This week we have a guest blog from Chargebee.
In 1938, two engineers decided to launch their own product. They built an oscillator and named it Model 200A. The next step was to decide its price. They settled on $54.40 because the number had sentimental value for them. Despite their random approach to pricing, the model turned out to be successful. Fortunately, Dave Hewlett and Bill Packard got lucky with their first product before they set up an empire.
However, we know that things aren’t so easy for most when it comes to pricing products for the simple reason that pricing is difficult. It is rarely a straightforward process where we can get by on a hunch – it depends on multiple factors like your customers, your competitors, and the type and quality of your product.
And this is exactly where pricing experimentation steps in, helping you hit the sweet spot to generate more revenue.
Why pricing experiments are vital
Imagine a simple demand curve where price is plotted vertically and purchasers horizontally. By looking at the area of the rectangle under the curve, you can work out the revenue you’ll make at different price points. Essentially, you figure out the rectangle (price x purchasers) with the highest area, aka, the highest revenue. Voila, you’ve found the right price, right? Not quite.
In the real world, this “simple” demand curve isn’t simple at all since pricing depends on several variables like the quality of your product, its perceived value, competitor pricing, and the like. For instance, when Microsoft released its first disk operating system, it was priced at $50. As operating systems were a new market category, this became the ‘fair price’. When IBM released a completely different OS a few years later and priced it at $340, customers were shocked. Since Microsoft made the first entry and established a reference point, IBM could not challenge it. This isn’t to say that you should copy reference points, but you can always demonstrate the worth of your product to customers before pricing it high. And what if, even then, customers were not willing to pay $340? What if the right price point was $280? The only way IBM would have figured this out is through pricing experimentation.
Relevant Read: Don’t Just Roll The Dice by Neil Davidson – A short guide to software pricing
SaaS pricing is a little different
While all the variables to consider during pricing remain similar for most products, SaaS pricing has a few more conditions. Customers buy SaaS products not because they think it’s worth the cost but because they think it will give them continuous value for the cost they’re incurring. While SaaS companies already offer an attractive pricing model, their profitability is a lot more dependent on CLV and CAC since they have to sustain customers every billing cycle, which is month on month. Additionally, they require more capital to sell their service as opposed to a one-off software license, and they have to put greater efforts to keep their customers happy.
To price a SaaS product, you begin by covering your costs – keep in mind the CAC, CLV, and the cost of setting up and maintaining a user in your system. Beyond which, other variables like customer perception, reference points, your ability to provide different versions of your software at different prices, and so on, come into play.
Pricing experiments help price your SaaS product accurately, ensuring you deliver the most value to your customers, gain competitive advantage, and boost sales.
Based on a Profitwell study of 512 SaaS companies, monetization – using pricing as a lever to maximize profits – has the largest impact on your bottom line.
Additionally, it is important to understand that pricing experimentation provides maximum benefit as a continuous process.
Profitwell’s study of 96 SaaS companies with ARR greater than $5 million found that companies that adjust their prices continually exhibited extremely robust unit economics.
Moreover, the study also found that companies that made price optimization a continual focus realized far more lifetime value from their customers than it cost to acquire them.
Pricing experiments include talking to customers and collecting insights on their perceived value for your product and its features (versus its objective value). In addition, there are popular strategies and models that you can experiment with to see how your SaaS product can make the most profits.
How do you go about pricing your SaaS product?
Pricing is multifaceted and depends on several aspects like product features, demographic, geography, industry, and more. There isn’t a fixed formula or rule for pricing but here are some well-known pricing strategies and models that can guide you.
SaaS Pricing Strategies
1. Cost-plus Pricing
Cost-plus pricing is the simplest of all pricing strategies. As the name suggests, the pricing considers the cost of production and adds a general markup to it (and for this reason is also known as markup pricing).
While this method ensures you cover your costs, it is considered conventional since it doesn’t give a complete understanding of your business’ profitability as it is solely based on costs and doesn’t consider other factors like customer demand and competition.
