When it comes to pricing, a lot of startups treat it more as a math problem, but in reality, pricing is a combination of marketing, psychology and of course, economics.
This article will reflect on some common mistakes, it will introduce some useful principles and also it will provide some tips that will help you in the process of figuring out the right price for your product. The article is based on Kevin Hale’s YC Startup School speech.
Most common mistakes that startups make when it comes to pricing
- Prices are too low: there is a tendency to consistently undercharge.
- Underestimating the costs: this will lead to several problems — mostly, the margins won’t be enough to cover the acquisitions.
- Not understanding the value offered or not being able to convince the customers about the value that their product offers will lead to the same result — they won’t charge the right price.
- Focusing on the wrong customers can happen when mainstream customers are in the company’s spotlight and not the early adopters (which are much more in need for the product).
3 key things that you should consider before putting a price tag on a product:
- Cost of production: the first step of any pricing effort is getting all costs included in your pricing. Beside the direct, manufacturing/developing costs to make your product, you must also integrate the indirect costs, such as: office rent, employee salaries, marketing budget, etc.
- Scarcity: one of the most fundamental rules of pricing boils down to basic economics: limited supply drives up your price. Many B2B services are not scarce. They have standard costs, high competition keeps prices fairly stable. Same goes for a lot of B2C products too.
- Estimate realistically: before you sink money into creating a new product, make sure you are being realistic about how much you’ll be able to charge in the long run and then you can work backwards to calculate how much you can afford to invest and ultimately to price.
- Perceived value: usually, companies tend to fixate on the gap between manufacturing cost and charged price. But you should also focus on the gap between your price and how much value customers think that the product/service delivers, a concept known as the perceived value.
When you are thinking about pricing you should use a concept called the price thermometer. There are two factors beside the price that play a major role in the process of pricing: cost and value. The interaction and relationship between these items highly affects how the growth happens inside the company.
The gap between price and cost is the margin, the incentive to sell. The bigger that gap is, the more you are driven to want to push your product to the customers.
On the other hand, the gap between price and value, is the incentive to buy. In this case, the larger that gap is, the easier it is to have customers that want to sign up or use a product.
By using this principle, there are two ways to figure out price: you either start with the cost — if you know what it is and you figure out where your price is based on that. This technique is called cost plus.
The other way to do it is to figure out what is the value of your company or product/service and then you figure out your price. This is called value-based pricing.
In startups and in almost all businesses, everyone is striving for value-based pricing, because it allows you to charge a whole lot more and also, it gives you the chance to manipulate the incentive to buy.
The rule of 10 / 5 / 20
This is a three-step formula for deciding the perfect pricing level that maximizes the profits, keeps customers happy, and creates a forcing function for the company to focus on creating more value.
Briefly, here are the steps:
- The perceived value by a customer should be 10X the price.
- Raise the price by 5%. Once you have a price, you should practice raising it, until:
- You are losing 20% of your customers.
- Put more effort when it comes to pricing: you have to understand that pricing is a function of a product’s value.
- Go after early adopters because they are the customers who try a product out and then influence their network of friends/family to buy it.
- Figuring out what goes through a customer’s mind when he/she first sees your product can help you set a price; this you can do easily by observing and talking with some of them while they look at your website or product.
- Cost, price, value. Make sure you got these concepts right and you understand how they fit in your startup.
Startups are challenged by many things, but pricing is one area where they can have some power to shape their own destinies, if they have a thoughtful strategy built on valuable insights, practical knowledge and leadership.
Make the effort as soon as possible to understand the components to be able to work on building a strong pricing strategy.