A Guide for Effective and Efficient Software Product Pricing

Pricing strategy is essential for every company - small and big, startup and established - to remain competitive and profitable at the same time. It is more so for a software product company. Your new software product could excite the investors, management, and target customers, but you are struggling to decide the pricing that would attract customers and generate cash for you. You must keep the price sensitivity of a product in mind and set a balanced price acceptable to customers and profitable for the business. 

 

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So, let us discuss what could be the strategies to be adopted and the challenges you might face in pricing a software product.

What is Software Product Pricing?

Software pricing is about setting a price for your final product in the market. The pricing can vary for the same product based on the functionalities and features as well the delivery model. For instance, the price for a full-suite ERP will be different from the same ERP offered only with certain modules. Likewise, the pricing plan changes based on the delivery model - whether on-premise licensing model or SaaS subscription route. 

In broader terms, the following factors need to be considered before finalizing the price for your software product:

  • Cost of software development based on the efforts
  • Cost of infrastructure required for development
  • Cost of support and updates
  • Other direct costs and overheads
  • Revenue goals
  • Cost and price analysis of competitive products

 

The right price is crucial for businesses to remain profitable and growth-oriented. If the software product pricing is not done carefully, the fundamental economics of the business can go awry.

All Parts of Business Influence Pricing

It is not just any single department in a company that is fully responsible for pricing as it touches every part of the business. Product pricing is not done in a silo but in a collaborative manner with inputs and insights from key functions, including product development, marketing, sales, finance, and management. 

Let us take a look at how each function in an organization influences software product pricing:

  • The product development team builds features and functionalities for a software product grounding on the understanding of the requirement of customers. The efforts going into the development and its corresponding cost have a substantial impact on the product pricing.
  • The marketing function has a solid understanding of the prospective customers and the market. They communicate with the customers and their decision-makers with the right message on the product and its pricing.
  • Sales teams who interact with customers have an understanding of the common questions and objections from prospective customers. They know the market well and the competition in the market. The input from the sales team is critical for the pricing decisions.
  • All executives including the CEO and CFO have roles in pricing by gathering and collating input the other functions across the business provide to decide on the right pricing. 

Pricing is Critical for Unit Economics

To achieve growth and enhance profitability, businesses strive to improve their customer lifetime value (CTLV) and reduce their customer acquisition costs (CAC). Reduced customer acquisition costs and better customer retention rates, resulting from a good pricing strategy, lead to revenue growth and improved profitability. 

You need to understand how CLTV and CAC impact unit economics to help you set the right price in the short term and long term:

  • CAC (customer acquisition cost) is derived by dividing the total cost of selling and marketing by the total customers onboarded which provides you with the sales and marketing costs you have to incur to acquire an additional customer. 

The formula for calculating is the Total cost of sales and marketing / Number of customers acquired. We will consider a simple example to comprehend CAC more clearly.

Sales cost - $300k

Marketing cost - $500k

New Customers onboarded - $800

CAC - (300=500)/800 - $1000

 

  • CLTV (lifetime value) tells you what earnings a business will make from each onboarded customer during the lifetime period they remain your customer. This is derived by using the formula (ARPA* Gross Margin) / Revenue Churn = CLTV. 

           Here’s an example:

  • ARPA of $700
  • Gross Margin is $100
  • Revenue Churn is $50

           CLTV - (700 * 100) / 50 = $1400

 

A CLTV/CAC ratio greater than 1 and your CLTV greater than CAC is vital for companies, particularly SaaS companies, profitability in the short-term profitability and growth in the long term.

Popular Software Pricing Strategies

Pricing is not a one-time exercise that is done at the time of the product launch. It is an ongoing process that helps the business achieve the best possible value from each sale. You should have a clear understanding of the popular pricing strategies and select the most appropriate one or a combination of them to get the pricing right. The common pricing strategies adopted by businesses include:

1. Market-based pricing

Using competitor or market pricing as the benchmark criterion to set software product prices is arguably the simplest strategy. The strategy has a drawback in that no two products can be exactly the same in terms of their functionalities and features. You must price your product based on the value it offers and the differentiating factors. In a nutshell, competitor price analysis can guide you in product pricing though not affect your pricing determination. 

2. Cost-plus pricing

Price is calculated by working out the cost of developing your product and adding the required profit margin using this pricing mechanism. If the company has a good understanding of its costs which include the cost of development, overheads that should be allocated to the product, how overheads will be allocated, and the profit margin required, you can easily calculate your price. However, the costs keep changing or all costs may not be known upfront, as in the case of SaaS products, and this makes this approach a bit challenging.

3. Value-based pricing

This strategy looks for inputs from your customers, that can influence pricing. This is a more complex strategy that considers the willingness of your customers to pay a price for the current product and future value adds so that you can set a price that breaks even or makes a marginal profit in the beginning and later revise prices while you enhance the features of the product. 

This strategy is more relevant in the SaaS model as you enhance the features and functionalities of your product in a progressive manner. This allows you to quickly revisit pricing strategies, and revise prices. A company that sells SaaS products needs to understand what price its customers consider as worth for its product. This will help you price products intelligently and retain customers while raising the price as you enhance the value of your product.

How to Price a SaaS Product?

The viability and growth indicators of a SaaS product are driven by customer acquisition, customer retention, and monetization. Monetization has the maximum impact on a SaaS company’s bottom line. There are studies that found that monetization was the key to the growth of SaaS businesses more than customer retention or acquisition. The data derived from such studies have shown that knowing how to set a price for a product appropriately was 2x as impactful as retention and 4x as impactful as acquisition in improving a SaaS company’s bottom line. 

Concluding Thoughts

Pricing and product development are correlated. They are both iterative, consistent, and dynamic. A data-driven approach using pricing software can be useful for you to determine product pricing on a continuous basis, in the short term and long term, to reap the benefits of a scientific pricing strategy. As a business, you must understand the variables that influence pricing and the best possible strategies and choose one that suits your kind of business, to come to a sweet spot that is beneficial for both you and your customers.

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