How not to price - the two most common approaches to pricing
Steven Forth is a Managing Partner at Ibbaka. See his Skill Profile on Ibbaka Talent.
We recently published some thoughts on future pricing methodologies. This looked at the emerging trends towards dynamic pricing, outcomes-based pricing, value-based pricing and machine-to-machine pricing (M2M pricing).
Traditionally people have talked about three basic approaches to pricing:
Value-based, in which price is based on differentiated value (the value compared to the next best competitive alternative)
Market-based, in which the price is determined by the market (Willingness to Pay is often positioned as a way to do value-based pricing when in fact it is a form of market-based pricing)
Cost plus, in which the price is a markup to some estimate of costs
In fact, none of these are the most common approaches to pricing. The two most common approaches to pricing are ‘throw it at the wall’ (also known as spaghetti pricing) and the ‘frozen accident.’ In fact, spaghetti pricing leads to a tangled network of frozen accidents.
What is ‘throw it at the wall’ pricing?
“Let’s throw it at the wall and see what sticks.” They say one way to see if spaghetti is cooked is to throw it at the wall and see what sticks. I have actually tried this. It is kind of fun but I have never found it a practical way to see if the spaghetti is ready. It works even worse for pricing.
“Let’s just put a price out there and see how the market reacts.” This almost sounds reasonable. It is after all ‘evidence based’ and it sounds as though it is based on the market. Economists tend to believe in market pricing. In fact there are three main problems with this approach:
It does not give any insight into why the pricing was accepted by the market. It does not help inform product development or marketing. It does not set up customer success for success. Pricing is disconnected from the rest of the business.
There is no method. Any further exploration of price, or attempts to use price as a strategic lever, is going to be random. In some situations a random walk is a good decision making tactic. Pricing is not one of them.
It is likely to find a local maxima but not the global maxima. In other words, it is a strategy for sub-optimization. The local maxima trap is a well known problem, throw-it-at-the-wall pricing is an algorithm for getting caught.
Over time, throw-it-at-the-wall pricing leads to the other common pricing approach, the frozen accident.
Frozen accidents in pricing
The term ‘frozen accident’ comes from evolutionary theory. Basically it describes the situation where some mutation or adaptation occurred at some point in the past and has gotten locked in. The reason the adaptation was adaptive have been lost in time, and is often no longer relevant, but the genetic code remains frozen in place. (if you want to geek out on this, and are interested in evolution, try Frozen Accident Pushing 50: Stereochemistry, Expansion, and Chance in the Evolution of the Genetic Code by Eugene V. Koonin.)
Sometimes the frozen accident lingers because it is not worth the effort to change it. Other times, it has been coded into other systems making it difficult to change. In business this is generally the CRM (Customer Relationship Management), the CPQ (Configure Price Quote) or the financial system.
One often finds frozen accidents in the pricing of companies acquired by private equity firms. The team that set the pricing model is gone, they may have had very good reasons to set the price the way that they did, but these reasons are no longer known. The go forward team has inherited the pricing but lost the context.
Frozen accidents can capture pricing in entire industries
Frozen accidents are not limited to individual companies. Buyers like to be able to compare prices. In mature categories the basic offer and the pricing metrics are generally set. Part of the definition of a commodity is that there is a standard way to buy and compare. Commodities are generally priced by market mechanisms and increasingly these mechanisms are realized in machine-to-machine pricing. It is difficult to introduce new pricing in such situations.
Frozen accidents and the transition to SaaS
The move to the subscription economy is a huge opportunity to thaw out these frozen accidents and to innovate on pricing metrics. Too often though, the people responsible for moving from one-time licences to subscriptions just do some sort of simple translation in their pricing. I charge a license of $1,000 and 20% maintenance and support. Hmm, that gives $1,600 over three years so I will divide by 36 and get my subscription price of about $44 per month or $533 per year. I am paying for the servers so I will round the prices up to $49 per month or $579 per year. We have seen too many companies apply some form of this approach. It just carries the frozen accident over into the subscription model.
A better approach is to use the transition to a subscription model to rethink your market segmentation, choose the best targets based on the value-to-customer (V2C) and customer acquisition costs, and then connect the pricing metrics (the unit in which you price) to the value metric (the unit of consumption by which the customer gets value).
Anti patterns in pricing
In software development there has been a lot of research into what are called anti patterns. From Wikipedia
An anti-pattern is a common response to a recurring problem that is usually ineffective and risks being highly counterproductive.The term, coined in 1995 by Andrew Koenig, was inspired by a book, Design Patterns, which highlights a number of design patterns in software development that its authors considered to be highly reliable and effective.
The anti pattern literature covers organizational and project anti patterns as we well as those found in software. The Wikipedia article will provide you with a good starting point if you want to dig deeper.
Ibbaka is doing research into pricing anti patterns. If you have some you would like to suggest a pricing anti-pattern please let us know at info@ibbaka.com and we will describe them in a future post.
How to know if you are trapped in one of these pricing anti patterns
How can you tell if you have one of these two anti patterns? Here are a few simple tests.
No one can explain where the pricing comes from and how it was derived.
The pricing is some version of ‘me too,’ we price this way because that is how others price.
The pricing does not track any other business variable (costs, value-to-customer, market prices).
Pricing experiments are random and cannot be tied to a set of underlying hypotheses.
People say “Our customers told us that this is how they want to pay.”
The last of these may seem counter intuitive. Surely we should ask our customers how we should price? No. Ask your customers how they get value. Then it is your job to design the pricing model that tracks to this.
Need some help pulling together your 2021 pricing strategy?
Check out our Strategic Choice Cascade for Pricing.
Or contact us at info@ibbaka.com
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