Saturday, January 1, 2011

Business Pricing Strategies

One of the toughest decisions for a small business or start up is pricing their product or service. When we launched Sprint PCS, we had 21 major pricing elements to evaluate for our initial launch pricing positioning. We had to determine what was bundled, what was free, and what was individually priced.  We also had to make sure that the overall yield was consistent with the business plan that supported billions of dollars of investment.  Today for start ups, the choices range from giving it away for free, to pricing based on costs, to charging what the market will bear. The implications of the decision you make are huge, defining your image, your funding requirements, and your long-term business viability.  Your revenue model is the key to your business strategy.  Doing it right the first time is important since making mid course changes can be disruptive to your business.

 Here is a summary of common revenue models used by businesses today, 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 a common model used by Internet start ups today, the so-called Facebook model, where the service is free, and the revenue comes from click-through advertising. It’s great for customers, but not for start ups, unless you have deep pockets and can convince investors of future revenue generation capabilities. If you have real guts, try the Twitter model of no revenue, counting on the critical mass value from millions of customers to generate revenues down the road.  Ning, a social network platform tried this with a and had to transition to a "freemium model" to a tiered paid model.
  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 recurring services. This is a good model for getting your foot in the door, but 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. LinkedIn's advantage is that they have been able to attract a segment willing to pay these fees. 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 a multiple of the product cost. If your product is a commodity, the margin may be thin. Use it when your new technology gives you a tremendous cost improvement. Skip it where there are many competitors.  A lot of contractors use this approach.  A key here is to monitor the appropriate multiple as cost structures do change over time.
  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 products that uniquely solve critical needs.
  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 and ongoing analysis 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 and make sure you have a good sense of your products economics with various volumes.
  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 start up. It is important to have strong elements such as service and quality.
  9. Feature pricing. This approach works if your product can be sold “bare-bones” for a low price, and price increments added for additional desirable 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. At Sprint PCS, we did the first inbound minute free at launch to make customers comfortable in receiving calls and giving out there PCS phone number to generate traffic and awareness since the existing analog cellular service was mostly outbound calling.
  10. Razor blade model. In this model, like cheap printers with expensive ink cartridges, the base unit is often sold below cost or with minimal margins, with the anticipation of recurring revenue from expensive supplies. This model that requires deep cash pockets to start, so is normally not an option for start ups.
Your business model interacts closely with your marketing model.  Marketing is required to get visibility and access to the opportunity, but pricing defines how you will actually make money over the long term and drives your cash flow. Your challenge is to set the right price to match value perceived by the customer, with a proper return for you.

I received the inspiration for this post from Martin Zwillings Startup Professionals Musings blog.
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