Jory MacKay on April 05, 2018 The Psychology of Pricing: How to Pick the Right Pricing Model for Your Company
You’ve got a great product. You’ve beat the odds, listened to your users, planned a killer product launch, and have thousands of potential customers clamoring to get their hands on your latest thing.
Then all of a sudden, Jeff from sales stands up and asks:
“So, what are we charging for this thing?”
The room goes silent as everyone looks around at each other.
Damn.
Pricing is one of those factors that feels like it should be natural, but rarely is. You have a feeling of what your product should cost, but you can’t just throw numbers at a wall and see what sticks. And worse than that, you know that wrong pricing is one of the biggest mistakes you can make.
This post will help you get pricing right. Here's how we're going to approach this:
Price your product too low and you might gain tons of customers, but you won’t make enough to pay salaries, support your many, many new customers, or pay for your fancy office.
Price your product too high and you most likely won’t land enough customers, and you still won’t be able to pay salaries, support your customers, or pay for your fancy office.
Either way, it feels like if you don’t get it right, your company’s going to sink.
Worse than that, there’s rarely a “right” answer for what to charge. Not only do you have to contend with what people are willing to pay, pricing yourself properly against your competition, and building a brand people value, but there’s also all sorts of weird psychology behind what people are willing to pay (seriously, have you ever wondered why you’ll spend $9.99 but not $10 on something?)
In short, pricing your product—whatever it is—is one of the most important decisions you’ll make. It’s also one of the most frustrating, seemingly illogical, and easy to screw up ones.
Pricing your product—whatever it is—is one of the most important decisions you’ll make. It’s also one of the most frustrating, seemingly illogical, and easy to screw up ones.
But when you understand pricing from a business perspective, as well as from a psychological and customer one, you have a better chance of nailing it and keeping your team and investors (and landlord) happy.
So, let’s dive in.
All pricing is a guess (at first). But it needs to be an educated one.
Wait a second. I thought you said we weren’t allowed to just throw prices out there and see what works!
Well, you’re not. Unless you have some crystal ball, there’s a certain level of guessing that comes into how you initially price your product. The key here is to do enough research to make the level of guessing as minimal as possible.
What we’re talking about here is smart pricing. Pricing that takes into account all the factors of your company, your customer, your brand, the market, and general economic trends to tell prospects, “Hey! This is a great product and totally worth what we’re asking.”
You also need to understand what your general pricing strategy is. Which could be:
- Skimming: Charging the first customer more than later ones
- Penetration: Under-charging to gain share in the market
- Maximizing: Charging the most you can for each sale
(If you’re giving away your product for free, or using a freemium model, you can read this fantastic post from Harvard marketing professor Vineet Kumar.)
For the sake of this article, we’re going to assume you’re trying to maximize your price. Which starts by answering a few key questions:
1. Who is your customer?
Let’s get the biggie out of the way first. Who are you selling to?
The more you know about who your customer is, their needs and wants, how long it takes them to buy, what colors they like the most, the easier it will be to sell to them.
As Close.com founder Steli Efti likes to say:
Whoever understands the customer best, wins.
When it comes to pricing, specifically, this means:
- Knowing their Desired Outcome: What does your customer need to feel successful and what is the right way for them to get there? In other words, how much value does your product or solution bring to them?
- Putting their willingness to pay at the core of your product design: What features does your customer need and are willing to pay for? As pricing expert Madhavan Ramanujam explains:
“Most companies postpone pricing decisions until after the product is developed. They embark on a long, costly journey of hoping they’ll make money rather than knowing they will. You can ensure your product not only stays alive, but thrives, by talking with customers early in the product development process. If you don’t, you won’t be able to prioritize the product features you develop, or know whether you’re building something customers will pay for until it’s in the marketplace.”
2. What are your per-unit costs?
How much is it going to cost you to make each unit/manage each license/look after each customer?
To know how much to charge, and maximize profits, you need to know what each incremental unit costs you (and therefore, how much you’re making in profit on it).
It’s easy to think at this point that you want to recoup all your R&D costs, but as Joel Spolsky, CEO of Stack Overflow explains:
“Maybe it cost you $250,000 to develop the software in the first place, but that’s a sunk cost. We don’t care about that anymore, because the $250,000 is the same whether you sell 1000 units or 0. Sunk. Kiss it goodbye. Set any price you want, the $250,000 is gone and therefore not relevant any more.”
3. What is your revenue target?
How much money do you need to make to keep the lights on (and then some)?
Businesses only survive if they make enough money to cover the bills plus profit. So what do you need? Add up your monthly costs—raw materials, labor and salaries, rent on your shiny office, paying back debt—and call that X. Then, understand what you want your profit margin to be. How much do you want to make on top of breaking even? That’s Y.
This is another slippery slope, as many businesses either don't factor in all their costs (and under price) or literally factor in all their costs and expect to make a profit with one product (and therefore overcharge).
