Figuring out the right pricing for your startup is a challenging, yet crucial, part of building a successful company. The way you price your product or service can make or break your startup. So, it’s important to understand the pricing landscape of your market and how your company fits into it to get your startup’s pricing right.

“So, it’s important to understand the pricing landscape of your market and how your company fits into it to get your startup’s pricing right.” 

Pricing is a balancing act that involves psychology, art and science. You must price high enough to make a profit and low enough to attract customers. Understanding the different pricing strategies and best practices can help you find the approach, and ultimately the prices, right for your business.

General Pricing Methods

There are many methods of establishing prices available to you:

• Value-based Pricing. Value-based pricing is based on the dollar value their products provide to customers. These businesses then set their price below the amount of value customers get from using their products. This approach charges customers a fraction of the incremental value created by the product or a fraction of the costs saved by the product. This is often seen in ad tech or any type of optimization technology (e.g., increase conversions by 50% and take 10% of the gain).
• Cost-plus Pricing. Cost-plus pricing is based on determining the exact costs of creating your product and charging some price higher than those costs – also known as “marking up.” Used mainly by manufacturers, cost-plus pricing assures that all costs, both fixed and variable, are covered and the desired profit percentage is attained. It’s very common in commodity or nearly-commodity industries, where customers know the prices of the components used to provide the service. Used mainly by retailers, markup pricing is calculated by adding your desired profit to the cost of the product.
• Competitive Pricing. Used by companies that are entering a market where there is already an established price and it is difficult to differentiate one product from another. Competition based pricing works well in markets where the price and value of a particular type of product are well established.
• Demand Pricing. Used by companies that sell their product through a variety of sources at differing prices based on demand.

General Principles to Follow

To harness the various pricing tactics available into an effective strategy requires following a few key best practices and principles.

• Be Different. Establish a different price point from your competition, even if it’s only slightly different. Research says identical pricing tends to discourage sales.
• Keep it Simple. Research published in the Journal of Consumer Psychology found that prices with more syllables look and sound higher to consumers. For example, $1,500.00 looks more expensive than $1,500, and $1,500 looks more expensive than $1500.
• Focus on Perception. Consumers make pricing decisions based on the perception of how gain outweighs pain. An $84 monthly subscription sounds less painful than a $1,000 annual subscription, even though they come out to about the same amount over the course of a year. Similarly, the context of an offer can affect price perception. People will pay more for a multimedia course than an article even if the content is the same.
• Bundle. Bundling items, emphasizing free offers or adjusting sales copy can also influence perceived value and pain.
• Don’t Emphasize Bargains. While this may work for some brands with superior logistics capabilities like Amazon or Walmart, for most companies, it will create a perception of lower value, along with diminishing return on investment.
• Associate with Experiences. Memory associations play a role in perceived value. Ads for beer brands try to associate their products with good experiences such as social gatherings and watching sports events.
• Use Price Anchoring. The first piece of pricing information consumers see affects or “anchors” their perception of subsequent items. This means that contrasting a premium product with other products can help enhance its perceived value.

No single strategy is appropriate for all situations. Selecting a pricing strategy that fits your business requires knowing your company’s target market, accurate market data analysis, knowing your your production costs and capability and logistics and understanding your capital.

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Choosing the Right Pricing Model

Most of us play defense when discussing pricing with customers. The best companies lead customer use pricing as an offensive tool to reinforce their product’s value and underscore the company’s core message. These are the several factors you should consider when pricing when you go to market:

• Positioning.Used strategically, pricing can be a weapon, a source of competitive advantage in the market. Your company can employ pricing to communicate to the market whether your product is a premium, mid-market or low cost alternative.You can choose to price
  • below the market price to gain share and grow quickly (Zendesk, AirWatch);
  • at the market price and differentiate based on product features (Dropbox and Box) ;
  • at a premium price to the market, which reinforces their positioning as the gold-standard in the sector.

