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New product pricing strategies – 3 essential tactics for startups

Financial management

Financial management

New product pricing strategies – 3 essential tactics for startups

Wout Bobbink, 6 March 2018

Whether you sell bicycles, Software as a Service, state-of-the-art 3D printers or legal services, one thing is certain: the selling price of the products or services you offer is crucial for the success of your newly started business.

But how do you define the pricing strategy for new products or services that are not yet ‘out there’ in the market? And how do you plan the development in your selling prices for the years ahead? Read all about it in this blog highlighting three new product pricing strategies for startups.

In an earlier blog we described how you can build a full-fledged sales forecast being a fresh entrepreneur. We covered different methods that help you define sales targets. Very important, but less prominently described in our earlier blog, is how to determine the related selling prices. Therefore, this blog is fully dedicated to that topic: pricing strategies for startups offering new products/services.

Determining selling prices is sometimes portrayed as a science of its own, especially if you do not have any sales yet and can only guess for the right pricing. Nonetheless, in many cases entrepreneurs have to be able to substantiate their pricing strategy already in an early stage; for instance when you are about to launch your product/service or when you need to build a financial forecast to convince investors of the potential of your company. Worry no more! With the help of this blog you will take the first steps to the right pricing strategy for your company.

1. New product pricing strategies – Pricing based on costs

The first method of pricing new products/services is the most mathematical of the three pricing strategies we cover and takes the costs your business generates as the starting point. Calculate the direct costs and indirect costs generated per sale and then add a profit margin to get to your selling price.

Direct costs (or Cost of Goods Sold/COGS) include all costs that are directly allocable to the production of the goods sold (or services performed) by a company. For a producer of 3D-printers direct costs could include the costs of purchasing raw materials used in producing the printers. For a SaaS company direct costs could include hosting and online payment fees. For a service company COGS could include the personnel costs of the employees that deliver the services. The similarity among all three examples is that without incurring these costs sales literally cannot take place; therefore they all concern direct costs.

Indirect costs or overhead costs are all remaining costs that are not related to the production of the goods sold by a company (or generated to perform services). Examples are event costs, office supply costs, online marketing costs or office rent. These costs are not necessarily required to produce a good or to deliver a service and are therefore called indirect. Also without these costs a sales can take place.

Example

Below we present a simple example of how your costs can help you define selling prices. Note: direct costs and indirect costs per sale presented in the example below are calculated by dividing the expected total direct and indirect costs by the expected total number of sales:

Direct costs (per sale)

€60

+ Indirect costs (per sale)

€40 +

= Total costs (per sale)

€100

+ Desired profit margin (e.g. 25% per sale)

€25 +

= Desired selling price

€125

This example shows a selling price of €125 is required to cover for all costs and to secure a profit margin of 25% per sale. This specific pricing strategy works well for business models in which costs are easy to allocate to the unit in which you define a sale. Think of, for instance, selling 3D printers where one sales unit is equal to one printer or delivering legal services where one sales unit is equal to one hour.

You can also apply this method very well for small businesses and freelancers that experience organic growth: if the selling price for such businesses does not cover all costs and does not deliver a certain profit margin a small business owner is simply not able of providing income for his livelihood. Moreover, for small business owners external financing is often not abundant, meaning growth has to be financed from the business’ income.

Inside-out

This method also has its drawbacks. First of all, it takes a strong inside-out view on things: it mainly takes the perspective of the company and does not really take into account the needs of the market or the customer.

Moreover, it is a strongly mathematical exercise: if the calculated costs per sale are not correct (this can easily happen for instance when you have just started your company, which makes it hard to exactly forecast the expected costs and sales) your run the risk of making your prices too high or worse: too low, meaning you might make losses on your sales.

As soon as you have your sales going on for a while it is thus advisable to check the realization of your expected costs. Are the actual direct and indirect costs per sale as you estimated or are they perhaps higher (or lower)? Based on that exercise you can then adjust selling prices again.

There are also good reasons to (temporarily) sell without profit margins or even below the cost price. This happens often amongst startups: in order to grow fast it is frequently strategically decided that high expenses are needed (for instance for sales and marketing around a product launch) that cannot (yet) be financed from income resulting from sales. If these costs were to be included in the calculation of the desired selling price, they would probably turn out to be way too high.

On the other hand, it goes without saying that in the long term selling prices must cover all costs to create a sustainable business.

It goes without saying that in the long term selling prices must cover all costs to create a sustainable business.

