THE TOP 10 PRICING MODELS USED TODAY AND HOW TO PRICE YOUR PRODUCT OR SERVICE TO MAKE MONEY AND COMPETE EFFECTIVELY

 

One of the toughest decisions for a startup is how to price their product or service. The alternatives range from giving it away for free (like Twitter), to pricing based on costs, to charging what the market will bear (premium pricing). The implications of the decision you make are huge, defining your brand image, your funding requirements, and your long-term business viability.

The revenue model you select is basically the implementation of your business strategy, and the key to attaining your financial objectives. Obviously, it must be grounded by the characteristics of the market and customers you choose to serve, the pricing model of existing competitors, and a strategy you believe is consistent with your future products and direction.

So what are some of the most common revenue models being used by startups today? Here is a summary, with some of the pros and cons or special considerations for each:

1. Product or service is free, revenue from ads and critical mass. This is the most common model touted by Internet startups today, the so-called Facebook model a.k.a. ad-supported revenue model, where the service is free, and the revenue comes from click-through advertising. It’s great for customers, but not for startups, unless you have deep pockets. If you have real guts, try the Twitter model of no revenue, counting on the critical mass value from millions of customers.  NOTE: This is incorrect.  Twitter is also utilizing the ad-supported revenue model and has revenues.
2. Product is free, but you pay for services. In this model, the product is given away for free and the customers are charged for installation, customization, training or other services. This is a good model for getting your foot in the door, but be aware that this is basically a services business with the product as a marketing cost.
3. “Freemium” model. In this variation on the free model, used by LinkedIn and many other Internet offerings, the basic services are free, but premium services are available for an additional fee. This also requires a huge investment to get to critical mass, and real work to differentiate and sell premium services to users locked-in as free.
4. Cost-based model. In this more traditional product pricing model, the price is set at two to five times the product cost. If your product is a commodity, the margin may be as thin as ten percent. Use it when your new technology gives you a tremendous cost improvement. Skip it where there are many competitors.
5. Value model. If you can quantify a large value or cost savings to the customer, charge a price commensurate with the value delivered. This doesn’t work well with “nice to have” offerings, like social networks, but does work for new drugs that solve critical health problems.
6. Portfolio pricing. This model is relevant only if you have multiple products and services, each with a different cost and utility. Here your objective is to make money with the portfolio, some with high markups and some with low, depending on competition, lock-in, value delivered, and loyal customers. This one takes expert management to work.
7. Tiered or volume pricing. In certain product environments, where a given enterprise product may have one user or hundreds of thousands, a common approach is to price by user group ranges, or volume usage ranges. Keep the number of tiers small for manageability. This approach doesn’t typically apply to consumer products and services.
8. Competitive positioning. In heavily competitive environments, the price has to be competitive, no matter what the cost or volume. This model is often a euphemism for pricing low in certain areas to drive competitors out, and high where competition is low. Competing on price alone is a good way to kill your startup.
9. Feature pricing. This approach works if your product can be sold “bare-bones” for a low price, and price increments added for additional features. It can be a very competitive approach, but the product must be designed and built to provide good utility at many levels. This is a very costly development, testing, documentation, and support challenge.
10. Razor blade model. In this model, like cheap printers with expensive ink cartridges, the base unit is often sold below cost, with the anticipation of ongoing revenue from expensive supplies. This is another model that requires deep pockets to start, so is normally not an option for startups.

Your business model interacts closely with your marketing model, but don’t get them confused. Marketing is initially required to get visibility and access to the opportunity, but pricing defines how you will actually make money over the long term.

Overall, I’m a huge fan of the “keep it simple (KISS)” principle – customers are typically wary of complex or artificial pricing. Your challenge is to set the right price to match value perceived by the customer, with a fair return for you. It’s not a game show, so don’t guess - do your research early with real customers.

Marty Zwilling

COMMENTARY:   Developing a revenue model requires a thorough understanding of competitors, your competitive strengths and weaknesses and those of your competitors, how products or services in your industry are distributed, how those products and services are priced, factors affecting product production costs, types of customers who buy the products, trends in the marketplace, and other factors.  

Strategic Innovation In Developing A Pricing Model

Most companies compete on the basis of price, differentiation or product niche.  I am of the opinion that you should try to compete on three fronts by striving to differentiate yourself from the competition and lowering costs simulataneously, then if possible, expand the existing market by targeting a different class or type of customer not presently being served by the marketplace. This strategy requires excellent strong leadership abilities with the ability to convince the members of your management team to pursue this three-prong strategy.

