Among the many pricing methods available, there are three methods that software companies generally use to create pricing plans for their products.
Cost-Plus Pricing
In this method, your price to the customer is a margin you add to the cost of the product. So if it costs you $100 to make the product, your final price to the customer will be $120 if you aim to make a 20% gross profit. Freelancers and agencies tend to use this form of pricing where they add up the various costs such as man hours invested, equipment cost, travel cost etc. and then put a margin on this cost to calculate the final price. More generally, if you have a single buyer, as is the case with freelancers, agencies etc. or even in government contracts, where the product is being built to specification, you would tend to use cost-plus pricing to create your final pricing.
Competition-Based Pricing
If you’re launching your product in a category where you already have competitors, you will likely use your competitor’s prices as a benchmark to price your product. So if you have two competitors that are charging $90 and $100 for similar products, perhaps you could price your product anywhere in the range of $80 to $100. If you’re launching another generic cola to compete with Coke and Pepsi, you’re likely to price your product around the price that these companies change for their cola. In the software industry, if you’re launching another customer support software like Zendesk or Freshdesk, you wouldn’t want your product’s price to be too high or too low compared to the cost of the Zendesk or Freshdesk products.
Value-Based Pricing
Any SaaS product benefits customers in one or more of the following ways — increase revenues, reduce costs, or save time. In value-based pricing, you would first quantify the value (in dollar amount) your customer derives from your product. Eg. Using your marketing software, customers are able to increase their revenues by $1 million every year. You would then price your product at a fraction of this quantifiable value. In our example above, if we decide to take 10% of the value that the customer derives from our product, our price would be $100k per year. Similarly, if the customer ends up saving 20k man hours of time per year by using your product, you could price your product as factor of the time saved. If we assume that the man hour cost is $250 per man hour, this would mean that the customer is saving $5 million (20k * $250) per year. You could then price your product at $500k per year so that you take 10% of the total value saved by your customer.
Which Method Should You Use To Price Your SaaS Product
If you’re in the SaaS business (or actually any business for that matter), as a seller you want to ensure that you’re not leaving money on the table. The only way to do that is by using the Value-Based Pricing mechanism to price your product. Value-based pricing also ensures that you’re not overcharging or undercharging your customers. As an example, charge the customer X amount if the customer is able to derive 10X the value from your product.
Value-based pricing also allows you to scale your pricing based on the usage and the value that the customers are deriving from your product. If the customer is now able to derive 20X the value from your product, there is no reason you should not be able to charge 2X as the price of your product.
However, creating pricing plans based on value-based pricing method can require concerted effort where you understand your customers in-depth — their pain-points, how best to solve their problems, the benefits they will derive from your product etc. If you’re launching a new SaaS product, perhaps it might be better to go with competition-based pricing than value-based pricing. And if you’re able to reach a product-market fit, then invest efforts in building value-based pricing.
So that was it for this post. In my next post, I’ll cover how we used value-based pricing to create pricing plans for BrowserStack.
Update: You can read the next post here.