2. New product pricing strategies – Pricing based on positioning

A second way to determine pricing strategy is based on the positioning of your product or service in the market. This method is thus less focused on company internal factors such as costs, but has a more outside-in approach by means of positioning against competitors.

If you have competitors offering a similar product or service as you do, then you can use their pricing as inspiration for yours. Do they for instance sell 3D printers with similar features as the 3D printer you offer for a price of €1.500, then you can take that price as a starting point and adjust up or down; depending on how you position your company/brand against the competition.

Would you like to position your product/service as a low-budget option? Then you probably need to go for price breakers. Can you benefit from the name recognition of a strong and qualitatively recognized brand, while your competitors are primarily startups? Then your prices will likely be higher. Do you want to position your brand as luxurious or high-end? In that case, your prices will most likely have to be higher than the competitors’.

Take into account that marketing and brand awareness are crucial though. If you want to position your company/brand in a certain way, you also have to make sure that customers will start recognizing and acknowledging you in this way.

A pricing strategy based on positioning is very useful when your product or service is not for sale yet, but when you already have to define your prices; for example, if you want to build a financial plan when setting up a new company. You also need a thought-out financial forecast if you want to convince the bank or an investor to raise funding.

If you do not possess any historical data yet that validates your selling prices, but if you can rely on the price validation of your competitors, then you can use your competitor’s pricing as substantiation of your own pricing towards potential investors.

3. New product pricing strategies – Pricing based on customer value

The third and final way of determining pricing strategy that we discuss takes the client as starting point. This is thus the method you could call the most outside-in of the three strategies we discuss in this article.

The purpose of this method is to define your customer (segments) as accurately as possible and to generate data about them that validates your pricing. Subsequently, you should match your pricing (page) to the different customer segments as good as possible.

This method is frequently used by software/IT startups as they often work very data-driven by definition already, can easily test through web/software analytics and can quickly implement new pricing models. For companies offering more ‘traditional’ products or services this approach is also very useful though, because it puts the customer first.

This is crucial because a mathematical exercise may show you the selling price of your 3D printer should for instance be €1.500 to cover your costs, but if a customer is not willing to pay more than €1.000… Well, your company will have a hard time.

How does this method work in practice?

Step 1: Define your customer (profiles)

The first step is to define clear customer profiles. These are also called ‘buyer personas’. Buyer personas are (preferably data-driven) role models that represent a customer segment. A well-written buyer persona vividly describes, amongst other things, the demographic background of a potential customer, the way he/she searches for information, which social media channels this person uses, the motives he/she has and the buying behavior that this person exhibits.

Usually buyer personas get a catchy name (for example: ‘Startup Sarah’ and ‘Scale-up Simon’). This name forces you to recognize differences between the different types of customers you service and ensures that everyone within an organization understands which customer profile is meant.

The next step is to assess what value your product or service provides exactly to the different buyer personas/customer profiles that you have identified. Your product or service probably has different features or benefits that, individually or collectively, solve a customer’s problem.

Startup Sarah may have different problems and needs than Scale-up Simon and the features/benefits that offer value to Startup Sarah might not necessarily result in value for Scale-up Simon as well. Features and corresponding benefits should therefore be fine-tuned to the different customer profile. The trick is to then adjust prices accordingly.

Startup Sarah may have different problems and needs than Scale-up Simon and the features/benefits that offer value to Startup Sarah might not necessarily result in value for Scale-up Simon as well.

Let’s take the example of e-mail marketing software company Mailchimp. Startup Sarah might use Mailchimp to share nicely designed weekly newsletters with a limited number of followers. Startup Sarah does not have any revenues yet and has not raised any funding yet either. Therefore, Startup Sarah does not have too much to spend yet.

Mailchimp thus offers a free version of its online e-mail marketing platform to buyer persona Startup Sarah, hoping that when her company and e-mail marketing efforts grow, she will switch to a paid account.

Scale-up Simon on the other hand already has a couple of thousands of e-mail followers, which makes managing his e-mail marketing efforts more time-consuming. Therefore, Scale-up Simon would like to automate his online marketing efforts and manage all important e-mail marketing activities from one place.

Scale-up Simon is therefore interested in Mailchimp’s marketing automation features, the integration with Facebook advertising and his CRM system, and Mailchimp’s dashoards with all important steering information visible at a glance. Scale-up Simon has a sustainable and profitable business and is therefore willing to pay more than Startup Sarah.

For that reason Mailchimp offers a paid version including the abovementioned features to customers such as Scale-up Simon. The actual costs for Scale-up Simon depend on the number of e-mail subscribers he manages using Mailchimp.

