Pricing has always been a simple math formula: cost of goods sold + markup (based on several risks and willingness to pay). In a way, it’s calculated inside-out: you set the price beforehand, and after a few weeks in the market you start getting feedback on how it has been perceived.
This model is much more predictable and great to do business modelling, since the price of the final product will fall into a standard range. Given the costly distribution channels (you can’t put your physical product in thousands of stores just to test the price), it is the only way to do it.
From my years studying business, this is exactly how we were taught. Since management began, pricing was probably one of the few aspects of your marketing mix that is fairly simple.
… then, the Internet happened: distribution channels for digital products are fragmented and marginally free, products are very cheap to create, which means that it is not indexed to the cost of production anymore. Not too dissimilar to the fall of the gold standard.
So how to you find the right price for your product?
In software startups, the price is calculated the other way around – you only take into account what the market is willing to pay, and since your distribution channels are virtually free, you can test pricing before you even have the product available. This way, the price is set outside-in: the market tells you what your price is, it’s not decided internally.
Let’s say that you have a task list app that you want to charge $10 a month per user. To decide if it’s too expensive or too cheap, you should benchmark to other apps in the market that are selling already, even if they have a different set of features, to get a sense of the willingness to pay.
You might notice that the average price of other task list apps is 5$, which means that you can do two things:
- Keep the price at $10. You have to invest in marketing collateral to show your potential users why they should pay double the price.
- Lower it to the market benchmark. If you don’t feel like your app has a perceived value proposition above your competitors, you can’t price it above. it would be as unsustainable as point 3.
- (not really) Price it below market. This is a race to bottom, where you’ll easily find an open source project that can do what you can do. You might sell more in the short term, but your business will not be viable in the longer run.
At the end of the day, setting price becomes much more iterative and a learning game, instead of a long-term component of your business plan. It removes the structure of the pricing strategy, which gives you many more options to play with.