OK, so you’ve got the idea and maybe you even have a prototype of the product or service your are planning to offer. How do you determine what the price of your offering should be?
This question is often flummoxing for early stage entrepreneurs. After all, you are running an innovation-driven enterprise — your idea is new and meant to change the way people are currently doing things! How do you price something that has no direct comparison?
The first method of pricing is cost-plus whereby you determine the cost inputs that go into the delivery of your offering and charge a flat markup, say 20%, to come up with the final price. Cost-plus pricing is commonly requested from contractors by military and government agencies.
While cost-plus is the simplest way to determine your pricing — and often a good exercise as it forces the entrepreneur to understand the cost structure of their offering and the lowest price possible to remain profitable — it often leaves a lot of value on the table. In the early stages of your product or service lifecycle there are early adopters who are willing to pay a premium to have access to the product or service before anybody else. Also remember: your costs are irrelevant to your customer. They just care that your product is providing value at an amount they can afford!
Understanding pricing of your offering begins with understanding the Quantifiable Value Proposition (QVP) to your customer. In a B2B setting, the QVP can often be determined as the revenue gains or cost savings the business will obtain through the delivery of your offering. A good rule of thumb is to target your pricing to be about 20% of your customer’s QVP.
Let’s assume that you have done your research and are confident that through the use of your offering a company can reasonably expect to earn an additional $100K in revenues. As a first approximation, an offering price of $20K would be a good place to start — the client obtains plenty of value from having your offering and you extract a modest amount of the benefits. You have set up a win-win for both sides provided your cost structure allows for profitability at that price point.
The 20% figure is just a goal post in determining the pricing of your offering. There are other important factors to consider when you are looking to decide your pricing.
Does your company have a monopoly? If so, you may be able to command higher pricing.
Does the price come within your decision-maker’s budget? If not, your offering may require additional approvals and lengthen your sales cycle.
Does the price exceed the reimbursement the customer receives? Even if your customer receives benefits from your offering outside of reimbursement, it can be difficult to craft an appeasing story to the acquisition committee who may have a few metrics they make decisions on.
There are several other methods for determining pricing that can help you triangulate on your target customer’s willingness to pay. One method is looking at comparables: what are people already paying for similar products and services? If a customer has previously paid for a similar offering then it’s probably already in their budget. The friction to replace an existing offering is often a lot lower than bringing in something completely new. Another method is substitution: if a customer isn’t already using something similar to your offering what are they using instead? Understanding how much a customer is spending on substitutes can often lead to interesting dialogues with the customer about how your offering can better serve their needs and position them for future success.
Different customers will derive different QVPs from your offering so be sure to segment appropriately! Segmenting in this way can help to determine beachhead markets and branding opportunities within your offering. As you scale and are able to lower your cost structure, opportunities may open at the lower ends of the market where you can sell to customers and maintain similar profitability.
Finally, at the early stages of your company it is often necessary to offer a discount to early customers in order to build the customer base and win referrals. While discounts are a great way to drive sales, take care not to erode the perceived value of your offering and make sure there is a timeline on them so that the customer knows they are receiving a discount because they are taking an early risk. Hardware discounts are often much easier to remove than software discounts as people more readily recognize the tangible value of hardware.
Pricing your startup’s offering depends on several levers and requires an in-depth understanding of your customers needs and their willingness to pay. Cost-plus pricing should be avoided if possible as it tends to leave a lot of value on the table and entrepreneurs should focus on delivering and extracting value through their quantitative value proposition. Once you have settled on your business model and pricing you can now look at calculating your customer lifetime value (LTV)!