To be effective, a pricing strategy must align with its marketing, messaging, website, PR releases and sales pitches. If everything rows in the same direction, then pricing becomes an asset to reinforce the company’s position in the market.

• Customer Base Size. The number of total potential customers multiplied by the selling price of the product equals the total addressable market (TAM). Generally speaking, bigger TAMs are better. If there are a small number of relevant customers, the average revenue per customer must be very high. On the other hand, the average revenue per company can be much smaller and still justify a billion-dollar-plus TAM.
• Sales Team Structure. Pricing impacts the structure of a sales team and their day to day performance for two reasons. Higher price points decrease sales volume and the chances a deal closes. Higher price points also require more skilled, more expensive salespeople. Outside sales teams chase larger accounts, and may close 1-3 per year. But if all of them go sideways, the company’s revenues for the year will suffer materially.
• Contract Length. Many startups launch with monthly pricing which encourages customers to try the product and engenders demand. At some point, most switch to annual contracts for three reasons. First, revenue becomes much more predictable. Second, annual contracts often include terms that require pre-payment up-front which rewards the startup with lots of cash to grow faster. Third, contracts mitigate churn rates because the customer is only making a renewal decision once per year, instead of 12x per year.
• Your Economics. Your pricing plan has to enable the company to become profitable at some point. Adopting a lower price point may create lots of demand, and keep sales teams happy, but if the price point doesn’t generate enough gross margin to achieve reasonably quick payback periods, and the business suffers from an increase in churn, the company is in trouble.
• Margin of Your Customers. The margin structure of your customers matters a great deal when setting pricing. Compared to software companies, grocery stores are terrible customers because grocery stores have single digit margins. All of your product’s cost must be paid from your customers margin. The more margin your customer has, the more they can pay you for your product.
• Competition Pricing. This is how most businesses determine the prices for their products. Besides looking at competitors for their pricing information, you should do this anyway to get a sense of how the market looks. Look for patterns in the pricing data of your competitors and decide where you want to position your product’s price in the market.
• Substitute Pricing. Does your product have no competitors? Is it truly innovative in the sense that it’s the very first product of its kind? If your answer to both of those questions was “Yes,” then you might be thinking that you have no pricing data to use when creating your pricing strategy. If you have a completely new product (which you likely don’t), look at the pricing data for its potential substitutes. Analyze it to find the ideal price for your product.
• Use AdWords and Ads to Test Points. Create several different versions of the same ad for your product where the only difference between each of them is your product’s price. Then, run these ads for a few days with a small budget and see which one performs the best. Use the price from the best-performing ads as your product’s main price.
• Ask Customers When They Feel The Price is Too High or Low. With this bimodal distribution analysis, you can use a similar strategy to find your product’s optimal price.

Developing pricing is a never-ending exercise. A startup’s environment, its product and its positioning change with time, and price must evolve in tandem.

Common Pricing Mistakes

The most common pricing mistakes you should avoid:

• Overcomplicating. This only wastes time and discourages early adopters from using the product. Instead, launch your product with one or two pricing tiers (three at the most) and add pricing segments for customers with different needs over time. When it comes to your startup’s pricing in the first 12 to 24 months, simplicity should be the rule.
• Selling Negative Versus Positive. Some products or services allow companies to operate with fewer employees. Telling potential customers about how much they’ll lower costs by laying off employees thanks to your product is an example of negative value. Instead, talk about the aspirational value of your product when selling it to prospective customers. Some examples of a product’s aspirational value are productivity increases, revenue growth, simplified workflows, page view growth, and more.
• Thinking Pricing is Static. You can change your product’s pricing at any time and should experiment with it. It’s not a good idea to change your product’s prices all the time as that will annoy and confuse customers but markets, competitors, products, customers, and consumer behaviors will change. As these variables change, your pricing should likely evolve as well.
• Not Thinking Size Matters. Enterprise customers expect very different pricing from small businesses, medium size businesses, or consumers. If you want to sell to the Fortune 500, you should know companies of that size expect to pay at least 5-figures and sign contracts when purchasing products or services. On the other hand, most small businesses expect to pay month-to-month for the products they use. Educate yourself about what prices different sized businesses will want and expect to pay for your product.