What your revenue target is will depend on a bunch of factors only you know. But be realistic with it.
4. What is your value to the customer (in both utility and brand)?
There’s a reason you’ll spend $1000+ every year on the latest iPhone, or thousands of dollars on designer clothing. As Professor William Poundstone, author of Priceless: The Myth of Fair Value, explains, most of us are clueless about the concept of “value.” And as such, we can be swayed in ways we wouldn’t believe possible.
What work have you done before selling your product to sway your customer one way or the other? Do you have a strong brand? Are you positioned as a luxury (versus budget) item? Have you targeted a clear demographic and showed all the value you can create for them? Do you have strong testimonials and case studies from past customers?
As Redpoint VC Tomasz Tunguz says: “Price reinforces brand because price telegraphs whether a product is a premium product or a value product.”
People are irrational and believe you get what you pay for. The general consumer is going to believe the most expensive option is the best. Because as long as nothing’s setting off their scam alarms, why wouldn’t they?
5. Who are the competition?
Take a look at the market. Who’s already selling what you’re selling? How much are they charging for their product.
While it’s important to know what the competition is doing, you shouldn’t just rely on them to set the value of the market. Also, you need to remember that no matter what, your customer is looking at all their options before purchasing. Which can have unintended disastrous effects.
Let’s say your competitors are charging between $100 and $500. You decide you’re ‘about in the middle’ and charge $300. While you might be thinking this shows just how good of a value your product is, what you’re actually telling customers is that you think you’re “meh.”
Your price doesn’t live in a vacuum. And you need to be super conscious of the context your customers are viewing it in.
6. Where is the market headed?
Just like you need to know your competition, you need to know where the market is going in general. Selling high-priced cloud storage space made sense back in 2007. But over a decade later, there’s a reason Dropbox is changing its focus.
When you’re figuring out the price of your product, you need to look forward to what the market is doing. Is what you’re serving going to continue to be valuable, or are you selling dirt in a drought?
So, what do you do with all this information?
You make a guess. Well, an educated guess.
You can do as much research as possible, but the only way you’ll actually “know” if you’re on the right track is to listen to paying customers. People are the most honest when they pull out their wallets.
But you need to give them somewhere to start.
Take all those figures and facts and research and come up with a number that makes sense. Maybe you’ll use the 10X value rule, by figuring out the value your customer will get from your product and pricing at 10% of that.
Or, put together your own best guess and use market factors and competition as a gut check. However, don’t just copy the competition without a deep understanding of why they priced that way. (Hint: they might have just pulled that number out of thin air.)
Basic, Standard, Pro (oh my!): How segmenting lets you squeeze the most from all your potential customers
This guess has given you a pretty good starting point. Now how do you make sure that price is maximizing your profits?
First, let’s talk about a basic economic term: Demand.
For every product, there’s a certain level of demand that you can expect for it. Look at competitors in the space or what the market cap is for your industry. How many people do you expect to buy your product at the price you’ve come up with?
Let’s say you’re pricing your product at $100 and 50 people are going to buy it. That means you’ll make $5000. Nice! But what if you upped the price to $150 but only 40 people bought it? You’d make $6000. A full $1000 more profit for less sales.
What about if you dropped the price to $80, but this time 100 people bought it? That’s $8000.
If you map all these numbers out, you’ll get what’s known as a Demand Curve. This graph shows you roughly how many people will buy your product at what price. It’s downwards sloping (as more people will buy at a cheaper price and less at a more expensive one).
Once you have it mapped out, you can pick the number with the highest revenue based on the proposed price and number of potential customers. Boom. Done!
But wait. What about all those people who were willing to spend more and are getting a deal. Or the people who would’ve bought if you were $20 cheaper? Isn’t that just money left on the table?
There’s another economic term we need to throw out there for these people: Consumer Surplus. The profits lost by not pricing your solution exactly to what a customer is willing to pay.
If we want to maximize our profits, we need to find ways to suck up as much of that surplus as possible. We want to be able to charge more to those who are willing to pay more, and less for those who aren’t. Lucky for us, you can do that in the form of segmentation.
Look at most SaaS (software-as-a-service) products. They know different customers will use their products in different ways. And so instead of one price for unlimited access, they choose prices that reflect the values of their users.
Let’s take Planio's pricing as an example:
As a project management tool, they know that the most important feature for their customers is managing projects. But rather than charge $69/month and have people only managing 3 projects get pissed off that they’re paying too much (and giving a crazy deal to busier teams), each price point reflects a different customer segment.
Segmentation is used in lots of different ways across industries. Products that offer coupons in local newspapers are effectively segmenting their product for different buyers (people with a lower income and where it makes sense to clip coupons vs. those who are busier but willing to pay more for the same product).
Or just think about any time you’ve tried to book a flight. Not only are there different classes of seats, but airlines segment based on when your trip is, how long you’re going for, what specific days you are away for.
Each form of segmentation is trying to capture the most profit from your customers as possible.
