affect sales in ways that the demand curve does not predict. For example, when buying a brand-name product, you are intentionally paying a premium because the perceived value is higher, even if the objective value is the same. Some brands purposely price higher in order to increase the perceived value and thus sell more.
Pricing Higher And Selling More
Taking the fictional issue tracker in Neil’s book:
Back to Willhelm and the Time Tracker 3000. If you want to change how much Willhelm will pay for your product, then changing the product is one option, but only if you can also change his perception too. In fact, it turns out that you can change Willhelm’s perception of your product’s worth without touching the product at all. That’s one of the things marketing is for.
That’s right. You can set a higher price without changing your product just by changing the potential customer’s perception of the product. For example, you could increase perceived value by writing better marketing copy (focusing on the value that you’re providing or the pain that you’re solving). A killer demo can do wonders, as can strong testimonials and well-known partners.
One of the best ways to increase perceived value is to have better visual design — which, not surprisingly, is one the weakest links in marketing for most software developers. A well-known fruit company has become a giant by out-designing its competition, and it’s no coincidence: Apple charges a premium because of the perceived value of its products.
One common way to identify perceived value is to check the competition. Are you selling a WordPress plug-in for newsletter management? Google the keywords to see what else is on the market. If you’re in luck, you’ll be providing the only solution in this space. If not, you’ll have to consider that your clients can use Google just as well as you can and thus take your competitors’ pricing into account.
What do you do if a free product does what your product does? In this case, you have four options:
- Demonstrate that your product either is clearly superior or has features unique to it;
- Work on creating such differentiators;
- Win on marketing;
- Provide support.
Providing support is an important differentiator; one of people’s biggest deterrents from using a lesser-known free or cheap product is their concern about ongoing problems and future needs. A commercial product that comes with support will often win over customers who want that assurance that someone will be on the other end of the line should they need it.
Providing support has another benefit in addition to increasing the value of the product: it’s a chance to get real feedback! The feedback you get from support requests will enable you to improve the product and thus sell more (or increase the price) in the future.
A Real-World Example
The start-up that I co-founded, Binpress, is a marketplace for source-code components. One of our components, an import and export rules module for Magento, started out priced very low: $4.99 for a basic license, which is actually the minimum price that we allow.
We noticed that it was getting good traction and that people were looking for this particular functionality and that no good alternatives existed. We suggested to the developer that he raise the price. And he did, in stages:
- At first, he raised the price to $9.99, which did not affect sales (i.e. the conversion rate stayed the same);
- He then raised the price to $14.99 — again, the rate of sales remained the same;
- The price is now $19.99, and sales are slowing down somewhat.
So, the optimized point lies somewhere between $14.99 and $19.99 — more than three times the original price! That is, the developer will generate over three times the revenue simply by optimizing the price and not actually changing the product. Without having tested different points, the developer would still be stuck at $4.99.
The prices should attract your customers, not drive them away. Image Source
Pricing A New Product
So far, I’ve talked about perceived and objective value and maximizing the demand curve. But what about the initial price tag?
When you go about pricing a product, run through the following exercise.
1. DETERMINE THE PRODUCT’S OBJECTIVE VALUE
How much would people pay if they were indeed rational decision-making machines. With software, the calculation can be as simple as:
(Hourly rate × Development time in hours) − Price = Value
This simple calculation would determine the product’s value if the customer were making a completely logical decision. (Of course, this will vary depending on the hourly rate of the developer and their experience, which will affect development time. But those two numbers are usually related.)
2. UNDERSTAND THE PRODUCT’S PERCEIVED VALUE
Who is your target audience? How will the product help them? (Will it save them time, improve their business, etc.?) Who will ultimately be making the decision to buy your product? (A developer? A project manager? The dude holding the company’s credit card?)
To answer these questions, research your market. What are the competing products? What is the demand? Who needs this solution, and how unique is it? How hard would it be to develop the product from scratch?
The Programmers section of StackExchange has a good overview of these considerations. Unless your circumstances are highly unusual, you can find answers to these questions relatively easily by using Google and by visiting relevant community-powered forums and Q&A websites such as StackExchange.
3. WHAT VALUE DO I WANT TO CONVEY THOUGH THE PRICE?
A product priced at $1.99 sends a very different message to potential customers than one priced at $19.99 — the difference in conveyed value is by an order of magnitude. Don’t lower the price early on merely to try to generate more sales, because you would be conveying to customers that the product is worthless.
After determining the perceived value of the product and deriving a price from that, we can try to optimize the price in several ways…
1. IMPROVE PERCEIVED VALUE WITH MARKETING
I’ve already covered several factors related to marketing, such as copy, visual design and demos, and I might expand on others in a future post. Consider these elements when trying to increase perceived value. If we find that the perceived value is below our objective value, then we can almost certainly raise it to at least the objective value. And with creative marketing, we could probably go far past that.
2. IMPROVE OBJECTIVE VALUE
To quote Joel Spolsky in his excellent article on Simplicity (bolding is mine):
With six years of experience running my own software company I can tell you that nothing we have ever done at Fog Creek has increased our revenue more than releasing a new version with more features. Nothing. The flow to our bottom line from new versions with new features is absolutely undeniable. It’s like gravity. When we tried Google ads, when we implemented various affiliate schemes, or when an article about FogBugz appears in the press, we could barely see the effect on the bottom line. When a new version comes out with new features, we see a sudden, undeniable, substantial, and permanent increase in revenue.
Going back to the point I made earlier, you can price higher through differentiation if you understand what people need and then exploit weaknesses in the competition. Everybody uses Magento because it delivers a lot of value, but customers keep complaining about its speed, among other things. Suppose you built a similar e-commerce platform that is blazingly fast? Bingo! You’ve targeted the biggest pain point for your competitor’s clients. Sometimes, having competition is helpful just to know what people really need.
3. TESTING
When all is said and done, determining the ideal price from the get go is hard. You’ll need to test several prices and plot the demand curve of your product to find that sweet spot.
4. TIERED PRICING
This is critical from a psychological point of view. By setting just one price for your product, you don’t provide any points of reference (except those of your competition). You can increase the perceived value of your regular price by adding a premium package that is priced much higher. The point of the premium package is not to generate revenue (although it will do that — always give people the option to pay more if they want to), but rather to make the regular price seem like a better deal.
Start With A Good Guess And Then Optimize
By now, you should have the basic process down for how to price your product. There are no absolute truths in pricing: it’s best to start from a good guess and then test as much as possible. This article is meant to lay out the process to make that initial guess and the considerations that go into it.
There could be any number of reasons why a product is not selling as well as it should, aside from pricing. Always try to get feedback from potential customers (i.e. your website’s visitors) using tools such as KISSinsights, Total Feedback and even a simple contact form. The reasons could be a lack of information, missing features or simply a broken purchasing link.
What experience do you have in pricing software? I would love to hear about it and any questions you have in the comments!
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