Pricing Software Is Hard
Pricing software is hard. It's a difficult skill for which there are few books or guidelines. Many software companies cause themselves enormous quantities of pain by simply picking numbers that "feel right." Don't just pluck numbers out of thin air. If you want to succeed in business, you need to think before you price.
This guide presents ten common mistakes that companies make when pricing their products.
No Pricing Goal
I recently spoke to a director of business development. He had just established a pricing model for his company and wanted to show off his business expertise. He challenged me to engineer a better pricing strategy on the spot.
So I started by asking the most important question of all:
"What is your goal?"
At this point I received nothing but a blank stare and a look of astonishment. He had never thought about what he was trying to accomplish with his pricing.
The truth is that there is no such thing as a perfect price. There are only prices that make sense for a given business goal. Here are just a few examples of pricing goals:
Goal Typical For Pricing Strategy Maximization of profits Established companies Calculate the maximum that each customer is willing to pay. Charge that amount. Penetration of a market Well-funded businesses entering new markets Put the focus on user count rather than growth. Many firms will attempt to temporarily select prices below those of established competitors. Note that this risks branding the product as an inferior good. Saturation of a market Dominant firms Businesses pursuing this goal may choose to offer at least one tier priced below the profit-maximizing price. This is done so as to prevent new entrants from establishing a foothold in the marketplace. Maximization of liquidity Firms with limited financial runways (new, bootstrapped firms or firms that are losing money) Offer discounts for better payment terms (prepayment). Firms using this strategy will reduce income uncertainty and receive immediate infusions of cash in exchange for lower expected income. Maximization of goodwill Companies producing items that are ancillary to their core business and individuals looking to build their reputations Firms willing to subsidize the costs of their software may see their reputations rise and attract attention toward their other products. This strategy must be implemented carefully, lest the price reductions be seen as a signalling of weakness. Do note that non-software products can be provided under this strategy. Common examples include: products and certifications.
The Two Option Strategy: Take It or Leave It
Large profitable businesses are often willing to spend more money than cash-strapped consumers. Therefore, sales to high-end corporations are often a very good thing.
Oddly, many software companies miss an easy avenue for large sales. One of my biggest pricing tips is to always include a pricing tier with a vague description and no price. This will act as a signal to big firms that you're willing to tweak your offerings, as long as they're willing to pay.
How is this better than offering a concrete, expensive plan for the big spenders?
- Unique needs: Some customers will be willing to pay great sums of cash in exchange for features that you never considered. If you stick with pre-designed plans, some big spenders will see that you don't offer what they need and buy from your competitors instead.
- Unique wallets: Some customers have a lot of money to spend, but others have a lot more. When a visitor sees "contact us" as a pricing tier, he knows that the offering will be expensive. As a result, only customers willing to spend a lot will contact the vendor. Vendors can use skill, experience and knowledge to ensure that each buyer spends near the top of his budget.
Only 33% of the products surveyed publicly offer custom-priced tiers. The "publicly" part is important, because I know that some companies offer custom plans privately. Why would they do this? I have no idea. There may be logical reasons for this, but I can't think of any that make a whole lot of sense.
Obviously, your custom-priced plans should be targeted at the high end customer. The increased complexity and overhead involved in managing customized packages are generally not worth the money for small sums.
High Sales Friction
I've spent a lot of time arguing against free items. It's a basic tenet of capitalism that you need to charge money to someone in order to earn a profit. That said, sometimes free does make sense.
When a customer buys a product, he takes on far more risk than does the vendor. This is because the buyer has an information deficit. He can read specifications and descriptions for as long as he wishes, but no matter how much time he spends, he's forced to make a lot of assumptions about the value that the software will provide. The seller, on the other hand, knows exactly what he is going to receive - money.
A freemium tier allows vendors to remove much of the risk that a customer normally accepts when making a purchase. Sure, screenshots and explainer videos are nice, but actually using a system can make potential customers feel more comfortable opening up their wallets. In my survey, only 52% of software systems offered a freemium plan.
Of course, implementing a freemium plan incorrectly can wreak havoc on the bottom line. When designing a freemium tier, businesses must be careful to remember that a freemium user can only provide value in two ways:
- Convert to a paying customer
- Attract a paying customer
As a result, care must be taken to ensure that a free plan isn't so good that no users sign up for paid offerings. Free tiers must be limited in some way. Here are a few commonly used limitations:
- User count - Only allow one user account per company (rather than allowing accounts for each team member).
- Features - Remove, limit or add complexity to a few key features (reduce the value of your system's functionality).
- Time - Only allow usage at certain times of the day or for a certain amount of time.
- Content - Limit the content that the system uses, analyzes or displays. Alternatively, reduce the quality of the system's output (either through watermarking, adding noise to the results or limiting output size).
- Licensing - Prevent certain uses of the software via legal agreements or monitoring. For instance, software with academic licensing almost universally requires that the software not be used for commercial purposes.