Different Pricing Models: B2B versus B2C

There are different considerations if your product or service is for consumers (Business to Consumer or B2C) or businesses (Business to Business or B2B). Here are a few of those considerations.

Business to Consumer (B2C) Considerations

The most common B2B pricing models are:

• Enterprise Contracts
• One Time License Fees
• SaaS Pricing
• Per User Pricing

Some B2B considerations:

• B2B businesses generally have customers pay a monthly fee for access to their software. This type of pricing could be called a SaaS or monthly recurring revenue model.
• When B2B companies sell to enterprise customers, they generally have them sign contracts where they pledge to pay for at least a year of service. These enterprise customers will pay in full upfront or break the value of the contract up into monthly or quarterly payments.
• If your B2B company wants to sell to small and large businesses, then it will likely use a combination of monthly and contract pricing.
• Sometimes, B2B companies have per-user pricing. For example, Slack charges businesses for each user that has a “Pro” account on the site.
• Other B2B businesses ask users to pay a one-time license fee to access their products. WooThemes and online course businesses are examples of B2B companies that ask users to make a one-time e-commerce payment to get the product.

Business to Consumer (B2C) Considerations

The most common B2C pricing models are:

• Retail
• Free
• Freemium
• Monthly

Some B2C considerations:

• Some B2C companies charge consumers a monthly subscription fee to use their products. Examples of companies that do this successfully are Netflix, Spotify, Birchbox, and more.
• While some B2C companies use monthly pricing, the most common pricing models for consumer companies are free, freemium, and one-time payments for goods.
• Facebook, Twitter, and Snapchat are services that offer their products to consumers for free in exchange for the right to use users’ data for advertisements.
• Freemium B2C companies include LinkedIn, Dropbox, SoundCloud, Evernote, and more. It’s more common to see freemium B2C software companies and startups, but plenty of B2B companies use freemium pricing as well.
• Retail and ecommerce pricing models are the most common ones used in B2C businesses. Amazon, Walmart, Alibaba, Priceline, The Home Depot, CVS Caremark, and more all have customers pay one-time fees in retail and/or ecommerce.
• B2C businesses often use cost-plus pricing when figuring out how much they want to charge customers.
• B2B businesses, particularly in the software industry, use value-based pricing.

Alternative Pricing Models

We have outlined some of the most common pricing models. Here are other strategies to consider:

