Pricing for Software Product Managers

August 09, 2007

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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.

These two markers set the price range for a new product. Follow the relevant guidelines in the previous section to finalize the price point.

Comments on Setting Prices
  • Before making pricing decisions, you must thoroughly understand your target market’s decision-making and buying processes.
  • Properly priced software will not guarantee the company’s profitability.
  • The price has to take into consideration what the customers feel is reasonable. For example, market leaders are expected to charge more hence their higher prices can be perceived as “legitimate” (up to a certain level).
  • When deciding on which product competes with your own, the market’s perspective is what counts.
  • Internal company parameters such as distribution costs come into play only when looking at the potential profitability of the product. I.e. can the company make money selling the product at a given price point?
  • The price of the software must be higher than the cost of selling it and the margins must be higher than the cost of creating, marketing, selling and supporting it. Or else the product will lose money.
  • Using the pricing model as a differentiator is always worth considering as long as the model is easy to explain and it makes sense to the customer.
  • The costs of training, implementing and supporting the product are perceived as additional costs by the customer.
  • When new to a market, being a small, unknown company minimizes brand value. Lower, “penetration” pricing may be required.
  • If customer segments value the product significantly differently, this may justify segmenting the product for each of these markets.
  • When attempting to price commodity products, it is basically the competition that sets the price of the product. Setting a higher price in a commodity market is limited to the company’s ability to differentiate the product from its competition.  On the flip side, offering a lower price in such a market is sustainable only if the company has a lower cost structure.
  • When setting the price within a range of competing products, it is important to understand how reference prices affect your customer’s price evaluation. This is imperative when customers have limited product or price knowledge.
  • Just like other aspects of the product, pricing needs to follow the technology adoption life cycle of the product. Early market buyers may be interested in your product but tend not to be willing to pay its full price. It may make sense to price the product at its target price for larger markets and offer early adaptors the product at a discount.
The Software Price Dead Zone

The Pricing Dead Zone is a price range between $5,000 and $20,000. Some would even say that the range extends up to the $40,000--$50,000 range. Software products in the “Dead Zone” are the exception. This is because software priced in this range is hard to sell profitably. Products that cost less than ~$5,000 can be sold over the web or through channels. A purchase of this size is within the decision authority of middle managers and there is no need for on site visits to close a sale. More expensive products require higher level signing authority or purchasing committees. A committee’s decision can cause the sales cycle to drag on for months and get entangled in internal politics. These products require sales reps’ on-site visits but have to produce enough profit to support this type of sales effort. $20,000 is at the bottom of the price range that can support a complex sales process. The exact boundaries of the “Dead Zone” depend on the specifics of how the product is sold.

Typical Software Price Ranges
  • Utilities cost up to the $50--$70 range. Purchases of utilities are many times spur-of-the moment decisions. Customers need to feel that the potential financial risk of buying the wrong product is minimal.
  • Productivity tools – $100 to $500. These are purchases that are within the budget of a low level manager.
  • Professional tools – $1000 to $5000. Applications that are required by professionals to do their job such as computer aided design tools such and many others.
  • Enterprise applications--$20,000 and up. Applications that impact many functions and departments in the customer’s organization and that require an evaluation process and sometimes, a purchasing committee. Selling into such a customer is many times a costly and labor-intensive process.
Perpetual vs. Subscription Licensing

Subscription software is an application that is “rented” on a temporary basis. Licensing is usually on an annual basis but monthly terms are available as well. Salesforce.com is a classic example of a hosted product that is priced per user per month. Subscription licensing works when customers see an ongoing benefit from the software. From the customers’ perspective, it lets them buy into the product while minimizing their initial investment and exposure. From the ISV’s perspective, it keeps them focused on making the customer successful with the product rather then the 'fire and forget' approach to selling software.

Moving from a perpetual license to a subscription model increases the vendor’s risk as it becomes easier for customers to bail out on them. It may also have a negative effect on the short-term stock price due to Wall Street's focus on quarterly revenue vs. cash flow as the vendor is mortgaging their present for their future.  This is because, over time, the income statement reflects the growth from prior years’ bookings, as the deferred subscription revenue is transferred to the income statement. Over the long term, the subscription model allows for significantly better revenue visibility and consistency. This is beneficial, as Wall Street loves companies that make their numbers. For example, when signing a three-year license for $100,000, one twelfth of it can be recognized each quarter with high certainty. In such a case, cash flow becomes the much more representative indicator of income. This works as long as the renewal rate is high.