2. Competitor-based Pricing
Competitive pricing is based on how/what your competition is charging. This method is generally used when the product has reached stability or if it’s in a highly competitive market with no real alternatives. Hence, it is important for companies that rely on competitive pricing to understand what they’re selling and the type of competitors they’re up against. Keeping an eye on the existing and emerging competitors and how they operate gives you an idea of better managing your business. You can always sell lower than the competition and ensure you stay on top that way. On the other hand, if your product has something different, you can choose to price it higher. Examples of companies that price competitively are Shopify and BigCommerce.
However, this type of pricing offers the same downsides as cost-plus pricing in that it doesn’t take into account the costs and customer demand. Moreover, constantly trailing your competition and understanding how they are setting prices can be a downside if not carried out properly, and you don’t have the automation to support it.
3. Value-based Pricing
The value-based pricing model sets the price point of a product or service by how valuable this solution is to your customer. By continuously engaging with your customers, you can find out how valuable your product is to them. With this information, you have the liberty to experiment with your pricing.
You begin by figuring out your customers’ Willingness To Pay (WTP). This can be done through statistical research like conjoint analysis where you ask users to directly compare different features to determine how they value each one. The next step is to find a “value metric” you can base your pricing on. It is the unit upon which the buyer perceives value out of your product or service.
For instance, at Chargebee, we use ‘revenue’ as a value metric since we derive value from the revenue that our customers process through our solution. Similarly, other SaaS companies price based on their own value metrics – for HubSpot it’s marketing contacts, and for Freshdesk it’s sales agents.
On any day, value-based pricing is a lot better than slapping a random markup through cost-plus pricing. And, relying on competitor pricing may not work in the long term because you need to evolve your pricing strategy based on your product and not what others offer. What matters is the value of your product and differentiation, which this pricing strategy tries to capture.
Finally, keep in mind that value-based pricing might not give you one magical price point but will give you a range of prices. You can go about packaging it with the help of different pricing models.
SaaS Pricing Models
1. Flat-rate Pricing
A flat fee is a universal subscription pricing model for SaaS businesses. The method is based on the “one size fits all” pricing strategy, and you charge your customers the same amount monthly/annually regardless of how many users or their usage is. For example, Basecamp uses flat-rate pricing.
2. Usage-based Pricing
There are four different ways to charge your customers when you opt for a usage-based pricing model. You can base your pricing model based on the number of users, the total volume, or the tiers it covers. For instance, a customer using 15 licenses will have to pay $15 for the first nine licenses and $10 for the rest. Or even price for consumption depending on the slab it falls under, irrespective of the usage. For example, a cloud storage business charges $100 for 500GB, $200 for 2 TB, and $400 for 4 TB of storage space. Chargebee, for instance, charges the customer by directly syncing the price charged for the pricing tier with revenue generated by the customer.
3. Per User Pricing
This model allows businesses to charge based on the number of individuals using the product. The revenue scales with the product’s adoption by the users in the company. An example of a company executing per user-based pricing is Canva.
4. Per Active User Pricing
In this model, you charge your subscribers only based on how active they are. In other words, you only charge the users who use the product. Slack charges based on active users. We’ll cover Slack’s pricing in detail further in the article.
5. Per Feature Pricing
The product is priced based on the features and functionality which is offered to your customers. The more features, the more your customers pay and vice versa. QuickBooks’ pricing tiers are separated based on the functionality available for each tier.
6. Tiered Pricing
In the tiered pricing model, different versions of the product are offered at varied prices. These can be based on features, a number of users, or usage and are decided by the business based on its product. Usually, 2 to 5 tiers are created, and your customers can choose from the same based on their needs. Using this pricing model, you can upsell to your customers incrementally, including features as they scale. The tiered pricing model is extensively used by SaaS companies, for any pricing model they choose to use. Most of the examples we discussed above – Chargebee, Slack, and QuickBooks – also offer tiered pricing. Even if a SaaS company charges a flat fee, they can offer different plans-say basic, gold, and platinum and also bundle some of the plans to serve different audiences.
