Pricing is one of the most complex and impactful business decisions a product or service company has to make. Getting your pricing strategy right can spell the difference between a startup that struggles to stay afloat, and one that is able to scale rapidly. However, many entrepreneurs and product managers often rely more on guesswork than structured thinking when deciding how to price their offerings. In this guide, we will walk through a step-by-step approach to building a high-impact pricing strategy tailored to your specific business context. We will look at understanding costs, sizing up the competition, analyzing willingness-to-pay among target customer segments, selecting pricing models, and setting tactical prices.
Whether you are creating a new product, looking to change prices, or optimizing an existing portfolio, applying sound pricing principles is key to maximizing revenues and profits in both the short and long term.
Understand Your Costs
The starting point for any pricing strategy has to be a clear-eyed view of costs. This includes both fixed and variable costs across your entire business model and production cycle. Analyzing costs sets the floor for viable pricing; you cannot rationally price below your breakeven point and expect to survive as an enterprise.
First, enumerate all the fixed operational expenses that are independent of production volume – salaries, rent, loan interest payments, software licenses, etc. Next, determine the variable costs associated with producing and selling incremental units of your product. This includes raw materials, assembly labor, distribution commissions, and sales & marketing expenses among others. The mix of fixed and variable costs differs significantly depending on your business model.
For example, an online SaaS company has very high upfront fixed costs in software development but very low variable costs per additional customer. On the other hand, a manufacturing company has lower fixed costs but higher per-unit variable costs. Carefully tracking all cost elements at scale is complex, but extremely vital. Talk to your operations and finance teams to access accurate data on cost drivers.
With your total fixed and variable costs enumerated, you can put together a Cost Structure Formula:
Total Costs = Fixed Costs + (Variable Costs x Units Produced)Now determine the minimum volume of units you need to sell just to break even. This breakeven point guides the lowest viable pricing and unit volume combination. If your fixed costs are $100,000/month and unit variable costs are $50, you would need to sell 2,000 units per month to cover costs.
Beyond breakeven though, pricing must account for desired profit margins. A general product company target is 40-50% gross margins, though this varies significantly by industry. Software/SaaS businesses often target 60-80% gross margins since most costs are upfront fixed costs. With the breakeven volume and target margins set, you can now rationally estimate pricing minimums.
Know Your Customers
While costs set pricing floors, effectively capturing value from your customer base determines price ceilings. Customers ultimately decide whether your product’s positioning and messaging successfully communicate the value you hope to create. Pricing power stems from creating a compelling reason to pay you over alternatives.
To evaluate pricing potential, you need to deeply understand your target customer segments – their needs, behaviors, and willingness to pay. Group customers into segments with distinct pricing tolerance based on attributes like demographics, psychographics, usage intensity, and benefits sought. Common patterns include:
- Basic vs. Premium Customers
- Casual vs. Power Users
- Price-sensitive vs. Quality-sensitive
- Early Adopter vs. Mainstream Customers
While segmenting customers, also analyze their expected lifetime value (LTV) based on usage and loyalty patterns. Optimizing LTV across target segments is key for long-term value creation.
Now conduct primary and secondary research to assess each segment’s willingness to pay. Useful inputs include:
- Past pricing for similar product categories
- Survey/interviews with prospective customers
- Test offering different pricing/benefits tradeoffs
- Analyze reaction to early competitor products
Combine quantitative pricing research with qualitative feedback on product positioning. Customers with similar demographics can have very different perceptual responses to pricing. The pricing sweet spot lies between covering costs, capturing segment value, and fitting brand positioning.
For example, a cold press juice company has two potential segments – gym goers focused on refreshing low-cost nutrition vs. health-conscious higher-income customers seeking premium quality. The premium segment supports much higher pricing despite similar variable costs. Testing messaging with both groups can reveal substantially different willingness-to-pay.
Getting pricing right is challenging because customers often anchor expectations based on incomplete perceptions. Grounding pricing in both costs and value requires aligning business systems with customer insights. We will explore bridging this gap further in designing pricing strategies and tactics.
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Analyze the Competition
Beyond costs and customers, the third major factor in developing a pricing strategy is analyzing competitive offerings. The prices that competitors charge and the value they deliver set constraints on your own pricing power.
First, comprehensively map out competitive products and services that target the same customer needs as you. Go beyond just direct competitors in your product category and include alternative solutions customers have. For example, car-sharing services like Zipcar compete with taxi cabs, car rentals, and even private car ownership.
For each major competitor, objectively evaluate:
- Product features, quality, and functionality
- Customer service and post-purchase support
- Brand messaging and positioning
- Business model differences like channels/partnerships
While feature-matching is important, also considers emotional elements of value creation. Tesla competes as much on tech-savvy branding for early adopters as on vehicle performance metrics.
Analyze competitor pricing along multiple dimensions:
- Published list prices as well as discounts/incentives offered
- Versioning – different prices for good/better/best product tiers
- Bundling – pricing interlocked ancillary products/services
- Lock-in pricing – subscriptions/replenishment purchasing
Talk to sales representatives, read public reviews, and examine SEC filings to gather pricing intelligence. Utilize pricing variation by geography or customer segment to extrapolate competitor pricing models.
Aggregate findings into a competitive landscape map – plot competitors by price and performance tiers to visualize white spaces. Size competitor market shares to estimate how much revenue they currently capture at different price points. This builds intuition on where pricing gaps may exist.
Besides overt market alternatives, also consider non-consumption substitutes. For example, consumers debate between purchasing a car vs. relying on existing public transport. Quantify the cost of such “do-nothing” options as an implicit ceiling on pricing.
Analyzing competitors in conjunction with your costs and customer demand provides boundary conditions for your pricing strategy. We will next assemble findings from all three areas to set pricing objectives.