By offering a subscription-pricing model, customers face smaller payments. From the sales reps’ perspective, a lower initial price lets them aim their pitch lower in the customer’s organization. Another advantage for the sales process is that a calculating an ROI on a shorter time scale makes it more tangible, hence helping the sale along.

When offering a subscription model, the vendor is betting their future on their ability to keep customers. For hosted apps, setting up a hosting environment, can be very costly and by doing so, the vendor is basically giving customers a loan that will be paid back over the length of the contract. This creates additional risks that vendors may want to steer away from.

So now, the bottom line. How much do you charge for a subscription model? There are no axioms here but many companies charge one third of the cost of a perpetual license for an annual term. When offering a subscription model, maintenance is usually mandatory.

Pricing Maintenance and Support

For enterprise applications, 18% to 20% of the list price is the “standard” cost of support [1]. This usually includes support over the phone for a single contact from the customer during regular business hours as well as product updates (both point and major releases). More advanced packages that include 24/7 support are priced higher, in the 20-25% range and require a minimum of $30,000-$100,000. Minimums of $200,000-$300,000 are the norm for packages that include assigned support engineers. Onsite support should always be priced as an extra.

Most companies have a no-discount policy on support. That is, even when the software is discounted, the support pricing stays at a percentage of the list price. Very large deals may justify a discount. For example, if all support calls are routed from a single person at the customer. One approach is to give away a few months of the first year. Psychologically, it’s better to give away “months” than to lower the price of the yearly contract.

For non-corporate users, there are two basic models for providing support:

  • The per-incident model: The most common model for personal support is “per incident”—that is, a flat rate for resolving each support question, regardless of call length. The median per-incident price for surveyed companies [2] that offer this option is now $100, with 50% of these companies charging per-incident prices between $35 and $185. Support for developer tools and more technically advanced issues run into the hundreds of Dollars per incident. For example, a call into Microsoft’s tech support for developers costs $245. These models typically include a refund if the problem is determined to be a defect in the vendor’s product.
  • The per-minute model: A less-popular model is a “per minute” rate. Here, there is less variation in pricing: The median per-minute price is $2.71 and the 50% range is $2.00 to $2.95. Note that the $3.00 per-minute rate is one of the few service prices where there’s significant customer sensitivity and pushback.
Discounting and Non-Linear Pricing

Discounts come in two variations, scheduled and negotiated. Scheduled discounts are those that are preapproved by the company, based upon predefined criteria such as the volume of the purchase. Negotiated discounts are an ad-hoc result of the sales process that differ from or go beyond the preset scheduled discounts. This article will only discuss scheduled discounts.

Volume Discounts

There are multiple reasons why ISVs offer volume discounts:

  • Many times, the utility to the customer of additional licenses decreases as volume increases. To guarantee that the value to the customer is more than the price of the software, the price must decrease as the volume goes up.
  • In many sales situations, the cost of sale per unit decreases. This savings can be then passed on to the customer.
  • A volume purchase increases the customer’s investment in your product and reduces the chance of their buying the competitor’s product.
  • Large customers are convinced that it is their God given right to pay less per unit than smaller customers.
  • Buying more units now than in the future has a discounted current value.

Once a discount is offered, buyers will assume that that discount—or a better one—will be offered for all future purchases.

Before offering discounts, you have to understand the impact on revenue. When offering a 10% discount at a contribution margin of 70%, you’ll have to increase sales – above baseline – by 17% to make a positive contribution to profit. For more on how to calculate the volume changes needed to compensate for a change in price, see Appendix B.

Calculating Volume Discounts

The way most companies calculate their discount schedules is surprisingly off the cuff. They simply decide how much money they would like to get from a large target customer per user and then draw a curve between the price of one unit and the price of a unit at the high volume level. They then stand back, look at the curve and play with it until “it looks good.”

Another, more rigorous method for calculating volume discounts, is to select a consistent discount rate for every growth in units. For example, a 10% discount on the 10 – 20 units, a 10% discount from the previous price on the next 10 units (=a 19% discount from the original price) and so on.

For three slightly different ways of calculating volume discounts, see Appendix C.

