How to Choose a Pricing Metric
Steven Forth is a Managing Partner at Ibbaka. See his Skill Profile on Ibbaka Talent.
Choosing a pricing metric is the most important pricing decision you will make.
It is more important than the price level, your discounting policies, the tiered architecture (also known as Good Better Best Pricing), or your dynamic pricing and CPQ (Configure Price Quote) system. It is the frame for all other pricing decisions.
What is a Pricing Metric?
The pricing metric is the unit of consumption that a buyer pays for (contrast this with the value metric, described below). What are some examples of pricing metrics?
Bulk chocolate by weight
Chocolate bar by bar
Chocolate truffles by the piece
I pay for fuel by volume. I could pay by weight, which would be interesting in places where there are big temperature swings and the weight/volume ratio changes. If different fuels let me drive different distances I might want to pay by distance/volume, this would be possible with modern vehicles that track lots of different data.
In software and Software as a Service there are many different pricing metrics being used. One of the most common is per user.
Per user
Per named user
Per transferable named user
Per active user
There can be different types of user as well: administrative users, analyst users, users classified by business function. The per user pricing metric will reflect how the different types of user get value.
Of course there are many other possibilities. Some that Ibbaka has worked with recently include …
Per process defined
Per process executed
Data transfer
Data transfer rate
A business metric impacted, such as freight under management
Per campaign
Per community
Per report
Per transaction type
Per view
Per action
The variety of pricing metrics is as vast as the different types of solution available and how they create value. As more and more software lives in the cloud, and more and more data is collected, the opportunities for pricing metric innovation expand.
The Pricing Metric and the Value Metric
Before choosing a pricing metric, you should know the value metrics for your product or service. If the pricing metric is the unit of consumption that is priced, the value metric is the unit of consumption that creates value.
The fundamental idea in value-based pricing is that the pricing metric should track the value metric (value-based pricing is not based in willingness to pay, and if your consultant or pricing software vendor tells you that it is they are wrong).
Generally there will be more value metrics for a solution than one would want to use as pricing metrics. There are two solutions to this challenge.
The simplest is to choose a pricing metric that is also a value metric. This is what we try to do as it generally make everything simpler, from value communication and value delivery to value documentation. The classic example of this in the pricing world is Rolls Royce’s Power by the Hour pricing. In this approach, introduced in 1962, the airline does not buy jet engines but rather leases them and pays only for the time the engine is being used to power a plane. This is a very good matching of the pricing metric and value metric, and transformed the jet engine industry, opening new business models around leasing rather than ownership.
There is a more sophisticated approach that we will explore in a later post. Basically, one goes deeper than the value drivers to look at the variables in the equations that define the value drivers. One then choose one or more of the variables and uses them to define the pricing metrics. When variables show up in more than the value driver equation they are often good candidates for pricing metrics.
How Many Pricing Metrics?
One can be tempted to use multiple pricing metrics to try to get the pricing model to better track value or to accommodate different use cases and market segments. Anyone who has purchased a major ERP (Enterprise Resource Planning software) knows just how complex this can get. These pricing models can include things like the number of server cores, the number of databases connected, complicated formulas for the number of different types of users, perhaps a factor for revenues, and so on. Buyers cannot understand these pricing models, even when they have access to them, and even the salesperson needs the help of a pricing expert. In some cases, the pricing is encoded into a CPQ (Configure Price Quote) platform.
These complex pricing models are increasingly seen as a worst practice or anti-pattern. Buyers do not want to buy if they cannot understand the pricing. Understanding pricing should not be a barrier to sales. There is a trend towards more transparency in pricing (see the roundtable conversation between three pricing experts that Ibbaka hosted in March 2021) and complex pricing models work against this.
Our advice is to have only one or two variables combined into your pricing metric. This covers the majority of situations and most buyers can understand and accept a two-factor pricing model. Things start to get much more complex with three pricing factors and complexity grows rapidly beyond three in a combinatorial explosion.
Pricing Metrics and Anchoring Effects
One of the most important functions of the pricing metric is how it works as an anchor to help people understand what they are buying and how it will create value for them.
We know that value is always relative to the alternative, but this begs the question, what alternative? If I compare my $4,000 titanium bike to an $800 bike that I can get at the local sports shop (once the supply chain heals, I am writing in late Fall 2021) my bike looks very expensive. If I am comparing it to a carbon fiber bike with similar weight and components the price looks reasonable and the choice comes down to questions of durability and ride quality (I like the way titanium bikes feel as I ride them).
We once had a customer selling a kind of collaboration software.
The Classic Pricing Metric Selection Filters
In Tom Nagle’s classic work The Strategy and Tactics of Pricing (now in its 6th edition, with various co-authors) he presents the following set of filters for choosing a pricing metric. These remain the best way to test the pricing metrics you come up with.
One begins with value and specifically the value for specific segments. This is why good pricing is built on a foundation of value-based market segmentation (a value-based market segment is a group of potential customers who buy in the same way and who get value in the same way).
One may need to consider the cost to serve, and to encourage behaviors that reduce the cost to serve. Pricing has a role to play here as well.
The pricing metric has to be easy to measure and enforce. Increasingly, this means that the data for the pricing metric is collected by the software that is part of the solution.
Pricing is part of positioning, and this is why anchor effects are an important consideration in pricing metric choice.
Finally, one wants the price to track the value experienced by the user across the different touchpoints in the customer journey.
The importance of each of these filters will depend on the solution, but all of them should be considered.
5 Steps to Choosing a Pricing Metric
Before working through the following 5 steps, decide if you are going to price differently for different segments or if you are going to have one pricing model that will work across all segments.
Also, give some thought as to whether you are going to need tiered (Good Better Best pricing). You will not actually design the tiers until you have chosen your pricing metrics.
Research the value drivers with customers
Define the value drivers by writing a simple equation
See if one or two of the value drivers is a good pricing metric
(If the answer is yes, stop here, you have found your metric.)Look at the variables used in the value drivers, pick one, two, or at most three that best track the value drivers (this can require a bit of math)
Construct a composite pricing metric from the variables, make sure to keep this simple enough that pricing is easy to understand and reasonably predictable
Choosing a pricing metric is one of the most important choices in pricing model design. Approach this with an open mind, expect to find new insights, and give it the time it requires. This is not the place to rush a decision.
Implement Customer Value Management with Value
How to choose a pricing metric (this post)
