In the last article, I covered the core pricing models used by enterprise software companies today: Competitive Pricing and Value-Based Pricing. In this article, I take these models and talk about how you leverage them to support your business strategy.
On their own, these models serve simply as reference points for how you go about pricing. Deciding when to use each model and how to apply it to achieve your objectives is, what I refer to here as Pricing Strategy.
Pricing Strategy: The approach to achieve business objectives through intentional pricing.
Therefore, before defining a Pricing Strategy, we must first understand the context that includes your business objectives.
The Pricing Context is comprised of many inputs. These can include both internal and external factors to the business.
First, let’s consider key internal factors:
Business Strategy: At this point in time what is the business attempting to do? Is it trying to grow the install base? Is it trying to increase bookings or meet some alternative financial metrics? Does the business want to re-enforce a premium brand?
Portfolio Strategy: How does this product fit within a portfolio of products targeting the same market? Is this product supposed to make all the margin or drive sales of other higher-margin products?
Product Lifecycle: Is the product new to the category and attempting to win its first reference customers? Is the product new but also defining a new category? Is the product mature, generating strong positive cashflow and you want to sustain commercial viability?
Now let’s consider some of the key external factors:
Product Category Maturity: Despite where your product lifecycle is, what is the general maturity of this particular category? Is it brand new or are there existing competitors and pricing expectations?
Competitive Strategy: How do your competitors price? Are they focused on gaining market share or profits? Maybe they accept low or negative margins to drive drag on business opportunities.
Market Health: Is the industry that you are selling into economically healthy? Are there external macro-economic factors eroding or increasing participants’ ability to purchase?
Perceived Value: How does the market perceive the value of your product? How does this compare to other products in the category?
There are a number of different traditional pricing strategies across different types of businesses. Here, like with the core pricing models, I am going to focus just a few strategies to take advantage.
Three basic pricing strategies: Skimming, Penetration, and Competitive.
A frequent business objective is to increase the share of the addressable market. The Penetration Pricing Strategy seeks to achieve this and can do so with both competitive and value-based pricing.
Typical characteristics of a penetration pricing strategy include:
Price set low enough to grow market share
Price often significantly lower than the perceived value
Long lifecycles expected to generate a large customer lifetime value
A good approach to launching a new product in the existing market
Value-Based Penetration Pricing Example
Consider that your product defined a new product category and you wish to rapidly grow your customer base as you know the switching costs will be high later on. In this case, you will identify the perceived value and price it substantially below in order to gain early mover advantage in the market.
Competitive Penetration Pricing Example
Entering an existing product category is difficult, even with a superior product. To gain fast market share from the incumbents you may set your price below theirs to drive sales volume. As long as your value/price ratio exceeds the incumbents your market share should grow.
Two common variants to this strategy include:
Loss Leader is a variation where you accept potential losses on a given product in order to build a market for related products, e.g. Inexpensive Email Marketing to drive sales of CRM Suite.
Captive Pricing is a variation where you penetrate with the specific goal of selling add-on products and services. In retail products, the often-cited example is Gillette razors with replacement blades. However, enterprise products have many examples too, including additional user seats, add-on reporting packages, or premium must-haves like disaster recovery.
Note: Freemium, though similar, is considered a marketing strategy and not a penetration pricing strategy. At its core, it is considered a lead generation investment to drive sales of premium versions of the same product.
When providing a new product into an existing or new product category it can sometimes be possible to skim higher profit margins out of the market without going after large market share.
In new product categories, this is frequently possible with innovators and early adopters. As identified in Geoffrey Moore’s Crossing the Chasm, these groups tend to perceive a higher value and are willing to pay a premium for it.
The downside of market skimming is that it constrains the market size. Therefore, over time, vendors will adjust the pricing down to increase unit adoption. This happens due to competitive pressure or when the early adopters are saturated.
Skimming the profits off of a market is a very appealing pricing strategy. However, few businesses can do this well. Typically, this has to go hand-in-hand with a strong brand. Other characteristics include:
Premium price with low volumes typically
Skim the profit from the market
Requires a high perceived value
Suitable for short lifecycle products or will come under increasing pressure over time as become more commoditized
Algorithmic traders are always looking for an edge to gain an asymmetric advantage over the broader market. If you can offer them an solution that accurately predicts market sentiment from public disclosures, they may pay a premium to get the trading edge. Once there exists broad adoption of this technology, the ability to charge a premium will erode.
Competitive Pricing Strategy
Pricing is like any other feature of a product. Some features offer differentiated values, some are on par with the competition, while others are simply table-stakes to be in the market.
A Competitive Pricing Strategy means that you are accepting that you will not be using pricing as a strategic lever to drive your business objectives. Instead, you will price to make it a non-issue in most competitive bidding processes.
Characteristics typically include:
Brand offers minimal competitive value
Existing markets you want to continue participating in
Prices set at/near competitor you want to be benchmarked against
Mature product categories
Competitive Pricing Example
Email clients today are considered a very mature product category. In fact, customers generally expect total message interoperability and feature parity. Including the common feature of a $0 price. These products are differentiated based on user experience and integrations with other value add services. Until recently, all vendors serving this market created a business model to support this user expectation while deriving their commercial benefit elsewhere.
Penetration, Skimming, and Competitive Pricing Strategies are foundational options to achieve your desired business objectives. They are not an exhaustive set of options and each has many variants. In fact, pricing strategy is how some products choose to differentiate themselves in the market.
By starting with these strategies, and intentionally planning your approach to pricing, you will be ahead of many competitors that enter your market.
In the next and last article in this Product Pricing series, I will cover how to set the price. It is like the last mile of a marathon. If you didn’t prepare properly you would not have made it this far, but without setting the price, discounting policies, and communicating it effectively, you won’t be crossing the finish line anytime soon.