In everyday life, you probably don’t spend a ton of time questioning why items cost what they do—you simply choose whether or not to buy them depending on your needs, desires, and budget.
But it turns out, a huge amount of thought goes into each and every price tag you see. And if you’re not making incredibly strategic decisions about your own product’s price, well, you’re sabotaging your business.
Here’s what you should consider before putting a dollar value on your goods or services.
The Three Basic Pricing Models
There are three foundational approaches to calculating prices: cost-based, competition-based, and value-based.
This method is the simplest. Start with how much you want to make on each product, then add how much it takes to make and distribute that product. The sum is your price.
Although cost-based pricing will give you the margins you’re looking for, most people agree it’s not effective because it’s not tied to customer demand, market conditions, or the product’s true value.
Using this approach, you analyze how much other companies are charging for similar products and choose competitive prices. If you use this model, your product needs differentiating features to give customers a reason to buy it.
If you’re in a well-established industry where consumers are familiar with how much the traditional product costs, competition-based pricing may be the way to go.
Value-based pricing is the most popular and effective. Of course, it’s also the hardest to nail down. To determine your value-based price, you figure out how much money or value your product generates for the user in the long run, then take a fraction of that.
For a simplified example, let’s say that you’re selling an email replacement tool that helps companies recover $7,000 in productive hours each month. Ten percent is a reasonable cut, so you set your monthly price at $700.
Obviously, if you’re selling something that’s not directly functional, value-based pricing becomes even more nebulous.
Get around this by gathering a sample of potential customers (i.e., people in your target demographic) and asking them if they’d buy your product at X price, at Y price, at Z price, etc. You’ll be able to generate a rough bell curve of the percentage of consumers who will buy at each price point. In general, the “value” of your product is at the peak of the curve. (That doesn’t mean that’s what your price should be, however—more on that in a bit!)
Even after you’ve found the most suitable pricing model for your product, you need to factor in your company’s business plan.
Make Money Fast
There are a couple situations that may demand bringing in as much profit as you can as quickly as you can. First, if you’re bootstrapping it (which means running your company with no outside money), you’ll need to generate profit right away. Second, if you’re looking to attract funding, showing profitability is a great way to convince VCs or angels that your startup will be a good investment. (Note: You don’t always need to be in the black to get investors excited—Snapchat and Facebook were worth billions of dollars before they ever turned a profit!)
Drive Your Revenue Up
Another goal is to generate huge revenues—but not necessarily huge profits. In other words, you’ll be making and spending lots of money. This strategy can help you establish dominance in the market. It can also enable economy of scale, which will help you lower your costs down the line.
Online marketplace jet.com is using this strategy. Jet has earned a $600 million to $3 billion (depending on whom you ask) valuation by offering lower prices than Amazon. Despite the valuation, it’s not making any money yet—the Wall Street Journal picked out 12 items on Jet (selling for a total of $275.55), researched how much it cost Jet to buy and sell those items, and found that Jet was actually losing $242.91.
Acquiring as many customers as possible is yet another goal. Uber is the poster company for this technique; it frequently gave away rides (thus operating at a loss) because it knew that once people rode in an Uber, they were very likely to become repeat customers.
If, like Uber, your product is “sticky,” or if it’s available as freemium, than getting customers should be your primary objective.
Develop a Reputation
If you’re positioning your product as affordable and attainable, your prices should be on the lower side. Alternatively, if your product is a luxury good, price it high. Many people confer high prices with better quality, even if there’s no real evidence that’s the case.
There are several psychological factors related to pricing that you can use to subconsciously incentivize your customers.
In other words, if you see a $20 meal on a restaurant menu, you’re automatically going to think a $12 or $15 meal sounds pretty reasonable—even if normally you wouldn’t pay more than $9.
Use this cognitive bias to your advantage. Present a premium or marked-up product near a less expensive one, and your consumers will be likelier to think they’re getting a great deal.