For more information, check out our Definitive Guide to SaaS Pricing Models which includes strategies, examples, and top metrics to track.
Companies that made it
Nobody can name the best pricing strategy or model. Every SaaS company is unique, and so, different pricing models work for different companies. It’s only through experimentation – pricing iterations and analyzing customer data – can you settle on the best pricing method that can generate the most gains for your company.
However, to gain a better idea (and some inspiration!), let’s go through the stories of some SaaS companies that crushed the pricing game.
When you hear the words “Zendesk” and “pricing” in the same sentence, it’s hard not to think of their infamous pricing blunder in 2010.
Three years after their inception, the Zendesk team raised their prices across the board, without a clear understanding of their customers’ perceptions. What’s more – they did not propose a way to grandfather existing users. And, much to their chagrin, it resulted in a major backfire.
The move forced the market leaders to vacate the helpdesk market’s entry space, leaving the door wide open for new players to enter and gain a foothold. By 2012, Zendesk was losing massively to Freshdesk, and they needed to demonstrate their competence in acquiring early-stage customers and growing before going public.
The most important lesson they took away from this setback? Price segmentation based on customer personas. They have since fine-tuned their price points to suit each customer segment.
Relevant Read: If you go through Zendesk’s pricing history, you can understand how each of their iterations focused on a particular slice of the market.
In 2018, a survey of 5,211 current, former, or prospective Zendesk customers found that WTP for core support pretty much mirrored Zendesk’s pricing model.
Zendesk’s is a classic tale of growing from a product known for core support to a customer experience suite; this gave them the ability to bring in a lot of expansion revenue. None of this could have been possible without learning from their mistakes and recovering by continually experimenting and optimizing pricing – knowing their customers well enough to grow to the scale they are today ($12.55B net worth) – and nailing their core product pricing.
Zendesk’s pricing today:
The commerce platform is (and has always been) a clear winner in the SaaS space, and boasts a net worth of over $200B today. While the perception is that Shopify struck gold on its very first foray and massively scaled in no time, the fact is the team focussed heads-down on perfecting their product for many years. When they decided to scale around 2011, they intricately wove pricing experiments through every stage of the product’s evolution. Right from the changes in value metrics (storage limits, transactions fees, credit card charges, feature-based differentiation), to the introduction and removal of new pricing sections (Sell online, Sell in person), every revision of their pricing has been closely coupled to the development of their product, and consequently, the value derived by the customer.
Relevant Read: If you go through Shopify’s pricing history, you’ll begin to see rapid iterations in pricing precisely around 2011, when they had shifted their focus on scaling.
Shopify’s pricing strategy led to rampant success mainly because they centered it around their mission metric – everything at Shopify revolves around increasing their customers’ sales and revenue. As a result, everything in the store, from the design of the templates to the pricing structure, works to align everyone with the mission of its customers.
- Shopify offers a low barrier to entry since it’s very easy to get started with. Its pricing page copy is extremely easy to navigate, and the basic plan has pretty much everything needed to get a customer started.
- Shopify rallies pricing around their mission metric – how they organize the navigation of their page, how they optimize their pricing strategy, how they change up their packaging structure, the products that they build – everything is focused on boosting the gross merchant value of their customers.
We can see that the success of a SaaS company has a lot to do with how it has priced its products. Developing a smart pricing plan is extremely crucial since subscribers may opt out if the price does not justify the value. Not to worry though, because this is where pricing experimentation comes in handy to figure out accurate price points for maximum revenue generation. However, keep in mind that experimentation works best as a continuous process and not as a one-time effort.
To stand out and be successful, fostering active experimentation from the get-go and continually is what will set you on the road to hyper-growth and massive success.