• Absorption Pricing.Absorption pricing is designed for the seller to recover all the costs of a product or service. The direct cost of materials and labor, as well as fixed and variable overhead costs are included in the price. Take the variable cost of the item, add a percentage of its fixed cost and then mark up to yield a profit.
  • Example. Automotive manufacturers have used absorption pricing to offset high fixed costs from factory leases and labor contracts. By mass-producing to capacity and spreading fixed costs out over all vehicles produced, car companies are able to lower per-unit production costs and raise profit margins. A car manufacturer produces vehicles that sell for $50,000. If they incur direct costs of $30,000 in materials and labor and $10,000 in overhead, they will net a profit of $10,000 per unit sold.
  • Issues to Consider. This can produce short-term profitability, but there is a risk to mass-producing to capacity. In the long term, if demand varies, you may face expensive inventory overstocking issues.
• Contribution margin-based Pricing. Contribution margin-based pricing maximizes profit earned on individual unit sales. Take the product’s price and subtract the variable costs required to produce it (materials and direct labor). The difference is called the contribution margin per unit, which can go toward paying for fixed costs (like rent, utilities and payroll).
  • Example. If a laptop computer is sold for $500 and the materials and labor used to produce it cost $100, the contribution margin would be $400. That $400 could be used to cover fixed costs and of that $400, whatever isn’t used for fixed costs is your profit. Accounting for variable costs can get confusing since the variable cost per unit increases the fewer units you produce. It may cost more to make 1,000 laptops than it does to make 100, but your profit margin for producing 1,000 units will be higher.
  • Issues to Consider. The contribution margin-based method maximizes profit per individual unit when considered over a quarter or a year. The strategy does not take into account how scaling up to produce more units can affect fixed costs by raising rent, equipment, and utility fees. It also does not address how sales of individual items impact sales of other items in the company’s product and service line. For instance, if McDonald’s sells more Big Macs, this might lead to fewer sales of cheeseburgers, which has an overall impact on total profits.
• Creaming or Skimming.Creaming, also known as skimming, sells individual units at a high profit margin so that a smaller number of sales are needed to break even.
  • Example. This strategy may be used for premium markets or to test early adopters who are willing to pay a higher price point for new technology. In 2015, Sharp released the world’s first 8K television at a price point of $133,000, aiming at early adopters in the corporate market.
• Decoy Pricing. Decoy pricing makes a high-priced item more attractive among competing products. Typically, three products are displayed for sale, including two similarly high-priced products. One of the higher-priced products is less attractive than the other, so that when the buyer compares prices, they will naturally choose the better value.
  • Example. This method can push sales of a particular product, but may lead to overstocking. Movie theaters often use medium boxes of popcorn as decoys to drive sales of large boxes.
• Freemium. Freemium (a combination of free and premium) pricing generates sales by offering a free item upfront as an incentive to purchase a related premium-priced item. For example, early razor blade manufacturers gave away free razors as an incentive for people to buy blades.
  • Example. Today, freemium pricing is frequently used to sell digital products or services. Dropbox users can sign up for a free account with limited space. The experience might motivate some users to upgrade to a paid account with more space.
• High-low pricing.High-low pricing promotes lower-priced items by offering them with lesser frequency than high-priced ones. A common deployment of high-low pricing is selling new products at a high price when they initially hit the market and then dropping them to a discounted price once their popularity and demand have peaked.
  • Example. Shoe companies such as Nike, Adidas, and Reebok make high-low pricing a major strategy for their industry.
• Keystone Pricing. Keystone pricing is a strategy that sets a retail price by doubling the wholesale price.
  • Example. If boneless chicken breast have a wholesale price of $2.09 a pound, keystone markup would place the retail value at $4.18 per pound.
  • Issues to Consider. Keystone pricing only works well if you can realistically sell the item at the doubled cost to consumers. If the supplier’s price for the item is high relative to the price you can sell it for, or if you are a discount vendor, keystone pricing may not work well for you.
• Limit Pricing.Limit pricing is a strategy which aims to monopolize a market. It sets the price of a product at a level below profitability or where it is barely profitable. This discourages competition from entering the market.
  • Example. McDonald’s and Amazon set their prices based on the competition.
  • Issues to Consider. Limit pricing can be illegal in some cases. It also has limited long-range effectiveness once competitors have successfully entered the market. It’s hard for small companies to use limit pricing effectively; it works best for large companies with the capability to produce and sell products at prices their competition can’t afford.
