5 Characteristics of a Superior Pricing Model
Steven Forth is a Managing Partner at Ibbaka. See his Skill Profile on Ibbaka Talent.
B2B SaaS companies are waking up to the importance of pricing. 10 years ago, when subscription models began to become popular, it was enough to offer the subscription equivalent to the on-premise pricing. There was even a commonly used rule of thumb that some companies used.
Take the on-premise price, divide by 36 (three years) or 60 (five years) and add in 20% (to account for the hosting and maintenance fee). Find some convenient pricing metric, often the number of users. Make that the price.
Sounds silly doesn’t it. And it is. That approach to pricing does not align with modern growth models, especially product led growth. Many companies recognize this today and are looking for better ways to design their pricing. There is a growing willingness to invest in the design of pricing models. This is an activity that requires research, data analysis, alignment with business goals and strategy and design thinking. With all that investment (typically from $50,000 to $300,000 depending on the level of research, the complexity of the solution and who is doing the work) one wants to know what a good pricing model looks like.
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What are the 5 characteristics of a superior pricing model
Ibbaka takes a design thinking approach to the design of pricing models. This means that we follow a process where we begin by understanding the strategic goals of the company and how pricing is meant to support those goals.
Connected to value
Scalable so that it can with your customers
Extensible so that new functions can be added
Fair in the eyes of buyers
Observable so that it can be tracked and improved
Let’s look at each of these.
Pricing should be connected to value
This is the fundamental premise of value based pricing, but what does it mean. It does NOT mean that pricing is set according to Willingness to Pay (WTP). Willingness to pay is one outcome of a well designed pricing model. And it is determined by many things other than value.
A simple test of value based pricing is that one or more variables in the value model are also used in the pricing model
Pricing should be scalable so that it can scale with your customers
Very few companies sell at one price to all their customers. If that were the case we would not need a pricing metric, just a price. The pricing metric needs to track value across the range of deal sizes you are likely to encounter. This is even more true with usage based pricing. The price needs to scale in a way that tracks value and reflects market norms across scale.
In most cases the issues emerge for very large and very small deals. For very small deals the solution is usually to have a floor price and a way to guide users to a free option. For large deals there are a number of common approaches dependent on strategy. Early on, large strategic deal are often negotiated and the pricing model provides guidance but does not determine the final price. As the company gains experience this needs to be brought into the pricing system. In many cases (not all) large deals are discounted and one can handle this with a discount schedule. One can also get fancy with the pricing metric and put it on a log scale so that price rises more slowly the larger the deal size.
What happens when more value is created with scale? This happens in solutions that enjoy some form of internal network effect. One interesting solution I have seen is to use Metcalfe’s law as part of the pricing metric. This is an advanced topic, and there are many things to consider, but if your solution has internal network effects, and increases in value with the number of internal connections then consider using some version of Metcalfe’s law in your pricing.
Pricing should be extensible so that new functions can be added
The power of the SaaS model is one of continuous innovation. New functionality, reports, integrations are added at a regular pace. In some cases these are important enough to warrant a rethink of the pricing model. This should be designed in from the start, but how to do this?
One approach is to think of the pricing model as a modular system. If you break down the packages and pricing into modules what would these be and how do they interact?
A helpful thought experiment is to ask
What is the smallest piece of functionality I could price.
In general, this maps pretty well to value paths. The most granular pricing one can execute on is completion of a single value path.
Design pricing to be modular so that you can apply the six modular operators on your pricing model. This is from Baldwin and Clark’s classic book Design Rules: The Power of Modularity. For ‘module’ read ‘pricing metric.’
Split a module in two
Substitute one module for another
Exclude a module
Augment a module
Invert a module
Port of module to a different system
Modular pricing is an emergent approach to pricing model design, but it will become increasingly important as we move towards solutions that are configured (often by an AI) to optimize value to customer.
Pricing should be fair in the eyes of buyers
Value-based pricing requires trust between buyer and seller. See Trust is the key to value-based pricing. To build trust people need to believe that pricing is fair.
Pricing is seen as fair when it is
Consistent (similar buyers get the same price)
Transparent (people can understand how the price was set)
Value based (there is an equitable sharing of value between buyer and seller)
Read more at Is your pricing fair and why you should care.
Pricing should be observable so that it can be tracked and improved
Observability is a hot topic in cloud computing these days.
Observability is the ability to measure the internal states of a system by examining its outputs. … Observability allows teams to monitor modern systems more effectively and helps them to find and connect effects in a complex chain and trace them back to their cause.
How does this apply to pricing design?
One should be able to observe the impact of different pricing actions on business performance.
Pricing actions come in several different forms. The tactical actions are
Change Unit Prices (Increase or Decrease]
Change Discounting (the percent discount or the commitments needed to get the discount)
Change Pricing Corridors or Guide Rails (the minimum and maximum prices that can be charged)
Enforce Contract Terms (many contracts have price concession that depend on the customer meeting certain performance requirements (and vice versa), but in many cases these terms are not monitored or enforced)
Change Offer (the value included at each price point for each segment, this can include products, services, data and access to unique capabilities)
Change Bundle (the combination of products, consumables, data and services sold together; this will often include products from multiple businesses
There are more strategic pricing actions one can take as well. The shift from a licensed offer to a subscription offer is one example (this is still an ongoing theme in many pricing projects), more important is a change to the pricing metric (the unit of consumption for which your customer pays, ideally closely connected to the value metric, the unit of consumption by which your customer gets value).
See Pricing Actions and Customer Experience (CX) and Pricing Actions and Pricing Action Portfolios.
A pricing action is observable when there is a way to see what impact the action has. At the simplest level a pricing action is observable when one can see the outcomes of an action. For example,
“A price increase of X% will lead to …
A change in volume of …
A change in revenue of …
A change in gross margin on …
A change in category share of …
A change in category size of …
A change in V2C (Value to Customer) of …
A change in LTV (Lifetime Customer Value) of …
A change in competitor volume of …
And so on …
There will be a great many outcomes of a pricing action that one will want to trace, but it is generally impossible to follow all of them so one should be choice-full. Ask which metrics do I need to be able to track to know if pricing is contributing to strategic objectives.
This is another active area of research, leaning on causal modelling (see Judea Pearl’s work in this area).
What is the business impact of pricing model excellence?
Having a pricing model with the five characteristics will transform your business. The pricing model is how you capture a part of the value you create for your customers. A good pricing model, one that is extensible, scalable, fair, observable and connected to value will help make your offers resilient (able to flex with changes in the business environment) and adaptive (able to change with changes in the environment. The result will be
Speed of response (pricing can be changed rapidly when needed)
Pricing performance (pricing will have a larger positive impact on the business)
Continuous improvement (pricing will improve with every design change and pricing action)