MarketShare’s report on discounting in the software industry [3] found that:

  • Discounting is widespread, and significant. All the companies surveyed reported using discounts, and those discounts averaged nearly 40% of list price.
  • Company growth rates appear to be inversely related to the extent of discounts allowed by respondent companies, with respondents in faster growing companies reporting discounts that were nearly 20 percentage points less than discounts given by slower growth companies.
  • Nearly 75% of respondents acknowledged one or more important benefits to monitoring discount activity.
  • The actual extent of discounts given is not generally known nor documented by respondents. Less than 50% of respondents reported that they track discounts either frequently or regularly.
  • Negotiated discounts were significantly lower in companies where discounting is tracked. Negotiated discounts by 'trackers' averaged approximately 7 percentage points below what was allowed by 'non-trackers.'
VAR Discounts

Value Added Resellers (VARs) get the software they resell at a discount. Discounts are typically between 40% and 60%, depending on the marketing and sales efforts required by the VAR to promote the software. Many companies incentivize VARs by creating volume thresholds that increase their discount level. Tier discounts require VARS to commit to sales volume. For example, a15% discount for no commitment, 35% for very serious commitments. VARs receive training & licenses for an additional cost. Just as a comparison, reference partners whose activities are limited to referring customers to the vendor, get 5-10% of the deal.

When setting a pricing schedule for VARs, one must take into consideration that the VAR has to make a profit and may be feeding their own distribution channels. This approach is relevant to OEM pricing as well.

OEM Pricing

One of the difficulties of pricing OEM deals is that there are no industry standards or accepted price ranges. A recent survey by SoftLetter [4] shows that:

  • Royalty-based payments are by far the most common model (92%) and the rest are 'flat fee' deals.
  • Royalties paid for OEMing are “all over the map” and range anywhere from 1% to 60%. The data doesn’t show a distinct median or a bell curve around a specific royalty level so “average rates” are not applicable.
  • The median deal size for royalty-based OEM contracts is $875,000, compared to only $200,000 for flat-rate deals.
  • Exclusivity yields twice the median royalty rate and almost twice the median deal size compared to nonexclusive licenses ($1,500,000 vs. $800,000).
  • Stand-alone products yield significantly higher royalty rates--30% vs. 6% for embedded or integrated features.

When signing an OEM agreement, some companies require an up front fee for Non Refundable Engineering (NRE). NRE are engineering efforts needed to tailor the product to the OEM’s specific needs. NRE fees include charges for developers, QA and project management. These fees can easily run into the six digits. Some OEM deals will tier their pricing based on the up-front fees and volume commitment. As a rule of thumb, the higher the commitment and up-front fee, the lower the royalties. See below for more details.

Site Licenses

Site licenses give customers unlimited use of a product across their enterprise while paying a flat fee. A buyer’s request for a site licenses is mostly a purchasing ploy. Their reasoning is that with a site licenses they don’t have to worry about counting seats. However, it’s only another way to ask: “what is your best price?”  One problem with this model is that as a vendor, you lose your ability to track the number of installations at the customer site, and if your product is successful, you will be leaving money on the table. Another drawback of site licensing is that when you sell a site license, you have effectively lost that customer for any repeat sales. If you are concerned about getting the product in front as many users as possible, just offer steeper discounts to encourage proliferation and use. Hence, rule #1 for site licensees for vendors: avoid them.

If you must, here are a few tips on making site licenses work [5]:

  • Make sure the site license fee bears a relation to the value derived by the customer. Have a site license price schedule that will ensure that a customer with a small number of users (or whatever you want to count) should pay less in total than the same application licensed to a large company. Whatever measure you use, make sure it is public. Consistency is probably better than accuracy and reduces the room for manipulation.
  • Site licenses need to be limited to a specific site so any changes to the site will trigger additional payments. This is especially important when an industry is consolidating and physical sites are sold off and logical or virtual sites are expanding.
  • Maintenance and support fees can be independent of the license fee and can scale independently (e.g. number of employees, number of updates distributed, etc.) Maintenance and support does not have to be fixed so it can provide the upside that a site license limits.

Site licenses must provide adequate safeguards so keep usage within the boundary of the site. Customers may not want to count “seats” but they need to have a means for controlling the use of the product.

Academic Pricing

From a pricing perspective, products that are sold to academia can be divided into two. Products that are used for teaching and that a company can expect the students to purchase later in their professional career and all other products. For the former, companies tend to price their products at a deep discount. For the latter, ISVs usually offer up to 40% discounts. A slightly different approach is for ISVs to start academic pricing at the “second copy” price. In other words, the discount offered is what they would give normal commercial users for purchasing a second copy.

Re. hardware products – due to the lower margins, vendors cannot offer the same level of discounts that software vendors offer. Whatever discounts are available, they are much smaller.

Pricing Discrimination

Price discrimination is a technique for maximizing profits by offering the same or similar product at different prices to different customers. The idea behind this is to set prices so that purchasers who are able and willing to pay higher prices do so. Pricing discrimination allows vendors to capture additional market share by addressing segments that attribute a lower perceived value to the product.

