Pricing for Software Product Managers

By Daniel Shefer
August 09, 2007

Pricing has far reaching effects beyond the cost of the product. Pricing is just as much a positioning statement as a definition of the cost to buy.

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Pricing has far reaching effects beyond the cost of the product. Pricing is just as much a positioning statement as a definition of the cost to buy. Price defines the entry threshold: who your buyers are and their sensitivities, which competitors you will encounter, who you will be negotiating with and what the customers’ expectations will be. Good pricing will remove the price issue from being an obstacle to a sale. Pricing is also used as a weapon to fight the competition as well as gray markets. Pricing is unique from other marketing decisions for several reasons:

  • Price is the only marketing element that produces revenue. All other marketing decisions produce costs.
  • Pricing is the most flexible marketing decision.
  • Pricing reflects a product's strengths and weaknesses. It implies value as well as positioning.
  • Pricing has the most immediate impact on the bottom line. In the high tech industry, a 1% increase in prices can lead to a 10% (or more) increase in profit. This is twice the effect that the same change in volume, fixed or variable costs have on profits.

Pricing Software Products

When it Comes to Pricing Software, Economics 101 is not Applicable

When pricing software, the “Economics 101” taught in college is irrelevant. There are many reasons for this:

  • Supply and Demand curves are based on the assumption that the marginal cost for manufacturing additional products is non zero and that it decreases with quantity. In the software industry, the marginal cost for an additional copy of software is zero.
  • Estimating price elasticity for a specific product is practically impossible.  Hence, pricing decisions cannot be based on supply and demand curves.
  • Estimating the potential market for a product is possible but estimating demand is problematic. Most customers tend to be enthusiastic when seeing a new product but their input is not a good indicator for real demand.
  • For enterprise software, sales numbers are too small for a statistical significant study. By the time a company has sold enough licenses, it has advanced on to a newer version or the market has changed or both.
  • For most products, there are competing products and their influence on the demand curve is hard to estimate.
  • Product life cycles are short, making comparisons more difficult.
  • Purchasing decisions are complex and are influenced my many, constantly changing factors.

When setting the price for a software product, classical economic theory comes up short. Here is an empirical, iterative method to arrive at a price.

Guidelines for Setting the Price of Software in Existing Markets

The purpose of these guidelines is to arrive at the 'right' price. This is the price that lets the company accomplish its goals for revenue, profit, market share, renewals, etc. The method detailed below will help you identify the highest price a market with existing competitor presence will bear:

  • The price of the software must be less than the ROI it provides. The smaller the ratio of the ROI to the cost of the software, the easier the sale.
  • Create a market segmentation chart based on feature sets. Identify all competing products and place them on this chart. Identify and group the value elements in the product that address the needs of each of segment. For each segment, identify the features that customers are willing to pay extra for and that differentiate your product from the competitor’s. Attach a price tag to the value of each attribute that is not identical such as: 1) The feature and functional differences. 2) The difference in brand value that customers attribute to the products. 3) The difference of cost for implementing the respective products. 4) Any other item that customers attach value to such as localization of the application, geographic proximity (for services) etc.

If the product excels in a certain aspect, then simply add that value to the price, if it lags, simply subtract the value. This step must be iterated for each competing product. The price of the software must be similar or less than that of the main competing product in each segment minus the difference in price that are justified by the functional and other aspects previously identified.

  • The price must be below the purchasing authority of the targeted decision maker signing off on the purchase.
  • The price should be outside the “Dead Zone” of $5000--$20,000. [For details on the “Dead Zone,” below.]
  • The price must fit how the market perceives the product category. For example, desktop utilities – up to $50, productivity tools, up to $500 etc. If the product is priced too high, the price will become an issue. If it is priced too low, customers will perceive it as not worthy.

Guidelines for Setting the Price of Software in New Markets

If there are no reference products, the approach is slightly different. The first step in setting a price is identifying how customers will position it in their mind. If the product is perceived by customers as a utility or productivity tool, price in these ranges. That is, until the product can be positioned (in the buyers’ minds!) as belonging to a higher place in the food chain. See below for examples of products and typical price ranges.

If the product does not fall into the previous category, start by defining the price ceiling. This is the highest price based on a product’s benefits. A high price will work if early adopters are willing to pay a premium for a new product. However this price level may prove to be unrealistic as there may not be a sufficient number of buyers for a new product at that price level.

Then, choose a “penetration” price. Penetration pricing is used when a product is first launched in order to gain market share.  A low penetration price is used to discourage competitors from entering the market and to gain market share. Its drawbacks are lower margins, difficulty in raising prices in the future because pricing expectations are now set and the risk of customers perceiving the low price as a low quality indicator. The penetration price has to be sustainable and higher than the company’s variable costs. If possible, the price should be low enough to remove the price of the product from the buying decision.

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