• Loss Leader. A loss leader pricing strategy sells or gives away a product or service at a low cost or even takes a loss on that item as a way to promote a higher-priced item.
  • Issues to Consider. A loss leader strategy can work effectively when the loss is not significant enough to hurt your profit margin and when the return on premium upsells is high enough to justify the loss. Loss leaders lose effectiveness when they are too costly to give away profitably. For example, many restaurant chains are less generous than they used to be with free napkins, plastic silverware and condiments because of these items’ rising prices.
• Marginal-cost Pricing. Marginal-cost pricing marks up based on the costs added by materials and direct labor. This strategy has a low profit margin, so it only works well in circumstances like driving sales of items that would not otherwise be sold.
  • Example. Priceline.com has used marginal-cost pricing to sell empty seats and hotel rooms by offering them at prices dictated by consumer bids.
• Odd Pricing. Odd pricing, also known as “just-below” pricing, sets prices by assigning the last digits of a price an odd number just below a round number, such as a multiple of 5 or 10.
  • Example. TV commercials that sell products for $19.95 instead of $20.
  • Issues to Consider. Some marketers swear by odd pricing, but empirical researchers and studies are split on the issue. In 2003 the Quantitative Marketing and Economics Journal published a study supporting odd pricing, but in 2013 Booz & Company published a summary concluding that consumers actually prefer round numbers.
• Pay What You Want. A pay-what-you-want (PWYW) strategy lets consumers name the price they’re willing to pay for an item.
  • Example. In some cases, consumers may not be required to set a price until after consumption — as with tips where diners do not decide how much to tip their server until after the meal.
  • Issues to Consider. A common PWYW strategy employed online is when software developers offer apps for free with the option of donating a dollar amount. PWYW pricing can be attractive to buyers initially, but with repeated transactions, margins tend to decrease over time.
• Penetration Pricing.Penetration pricing sets prices low in order to penetrate a market by attracting consumers, with the intent of raising the price later after a market niche has been established.
  • Example. Software app companies often offer a free trial period before raising prices. However, it requires enough capital to remain in business until prices can be raised. Once prices have been raised, ongoing discounts and sales are typically needed to retain customers and stave off competition.
• Predatory Pricing.Predatory pricing, also known as undercutting, uses unprofitable pricing to discourage competition. Where limit pricing seeks to discourage competitors from entering markets, predatory pricing seeks to eliminate existing competition.
  • Example. Some large cable companies have used predatory pricing to eliminate smaller competitors.
  • Issues to Consider. Like limit pricing, predatory pricing is most effective when wielded by large companies with deep pockets, but runs the risk of short-term effectiveness and illegality.
• Premium decoy Pricing. Premium decoy pricing is a variant of decoy pricing that sets one price arbitrarily high in order to promote a lower-priced offer. An online magazine might run an offer advertising a digital subscription for $25 and a print subscription for $50, expecting that the print option will make the digital option look more attractive to consumers.
  • Example. Apple frequently uses this strategy to promote products — like when it priced the iPod higher than the iPhone despite equivalent functionality.
  • Issues to Consider. Premium decoy pricing can be effective but the cost of producing the decoy must be low enough to offset the sales it loses to the competing item.
• Premium Pricing. Premium pricing deliberately maintains an item’s artificially high price to create a perception that expensive must equal brand value.
  • Example. Luxury cars and jewelry typically use this strategy.
  • Issues to Consider. Premium pricing has the advantages of delivering a high profit margin and making it difficult for competitors to enter a niche. However, it requires high unit costs and high expenditures to maintain brand image, as well as restricting sales volume to premium customers.
• Price Discrimination.Price discrimination sets different pricing policies for different market segments.
  • Example. Google Apps offers different pricing packages to consumers than it does for business users. Other variations of this method include movie theaters, which may charge different prices for different age groups or show times.
  • Issues to Consider. To use price discrimination effectively, three things must happen. First, have a good idea of what different market segments are willing to pay. Second, prevent resale of products from one segment to another. This occurs frequently with ticket scalping, for example. And third, have enough power over the market to control price changes.The absence of one or more of these conditions tends to make price discrimination less profitable.
• Price Leadership. Price leadership is a strategy employed by companies that control industries enough to establish a pricing pattern that competitors must follow. Companies sharing control of the market agree not to undercut each other through forms of competition such as price cutting or disproportionate advertising.
• • Example. Industry control may be achieved through implicit collusion, as when Apple conspired with book publishers to raise ebook prices in order to hurt Amazon and other book retailers, or through explicit agreements, as with OPEC (Organization of Petroleum Exporting Countries).