Price discrimination can be explicit or implicit. Explicit price discrimination is when a special price is limited to customers who meet certain criteria. For example, academic pricing is a form of explicit price discrimination because only students and faculty can buy at that price. Implicit price discrimination is when all customers are technically eligible for the special price, but the vendor inserts a condition that makes it unattractive to some. For example, rebate programs are a form of implicit price discrimination.

The justification behind price discrimination is that different market segments value the product differently and will therefore be willing to pay varying prices. If segment A values the product at $1000 and segment B values it at $500, when the price is $900, only segment A will purchase it. If the product is priced at $400, both segments will purchase but with respect to segment A, money will be left on the table.

To make Pricing discrimination work:

  • Each segment needs to have a version unique to that segment.
  • One market segment cannot buy the product created for another segment.
  • The difference in pricing must be justifiable and must not create a feeling with customers that they are being treated unfairly.

Academic pricing is one example of price discrimination where the same product is sold at a discount not available to other market segments. This works because other segments hold a common belief that education is important and that businesses are expected to support it. International pricing is another example of pricing discrimination.

Another common form of pricing discrimination is introductory pricing. The idea behind this technique is to release a new product at a price premium and to lower the price in time. This is a common technique in the computer chip industry where power hungry buyers are willing to pay a premium for the latest and greatest. The reverse can also be true: introduce a product at a significant discount for a limited period to stimulate early sales and then return to the higher list price once the initial surge of excitement has passed.

Illegal Pricing Discrimination

The Robinson-Patman Act made it illegal for sellers to directly or indirectly discriminate in the price of similar commodities, if the effect hurts competition. This is especially important when selling to distributors and VARs. For example, if a vendor has two distributors that compete with each other, they have to be offered the same basic terms. If one distributor is allowed to buy software from you at a lower price than another, competition is adversely effected because the second distributor, buying at the higher price, will have a greater difficulty in reselling the software.

A detailed discussion of the implications of the Robinson-Patman Act is beyond the scope of this article but it is important to note that there are situations where pricing discrimination is explicitly legal. These include situations where the vendor’s manufacturing, delivery or financing costs are different for different customers as well as situations where a competitor dropped their prices. Meeting the lower price is not illegal even if this price is not offered to other customers.

Note that the law applies only to products and not to services.

International Pricing

The international prices of identical products vary many times compared to US pricing. The “uplift” as it’s called, varies anywhere from zero to a premium of 50%. This uplift is justified by increased costs due to the need for localization of the product as well as marketing and sales expenditures the vendor faces in foreign markets. The cost of localizing the software has to be considered but in many cases is not the bulk of the investment in foreign sales. Higher support costs are due to the additional languages needed, the more expensive labor (at least in Western Europe) and of course increased business risk. On the flip side, in some geographies such as in Asia, services are less expensive than in the US.

Note that differential pricing in international markets runs the risk of creating a “gray” market for the product.

Another issue that makes international pricing difficult to manage is the fluctuations in exchange rates. There are two approaches to adjusting prices when the exchange rates change:

  • Adjust the local price to reflect the price in U.S. Dollars. This approach may cause difficulties in countries where the currency’s buying power decreases compared to that of the Dollar.
  • Adjust the local price to partially compensate for the change in the exchange rate.

Both should be done with an eye on optimizing sales, taking into consideration how revenue is affected as well as the effect the change has on gray market pressures.

Bundling

Bundling is when a group of products (or services) is offered as a single package. By offering bundles ISVs can increase their sales to segments that would buy only one product. There are two types of bundling:

  • Product bundling. Product bundling is when two products are integrated into a single package. The purpose of product bundling is to create a combined product that has more value to customers than the separate parts. An example of product bundling is the Oracle ERP package where the database and application layer are bundled into a single package.
  • Price bundling. This is when an ISV provides a discount to customers that buy two or more products at the same time.

There are basic differences between price and product bundling. Whereas price bundling is a pricing and promotional tool, product bundling is more strategic in that it creates added value. Price bundling products does not create added value in itself. Therefore, a discount on their combined prices has be offered to motivate consumers to buy the bundle.

Bundling can be “pure” or “mixed.” Pure bundling is when a vendor does not offer any other option but the bundled products. Pure price bundling is basically forcing a customer to buy at least one product that they are not interested in and can be illegal. See below for details. Mixed bundling is when a vendor offers both the bundle and the products separately.

Price bundling is used to:

  • Increase sales to segments have different perceived values for the vendor’s products.
  • Expose a new product to a large customer base.
  • Provide product visibility and a low cost opportunity for customers to test a new product.
  • By offering bundles, vendors make it difficult for consumers to price-shop.
Categories: Pricing

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