- Geography - Block connections between users of two geographic regions or usage of data with certain geographic properties. Language selections can often be used as a proxy for a geographic restriction (relatively few people in Japan would be able to use software with a Dutch interface).
Some companies try to use other means to reduce friction costs. The two most popular methods are:
- Money-back guarantee - I use this method for my book on software pricing, but it is less than ideal for software. It still requires trust on the part of the buyer. More importantly, it still requires many buyers to receive prior authorization to make the purchase. This may not be a problem when selling B2C software, but obtaining authorizations in most mid-sized and large businesses can be a serious undertaking. Some organizations won't authorize any charges without several levels of approval. A free tier would likely require little to remove the need for approvals from corporate overseers.
- First month free - Many companies will inform users that the first month of service will be free. Customers may cancel at any time to avoid being billed. Many vendors employing this method still require a credit card, so that users can be automatically billed in subsequent months. This method suffers from many of the same negative effects as the "guarantee" method. Another problem is that many firms act slowly and may require additional time to reach a buying decision. Allowing users longer periods of time to become dependent upon the system will provide vendors with significantly more pricing power.
The Wrong Number of Pricing Tiers
Pricing tiers are one of the most powerful tools in a pricer's toolbox. They allow vendors to target additional customers.
Unfortunately, selecting the number of pricing tiers can be a delicate balancing act.
- Not enough tiers will hurt your business - Offering too few choices will alienate potential customers. The fewer the number of choices, the less likely that a visitor will be well-suited for one of your plans.
- Too many tiers will hurt your business - Using too many tiers risks confusing and frustrating potential customers, as described by the paradox of choice. Don't believe me? Head over to your cell phone store and watch as people are presented with all of their options.
I generally suggest using three to four pricing tiers. The use of researched and well-designed customer personas can help significantly in their design.
Here's a look at how many tiers software companies typically use. Note I have removed all freemium plans and plans without a listed price.
Price Tiers Usage by Software Firms 1 2% 2 16% 3 43% 4 33% 5 4%
Thinking Prices Can't Shape Reality
A dirty secret is that dollar figures and product descriptions can influence buyer behavior.
We all know that placing a higher price on a product will lead consumers to assume that it is of higher quality (all things being equal). Without additional clues, most buyers default to a Price = Value thought process.
Marketers have long used decoy pricing to encourage customers to select higher-tiered plans. By adding an intermediate choice that is better that the bottom tier (but clearly a worse value than the top tier), prices are anchored higher and consumers become comfortable with the idea of spending more money.
You don't even have to be devious. You can simply add high-priced offerings that no one would ever buy in order to make it look as though rich, successful customers are buying high-end products or services from you.
Imagine a company that produces software priced at $50, $100 and $150 per month. What would happen if this company added a fourth tier at $5,000 per month? Or a consulting package for $40,000 per month? It would look like it supports very successful, demanding clients. As a result, smaller firms might feel more confident in the vendor's ability to satisfy their less complex needs.
Terrible Pricing Tier Names
William Shakespeare's most famous quote was likely
A rose by any other name would smell as sweet.
While many credit the man as the world's greatest playwright, few claim that he was a great economist. You need to ignore his writings and put great care into the selection of your tier names.
As a result of my research, I have been able to categorize tier naming systems into three broad categories:
- Progressive - This is the standard bronze, silver, gold naming scheme. Though many companies in this category chose different terms, they all benefited from a system that could be used to increase internal ranking. A visitor could clearly identify which tiers were superior to those below them. Unfortunately, every creative deviation from the "metal" naming system resulted in less information for the consumer. For instance, the company Firebase was very creative and named its tiers after various sizes of fires (the larger the fire, the better the plan). While this naming scheme allowed for simple comparison between tiers, each name provided little indication of its tier's value in isolation. One would have no idea how "good" the candle plan is without being able to reference the names of the other options. The traditional "metal" plan names alleviate this difficulty. One could see the silver plan and be fairly confident that it was a mid-level plan.
- Customer-focused - Rather than describe the product tiers, some companies chose to describe the ideal users for each plan (some variation of individual, team, enterprise). I see this approach as superior to the progressive naming convention as it will guide the customer into choosing the package that you (rather than he) think is most appropriate. Additionally, it will reduce the required cognitive workload for potential customers, thus increasing the likelihood that they will be willing to purchase your wares.
- Other - Companies not using either of the two strategies
above added confusion for no reason. I found no examples that proved
compelling or useful, but I will provide two examples to demonstrate their ineffectiveness:
- Wufoo utilizes random Latin phrases to uniquely identify each plan. Unfortunately, the names cannot be used to determine relative quality or appropriateness of any tier. It's a very scary thing when a customer with a pocket full of cash and a desire to buy the best product is forced to stop and read a pricing page with care and consideration.
- Uberflip must have flipped out. Its plan names include expert, exclusive, elite and enterprise. While I give the firm bonus points for alliteration, each of these names could apply to the most expensive plan a given company offers. As a result, customers have little means of understanding the relative value of any given plan.