Seller beware: Segmentation isn’t easy. And can just as easily erode your brand and sink your product
Wow, this all sounds too good to be true! We’ve got a price that makes the most sense for our users, and segmented out everyone else. Nothing left to do but sit by the pool and watch the cash roll in.
Not quite. It’s not enough to just put up a higher and lower price for your product and call it a day. Segmentation needs to work for your customers as much as it does for you.
Let’s jump back into our flight-booking example for a second. Back in the early-mid 2000s, airlines got so “good” at segmenting their customers that they pissed them off. Everyone knew they were getting hustled, and so when low-cost carriers came out, the industry was ripe for disruption.
When you’re coming up with your pricing formula, you don’t want to fall into this same mistake. Instead, you need to map your prices to the Desired Outcomes of your users.
This way, each tier of pricing is providing the value you need it to. And that person paying $100 more a month isn’t pissed off that they’re basically just paying more for the same thing.
Here’s a quick self-check to make sure you’re not falling into that trap:
- Is your pricing based on the right metric? What do your customers find most valuable about your product? Is it projects, seats, features, storage? What is the thing that as a customer uses your product more and more they say “yeah! I want more of that!”
- Do your segments limit or empower customers? Does each segment feel like it’s limiting the use of a user, or empowering them to do more? If you understand their desired outcomes and willingness to pay, you can lock them in and make more features/usage/space feel like a win for them. The more value they get, the more they’re willing to pay.
- Are you continuously testing? At first, it’s hard to know if you’re on the right track. And remember, customers vote with their wallets. If you can, bring in a small first cohort of users to understand how they’re using the product and what their price threshold is. How much can you increase the price before you get too much pushback/cancellations/returns?
Yes, we’re talking about pricing here. But proper pricing doesn’t feel like it’s taking away from the customer. It makes them feel like they’re getting something more valuable in return.
The weird science around how to make your pricing more appealing (or, the dumb things that make us pay more than we should)
We’ve been pretty practical so far about pricing, but it’s important to remember that a lot of pricing isn’t practical. Remember what Professor Poundstone said? None of us really have any idea how valuable something should be.
Pretty much every product you’ll sell won’t have an inherent value. We’re not talking about commodities here. So the value (and therefore the price) is subject to all sorts of weird psychological hacks that make them appear more valuable.
We’re not talking about screwing customers over, but just some of the strange ways humans interpret value and price, and how you can use those to your advantage.
Pick odd numbers
It’s one of the oldest pricing tricks in the book. But there’s a reason it’s still around. People call this ‘Charm pricing’ and it’s the positive feeling that happens when the left-most digit of a price changes. Our brains encode a price with the first digit we see, so a change from $9.99 to $9.19 won’t really matter. But go from $9.01 to $8.99 and all of a sudden there is a perceived value change.
Say it outloud (and use less syllables)
In a paper published in the Journal of Consumer Psychology, researchers found that prices that contained more syllables seemed drastically higher to consumers. This is thanks to how we read a number and its ‘fluency’. The harder a number is to say the worse we feel about it. So $1,999.99 (one thousand, nine hundred, ninety nine, and ninety nine cents) feels more expensive than $1999 (nineteen ninety nine). The more syllables, the more we think it costs.
Use price anchoring to your advantage
Thanks to a human tendency called anchoring, when it comes to displaying a price, what you see first is what you want in the end. Anchoring or focalism is a cognitive bias that says we rely too heavily on the first piece of information offered (the ‘anchor’) when making a decision. So how do you use this in your own pricing strategy?
For one, you can make sure higher numbers are shown earlier on your sales page (‘anchoring’ that price). Or, in one seemingly counterintuitive example, an analyst at McKinsey found when a semiconductor manufacturer put out a new product, instead of lowering the price of the older offering (like most of us would), they raised it. Not only did they make additional profits off selling old stock, but keeping the anchor price high made new buyers more likely to pay the amount asked for a new product.
Show physically smaller numbers
Studies have shown that placing your price in the bottom of a page rather than the top makes people perceive it as lower. Even crazier, the physical size of your font can influence how we feel about it. Thanks to processing fluency, people perceive your price to be smaller if you display that price in a smaller font!
When you’re setting a price, you’re sending a signal
Tricks and optimizations aside, pricing is something you need to be careful and deliberate with.
Not only does it have to reflect everything you know about your customer and the market. But your PR, marketing, and sales need to reflect your price.
If all the arrows point in the same direction, then pricing reinforces and justifies your position in the market. As Lawrence Steinmetz, author of How to Sell at Margins Higher Than Your Competitors so aptly put it:
What’s the difference between an $8,000 Rolex and a $40 Seiko watch? The Seiko is a better time piece. It’s far more accurate. The difference is your ability to sell.
Pricing is important, but it’s just part of the feelings, beliefs, values, and brand you create around your company and your product—including the importance of what you choose to name your company. Get your pricing right though, and it’s like fuel on a fire.”