Select a Pricing Strategy
Armed with intelligence on costs, customers, and competition, we can now define pricing objectives and select an overarching strategy. Pricing objectives lay out clear numeric targets for revenue, profitability, and volume over a specific timeframe. Common examples:
- Achieve $10M in sales at 60% gross margin next 12 months
- Reach 20,000 active subscribers with $80 LTV by the end of 2025
- Increase market share from 12% to 20% in existing customer segments
The exact objectives depend on your business context – growth phase, incumbent vs. challenger position, cash constraints, etc. Prioritize 1-2 leading indicators like revenue or market share as primary pricing success metrics.
With pricing objectives framed, evaluating alternate pricing strategies and models becomes easier. Each approach has different tradeoffs between simplicity, risk, and adaptability. Common business pricing strategies include:
Cost-Plus Pricing: Base price directly on per-unit costs plus a pre-defined profit margin target. Simple to implement but leaves money on the table if customers are willing to pay more.
Value-based Pricing: Set price explicitly based on perceived value created for target customer segments. Maximizes willingness-to-pay but harder to quantify value delivered.
Penetration Pricing: Price low initially with the goal of gaining market share rapidly. Makes sense for network effects businesses focused on scale. Challenging to raise prices later.
Price Skimming: Charge higher prices initially to maximize revenue from early adopters. Useful for innovative offerings but invites competition over time.
Dynamic Pricing: Frequently adjust prices based on supply-demand changes and competitor actions. Enables price optimization but risks confusing customers.
Two complementary models to consider are:
- Versioning: Sell different product/service tiers at varying prices to segment customers. Eg: Good, better, best software packages.
- Bundling: Offer combinations of products as a package deal to increase user value.
Given pricing objectives and business context, choose 1-2 models aligning to your priorities. Balance simplicity vs. precision based on strategy execution capability. Outline tactical plans to operationalize – metrics, price lists, terms. We will tackle setting tactical prices and adapting them next.
Set Initial Prices
With a pricing strategy defined, the next step is setting initial tactical prices to take to market. This involves translating pricing models into specific dollar amounts for each product/segment combination.
If pursuing a cost-plus pricing approach, apply pre-set margins above per-unit costs to derive prices. For value-based pricing, conduct buyer research like conjoint analysis to determine willingness-to-pay thresholds. Dynamic and penetration pricing models involve temporarily pricing below long-term targets to stimulate trial.
Setlist prices at 2-3 tiers good/better/best for versioning schemes. Structure bundled packages to incentivize higher-value purchases. Optimizing initial pricing balances leaving money on the table vs. overpricing and limiting adoption.
Field testing pricing moves the analysis from theoretical to tangible. Offer samples of the target segment’s pricing/messaging tradeoffs using real dollar amounts. Measure observable metrics like email open rates, clicks, and conversions to gauge response.
For existing products, run A/B experiments with small customer cohorts. Evaluate effects on both adoption rates and overall revenue levels. This concrete feedback allows for refining prices, packaging, and messaging for optimum results.
When introducing entirely new products without prior sales data, utilize analog pricing from other categories as proxies to forecast. Supplement with economic modeling incorporating addressable market estimates, likely adoption curves, and future expansion potential.
Initial pricing rarely perfectly captures all value on the table. Prepare contingency plans for prompt price tweaks 6-12 weeks post-launch depending on urgency. Planning upfront for rapid adaptation ensures you stay aligned to objectives.
Adapt Your Prices
Launching is only the beginning. Markets constantly evolve and executing a pricing strategy must respond in kind. Regularly review performance metrics vis-à-vis objectives across multiple dimensions:
Financial: Sales revenue, blended pricing, unit margins vs. targets
Market: Customer segment response at each price tier, win/loss patterns
Competitive: Pricing/positioning changes from competitors
Metrics reveal how actual buyer behavior diverges from original strategic assumptions. Course correct pricing elements like list prices, discounts, and financing terms if critical KPIs risk falling short.
Adapt pricing to address revealed customer demand and sentiment. Upgrade premium packages with more value if uptake is lacking. Spot discount volumes if lower tiers over index. Introduce new periodic payment plans if high upfront costs deter.
Balancing agility with consistency is key for minimizing customer confusion from pricing changes. Clearly communicate expanded options as providing more tailored choices rather than inconsistent volatility.
SaaS and other subscription models lend themselves to gradual continuous optimization. For large enterprises selling high-touch deals, annual rate cards with 6-month advance notices may fit best.
Over longer horizons, revisit pricing via refreshing foundational strategic analysis. Fully re-assessing cost structures, expanding total addressable market size, and identifying new willing-to-pay cohorts opens additional pricing headroom.
Pricing well delivers windfall growth while pricing poorly proves product-market fit still lacking. Keeping pricing strategically aligned, tactically nimble, and communicating changes transparently sustain sales momentum.
Conclusion
Determining what to charge for your products may seem more art than science. However, taking a structured approach to building your pricing strategy pays huge dividends. First, analyze your costs and know what pricing minimums are needed to sustainably grow your business.
Next, understand your customers deeply – their needs, behaviors, and willingness-to-pay for the value you create. Evaluating competitive offerings in the marketplace reveals pricing ceilings and opportunities to differentiate.
Armed with intelligence on costs, customers, and competition, you can define pricing objectives and choose models that best fit your context. Setting initial prices, running field experiments, and promptly adapting based on data closes the loop between theory and practice.
Pricing well means continually reviewing and refreshing to capture value as markets evolve. Do not leave this vital activity to guesswork or inertia. Consistently applying pricing best practices maximizes your revenues, profits, and business valuation over the long term.