The three-prong approach described above does not necessarily mean adding more features to the product or service in order to differentiate.   In fact, the reverse maybe true.   Sometimes it is best to "Say no to 1,000 things" something Steve Jobs said, and reduce the number of product features, product sizes and colors.  A testament to the wisdom of this strategy is what Steve Jobs did upon his return to Apple in 1996.  He reduced the number of Apple products to about a dozen by drastically cutting back their numbers or totally eliminating them from the inventory.  Product accessories were eliminated from production, and outsourced through third parties.  Reducing the number of products reduced Apple's production costs, warehousing and inventory carrying costs. Steve also differentiated itself by redesigning products so that they were easier to use by eliminating nearly all buttons, levers and dials.  Apple products also came in only one color:  white. This strategy has been continued through today, with all iMacs, iPods, iPhones and iPads coming in white.  Product accessories that give each product different colors and personalities are still produced by third parties. 

In 1998, Steve Jobs hired Tim Cook to manage Apple's product manufacturing.   One of the first things Tim did was to outsource the manufacturing of all Apple products to third-party vendors, a practice which continues to this day.  This strategy allowed Apple to eliminate plant and equipment capital expenditures and maintain the highest product margins of any consumer electronics company in the World. 

CEO's should not be afraid to make bold, game-changing strategic innovations that disrupt industries when the opportunity presents itself, rather than making small incremental changes.   Steve Jobs did this at Apple by:

1. Disrupting the portable music player industry when Apple introduced the iPod. 
2. Disrupting the digital music industry when Apple launched iTunes.
3. Disrupting the smartphone market when Apple introduced the iPhone.
4. Disrupting the computer industry when Apple introduced the iPad.  

Apple is reported to be working on an Apple television set that could disrupt how we consume television content in the home.

Apple clearly implemented a three-prong strategic innovation approach when it reduced or eliminated products from its inventory, reduced product external features and produced everything in white, outsourced all product manufacturing to third party vendors, entered new markets where it had never competed in by introducing four new consumer electronics products that disruped entire industries.  These changes differentiated Apple from the competition, created higher perceived value, reduced its operating costs and greatly improved profits margins.   In doing so, Apple clearly adopted the Value business model.  Its customers are willing to pay premium prices for its products because they believe Apple delivers greater perceived value in terms of design, engineering and performance.

The important point is to never stop innovating or take your competition for granted.  The innovation strategies that made Apple into the largest and most valuable (in market capitalized value) consumer electronics company in the world, and has allowed Apple to maintain its competive lead in its markets, must not be taken for granted.    

Value, Perceived Benefits, Price and Why Consumers Buy

Customers do not make their purchase decisions based solely on price. They select the best value for themselves.  To increase your customers' perceived value of your product or service, either increase the benefits or decrease the price.   Surround your product or service with so many benefits of such great value to your customers, that they will pay a higher price, and you will attain a greater market share profitably.

Developing Prices For Products or Services

To help you decide what to charge for your product/service you must know the following:

• What are your costs to produce a service, or buy a product? (Direct and indirect) 
• What is the customer willing to pay? (The urgency of market demand)
• What are your competitors charging? (Market research data) 
• What do you need to charge to make a profit. (How much do you want to make?) 
• These factors must be balanced.  

There are a variety of pricing methods in use.  One of the most common is Formula-Based Pricing.

• This method is widely used by consultants.
• It is vital to research the competition and have set guidelines.
• Do not undercharge.
• Invoice customers at the end of the month for work in progress.
• Multiply salary by 3.  If you want to earn $20 per hour, you charge $60 per hour.  This figure covers salary, overhead and profit.

The Product Pricing Formula

(Direct Material Costs + Direct Labor Costs + Overhead Expenses) / No of Items Produced = Cost Per Item.

Let's look at each component of the Product Pricing Formula:

• Direct Material Costs. 
  • The raw material and component costs to produce a single item or unit.
  • OR Divide the total direct material and component costs of a batch of the same item, by the number of items produced to obtain an average direct material cost per unit.
• Direct Labor Costs.  
  • The direct labor costs to produce a single item or unit.  
  • OR Divide the total labor costs you pay your workers to produce a batch of the same item, and divide it by the number of items produced to obtain an average direct labor cost per unit.
• Indirect Costs or Overhead Expenses.
  • This includes expenses that are not directly incurred in the production of the product, but are never the less necessary and incurred by the business like rent, utilities, telephone, cleaning, insurance, depreciation, office supplies, postage, repairs, maintenance, research and development, warehousing and storage, delivery and freight charges, packaging and shipping supplies. TIPS:  1) If you are renting or own a building used to produce the item or items, you should allocate the indirect costs incurred on the basis of square footage allocated to production and non-production areas. 2) For accounting purposes always segregate business expenses by department (manufacturing, sales and marketing, warehousing, research and development, general administration, etc) so that you can allocate indirect costs more accurately.  
  • In some cases, indirect costs can exceed the direct costs. This is often the case for startups because they incur very heavy initial startup capital expenditures for plant, equipment, tooling, initial research and development costs and legal costs for patents that can be tied directly or indirectly to the product.       
  • If you are working from home calculate a portion of your total rent or mortgage payment, in proportion to your workspace, or assign a reasonable figure.
  • List all indirect costs or overhead expense items and total them.
  • Divide the total overhead figure by the number of items produced per month.  This amount will be your overhead cost per item. 
• Profit.
  • Your profit will depend on whether you are selling your product direct to the consumer or selling your product through authorized resellers.   
    • Direct-To-Consumer Prices - If you are selling your product direct to the consumer, multiply the cost per item (see the Product Pricing Formula) by 2. If you have a unique product and the competition is not offering anything similar to it, you may multiply your cost per item by 3, 4 or even 5, but don't get carried away.  The prices you set will depend on market conditions, alternatives and the costs to produce the item.  If you have very low production costs, a superior design, better features or game-changing technology, you may be able to charge premium prices.  Whatever you do, always research your market for competing products and market trends that could affect the demand for your product.       
    • Wholesale Prices -  If you are selling your product through authorized resellers your wholesale prices should be sufficient to yield a minimum profit margin of 65%.   