  • Issues to Consider. Price leadership can be effective in a market dominated by limited competition, but the emergence of disruptive competitors can undo its effectiveness, as illustrated by Uber’s disruption of the taxi industry.
• Psychological Pricing.Psychological pricing sets prices based on the assumption that a given price point, color or name has a psychological impact on consumers. This pricing strategy remains controversial.
  • Odd pricing. Odd pricing of products and services with digits ending in 9 (17.99 for example) is a form psychological pricing.
  • Colors. Another variant of psychological pricing uses different colors in advertising based on their perceived psychological impact. WhichTestWon study found that changing a website’s call to action button from light green to yellow increased conversion rates 14.5 percent.
  • Naming. Changing the name of a product to something deemed to sound more valuable is used to justify a higher price point — such as calling a club membership a Gold membership.
• Target Pricing. Target pricing sets prices at a level aimed to generate a target return on investment at a specific production volume.
  • Example. Automobile manufacturers may produce a certain number of a specific car model to be sold at a specific price point. This would be based on market research indicating that the sales point will be profitable at that production volume.
  • Issues to Consider. Target pricing works best for companies that invest significant capital into their products and services — car companies and utility providers for example. Target pricing does not work well for companies with low capital investment. It also relies on accurate market forecasting to anticipate how to match production levels to demand levels.
• Time-based Pricing. Time-based pricing is a method mainly used by online companies that use digital data to dynamically adjust prices to consumer demographic profiles, purchase history and willingness to pay. This technique depends heavily on accurate forecasting.
  • Example. The airline industry uses time-based pricing effectively through online travel sites. Airlines must have a reasonable idea how many passengers will want certain flight seats on a given holiday to know how high they can raise the price and still find demand for the seats.
  • Issues to Consider. For retailers moving physical merchandise, it also depends on the ability to adjust stock levels to reflect demand by using backorder options for out of stock merchandise strategies.
• Yield management Strategies. Yield management strategy sets prices by studying consumer behavior to maximize profit on perishable goods.
  • Example. Concert promoters may raise ticket prices as an event grows closer. This is based on the observation that fans become more desperate for tickets as seats become more scarce and time to purchase grows shorter.
  • Issues to Consider. This type of strategy relies on understanding consumer behavior and well-executed timing of price changes, in addition to effective inventory strategies to avoid stockout situations.
• Congestion Pricing.Congestion pricing adjusts prices based on congestion of availability.
  • Example. Traffic becomes more congested during weekends and holidays, limiting availability of cab drivers, so Uber raises rates during these times to take advantage of peak travel demand.
  • Issues to Consider. Other industries that use congestion pricing include electric companies, bus services, railroads, airlines and shipping. Effective congestion pricing depends on limited availability coupled with high demand. It also depends on your company’s logistical ability to deliver products and services in a congested environment.
• Variable pricing Strategies. Variable pricing sets prices by factoring in the variables in the cost of production.
  • Example. Insurance premiums may be priced differently based on different interest rates yielded by different policies.
  • Issues to Consider. Variable pricing aims to set product prices to balance sales volume with income per unit sold. This can help businesses accurately predict the total cost needed to develop a new product. However, because it doesn’t factor in fixed costs, it works best when variable costs have greater impact.
• Real-time Variable Pricing.Real-time variable pricing has grown more prevalent as technology has enabled finer control of yield management and congestion pricing strategies.
  • Example. An example of real-time variable pricing is an auction, where buyers bid for an item in real time. Auction sites such as eBay illustrate how this method can be adapted to an online environment.
  • Issues to Consider. The growing amount of consumer data available enables companies to deploy increasingly sophisticated pricing models based on accurate market analysis and prediction. Real-time variable pricing depends on big data and accurate forecasting.
• Scaled Pricing.Scaled pricing allows users to select from a range of price points that correspond to their needs. This model is particularly popular with cloud and SaaS offerings.
  • Example. Those who use Slack, the team collaboration and communication tool, are dropped into one of four buckets based on the capabilities the team needs or features they want. From there, teams pay per user.
  • Issues to Consider. This trend has impacted brick-and-mortar services as well. Physical-based retailers are using mobile marketing data to personalize pricing for individual consumers.

Pricing is both art and science. The more you know about your competition and the more you can sell to your value, the better off you will be.