Start-ups often wrestle with critical decisions on their pricing and business model; since I’ve consulted on these subjects for hundreds of companies of all sizes, entrepreneurs often ask me for recommendations.
It is hard to give general advice since each company faces different challenges depending on at least the product offering, the competitive landscape and the types of customer.
There are a few factors that are always relevant:
1. Value Based Pricing
Cost is obviously a consideration when setting prices, since no company can afford to sell below their cost for very long.
As long as you are selling above your cost, put thoughts of them aside and ask yourself how much your product is worth to your customers. Try to capture a fraction of the customer value in your pricing model.
Finding out the customer value is often difficult, depending on the situation.
In many B2B settings, you can calculate the customer’s return on investment from adopting your offer.
You’ll need to compare the benefits of your offer to your competitors’ offers and their pricing. If your offer improves something customers care about, you should be able to get a significant price premium.
Here is a Harvard Business Review article with a little more detail on value based pricing.
2. Customer Segmentation
Customer segmentation is widely talked about, but often misunderstood.
Correctly applied, it is about identifying groups of customers with different needs, seeking different combinations of benefits and having different willingness-to-pay. Identifying these customer groups and their needs is, of course, essential when packaging your offer into different bundles for those different customer groups.
Customer differences in needs seldom follow simple characteristics such as sex, age, type of industry or geographic location. To find your segments, you must do market research. Market research is quantitative stuff; you engineers ought to be comfortable with it. Since many companies don’t do market research, they go for a simple scheme, like selling different product bundles to different age groups. Those simple schemes do not capture real need differences between groups, and this approach therefore often fails.
3. The Business Model
Prices come in many shapes and forms. Most people think in terms of price level - “How much”. The way you price, the business model, is at least as important as the price level for commercial success.
There are many ways to sell and price products or services, including:
- Give it away and make money on advertising or some other indirect source of revenue. Prominent examples are Facebook and Twitter.
- Free (or almost free) Product bundled with paid services.
Companies can charge for installation, maintenance, training, customization, and consulting services. This model is often used by companies distributing Open Source Software, like Red Hat Linux.
- A Freemium Model. Software companies like LinkedIn and Dropbox offer a free, limited-functionality version of their product, hoping that enough users will pay for a premium version with more advanced features.
- Razor and blade Model. Sell a necessary base component cheaply and make money on consumables and maintenance or some other life-cycle dependent factor.
- Subscription Model. Instead of selling a product, offer it as a subscription including maintenance, service etc. This model may be used in a wide range of situations. Rolls Royce famously decided to supply jet engines at a cost per running hour, including service and maintenance, rather than sell engines outright as they and all their competitors had done before.
There is no recipe for which business model is best for your company but selecting the most appropriate one will definitely have a major impact on your commercial success and the future value of your company.