The Service Pricing Formula

(Hourly Rate + Hourly Overhead Expense) * 2 = Price per Hour

Let's look at each component of the Service Pricing Formula:

• Hourly Rate - Your time is valuable whether you work for yourself or someone else. Decide on what you are worth taking into account your industry experience, education, training, special knowledge and contacts.  Establish a reasonable hourly rate based on the above factors.   Compare your hourly rate to industry averages to insure you are within the ballpark.
• Hourly Overhead Expense Rate - Calculate all the costs related to operating your business from home or private office, and arrive at a total cost per month.  Divide this by the average number of hours worked per month, to obtain your hourly expense. 
• Price Per Hour -  Add your hourly rate and hourly overhead expense rate, then multiply the result by a factor of 2, to yield a Price per Hour.    Your competition, market conditions and demand for your services will dictate how much you can reasonably charge per hour.   The effects of the Great Recession, high unemployment rate and global economy means you may have a lot of competition from within your industry and from moonlighters and independent consultants.  

Price Ranges

Prices for products and services can vary greatly based on brand recognition, geography, knowledge and expertise, economic conditions, scarcity, monopolization and other factors.  The global economy means that you must compete not only locally or even nationally, but internationally as well.   The internet now makes it possible to quickly compare prices, find the lowest price and obtain product reviews.  The Great Recession reduced the prices of just about everything.  Real estate values in many parts of the country are still down, and many homeowners are underwater, owing more than their property is worth.  Due to high unemployment rates in many parts of the country, average hourly rates in many industries are down.  It's a buyers market. Having said this, prices generally fall into three categories:  High-end, Mid-range and Low-end.   Let's look at the characteristics of each price category:

• HIGH-END
  • Prestige and Image.  
  • Strong brand name. 
  • Numerous features.
  • Known for high quality.
  • Warranty.
  • Uniqueness.
  • Novelty. (price is not a major factor.)
  • Scarcity (valuable earth metals, diamonds, gold, real estate, etc.)   
• MID-RANGE
  • Good quality. 
  • Features. (Value is critical.  Trade off with Price)
  • Warranty.
  • Practicality.
  • Serviceability.
• LOW-END  (Caution.  In a service business, people tend to think that something is wrong, if your prices are too low.  They assume that the services are of inferior quality.) 
  • Inferior or poor quality.
  • Less features or services provided.
  • No customer loyalty.
  • Unknown brand name.
  • Competitors compete almost solely on the basis of price.  

Competing in the Mid-Range price range could be an advantage for some brands, especially during the Great Recession, because they can get customers from the High-End looking for a bit lower price and comparable quality and can get customers from the low-end spectrum who are looking to upgrade in quality and pay a bit more.  This has actually happened a lot with packaged goods manufacturers who have produced their products in smaller sizes to appeal to thrifty consumers looking for better quality and a prestige brand.  The same thing has happened in fashion apparel and accessories, with many designers producing mid-range fashion apparel and accessories to appeal to consumers looking for a prestige brand at a bit lower price point.  '99 cent stores' exploded during the Great Recession to meet the needs of the low-end consumer who just wants the lowest price possible while sacrificing quality and features.  

As an alternative to lowering prices, many producers have turned to discount coupons to lure customers.  This tactic allows them to keep customers loyal to their brand from buying mid-range brands.  This also allows mid-range consumers to upgrade to high-end brands.  This is a win-win for the consumer and keeps the producer's volume high enough to keep production costs under control.

 

Courtesy of an article dated April 21, 2012 appearing in Startup Professionals Musings

 

Comments

[Tommy]

Garage Equipment,

Thank you for your nice compliment about the pricing blog post. You will be surprised how often business owners and marketers get their pricing strategy completely wrong with disasterous consequences. This is particularly true for new consumer products or inventions. Hope you will continue to visit my blog regularly for marketing and business advice. Tommy

[Garage Equipment]

Good thing I came across to your site,Actually I'm looking for ways on how I will improve my marketing.And I'm glad that you shared a lot of things which I can consider in my business.