SaaS 102 #20 Why Do We Need to Keep Adjusting Pricing Strategies?
Many companies spend a lot of time trying to hire outstanding talent, develop and research products, develop company culture, and build the company brand. But aside from all that, there’s something else which is also very important and is often overlooked:
What pricing strategy should we use for the products we create?
According to research from Price Intelligently, many companies only spend an average of 11.5 hours annually on pricing strategy. That’s even less than the average of 15 hours they spend per year on choosing daily necessities like toilet paper.
Does this show that pricing strategy really isn’t that important after all?
The answer to that question is “no”.
Research also shows that SaaS companies that perform continual price optimization grow faster. They have a customer lifetime value to customer acquisition cost (LTV/CAC) ratio that grows more than six times faster than at companies with no resources dedicated to price optimization.
So, product pricing strategy is actually very important to companies.
What kind of pricing strategies should we use for SaaS products?
For many people, strategies such as competitor-based pricing or cost plus pricing come to mind easily. But fewer people think of value-based pricing.
What kind of pricing strategy is used should be decided according to company and market circumstances. But the fundamental point is:
We need to continually adjust and optimize the pricing strategy for SaaS products. What we can’t do is create a pricing strategy and then leave it unchanged for years.
In the rest of this article, I will describe several common pricing strategies:
- Competitor-based pricing
- Cost plus pricing
- Value-based pricing
I will also explain why SaaS product pricing strategies need to be continually adjusted.
What is competitor-based pricing?
Competitor-based pricing can be understood as follows:
We use the competitor’s price to determine our own price. If we don’t copy the price exactly, we might set it slightly higher (price A in the figure below) or slightly lower (price B in the figure below).
This, though, is a very passive kind of pricing strategy. If we follow this strategy and our competitor lowers their prices, we have to lower them, too.
A more important point to remember is that even our competitors will not have exactly the same products and target customers as our company.
For example, Apple and Xiaomi are competitors in the smartphone market. Both companies create smartphones, and both companies have customers all over the world.
Despite those similarities, the philosophy behind the way they create their products and their target customers are different. As a result of that, they don’t rely on looking at each other’s prices to decide on their own.
They don’t follow strategies such as selling at 800 US dollars if their competitor is selling at 1,000 US dollars, or selling at 500 US dollars if their competitor is selling at 800 US dollars.
There are many methods of competition. But I don’t think that producing a product that is almost the same as another company’s, and then trying to compete with them by undercutting their price is a great way to compete.
(If you want to understand this topic in more detail, you can refer to my previous SaaS 102 article: “SaaS102 #13 Why We Should Focus on Customers, Not Competitors?”)
Focusing on customers is especially important in the B2B SaaS field, where customers are also businesses. When companies purchase SaaS services, they are certainly doing so in order to resolve a certain specific challenge that has come up in the running of their business. They will not be making a purchase just because a product is cheap or because using it might be fun.
What is cost plus pricing?
Cost plus pricing can be understood as follows:
We decide the price by determining how much it costs to make the product, then adding a profit margin on top of those production costs.
But in the SaaS field, pricing products in this way can lead to the following two problems:
Firstly, there might be a very large difference between the cost of the software and the price it can be sold for.
As software can be developed once but sold many times, it’s usually the case that the more users a piece of software has, the more costs are shared out and the lower cost is per user.
If we have many users and we set our prices according to cost per user, we may lose out on a lot of profit.
Secondly, if we want to earn more money with this pricing model, we can only try to think of any way we can to reduce costs, or increase our product prices.
There is a limit to how much costs can be optimized, which also limits how much profit we can make by reducing costs.
If we increase our product’s prices, our customers might not accept the new prices.
Our customer is not concerned with our costs. Our customer is only concerned with their costs. In other words, our customer is concerned about our prices, but not about our costs or profit margins.
What is value-based pricing?
Value-based pricing can be understood as follows:
We decide the price according to how much value the product provides the customer.
Let’s look at an example to illustrate this.
If our product can create 10,000 US dollars of value for the customer, then we can charge the customer 10% (1,000 US dollars) as our fee for providing that product and service.
If our product can create 1,000,000 US dollars of value for the customer, then we can charge the customer 10% (100,000 US dollars) as our fee for providing that product and service.
The following concept forms the core of value-based pricing:
We continuously help our customers to increase their income, and by doing so we increase our income, too.
If the service we provide to our customers is better than before, and we help our customers to capture more value than before, then it is only natural that our prices will be higher than before. I have written more about this topic in my previous SaaS 102 article, “Why Does AfterShip Prefer Not to Sign Multi-Year Contracts?”
If we optimize our costs for providing a product or service, we should reduce the corresponding product price to pass along some of the benefits of the reduced costs to the customer, to help them increase their profits.
Embedded in the logic of value-based pricing is the idea that the customer isn’t really concerned with how high our product price is, but with how much value our product can provide them.
Why do we need to continually adjust the pricing strategy?
As a SaaS company, the ideal scenario is that we can create a great deal of value for our customers, and then price our products based on that value.
But there are two other factors that also affect what type of pricing strategy we will choose: supply and demand.
Supply: How many competitors in the market can provide the same value that we can?
Demand: How many customers in the market need our product, and how much do they need it?
Supply decides how much power we have to set prices in the market. Demand decides how many customers will be willing to pay for our product and how much they will be willing to pay for it.
If there are many other products on the market offering similar solutions to our product, and the value our product provides to customers isn’t much higher than our competitor’s solutions (for example, as illustrated by Figure 1 and Figure 2 below), then in this scenario we may need to set prices according to our competitor’s prices. For example if our competitor’s price is 20,000 US dollars, we might set our price at 15,000 US dollars.
But if, after we continuously iterate our product, it can create much more value for customers than our competitor’s products, then we can set prices according to value (as shown in Figure 3 above).
If you were the customer, which product would you want to use? The one shown in Figure 1, Figure 2, or Figure 3?
The answer goes without saying.
So, we need to continuously increase the value our products create for our customers, and adjust our pricing strategy accordingly.
That way, we can continuously make our products more and more competitive. By helping our customers succeed, and by helping our customers create more value, we will increase our own revenue.
Summary
For SaaS companies, pricing strategies are extremely important. A company that continually optimizes its pricing strategy might grow more than six times as fast as a company that doesn’t adjust its pricing strategy.
For SaaS companies, value-based pricing is more suitable than cost plus pricing or competitor-based pricing.
We should continuously focus on how to create more value for our customers and help our customers succeed, and reap the rewards proportional to how much value we have helped create.
This requires that we select suitable pricing strategies according to the current circumstances, and continue to adjust and optimize product prices on an ongoing basis.
I'm Teddy, Co-Founder & CEO of AfterShip, SaaS 102 is a series of articles where I share my experience in SaaS startups.
We are looking for great SaaS sales talent and welcome you to join us at careers.aftership.com.
(Article translated by Joseph O'Neill)