Here's a table indicating the popularity of each naming system:
Naming System Companies Using It Progression 39% Customer-focused 18% Other 42%
Poor Spread of Price Points
Why doesn't Ferrari offer a reasonably priced sedan for the average working stiff? The "Ferrari" name would be enough to sell a lot of low-end cars. They could probably make a fortune!
The answer is simple. Yes, the firm would likely make more in the short term, but such a move would cause a lot of damage to the brand's reputation at the upper end of the spectrum. The brand would no longer be seen as a premium product. Customers looking for the best would begin to look elsewhere for their status-signaling needs. Here's an example of a company that is probably underpricing its offerings.
Price can say a lot about your company and your product. If you offer a very wide spectrum of prices, you won't be taken seriously by the market. Mid and high-end customers will assume that you're selling a low quality good.
A relatively narrow price focus will help customers laser in on your offerings and immediately decide if your products are a good fit. Of course, the narrower the space between your pricing tiers, the less able a given tier will be to attract a customer segment. It's a delicate balancing act.
The following table shows the ratio of most expensive to least expensive tiers for each product (free plans excluded).
Maximum Price / Minimum Price Companies Using This Multiple or Lower 3 12% 5 45% 7 60% 10 70% 25 83% 50 95%
Many marketers believe that the best approach to pricing is to copy the pricing structure of existing companies.
In a pure commodity market, where every offering is viewed as equal and entirely interchangeable, this line of thinking might make sense. However, the world of software is most certainly not a commodity market.
The Consumerist's article on grooming equipment demonstrated that a tangible product can be sold at multiple price points within a single physical store. Knowing this, one should certainly believe that software from different vendors can be sold at different prices too.
There are three main reasons why you should consider coming up with a custom pricing strategy:
- As we pointed out earlier, different companies have different pricing goals. Not only that, there is a strong possibility that the firms that you emulate may have different strengths, weaknesses, opportunities and threats.
- It is sometimes easier to target a different segment than the one that your strongest competitors have chosen. For instance, a large company may price high to dominate the enterprise market, whereas a small company could price relatively lower and dominate the small business market.
- There is no guarantee that a given company has priced its products appropriately.
Lack of Tier Differentiation
Businesses should ensure that more costly tiers provide more value to users. However, it's even more important for businesses to make the differences in value explicit.
One would think this piece of advice obvious, but I recently demonstrated that companies fail to denote the value provided by higher tiers. Sales pages should not be an Easter egg hunt. Value propositions should be readily apparent to even the most casual observers.
The differences between tiers should be both objective and specific. Basecamp makes it pretty easy to see the differences between tiers - it all comes down to the number of projects and storage space provided.
Do note that as the differences between tiers become more complex, two problems may arise:
- Customers will have to increase their cognitive workload to understand your offerings. This increases friction (and reduces the odds of a purchase).
- Customers may not understand the value provided by higher-tiered plans. As I pointed out in an earlier post, a poorly designed table of available tiers can hide the value of your offerings.
Focus on Features
It pains me that even established companies don't seem to understand the difference between the features and benefits.
- Feature - a description of your offering
- Benefit - an outcome that provides customer value
As a general rule, only the least educated and least experienced buyers will be impressed by features.
It's great that your system can run 10,000 simulations an hour, but how does that help the customer?
The more you can relate your product to actual benefits, the simpler and more effective your sales process will become. You'll be able to command higher prices and attract more customers.
Ideally, your benefits will involve either a cost savings for the customer or (preferably) a means of increasing his profitability. Once you can quantify a benefit in dollars, you can charge much higher prices. This is because your sales technique will be reduced to something like the following pitch:
Hello, Mr. Customer. I have a magic box. Every time you put $1 inside, I'll give you $3.
Welcome to the world of value-based pricing.
Do note that many people wind up choosing the wrong benefits to highlight. Amateurs select benefits that matter to their users. Slightly more educated amateurs select benefits that matter to the people who pay for their products. Professionals select benefits that matter to the people who make the decision to buy.
Let's look at an example:
You're selling software for accountants that is so efficient that it will make 50% of the world's accountants redundant. Should you mention this as a benefit?
The answer is an emphatic YES! While many users (accountants) might be terrified that it will cause an end to their tenures, the owners of the firms will certainly appreciate the potential savings.
SummaryPricing is important, but it's really hard to get right. Don't just pick a number and hope for the best. It's much better to think about your goals and take some time to think about how pricing can help you achieve them.
Shameless Commercial Plug
Are you thinking about correcting your prices? Why not contact me for a consultation? I can help you make sure that you aren't leaving money on the table.
Oh, You're Shy?
That's OK! You can buy a copy of my book on software pricing. It covers the main concepts of software pricing and explains them in plain English. Every single nugget of advice that you get out of this book could be worth a fortune! Remember: small changes in pricing can yield big changes in profit!