Evernote is clearly optimizing for the anchoring effect on their pricing. They offer three subscription options: Basic, which is free; Plus, which is $24.99 per year; and Premium, which is $49.99 per year. When you compare the Premium price to the Plus price, the latter looks affordable.
The Number Nine
Evernote is also clearly aware of the power of nine. In almost every situation, prices that end in nine improve product sales.
For example, when MIT and the University of Chicago sold the same woman’s shirt at $34, $39, and $44, the $39 shirt was the most popular—even though it was more expensive than its identical $34 counterpart.
Furthermore, in Priceless: The Myth of Fair Value (And How to Take Advantage of It), William Poundstone explains that setting prices that end in nine will increase sales by an average of 24%.
You can force consumers to rethink their evaluation of your product by offering a “bridge” product.
Take the New York Times subscription model. After a four week introductory rate, you can pay $3.75 a week for web and smartphone content access, $5 a week for web and tablet access, or $8.75 a week for all digital access.
There aren’t too many customers who want to read the newspaper on their tablet or their phone, but not both. By providing a slightly unappealing bridge option, the New York Times convinces those that would have gone for the cheapest option to spring for the “value-added” one.
Other Best Practices
There are a couple other ways to optimize your pricing, depending on your product.
You should launch with a high “introductory” price, argues Steven Dupree, a general partner at Richmond Global.
An introductory price can create a sense of urgency among potential customers, who feel driven to act now so they won’t face higher prices later. Dupree suggests that you share this introductory price with beta users, newsletter subscribers, and other people who are ready to buy.
An introductory price should be at the high end of your comfort zone—not only will this display confidence in your product’s quality, but it’s much easier to adjust your price downward than up.
Dupree advises testing different price points over time by using promo codes, discounts, and so forth to find to which price consumers are most responsive.
The debate over whether businesses should publish price information on their sites is unexpectedly heated.
You’ll mostly see hidden prices in SaaS, customized products, and service industries.
On the one hand, keeping your prices hidden allows you some leeway to choose a different price for every customer. Plus, by asking customers to reach out when they’re ready to discover the price, you’re ensuring that every customer you talk to is fairly likely to buy. Finally, you can can avoid getting in price-gauging wars with your competition.
But on the other hand, publishing your prices will help give your visitors valuable information that they might seek elsewhere if you don’t provide it. Let’s say you sell cloud security software. If you don’t including pricing on your site, an interested consumer will find a work-around by searching “cloud security software price.” By being transparent about your product’s cost, you can set your customers’ expectations appropriately.
You’ll also win their trust. For proof, check out Everlane, a high-quality fashion ecommerce company. Everlane includes a detailed cost break-down for every item on its site—which shows its customers how ethical and “non-corporate” the company is.
Buffer, the social media scheduling app, followed Everlane’s approach by publishing exactly what each subscriber’s money pays for.
Use Discounts Strategically
When used correctly, discounts and promotional offers are an effective method of driving sales. However, they have a dark side.
Research has shown that consumers are less likely to search for similar products from other merchandisers when the original item is discounted. First, they assume they’re already getting a good (if not the best) deal. Second, discounts motivate people to act quickly—they don’t want the product to sell out or go back to its original price.
But if you’re always rolling out deals, your customers will come to expect them and will be reluctant to purchase anything at its original price. That’s what happened to J. Crew Factory, the lower-price “sister” of J. Crew. As Jezebel announced in a scathing May 2014 article, “Your J. Crew Clothes Aren’t ‘Discounted,’ They’re Just Cheap.’”
Some companies, like Lululemon, never have discounts at all. Clothes that aren’t selling or go out of season are put on sale, but you can expect to always pay full price for their popular items. Consider following this approach if you have an in-demand, premium product—it will maintain your brand integrity.
Naming your price involves setting a delicate balance between your business model, objectives, market position, and customer insights. It’s not easy—but if you do it right, you’ll literally profit.