A benefit of working with buyer personas is that it not only helps you define current pricing, but is also useful for forecasting prices. The reason for this is that buyer personas force you to think about how to grow your product with its users, even if you are still in development and only have a prototype or MVP available.

Do you succeed in validating the pricing for the first version of your product (even if it is a prototype), then this also provides insights in a logical price for a more ‘advanced’ product offering new features for the more advanced user.

Step 2: Validate the pricing per customer profile

After you have clearly defined your buyer personas, the next step is to validate the pricing for each buyer persona. There are many ways in which you can validate pricing. The suggestions presented below are methods applied by ourselves while validating pricing for our own new business EY Finance Navigator. For more inspiration, definitely check out this article as well.

The ultimate form of price validation is of course a paying customer. But what if you do not have a product or service to offer yet? How do you validate your pricing in that case? As mentioned before, it is advisable to check out competitor pricing to start with. Which features do they offer for which prices? Which needs of which buyer personas do they seem to address? The answers to these questions already give you a great starting point.

To validate pricing online businesses can set up a landing page (for instance using Unbounce) with a clear call-to-action. Have your website visitors sign up for different plans offering different features and prices that match with your expected buyer personas.

Try to experiment with both the prices and features and track the conversion from website visitors to subscribers. To attract visitors to your website, you could perhaps invest a bit in social media or Google advertising.

Is your product already in a phase where you have designs, a prototype or an MVP available? Then reach out to your potential buyers and try to convert them into pilot customers! Pitch your proposition, demonstrate your prototype or MVP and perform a questionnaire.

With that questionnaire try to validate your buyer personas and test your prices. At the end of the questionnaire, you could ask for example what the potential customer would pay for your product as soon as it is live.

Does the customer indicate that he/she is prepared to pay an X amount? Then pull a pilot form out of your bag and ask the customer to sign up. Signing the pilot form could commit the person for instance to providing you with product feedback on an occasional basis and/or to paying a certain amount he/she is willing to pay for your product as soon as it is live. This not only gives you insights in a possible selling price, but also in the actual ‘willingness to pay’ of this person.

Is your product or service ready for sale? Then again engage with (potential) clients, whether that is online or in real life! Introduce him or her to your product (for example by providing a demo or free trial account) and make sure you collect data. Present the customer a number of different price ranges to pick from and ask the following questions:

  • At what price level is my product/service so expensive that you would never consider purchasing it?
  • At what price level is my product/service on the expensive side, but you would still consider buying it?
  • At what price level is my product/service a fantastic deal and you would buy it immediately?
  • At what price level is my product/service so cheap that you would question the quality of it?

The answers to these questions provide a great deal of insight into what the customer is willing to pay for your product. Do you want a sneak preview as well of the selling prices that you might be able of asking as soon as you have added new features to your product?

Show the customer a list of new features that you are considering to build and have him/her choose five features from this list which would add the most value to him/her if they would be included. Thereafter, ask the four pricing validation questions again that are mentioned above, but then assuming that the five features that were selected by the customer have been built already and added to the current product. This not only gives you some first insights in a potential price level for a more advanced product, it also tells you which features are most relevant to the user.

No matter what phase your company is in, it is crucial to collect data that validates your buyer personas. This allows you to address the right customer profile with the right combination of features, proposition and price.

You may also find out that a certain buyer persona is not worth investing in, for example because this persona does not want to pay for your product/service. Such a customer is called a ‘negative buyer persona’ and is a client you deliberately do not invest time, money and effort in.

Step 3: Apply the pricing strategy and optimize!

Now you have defined your buyer personas and have validated the pricing per persona it is key to apply your pricing in a way that clearly demonstrates on which axes your selling prices are based. For example, Mailchimp has a pricing page that shows prices are determined using three different axes: 1) per month, 2) per e-mail sent and 3) per feature. It is important that your selling price reflects the research you have performed under step 1 and 2 above. The features, proposition and prices you offer are thus specifically adjusted for each buyer persona.

Does this mean you are done now? Definitely not! Client needs, buyer personas and buying behavior change continuously. Moreover, your product or service will change as well as it is likely you keep on improving it. Therefore, keep testing and optimizing your pricing strategy, keep collecting data and keep in close touch with your customer.

When determining your pricing do not forget to take into account your costs and your positioning against competitors as well. Will you continue to apply these pricing strategies consistently? Then eventually you will find the right pricing for any product or service you offer, whether it is a new or an existing one!